Will The 3.8% ‘Investment Income’ Tax Apply to Your Business Exit Transaction and Proceeds?
Business owners who plan to cash in on their privately-held businesses know that they will pay a substantial amount of taxes for their transaction. In fact, the recently passed American Taxpayer Relief Act of 2012 (or ATRA) included a number of tax increases that impact owners who are ‘cashing in’. Beyond the ATRA changes, there is also the issue of the Affordable Care Act (otherwise known as “Obamacare”) which imposes an additional tax of 3.8% on ‘net investment income’. Now, even though the sale of a business is likely to be characterized as ‘investment income’, it may be the case that the 3.8% tax does not apply to your exit transaction if you, the owner, are an active participant in the business being sold. This newsletter discusses these rules and how your exit transaction may or may not be subject to this additional tax.
A Review of the 3.8% ‘Investment Income’ Tax from the Affordable Care Act of 2011
As part of the funding for the Affordable Care Act, effective in 2013 an additional 3.8% tax will apply to individuals on their “net investment income”. Net investment income generally includes income from interest, dividends, rents and royalties. In addition, business profits and gains from the sale of business assets are also considered investment income under the new law if the business is a passive activity with respect to the individual owner (more on this below).
The tax applies when an individual’s income exceeds certain minimum threshold amounts ($200,000 for single individuals and $250,000 for married couples). It is applied to the lesser of the amount of net investment income or the amount by which total income exceeds the minimum thresholds.
Using a simple example, let’s assume a married couple has combined wages of $230,000 and other investment income consisting of dividends, interest and capital gains of $100,000. In 2013, they would incur an extra tax of $3,040 under the new law (3.8% * ($330,000 – $250,000)).
An Overview of the ‘Passive Investor’ Rules
The important consideration for business owners is that the 3.8% tax specifically applies to business income and gains from the sale of business assets if the business is a “passive activity” with respect to an individual owner. Therefore, it is important to understand when the passive activity rules apply.
Generally, a business will be considered to be a passive activity with respect to an individual owner if he or she is not involved in the business on a regular, continuous and substantial basis. Whether a business is treated as a passive activity is determined separately for each owner based upon their individual involvement in the business. The IRS provides several tests that determine when an activity is considered passive, including the time spent working in the business.
In fact, many owners will likely not be considered as “passive”, particularly if they are the founders of the business and are actively involved on a day-to-day basis. In this case, the additional tax may be avoided with respect to their share of business profits and the gain from the sale of their interest in the business.
However, where there are multiple owners, some of whom are not active in the business, the tax could apply to their share of pass through income as well as to the gain recognized by them on the sale of the business.
This could be the case, for example, where ownership has been transferred to trusts or non-active family members in connection with estate planning.
How an Additional 3.8% Tax is Likely to Impact Your Exit Proceeds
Consider the following examples of the application of this tax, assuming that the business, an S corporation, generates approximately $500,000 of profit in 2013 and that the business is sold at the end of the year for a gain of $3 million.
One owner – “active” in the business: The pass through income of $500,000 and the gain on sale will likely not be subject to the 3.8% tax.
One owner – “passive” in the business: Both the pass through income for 2013 as well as the gain on sale will be subject to the 3.8% tax, costing approximately $133,000 of additional tax.
Two 50% owners – one “active” and one “passive: The active owner will not be subject to the tax on the pass through income or the gain on sale. The passive owner will incur a tax of approximately $66,500 on his share.
Even if the selling owner is an active participant in the business, there are situations in which the 3.8% tax may apply to certain aspects of an exit transaction.
Consider the following, for example: A seller takes a note for part of the sale, which generates interest income, subject to the tax.
A seller receives stock of the purchasing company as part of the consideration – subsequent dividends will be subject to the tax. In addition, it is not clear whether the subsequent sale of the stock received will be subject to the tax.
At the end of the day, it is more important to ‘know what you will keep’ from the sale of your business interests, not necessarily ‘what you will get’. As demonstrated above, the 3.8% tax could have a meaningful impact on your exit proceeds. Therefore, given that an opportunity to avoid this additional tax exists, you are well counseled in seeking the expert advice of your tax professionals to make this determination for your personal situation. We hope that this information and newsletter is helpful to you in keeping more of what you get for your business exit.