Editor’s note: Throughout 2013, the American Rental Association (ARA) has been breaking down various provisions of the Patient Protection and Affordable Care Act (ACA) in order to explain what business owners need to know and do in order to be in compliance with the law. One particularly complex provision is the 3.8 percent Net Investment Income (NII) tax. After much research and collaboration with tax law experts, ARA has determined that the effect this provision will have on equipment rental store owners depends largely on how the business is categorized and the level of involvement the owner has in the business. To help rental store owners and managers better understad the NII tax, John McClelland, ARA’s vice president for government affairs, has written the following white paper for Rental Management.
The Net Investment Income (NII) tax was passed as part of the Patient Protection and Affordable Care Act (ACA). The ACA imposes the 3.8 percent NII tax as a surtax on certain income, including what is referred to as “passive income,” if a taxpayer’s taxable income is in excess of statutory thresholds set forth in the ACA. The NII tax is in effect for taxable years 2013 and beyond.
The NII tax is linked to the passive income and loss provisions that were enacted in 1986. Those provisions and the regulations that followed were put in place to limit the ability of so-called passive investors to deduct large investment losses generated from “tax shelters” on their federal income tax returns and consequently pay little or no federal income tax.
The purpose of this paper is to provide insight into how equipment rental businesses may be affected by the 3.8 percent NII tax as a result of the cross-reference in the ACA to the passive income and loss provisions.
The NII tax issue is complex. Liability, if any, for payment of NII taxes is highly dependent on the individual circumstances of an equipment rental business and its owners. Therefore, ARA strongly suggests that rental business owners consult directly with their tax professionals about their own circumstances with respect to the NII tax.
The passive income and loss rules contained in § 469 of the Internal Revenue Code (IRC) provide that passive income and losses are income and losses from a passive activity. Passive activities are defined as follows:
(1) In general
The term passive activity means any activity:
a. Which involves the conduct of any trade or business, and
b. In which the taxpayer does not materially participate.
(2) However, unless a specific exception applies, the term passive activity includes any rental activity.
(3) Specific exceptions for rental activities to avoid treatment as passive activities include:
1. The average use of the equipment is less than seven days.
2. The average use of the equipment is less than 30 days and the renter provides significant personal services.
3. The renter provides extraordinary personal services.
4. The rental is incidental to a non-rental activity.
5. The property is customarily available to customers during defined business hours for the nonexclusive use of customers.
6. The taxpayer provides the property for use in a non-rental activity of his own S corporation, corporation or joint venture.
If an equipment rental business does not qualify for one of these six exemptions, the IRS may consider income from that business to be derived from passive activities and subject to the NII tax. Such a business will be referred to as an NII tax business throughout the remainder of this paper. However, there are several other factors that may affect a taxpayer’s liability for NII taxes. In addition, we will discuss below the issues associated with these exemptions and our view that the guidance they provide the taxpayer is not completely clear.
The income threshold for a taxpayer to potentially be subject to the NII tax is $250,000 for married couples filing jointly, $200,000 for individuals and $125,000 for married couples filing separately. These thresholds are not indexed for inflation.
If you are an owner, partner or shareholder in an equipment rental business and your annual adjusted gross income (AGI) does not exceed the appropriate threshold, you generally should not be subject to the NII tax.
The NII tax does not apply to Schedule C corporations, charitable trusts or nonresident aliens. Therefore, if your equipment rental business is organized as a C corporation, the C corporation has no liability for the NII tax. However, if you have an adjusted gross income (AGI) in excess of the appropriate threshold amount, your dividend distributions from that or any other C corporation may be subject to the NII tax.
If a taxpayer’s AGI does not exceed $250,000 in the case of a married couple filing jointly, $125,000 for a married couple filing separately, or $200,000 for a single taxpayer, the taxpayer generally should not be subject to the NII tax.
Question: What happens if a taxpayer’s AGI exceeds one of the appropriate thresholds?
Answer: If this is the case, the taxpayer needs to look further at their sources of income to determine whether any income is subject to the NII tax.
Any income that is subject to self-employment taxes (SECA) or FICA taxes is not subject to the NII tax even if the income is derived from an NII tax business. For example, if you are an owner of an S corporation that does not qualify for an exemption under the passive income rules and your wage income from that S corporation is subject to FICA, that wage income is not subject to the NII tax. It is important to note that we are specifically talking about wage income and not income allocations or distributions in this case.
Question: What if a taxpayer’s AGI is in excess of the threshold and the taxpayer receives an allocation of taxable income on an IRS schedule K-1 from an S corporation of which the taxpayer is an owner in full or in part?
Answer: S corporation allocations are not subject to SECA or FICA. Consequently, the allocation would be subject to the NII tax if the S corporation is a NII tax business or is otherwise a passive activity.
A taxpayer who’s AGI exceeds the appropriate threshold is subject to the NII tax if:
1. Any income is derived from an NII tax business, or
2. The income is derived from a trade or business in which they do not materially participate, or
3. The income is from interest, dividends, annuities, royalties and rents.
In the case of an equipment rental business, failure to meet one of the six exemptions means your income is derived from an NII tax business and any distribution you receive from that S corporation or other pass-through entity is subject to the NII tax. Even if your equipment rental business meets the criteria of one of the six exemptions, if you do not materially participate in the business, any income that causes the taxpayer to exceed the threshold will be subject to the NII tax. Note that the NII tax is imposed on the greater of the amount of income subject to the NII tax or the amount by which your AGI exceeds the threshold.
Under the passive activity rules, a taxpayer is considered to materially participate in an activity if he or she meets one of the following standards:
1. The taxpayer participates in the activity for more than 500 hours during such year;
2. The taxpayer’s participation in the activity is substantially all of the participation in such activity;
3. The taxpayer works more than 100 hours in the activity, and no one else works more than the taxpayer;
4. The taxpayer participates in an activity for less than 100 hours for the year (“significant participation activity”), and the sum of the taxpayer’s participation in all significant participation activities for the year exceeds 500 hours;
5. The taxpayer materially participated in the activity in any five of the previous 10 years;
6. The activity is a personal service activity and the taxpayer materially participated in any of the prior three years.
7. Based on the facts and circumstances, the taxpayer participates in the activity on a regular, continuous and substantial basis during such year. However, this test applies only if the taxpayer works in the activity at least 100 hours, no one else works more hours than the taxpayer in the activity and no one else receives compensation for managing the activity.
This brings us full circle back to the specific meanings of the six exemptions listed earlier in this article. We will narrow that to the first two because we believe these are the only exemptions that apply to equipment rental businesses. This belief is based on our interpretation of written guidance issued by the IRS.
The first exemption is quite clear: If the average rental period is seven days or less, your equipment rental business is not an NII tax business. The next exemption is less clear.
We have been advised by counsel that if your average rental period is greater than seven days, but less than 30 days, and the personal services you provide are worth more than 50 percent of the cost of the rental, then these personal services should be treated as significant and your equipment rental business should not be treated as an NII tax business. If conversely, the value of personal services you provide is less than 10 percent of the value of the rental, those services likely are not significant and your equipment rental business is likely an NII tax business. If the value of the personal services is between 10 percent and 50 percent of the value of the rental there is no clear guidance.
ARA has undertaken an extensive analysis of the ACA provision that imposes a 3.8 percent NII tax on certain types of passive income. We did this because of concerns that some ARA members could be subject to the NII tax and we needed to determine what that exposure might be and what steps ARA can take to help members mitigate or eliminate any such exposure. In summary, we have learned:
Income exempt from the NII tax
1. Any income that does not exceed the AGI threshold of $250,000 for married taxpayers filing jointly, $200,000 for single taxpayers, or $125,000 for married taxpayers filing separately is not subject to the NII tax regardless of the source of the income.
2. Income of a C corporation is not subject to the NII tax; however distributions from a C corporation to shareholders can be subject to the NII tax if the taxpayer receiving these distributions has an AGI above the appropriate threshold.
3. Income that is subject to SECA or FICA is not subject to the NII tax.
Income not exempt from the NII tax
1. Income for a taxpayer that has AGI in excess of the appropriate threshold, which is derived from passive sources such as dividends, interest, distributions or income from an NII tax business that is not otherwise exempt (i.e., wages or self-employment income that is subject to FICA or SECA).
2. Rental income derived from a trade or business that does not meet one of the six exemptions listed on page 22, and specifically exemptions one and two.
3. Income from any trade or business in which the taxpayer does not materially participate.