With 2013 coming to a close and the individual compliance season on the horizon, clients with historically passive income would be well advised to spend some time focusing on their possible net investment income (NII) tax liability to determine whether there might be an opportunity to reduce their possible tax. One such opportunity, found in the NII tax final regulations, is the fresh start regrouping election for passive activities. This election may allow a client to convert passive income, which is subject to the NII tax, into active trade or business income as determined under Internal Revenue Code Section 469 and the regulations thereunder, which is excluded from the NII tax base.
Background
For tax years beginning after Dec. 31, 2012, the NII tax is imposed on individuals, estates and trusts at a rate of 3.8 percent on certain types of income if threshold amounts are exceeded. There are three distinct categories of income that are subject to the NII tax: (1) portfolio income, which includes interest, dividend, annuity, royalty, rental and income from passive foreign investment companies; (2) trade or business income, which includes income from “passive activities” as defined by IRC Section 469 or income from the business of trading in financial instruments or commodities; and (3) gains from the disposition of property. The NII tax provides an exception for income from an active trade or business as determined under IRC Section 469.
Section 469 defines a “passive activity” to include one involving the conduct of a trade or business in which the taxpayer doesn’t materially participate, as well as rental activity and other specifically enumerated activities. Section 469 further provides that taxpayers will only be treated as materially participating in an activity if their involvement in the activity is regular, continuous and substantial. Temporary regulations Section 469 details standards for “material participation”, but the most commonly recognized is the “500 hours” test, which states that a taxpayer will be deemed to be materially participating if the individual participates in the activity for more than 500 hours during a tax year. Section 469 does provide taxpayers with the opportunity to group their trade or business activities to take advantage of certain income tax benefits. However, once taxpayers have grouped their passive activities, they may not regroup those activities in a subsequent year without a change in facts or circumstances making the original grouping clearly inappropriate.
Regrouping Activities
With the enactment of the NII tax and the inclusion of passive income in its tax base, the Treasury Department and the Internal Revenue Service determined that taxpayers should be provided the opportunity to regroup their passive activities, that is, the fresh start regrouping election. Consequently, the final NII tax regulations state that taxpayers that meet the “eligibility criteria” may elect to regroup their trade or business activities during the first taxable year beginning after Dec. 31, 2012. Under the final regulations, “eligibility criteria” means that an individual, estate or trust has NII, and such individual’s modified gross income exceeds the applicable threshold or such estate or trust’s adjusted gross income exceeds the taxable threshold for the NII tax.
Taxpayers that meet the “eligibility requirements” and are considering a fresh start regrouping must look to the regulations under Section 469, which describe the manner in which activities may be grouped. The Section 469 regulations state that: “one or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469.” When determining if certain activities should be considered an appropriate economic unit, the regulations use a facts and circumstances test, and state the following examples of when it may be appropriate to group certain activities:
- When similarities and differences in the types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- The geographical location, and
- The interdependence between or among the activities.
For purposes of the NII tax, if a taxpayer can regroup their passive activities in such a way that will establish material participation in a trade or business under Section 469, then the business income from the previously passive trade or business income will be considered active trade or business income and won’t be subject to the NII tax. It’s important to note that if the trade or business generates revenue from the other two categories of income that make up the NII tax base, that is, portfolio income and gains from the disposition of property, then they will retain their character and still be subject to the NII tax whether or not the taxpayer materially participates in the trade or business. Likewise, income from a business of trading in financial instruments or commodities would still be subject to the NII tax, even if the taxpayer materially participates.
Example
As an example of the impact regrouping may have on a NII tax liability, assume Taxpayer has an interest in a grocery store in Boston that’s organized as an S corporation. Taxpayer also owns an interest in a partnership that owns other grocery stores. Taxpayer doesn’t meet the material participation threshold its interest in the partnership, but it does materially participate in the S corporation. Taxpayer receives a K-1 from the partnership reporting $135,000 of ordinary business income and $25,000 of interest income. Taxpayer also receives a K-1 from the S corporation reporting $25,000 of ordinary business income and $3,000 in royalty income.
Under the fresh start election, Taxpayer might be able to regroup his partnership and S corporation activities. And, if the two activities are viewed as a single economic unit, then his participation in the partnership will be deemed to be material, converting his passive income into active trade or business income.
If Taxpayer doesn’t act on the fresh start regrouping election, Taxpayer’s NII tax will determined be as follows (assuming his modified adjusted gross income exceeds the threshold by an amount that is greater than his NII):
Partnership
Ordinary business income $135,000
Interest income $ 25,000
S corporation
Ordinary business income $ 0
(Excluded as active trade or business income)
Interest income $ 3,000
NII Tax base $163,000
NII Tax rate 3.8%
NII Tax $ 6,194
If Taxpayer elects to regroup his activities, including the partnership and S corporation as one economic unit, then his NII tax will be:
Partnership
Ordinary business income $ 0
(Excluded as active trade or business)
Interest income $ 25,000
S corporation
Ordinary business income $ 0
(Excluded as active trade or business income)
Interest income $ 3,000
NII Tax base $ 28,000
NII Tax rate 3.8%
NII Tax $ 1,064
Is It Beneficial?
If your clients meet the eligibility criteria, it’s imperative to review the sources of their passive income and determine if making a fresh start regrouping election is beneficial. However, clients should also be aware that their fresh start regrouping may have a negative income tax impact if circumstances change in the future. For example, if a client is considering decreasing his participation in the activity that qualifies the group as a materially participating in the near future, then a different grouping might provide a longer-term NII tax benefit. Another issue clients should consider is how their passive income and passive losses offset each other and whether a fresh start regrouping might negatively affect this offsetting. Clients with passive income should make every effort to review their trade or business activities to determine if regrouping will provide benefit and, if so, they follow these procedural requirements to ensure their long-term benefit.
Finally, clients who elect to regroup their trade or business activities should be aware that there are specific procedural requirements under the Section 469 regulations and Revenue Procedure 2010-13, including a written statement detailing the regrouping that must be attached to the originally filed return. Also, the final regulations make it clear that, except for very limited circumstances, such as adjustments from an audit or that otherwise require the filing of an amended return, taxpayers will only be allowed to regroup their activities in the first year in which they’re subject to the NII tax. So, failing to review their current groupings may have a long-term impact on their NII tax liability.