Gains & Losses
The new tax on net investment income has crowned a new rule: A once-obscure recharacterization provision is threatening to swallow the broader material participation tests under Sec. 469 for many taxpayers when they apply the passive loss rules to determine whether they owe tax under Sec. 1411.
Sec. 1411 created a new 3.8% tax on net investment income beginning in 2013. Whether income is included in net investment income often hinges on whether it is considered passive under Sec. 469. Because the passive loss rules have historically mattered little for taxpayers without losses, many people are essentially applying Sec. 469 for the first time. The new emphasis on these rules was supposed to make the seven material participation tests used to establish an activity as nonpassive more important than ever. Instead, for net investment income purposes, a smaller recharacterization rule under Temp. Regs. Sec. 1.469-2T(f)(2) is making the seven tests increasingly obsolete.
Net Investment Income and Material Participation
Net investment income generally includes investment income such as interest, dividends, rent, and royalties unless it is derived in the ordinary course of a trade or business that is not passive to the taxpayer under Sec. 469. In addition, any income from a passive trade or business activity is always net investment income regardless of its character. So a taxpayer with income from a partnership or S corporation will generally include all of it in net investment income if the activity is a passive activity with respect to the taxpayer.
The rules in Sec. 469 originally were created to limit a taxpayer's ability to deduct passive losses against nonpassive income. Although there are special rules for items such as rent and other specific situations, the regulations generally provide that an activity will not be passive if the taxpayer materially participates by satisfying any one of seven tests laid out in Temp. Regs. Sec. 1.469-5T(a). The most commonly known test is annual participation in an activity for 500 hours, but there are five other tests based on specific thresholds, and a final test that is a facts-and-circumstances determination of whether participation is regular, continuous, and substantial.
Although these rules are most often applied to determine whether a loss is passive, they also are needed to determine whether income is passive and can be used to offset passive losses. It can therefore be advantageous to taxpayers to characterize an income-producing activity as passive. In response, the IRS created several rules to recharacterize certain passive income as nonpassive.
Significant Participation Rule
Temp. Regs. Sec. 1.469-2T(f)(2) creates a special rule for significant participation. If passive income arises from an activity in which the taxpayer significantly participates (but does not materially participate), then that income is recharacterized as nonpassive. So what is significant participation? Significant participation is participation by the individual in the activity for more than 100 hours during the tax year, and this is all the recharacterization rule requires.
The net investment income regulations under Regs. Sec. 1.1411-5(b)(2)(i) specifically provide that any income recharacterized under this rule is not passive for purposes of Sec. 1411. So an originally unfavorable rule that limited a taxpayer's ability to take passive losses has become a favorable rule for avoiding passive income that is subject to the net investment income tax.
The recharacterization rule generally applies only to trade or business activities and not rental activities. There is a calculation for determining how much significant participation income is recharacterized, but the calculation essentially nets significant participation losses against significant participation income before recharacterizing any remaining income. So for practical purposes, significant participation will always have the effect of making any potential net investment income nonpassive.
For example, consider a taxpayer who reports $100 of income from a significant participation activity that is otherwise passive and a $60 loss from a significant participation activity that is otherwise passive. Only $40 of the income is recharacterized as nonpassive, but the other $60 will typically be offset by the passive loss for net investment income purposes anyway. If the $60 loss was not from a significant participation activity (meaning the taxpayer cannot use the loss), then the entire $100 of income would be recharacterized as nonpassive. When significant participation losses exceed significant participation income, the remaining losses are still passive and are not recharacterized.
On balance, the recharacterization rule for significant participation could completely replace the material participation tests for the net investment income calculations of most taxpayers. Why? In the overwhelming majority of cases, it will be a lower threshold to satisfy. There are only a few situations in which it will be easier to materially participate than significantly participate. For instance, taxpayers who participate for less than 100 hours may still be able to establish material participation if they materially participated in the business in five of the last 10 years or if it is a personal service activity in which they participated for any three years in the past (two of the seven material participation tests, see Temp. Regs. Secs. 1.469-5T(a)(5) and (6)).
Despite the significant opportunities provided by the significant participation rule, it does not come without important considerations.
Using significant participation to recharacterize income as nonpassive and exclude it from net investment income tax could backfire if a taxpayer has not treated the same activity consistently in previous years. For example, a taxpayer may have failed to recharacterize this income in past years and used it to offset passive losses. If the taxpayer is now claiming significant participation to avoid the net investment income tax, it could prompt the IRS to look at previous years. If the activity should have been a significant participation activity in previous years, the IRS could recharacterize the past income to disallow a previous passive loss. Claiming significant participation in an activity could also compromise a taxpayer's ability to use the future income from the activity as passive against future passive losses.
The determination of whether an activity is passive is made annually, so, presumably, a taxpayer could start significantly participating in the activity only when the new tax applied, or stop significantly participating in a future year when it is again beneficial for the activity to be passive. But taxpayers should be careful because changing the treatment from year to year may lead to IRS scrutiny. If the treatment of the activity is inconsistent, and the taxpayer cannot actually demonstrate or substantiate a change in the level of participation, the IRS will be able to challenge one or more years.
The significant participation rule could also put pressure on substantiation. IRS officials have indicated that relying on the lower significant participation threshold could prompt extra scrutiny on substantiating hours. Taxpayers, however, should always be able to substantiate their participation. The Tax Court's body of case law on Sec. 469 is littered with decisions denying taxpayers participation based on inadequate substantiation, and judges have made quite clear since one of the first cases in 1993, that "ballpark guesstimates" made in hindsight are not acceptable (see Goshorn, T.C. Memo. 1993-578).
The Tax Court has often seemed to apply even stricter substantiation standards than the IRS's own regulations, which say contemporaneous time reports or logs are not required. The regulations under Temp. Regs. Sec. 1.469-5T(f)(4) allow taxpayers to use "any reasonable means," and specifically cite the approximation of hours based on appointment books, calendars, and narrative summaries. But the Tax Court has been reluctant to accept affidavits and narrative summaries under its "ballpark guesstimate" prohibition. Taxpayers would always be well-served to do exactly what the regulations say is not required: contemporaneously track their activities.
It is also important to keep in mind that even when taxpayers can substantiate their participation, their participation can be challenged over the investor participation rule, which denies credit for participation in an activity as an investor "unless the individual is directly involved in the day-to-day management or operations of the activity" (Temp. Regs. Sec. 1.469-5T(f)(2)(ii)(A)).
The regulations initially define participation rather generously as any work done for a business in any capacity, but then immediately poke holes in this definition with several exceptions. Most significantly, Temp. Regs. Sec. 1.469-5T(f)(2) carves out any work done in an "individual's capacity as an investor." Taxpayers who fail the traditional material participation tests but squeak over the 100-hour threshold may be more likely to see their participation challenged as investor activities.
Investor hours are generally defined as any work studying or reviewing financial statements and operations reports; preparing summaries or analyses of finances or operations for the taxpayer's own use; or monitoring the finances or operations in a nonmanagerial capacity. Although there is no shortage of case law in the Tax Court on the question of investor hours, clear standards remain elusive.
In cases such as Serenbetz, T.C. Memo. 1996-510, hours spent at condo board meetings were treated as investor hours, while in cases decided at nearly the same time, such as Mordkin, T.C. Memo. 1996-187, and Scheiner,T.C. Memo. 1996-554, hours spent at board meetings were considered to be hours participating in an allowable managerial activity.
Application to Trusts
The 3.8% tax on net investment income also applies to undistributed trust income, so it is just as important for trusts to avoid passive characterization. It is clear from the statutory language of Sec. 469 that the material participation standard applies to trusts, but the seven material participation tests explicitly apply only to "individuals." It has long been far from clear how a trust establishes material participation, although the Tax Court recently provided guidance in Frank Aragona Trust, 142 T.C. No. 9 (2014).
Recharacterization for significant participation explicitly applies to a "taxpayer's" gross income from a significant participation activity. The term "taxpayer" indicates it would presumably apply to trust income, but the rule also defines significant participation using the seven material participation tests that explicitly apply only to "individuals." So the questions on whether trusts are encompassed by the rule and how a trust significantly participates lack the same kind of clarity as the question of how a trust materially participates in an activity.
Taxpayers should take some comfort from Aragona, which stands for the proposition that a trustee's participation in the activity establishes material participation, even if the trustee is acting as an employee or owner of the business. The decision also concludes that a trust can be a "real estate professional" under Sec. 469, which further supports the argument that trusts are among the "taxpayers" for which the recharacterization rule applies. Taxpayers should be able to take the position that a trustee's activities could also establish significant participation and recharacterize trust income as nonpassive.
Grouping Before Applying the Recharacterization Rule
Finally, there is the question of whether taxpayers can group their activities before applying the significant participation recharacterization rule. Regs. Sec. 1.469-4(c) allows taxpayers to group activities that represent an appropriate economic unit, and the regulations under Sec. 1411 allow taxpayers a one-time regrouping opportunity in 2013, 2014, or the first year after 2014 that they would be subject to tax on net investment income.
Using a grouping election might offer an even lower threshold for avoiding the net investment income tax on passive income. For example, a taxpayer could do as little as 35 hours of work in three activities and group them to get 105 hours of participation and escape the tax. It hardly seems to be what Congress had in mind when it enacted Sec. 1411, but a plain reading of the regulations seems to support the position.
To be sure, there are limits to grouping. Taxpayers are generally not allowed to group rental activities with nonrental activities, and the activities must always represent an "appropriate economic unit." But assuming a grouping is valid, Regs. Sec. 1.469-4(c)(1) states that the election treats grouped activities as a "single activity." That language implies that once a grouping election is made, the activities have basically become a single activity for purposes of the rules in Sec. 469 that use the term "activity." Since the recharacterization rule of Temp. Regs. Sec. 1.469-2T(f)(2) refers to a "significant participation passive activity," this should allow for the possibility that the activity is a combination of several activities that have been grouped to be treated as a single activity for purposes of Sec. 469.
What Is Next?
It seems clear that the various opportunities to recharacterize activities could shrink the scope of income that originally appeared would be included in net investment income tax when Sec. 1411 was first enacted. But questions remain, and more guidance could be on the way.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.