The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with a financial advisor in California is representative of a common question we receive related to net investment income. The advisor asked:
“I have a client who, in addition to being an employee at a business and a participant in his employer’s 401(k) plan, has additional miscellaneous income from an unrelated side business. Does the IRS consider the “side income” to be net investment income (NII) for NII tax purposes?
Highlights of Discussion
• It depends; that is why it is important for your client to seek guidance from his tax professional. Generally speaking, the IRS considers income from a trade or business as NII if the business owner is merely passively involved, or he or she is in the business of trading in financial instruments.
• If the business owner is “active” in the business, then most of the income[1. There is an exception for income from the investment of working capital. Working capital generally refers to capital set aside for the future needs of a trade or business. The investment of working capital can give rise to portfolio income that is considered NII.] will be excluded from NII. It is, however, included as modified adjusted gross income (MAGI), and if a taxpayer’s MAGI crosses the prescribed threshold, it will require an NIIT calculation.
• In order to demonstrate material active participation, a business owner would have to meet one of seven IRS tests as defined pursuant to Internal Revenue Code Section 469 (related to passive activity loss). For example, “Does the taxpayer and/or spouse work more than 500 hours a year in the business?” Such activity would be considered as material participation. But even if the taxpayer does not meet the 500-hour test, if his participation is the only activity in the business (e.g., sole proprietor with no employees), then he is considered to materially participate in the business.
• The earned income from active participation in a business or trade not only is excluded from NII, but could enable the income-earner to establish a business retirement plan, for example, a 401(k)/profit sharing plan or a cash balance defined benefit plan or even a Simplified Employee Pension (SEP) IRA. Such plans would allow the small business owner to funnel at least some business earnings into the retirement plan as pre-tax contributions; thereby currently lowering the business owner’s MAGI for NIIT purposes as well.
Conclusion
Some food for thought: Shifting passive to active involvement in one’s income-generating business may lessen the impact the NIIT has on the business owner. Contributing at least a portion of what would otherwise be earned income from a business to a qualified retirement plan can help reduce MAGI for NIIT purposes as well. Of course, business owners should always consult their personal tax advisors and or legal counsel before making any investment, financial planning or tax related decisions.
The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2013 Columbia Management Investment Advisers, LLC. Used with permission.
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