With the implementation of the Affordable Care Act, a new focus has been placed on passive and non-passive business activity for income tax purposes. Due to the additional 3.8% tax on investments that resulted from this legislation, it is in the taxpayer’s best interest to take a fresh look at the reporting of business and investment income on tax returns.
If you have a business structure where you own multiple entities, you should review with your CPA what your role is with all the entities you own and what their current classification is on your 1040. There are a few options available to re-classify a taxpayer as being non-passive (not subject to the 3.8% tax) in an entity, if they qualify. You can make an election to group certain business activities together based on their activity, function, location, etc.
For example, you own a construction business in an S corporation and you rent all your equipment from a separate LLC that you own. Since you’re not spending much time with the LLC, you have treated it as a passive activity in the past. It wasn’t an issue in the past if you had passive income, but with the new law you could now be paying an additional 3.8% in federal tax if you continue treating the rental activity as passive. You have the option to group this rental activity with your construction company as non-passive as they are essentially all part of the same business.
Another example would be if you are involved in real estate development and/or rental property along with your construction business. The option of making the election to be treated as a real estate professional may exist depending on the amount of time you spend in real estate activities. If you qualify for this treatment, although it is difficult to meet the criteria, then all your real estate rental and development activities qualify to be treated as non-passive and not subject to the additional tax.
There are also other advantages to evaluating the status of all of your business entities such as not creating suspended passive losses and not paying the additional investment tax if you sell the entity. Be sure to discuss passive income with your tax advisor; you may be pleasantly surprised at the potential tax savings!