Reprinted with permission from the Philadelphia Estate Planning Council Newsletter Vol. XXII, No. 3, Spring 2013.
As you are likely aware, for tax years beginning after 2012 there is a new 3.8% tax imposed on certain passive investment income of individuals, trusts and estates under section 1411 of the Internal Revenue Code. Congress enacted section 1411 (which comprises new chapter 2A of the Code) as part of the Health Care and Education Reconciliation Act of 2010, ostensibly to support new health care expenditures related to so-called "Obamacare" initiatives. This new tax on "net investment income" is in addition to the normal income tax and generally applies only to the extent a taxpayer's adjusted gross income exceeds a designated threshold (for married individuals filing jointly, $250,000, for single individuals, $200,000, and for trusts and estates, $11,950 for 2013).
This new tax builds off of established concepts from the section 469 passive activity loss rules. In particular, passive investment income subject to the section 1411 tax will include income (including disposition gain) derived from the conduct of a trade or business considered a passive activity under section 469 rules. In order to avoid the section 1411 tax, trade or business income should be generated in activities that the taxpayer is active in (i.e., activities in which the taxpayer materially participates).
Estate planners should take particular notice of the intersection of the new section 1411 tax and the section 469 passive activity rules and their effect on existing and contemplated estate planning structures. Consider a simple family limited partnership structure that was put in place to facilitate the transfer of interests in a family business. Now, if the family business is sold by the limited partnership, each partner will be subject to an additional 3.8% tax unless the partner can establish that the underlying business was not a passive activity for such partner. If the family business has historically been profitable, 2013 may be the first year family members ask whether or not the business is a passive activity for them.
In light of the renewed importance of the section 469 passive activity rules, this discussion addresses the general legal standards under section 469 and presents a high-level summary of the practical considerations in establishing material participation. In particular, this discussion focuses on: (1) establishing the parameters of the relevant trade or business activity; and (2) establishing material participation.
1. Establishing the parameters of the relevant trade or business activity
Generally, a passive activity is one involving the conduct of a trade or business in which the taxpayer does not materially participate. Section 469(c)(1). Subject to certain exceptions, a "rental activity" is treated as a per se passive activity without regard to whether the taxpayer materially participates. Section
469(c)(2) and (4). A "rental activity" is one in which payments are principally for the use of tangible property. Section 469(j)(8).
While rental activities are normally per se passive activities, section 469(c)(7) creates an exception for rental real estate activities that is only available to "real estate professionals." A real estate professional is a person that: (1) provides more than half of his or her services in real property trades or businesses that involve material participation; and (2) provides more than 750 hours of services in real property trades or businesses that involve material participation. A taxpayer's real property trades or businesses are not just limited to rental real estate, but will include any "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business." The IRS has traditionally taken the view that a real estate agent is not engaged in a real property trade or business, but this view was just rejected by the Tax Court in Fitch v. Commissioner, T.C. Memo. 2012-358.
A taxpayer that qualifies as a "real estate professional" removes the per se passive taint for his or her rental real estate activities; however, that taxpayer will still need to establish material participation to escape the passive characterization. Under section 469(c)(7)(A), a taxpayer is required to treat each rental real estate property as a separate activity unless an election is made to treat all rental properties as a single activity. The real estate professional rules are particularly important because the tax law has traditionally accepted that the rental of real property will represent a trade or business activity. See, e.g., Higgins v. Commissioner, 312 U.S. 212 (1941). If the IRS holds to this traditional view, then the real estate professional rules may be the only way to remove income and gain associated with rental properties from the scope of section 1411.
For purposes of framing the relevant trade or business for section 469, one or more trade or business activities or rental activities may generally be treated as a single activity, or "grouped," if the activities constitute an appropriate economic unit for the measurement of gain or loss. Section 1.469-4(c)(1), Income Tax Regs. The regulations contemplate that there is a flexible analysis for determining the existence of an appropriate economic unit, but there are certain grouping restrictions (e.g., a rental activity cannot be grouped with another trade or business activity unless certain other exceptions are met).
Due to these grouping rules, a key point to working with section 469 (and now section 1411) is that the relevant activity is not always determined by the parameters of a legal entity. A pass-through entity is required to make an initial grouping of its activities for purposes of section 469, but partners and shareholders may then group the activities conducted through those entities with activities conducted through other entities or with activities conducted directly. Section 1.469-4(d)(5)(i), Income Tax Regs. This means that a taxpayer's "activity" for purposes of section 469 may be conducted through multiple entities.
Once a taxpayer has grouped activities for purposes of section 469, the taxpayer may generally not regroup those activities in subsequent taxable years. The IRS and Treasury recently proposed regulations that would give taxpayers subject to section 1411 a one-time opportunity to regroup their activities. Section 1.469-11(b)(3)(iv), Prop. Income Tax Regs.
The importance of these rules becomes clear when we return to the simple example of the family limited partnership that sells its operating business in 2013 and expand the facts to include Son, a limited partner who has not been involved with the family business. Before we can address whether Son will be subject to the extra 3.8% tax on his share of the gain, we first need to determine whether Son's activity for purposes of section 469 was limited to the business conducted through the family limited partnership. Larger activity groupings tend to encompass more hours of participation, which will make the resulting activity less likely to be characterized as a passive activity with income subject to section 1411. If Son is involved with a second activity outside of the limited partnership, and the two activities could be grouped together under the regulations, then establishing a larger activity may remove Son's disposition gain from the reach of section 1411.
2. Establishing Material participation
Material participation is defined as involvement in the operations of an activity that is regular, continuous, and substantial. Section 469(h)(1). The IRS takes the position that an individual will only be treated as materially participating if he or she satisfies one of seven largely quantitative regulatory tests. Section 1.469-5T(a)(1)-(7), Temp. Income Tax Regs. Specifically, the regulatory tests look to the individual's participation and ask whether one of the following tests can be satisfied:
(1) Was there more than 500 hours of participation?
(2) Did the participation constitute substantially all participation in the activity for all individuals (including nonowners)?
(3) Was there at least 100 hours of participation with no other person (including nonowners) participating more than the individual?
(4) Was the participation in a "significant participation activity" (between 100 and 500 hours) with the individual having more than 500 hours in all significant participation activities?
(5) Did the individual materially participate for any five of the prior ten taxable years?
(6) If the activity is a personal service activity, did the individual materially participate in the activity for any three preceding taxable years?
(7) Assuming there were at least 100 hours of participation, was the participation on a "regular, continuous, and substantial basis" during the year under the facts and circumstances?
Individuals that own an activity through a limited partnership (or through an entity such as a limited liability company that would be treated as a limited partnership under proposed regulations) can only use the 500 hours test, the "five of ten" prior year test, or the "any three" prior year test for personal services.
Not all time will count for testing as "material participation." Among other things, the regulations carve out work done in an individual's capacity as an investor unless the individual is directly involved in the day-to-day management or operations of the activity. Work done as an investor includes: (1) studying and reviewing financial statements or reports on operations; (2) preparing or compiling summaries or analysis for the individual's own use; and (3) monitoring the finances or operations of the activity in a nonmanagerial capacity. The courts have been fairly quick to characterize a taxpayer's involvement and oversight as "investor hours" that may be disregarded when there is a third party providing the full time management (as in Iversen v. Commissioner, T.C. Memo. 2012-19) or when a management fee is being paid to a service provider (as in Goshorn v. Commissioner, T.C. Memo. 1993-578). A taxpayer that uses a professional manager for his or her trade or business should anticipate that the IRS may characterize the taxpayer's hours as mere "investor" hours.
The regulations equate "participation" with "work," which raises an interesting issue about whether travel time should count toward material participation. The IRS has traditionally taken the position that travel time by itself would not count as participation. However, in the recent case of Trzeciak v. Commissioner, T.C. Memo. 2012-83, the IRS conceded this issue and allowed the taxpayer to consider the time spent traveling between her personal residence (which was her primary place of business) and her various rental properties as part of her calculation of relevant time. Taxpayers who are relying on travel time to establish material participation should consider that case carefully.
The largely quantitative tests under section 469 ultimately present a practical issue -- how can a taxpayer prove material participation? On this point the regulations provide that an individual's participation may be established by any reasonable means, and that a taxpayer need not have "[c]ontemporaneous daily time reports, logs, or similar documents" if the extent of such participation (i.e., hours and services) can be established by other reasonable means. Section 1.469-5T(f )(4) Temp. Income Tax Regs. Despite the apparent leniency of the regulations, the courts have been very reluctant to accept noncontemporaneous evidence of participation, often dismissing such evidence as a "ballpark guesstimate" of time committed to participation in an activity. See, e.g., Bailey v. Commissioner, T.C. Memo. 2001-296.
Best practices in this area would therefore involve a daily activity log because contemporaneous documentation tends to be more persuasive for the IRS (and ultimately the courts). However, there are a few cases that illustrate how taxpayers can meet their burden without contemporaneous documentation. For example, in Al Assaf v. Commissioner, T.C. Memo. 2005-14, the issue was whether the taxpayer materially participated in her office building activity. In that case, the taxpayer was unable to provide any contemporaneous logs or calendars, but was able to provide testimony and evidence of her current involvement and testified credibly that the degree of her participation had not changed. Similarly, in Harrison v. Commissioner, T.C. Memo. 1996-509, the taxpayer was able to present third party testimony that accounted for 300 actual hours for his treasure hunting activity (his time hauling heavy equipment and manning pumps at the excavation points) and was able to persuade the court that his miscellaneous other activities accounted for at least another 200 hours. An important element from both the Al Assaf case and the Harrison case was that the taxpayer could produce credible third party witnesses to support the claimed participation.
As a practical matter then, if a client is not maintaining contemporaneous records, will the client be able to produce evidence of an equivalent nature? Changes in circumstances between the year at issue and the current year may make such a showing difficult. For example, if there has been turnover at the employee level, are there knowledgeable workers who are willing to testify as to the owner's involvement? Alternatively, are there archived e-mails or phone records that could be used to reconstruct participation? If a client has not maintained contemporaneous records during the taxable year, it may be helpful to assemble documentation as part of the return preparation while memories are still fresh and materials are still available. A taxpayer's failure to document material participation may now mean an extra 3.8% tax burden as a result of section 1411.
A taxpayer should always provide consistent and credible records. Not surprisingly, valuable guidance in the case law comes in the form of negative examples involving apparently unreliable records. For instance, a taxpayer would be well advised to claim no more than 24 hours of work for a single day. See, e.g., Goolsby v. Commissioner, T.C. Memo. 2010-64. Similarly, a taxpayer would be equally well advised to claim no more than 52 weeks for a year. See, e.g., Hill v. Commissioner, T.C. Memo. 2010-200. Last, and certainly not least, the courts will not find a "contemporaneous" record credible where purported activity is memorialized in the generic calendar that was copyrighted in a subsequent year. See, e.g., Hassanipour v. Commissioner, T.C. Memo. 2013-88.
The new 3.8% tax on passive investments under section 1411 is going to require taxpayers and their advisers to consider the application of the section 469 concepts of "passive activity" and "material participation" from a fresh perspective. Historically, income from a passive activity was a good thing because it helped to trigger losses from passive activities. Now that income from a passive activity will carry an added tax burden, it may be appropriate for taxpayers to reconsider the scope of their respective activities and the manner in which they have been measuring (and documenting) material participation.