The Tax Update is traveling. Posting will be erratic at best. Even more than usual, I mean.

The Obamacare Net Investment Income Tax will make owners of “passive” businesses pay 3.8% additional tax on income from their businesses, as long as their income is high enough for the tax to apply in the first place.

Taxpayers with only profitable businesses haven’t had to worry about whether they were “passive” before.  It only mattered if you had losses.  Now it matters a great deal, and a case this week out of Tax Court helps illustrate some of the challenges these taxpayers will face.

The Net Investment Income Tax piggybacks on the Section 469 “passive loss” rules in determining whether the tax applies.  There are a number of ways you can be non-passive (see summary below), but they generally involve showing that you have spent enough time working in the activity to be “non-passive.”

A retired soccer coach in California kept busy buying and renting residential property; when the IRS came looking at their tax return, he owned eight properties with his wife.  As his business was real estate rental, he had to meet a higher standard to avoid the passive loss rules.  Rental losses are automatically passive unless you both spend 750 hours on real estate activities and spend more time on that than on non-real estate activities.  As he was retired, the 750 hour test was the issue.

It’s up to the taxpayer to prove that they are non-passive, and proof was the problem.  The Tax Court explains the rules (my emphasis)

    Ideally, a taxpayer who claims to be described in section 469(c)(7) would maintain a contemporaneous log or record showing with particularity the amount of time devoted to the rental real estate activity on an event-by-event basis. See sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). Ideally, the log would be detailed enough to allow for someone who reviewed it to make an informed judgment as to the accuracy of the information reported. The creation and availability of a detailed log is important, especially if that reviewing “someone” is an Internal Revenue Service employee considering the log in connection with an examination of the taxpayer’s return on which rental real estate losses are deducted. Apparently, petitioners were not aware of the importance of keeping such a log and, as noted, neither kept a log during either year in issue.

     Recognizing that many taxpayers might not be aware of the importance of keeping a contemporaneous log of time devoted to the taxpayer’s rental real estate activity, the Commissioner’s regulations provide a second-best alternative. Section 1.469-5T(f)(4), Temporary Income Tax Regs., supra, provides:

(4) Methods of proof. The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.

The retired coach didn’t keep a log, so he tried the “second-best alternative,” using logs put together for the trial.  It wasn’t enough:

Simply put, the logs do not allow for a review of activity related to the rental properties on an event-by-event basis to the extent necessary to establish that the 750-hour test has been satisfied.

The moral: If you want to prove that you are non-passive, and it’s not obvious otherwise (e.g., a full-time job), you should keep a daily calendar of your time spent.  I know that for some of you, tracking hours is why you got out of lawyering or public accounting in the first place, but there it is.  If you are an owner, just getting a W-2 won’t prove you are active if you live in Florida and your business is in Iowa.

Bonus observation: The Tax Court seems to no longer give weight to the IRS position that you need to hit 750 hours to materially participate in a given real estate activity.  From the opinion:

Keeping that definition in mind, and because petitioners elected to treat the rental properties as a single activity, we are satisfied that they materially participated in the rental property activity during each year in issue, and respondent does not seem to suggest otherwise.

The judge said they “materially participated” even though in one year they only documented 379.5 hours.  It would have been enough in a non-real estate activity, but not enough for the stiffer real estate standard.  The election they refer to is the election to treat all rental real estate operations as a single activity.

Cite: Hofinga, T.C. Summ. Op. 2013-43.

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The Congressional Budget Office has issued a report on tax breaks.  The report has drawn much comment by pointing out the obvious — that most tax breaks go to people who actually pay taxes.  As most taxes fall on the rich, they benefit the most from tax breaks.

But a sharp-eyed reader pointed out something strange: a finding that three percent fo the Earned Income Tax Credit goes to the top 20% of taxpayers.

That would seem impossible.  The 2010 IRS income statistics show that 84,475,930 1040s were filed.  That would mean 16,895,186 would be in the top 20%.  18,147,511 2010 1040s showed income over $100,000.  The Earned Income Tax Credit phases out when AGI reaches about $50,000.  So how could the top quintile possibly claim the credit?

Because the CBO doesn’t measure income like we tax people do.  From their report:

 CBO calculated a broad measure of before-tax income, including  market income (such as labor income, business income, and capital income) and government transfer payments (such as Social Security benefits).In this analysis, CBO presents results for various subgroups of the population, such as the lowest quintile or the top 1 percent. In constructing those subgroups, households (all people living in a single housing unit) are ranked by income that is adjusted for household size, to reflect the fact that larger households need more income than smaller households to achieve the same economic status.

So they didn’t use AGI, or even actual tax returns.  They used households and a strange definition of income not directly tied to taxable income.  So it becomes possible to come up with ways the top quintile of “households” could have earned-income credit:

- The live-in girlfriend with kids.  Boyfriend might have money or a good job, but girlfriend has only limited wage and investment income.  By filing her own single return, she might qualify for the earned income credit.

- The prodigal daughter.  A single or divorced daughter could move back in with wealthy mom and dad with her children.  If they are all counted as one household, then a rich household could have earned-income credit; the daughter would not be on the parents’ return, and might qualify for the credit on her own 1040.

- The cash-poor family with lots of real estate.  If “capital income” includes, say, real estate appreciation, a family with modest earned income could have earned income tax credit because capital appreciation isn’t counted in AGI.

But the CBO study shows no way for a $100,000 AGI return to have earned income credit.  At least not honestly.