For most of us (or perhaps all of us), writing checks to the IRS does not make our Top Ten list of things we look forward to. This year in particular was likely more painful for many business owners and other taxpayers due to a series of significant tax changes that took effect in early 2013.
In particular, the 3.8 percent Net Investment Income Tax was enacted as part of the 2010 health care reform legislation and was imposed on “investment income” earned as of Jan. 1, 2013. Investment income generally includes income such as interest, dividends, capital gains, rental income and business income earned by owners who may not have been or are no longer active in their businesses.
This new tax has certainly affected family businesses given that many are structured as flow-through entities for tax purposes (S corporations and partnerships). If an owner is not actively involved, they are subject to the additional 3.8 percent tax on the income that flows through to them. Partners in a partnership had a particular double-edged sword with the tax law changes. If partners weren’t actively involved, their flow-throw income was subject to the 3.8 percent tax, whereas if they were actively involved, that income very likely still had a 3.8 percent tax since the Medicare portion of self-employment rates also increased the same year.
Thankfully, contained within the 400 pages of regulations issued in November 2013 are opportunities for family business owners and others to take a proactive approach and minimize these additional taxes.
An advertisement for investment firm Morgan Stanley noted at one time: “You must pay taxes. But there’s no law that says you have to leave a tip.” That’s certainly true in this case. While we are legally required to pay our share of taxes due, that doesn’t mean we can’t appropriately plan around them. For example:
Many closely held businesses may have separated various aspects of their business into separate legal entities for estate planning, general business or other legal reasons. Perhaps the business owner is actively involved in the business of one, but not all businesses. Rules have been in place for some time regarding the concept of “grouping” those businesses together for nonpassive (active) verses passive tax categorization. Depending upon specific circumstances, many business owners and their advisors, however, may not have made the necessary election to group those businesses together in order to form one unit used to determine whether the owner would be considered actively involved in all businesses.
The new regulations, however, outline a one-time opportunity to re-group those businesses when certain conditions are met, thus ensuring that the time a business owner spends in one business (generally the main business) counts toward the others as well as allowing all income to be considered nonpassive (i.e., not investment income) and preventing the imposition of the additional 3.8% tax. If that election was not already made on your 2013 filings, you have one final chance when filing 2014 taxes.
Perhaps you are like many other business owners and have separated your real estate into a separate entity and charge rent to your main operating business. As mentioned earlier, generally rental income now has an additional 3.8 percent tax cost. The IRS, however, recognized this potential issue and excluded rental income charged to another business with the same owner. Business owners and their advisors should ensure this is handled appropriately.
A similar rule applies to interest income derived from personal loans you make to your own business. While interest income is clearly defined as investment income under the net investment income tax rules, if that interest income is derived due to loans you make to your business, it too is exempt from the extra tax.
Are you actively involved in your business structured as a partnership and subject to self-employment tax on your flow-through income? Depending on your plans for your business, you may consider converting that partnership to an S corporation and save 3.8 percent of every taxable dollar you earn thereafter.
Are you actively involved in your business that is considered a C corporation and regularly take dividend distributions or have plans to sell in the near future? Consider making an S corporation election here too if your facts allow it. Not only will you save the 3.8 percent on your dividends, you will likely not pay any taxes at all on any cash you distribute. Further, when the business is sold, you will save the 3.8 percent tax upon sale and have the additional benefit of increased basis (to offset your total taxable gain) for undistributed income earned in the years preceding the sale.
For estate planning and other reasons, many family businesses are actually owned by various types of trusts. Depending on the type of trust, the net investment income tax rules may not be friendly to those situations. All hope is not lost, however, as there are still some opportunities to reduce the tax impact.
Your choice of trustee should be carefully considered when setting up the trust from the very beginning, but if the seriousness of the fiduciary duties weren’t enough, perhaps increased cash flow via reduction in taxes is. There are arguments to be made that a trustee that is actively involved in the underlying business, in his/her capacity as trustee, may allow the income generated from the business to be considered nonpassive and thus not subject to the net investment income tax. While taxes shouldn’t be the sole factor in choosing a trustee, it does provide another factor to consider.
While those tax payments to Uncle Sam may never be a joyous occasion, there is still time before the end of the year to reduce those looming April 15, 2015, tax liabilities by reviewing the structure of your business and considering appropriate planning opportunities.
Katie Ferris is a tax senior manager with the local office of international accounting firm BDO USA LLP. The views expressed are those of the author and not necessarily of BDO. The comments are general and not to be considered specific advice. Readers are advised to consult their professional advisers before acting on any items discussed.