Protect Your Personal Income from Excess Tax

In the wake of the Affordable Care Act, Congress authorized the imposition of a 3.8 percent net investment income tax on individuals with significant modified adjusted gross income (AGI). In particular, once a married couple filing jointly reports AGI in excess of $250,000, a 3.8 percent incremental tax applies to all passive income beyond that threshold. Individuals cross the mark at $200,000.

Understandably, higher income folks did not greet this change with enthusiasm. Many simply took their proverbial lumps and applied the new standard to all of the passive income that crossed the threshold. Yet for some taxpayers, this approach may have resulted in a needless “contribution” to the taxing authorities.

For example, many farm owners find it advantageous to own the land and buildings as individuals, or in a separate limited liability company (LLC). It affords them the opportunity to shield these assets from claims by the farm’s creditors or by virtue of other legal action. The owners then earn rental income from the farm for use of these properties (a.k.a., “self-rental”). If farming is a passive investment for the property owner, then the 3.8 percent net investment income tax applies to the rental income. However, if the property owner is an active member of the farming business, then self-rental income is not subject to the 3.8 percent tax.

In like fashion, a farm owner may find it advantageous to serve as the farm’s creditor. If the owner is an active participant in the farming business, then the interest income earned through this arrangement is not subject to the 3.8 percent tax.

In both cases, the word “active” plays a significant role in determining tax treatment. The law sets standards for what constitutes active participation in a business. A tax advisor can review these benchmarks and provide guidance and the requisite documentation to pass scrutiny should one’s returns be subject to audit. In addition, the following actions should be taken to support the case for favorable tax treatment:

• Prepare and execute an appropriate rental agreement between the property owner(s) and the farming business. Make sure that all rents align with fair market values.
• Prepare and execute lending agreements to address monies loaned by individuals to the farming business. Use interest rates consistent with other creditors in the marketplace based on the type of loan, the duration, and risk assessment.
• Where possible, incorporate a description of the role the property owner (or lender) plays in the ongoing management of the farm. This documentation strengthens the case for “active” participation.

While this treatment has been in place since 2013, a taxpayer may not have taken advantage of it in the 2013 or 2014 tax years. It’s still possible to remedy that situation with amended returns. However, the taxpayer forfeits those savings if too much time lapses.

Contact your tax advisor to see if your circumstances warrant a review of prior year returns. If this treatment provides benefits in 2015 and beyond, your advisor can establish the means to build your case and calculate the benefit.