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January 18, 2020

Basic Rules of Passive vs. Non-Passive Income

The net investment income (NII) tax is a 3.8% surtax on investment income that was created by the Affordable Care Act in 2013. To avoid the 3.8% surtax, your investment income must be offset with investment losses or your income has to be considered non-passive vs. passive. For income to be considered non-passive, the taxpayer must materially participate in the activity. This is determined on an annual basis; because a taxpayer qualifies in one year does not automatically qualify him or her in subsequent tax years.

7 Tests of Material Participation

Material participation occurs when a taxpayer’s involvement in the trade or business is regular, continuous, and substantial. Any work an individual performs in an activity in which he or she owns an interest generally is considered participation. However, not all participation is considered material. An individual materially participates in an activity if any one of the following tests is met:

  1. The taxpayer participates in the activity for more than 500 hours during the year,
  2. The taxpayer’s participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year,
  3. The taxpayers’ participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than the taxpayer,
  4. The activity is a significant participation activity in which the taxpayer participates for more than 100 hours during the year and the taxpayer’s annual participation in all significant participation activities is more than 500 hours,
  5. The taxpayer materially participated in the activity for any five years (whether or not consecutive) during the 10 immediately preceding tax years,
  6. For a personal service activity, the taxpayer materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or
  7. Based on all the facts and circumstances, the taxpayer participates on regular, continuous, and substantial basis during the year.

In general, these seven tests are used for determining material participation for any business activity in which a taxpayer is involved. If one or more of the tests are passed, the activity is non-passive and the 3.8% surtax does not apply. However, exceptions to this general rule apply to working interests in oil or gas activities, to limited partnership interests, and to grouping activities. For additional guidance and planning, please contact an Anders advisor below.

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