Uncle Bill’s Net Investment Income Tax Quandary
Suffice it to say that Uncle Bill had a good year in 2021.
As you may remember from this article, Bill and Ethel’s daughter Moon (neé Jaime) was one of the initial investors in a small online book retailer based out of Seattle that was founded by her friend Jeff. When the website took off, Moon made a pretty penny (or 304 billion pretty pennies). Bill invested a small amount of his Emu-based earnings in the company, and the hens came to roost in 2021. As a consequence, Bill’s investment income alone was above $250,000.
Growing up on Ray Street in Biddeford (the dodgy end), Bill’s next-door neighbor was a chubby, freckled kid named Larry Baker-Cook. Despite four generations of Bakers running the Main Street Delicatessen, Larry became one of the seven police officers in the town, which was a smidge bigger than Stockbridge, Massachusetts, which (at the time Bill and Larry graduated high school) had three stop signs, two police officers, and one police car. Nonetheless, Larry could not resist the siren call of corned beef piled high on seeded rye, and five years into his law enforcement career, he founded Blue Line Subs with seed money that he received in large part from Uncle Bill.
If Bill loved anything more than his emus, it would have been a submarine sandwich. Not only did Bill eat at Blue Line at least five times a week, but he ultimately served on the Board of Directors and was actively involved in the management of the company. Blue Line opened a few more locations in Biddeford, then expanded to Portland, Bar Harbor, and Augusta. Blue Line’s market value skyrocketed as it made its way down the eastern seaboard.
Then the Colonel came knocking.
Larry and Bill ultimately sold what had started as a hole in the wall sandwich shop to the Kentucky Colonel for a cool $120 million, a third of which was allocated to Uncle Bill. Naturally, after such a windfall, Bill’s paranoia kicked in, and he became deeply concerned that the Internal Revenue Service would seize the majority of the profits from the sale of Blue Line.
It was a blustery Tuesday in late February when Bill called you to discuss the net investment income tax as it pertained to the sale proceeds of Blue Line. Although you were generally aware of the 3.8% net investment income surtax, admittedly you are not as well versed on the intricacies of the law. You told Bill that you would get back to within the week, and, candidly, you have better things to do until Friday morning when you pulled up the Google and began your investigation of the net investment income tax.
The net investment income tax is a 3.8% surtax on a portion of a taxpayer’s modified adjusted gross income (MAGI) over certain thresholds. An individual may be subject to the net investment income tax if he has investment income and a modified adjusted gross income that exceeds certain thresholds—unless an exception applies. In Bill’s case (married filing jointly with Aunt Ethel), such threshold is $250,000.
The net investment income tax, which acts as a surtax to ordinary income taxes, was codified by Congress in IRC § 1411 in 2013. The net investment income tax applies to “investment income,” unless it is derived in the ordinary course of a trade or business that is not passive to the taxpayer under IRC § 469. The regulations generally provide that an activity will not be passive if the taxpayer “materially participates” by satisfying any one of seven tests laid out in Treas. Reg. § 1.469-5T(a).
Investment income is defined in IRC § 1411(c)(1)(A) as gross income from interest, dividends, annuities, royalties, rents—unless the foregoing is derived in the ordinary course of a trade or business that is not passive to the taxpayer—as well as net gain attributable to the disposition of property (unless such property is held in a trade or business that is not passive to the taxpayer).
Significant Participation Activities
Treas. Reg. § 1.469-2T(f)(2) carves out a bit of an exception from the material participation rules and creates a special rule for “significant” participation. If otherwise passive income arises from an activity in which the taxpayer significantly participates (without “materially” participating), then that income is recharacterized as nonpassive. For purpose of the regulations, “significant participation” is participation by the individual in the activity for more than 100 hours during the tax year.
Thus, the recharacterization rule requires just over 2 hours of participation per week to establish significant participation. The net investment income tax regulations under Treas. Reg. § 1.1411-5(b)(2)(i) specifically provide that any income recharacterized under this significant participation rule is not passive for purposes of IRC § 1411.
Scrutiny and Substantiation
IRS officials have indicated that relying on the lower significant participation threshold could prompt extra scrutiny when it comes to substantiating hours for net investment income tax purposes. Bill grumbles at this interjection. You remind him, however, that taxpayers should always be able to substantiate their participation through books and records under IRC § 6001. The Tax Court’s body of case law on IRC § 469 is littered with decisions denying taxpayers participation based on inadequate substantiation.
The net investment income tax regulations allow taxpayers to use “any reasonable means,” and specifically cite the approximation of hours based on appointment books, calendars, and narrative summaries. However, the Tax Court has been reluctant to accept affidavits, after-the-fact narrative summaries, or other self-serving testimony. Thus, you explain to Uncle Bill, whenever possible, he should do exactly what the net investment income tax regulations say is not required—contemporaneously track and record his “significant participation” activities.
Investor Participation Rule
Importantly, even when a taxpayer can substantiate his participation, it may be challenged under the “investor participation rule,” which denies credit for participation in an activity as an investor “unless the individual is directly involved in the day-to-day management or operations of the activity.” Generally, any work done by an individual in connection with an activity in which he owns an interest at the time the work is done is treated as participation of the individual in the activity. However, Treas. Reg. § 1.469-5T(f)(2) carves out any work done in an “individual’s capacity as an investor.”
The regulations provide that “[w]ork done by an individual in the individual’s capacity as an investor in an activity shall not be treated as participation in the activity for purposes of this section unless the individual is directly involved in the day-to-day management or operations of the activity.” In turn, “work done by an individual in the individual’s capacity as an investor in an activity” specifically includes (1) studying and reviewing financial statements or reports on operations of the activity; (2) preparing or compiling summaries or analyses of the finances or operations of the activity for the individual’s own use; and (3) monitoring the finances or operations of the activity in a non-managerial capacity.
The “Investor Activity” Gray Area
You explain to Bill—whose attention is still rapt on your every word—that there is a bit of a gray area when it comes to whether an individual performs work in the capacity of an investor, or whether the individual performs work in an “allowable managerial activity.”
This split of authorities is most easily illustrated with three cases from 1996. In the case of Serenbetz v. Commissioner, T.C. Memo. 1996-510, hours spent at condo board meetings were treated as investor hours. However, in Mordkin v. Commissioner, T.C. Memo. 1996-187 and Scheiner v. Commissioner, T.C. Memo. 1996-554, hours spent at condo board meetings were considered to be hours participating in an allowable managerial activity.
The Tax Court generally looks towards the characterization of “activities geared towards increasing the value of investments” first outlined by the Supreme Court in Whipple v. Commissioner. In Mordkin, the Tax Court held that the work done by a taxpayer on the board of directors dealing with a wide range of issues relating to the operation of a condominium hotel was not investor participation within the meaning of Treas. Reg. § 1.469-5T(f)(2)(ii)(B). In Scheiner, the Tax Court likewise held that a taxpayer’s activities as an officer and member of the condominium’s board of directors, in which the taxpayer “review[ed] the records of the condominium association to be certain that accounting principles were properly applied.”
By contrast, in Serenbetz, the taxpayers claimed that “managerial activity” included 20 hours of travel time to and from Vermont for annual board meetings (and a party of the condominium association), as well as other activities of a clearly “personal nature.” Further, the financial work done by petitioners was in connection with their investment, whereas the management/operations of the condominium was performed by a full-time staff rather than petitioners.
As you notice the first hints of that glazed look in Bill’s eyes that you have become accustomed to during your tax dissertations, you explain even when a person (an entity, individual, or board of directors) is not responsible for actively managing a business, service on the board may still qualify as managerial activity.
For example, in Scheiner, in which the court found the activities to be managerial rather than in the capacity of an investor, “[d]uring the years in issue, the board of directors was required to deal with a number of serious issues with respect to the condominium hotel complex. While the board was required to consider issues and establish policies, it was generally the management company that put the policies into effect.”
Recent Cases on Investor-Related Activity
Bill asks you to dig a little deeper at the most recent cases decided by the Tax Court with respect to Treas. Reg. § 1.469-5T(f)(2)(ii)(A). It’s not that Bill doesn’t trust you, but $1.52 million (3.8% of 40 million) is an awfully big chunk of change for a grizzled old emu farmer. You happily oblige with the knowledge that now Bill has no excuse not to pay your bill.
- In Robison v. Commissioner, T.C. Memo. 2018-88, the Tax Court found a couple’s activities related to their ranch not to be day-to-day activities or management, and the court held that the activities spent managing the property while at the ranch did not overcome the investment-related hours.
- In Baniskis v. Commissioner, T.C. Memo. 1999-258, the Tax Court held that the taxpayers’ “activities of organizing their personal records, preparing their taxes, paying bills, and reviewing their monthly statements of the rentals of their unit all constitute investor activities.”
- In Shaw v. Commissioner, T.C. Memo. 2002-14, the Tax Court found that a taxpayer’s “monitoring the operations and reviewing financial statements of restaurant franchises were not treated as participation because petitioner was not involved in the day-to-day operations of the restaurants.” Importantly, the Shaw case is distinguishable from Bill’s role on the board of directors of Blue Line.
- Bill is not an owner of a Blue Line franchise, who looks at books and records to make sure his investment is performing well.
- Bill is active in the oversight of the Blue Line parent company.
- Although he is not involved in the day-to-day management of the franchises, his work on the board is likely integral to the operation of the corporation as a whole, with his activities directly affecting the day-to-day operations of the restaurants.
- Thus, the Lamas (below) and Scheiner are far more applicable.
- In Lamas v. Commissioner, T.C. Memo. 2015-59, the Tax Court found that a taxpayer’s promotion of the business and solicitation of investors was not, itself, activities on an investor—but were instead active work towards building capital for in an attempt to cure a capital deficit. Importantly, in Lamas the Tax Court illustrated that the activity need not be “day-to-day” so long as the non-investor activities exceeded the investor-type activities.
- In Ackerman v. Commissioner, T.C. Memo. 2009-80, the Tax Court held that if a taxpayer performs work on a board or otherwise advising/managing the company “in exchange for a fee or a commission or any other compensation other than the normal investor’s return,” such factor would be favorable to determining that the taxpayer performed the activities in a non-investor role.
- Similarl to the Ackerman decision, in Coastal Heart Medical Group, Inc. v. Commissioner, T.C. Memo. 2015-84, the Tax Court likewise held that a director or board member who meets the participation tests will likely be found to not be acting in an investor capacity when performing activities for the company.
- In Assaf v. Commissioner, T.C. Memo. 2005-14, the Tax Court found that a taxpayer who was engaged in “leasing activities and legal support services” to a business, despite having another full-time job, was sufficient to qualify as active, non-investor participation.
Bill arrives at your office with a banker’s box full of notes, receipts, planners, meeting minutes, and other miscellany, which he claims will be sufficient to establish significant participation in allowable managerial activities for purposes of the net investment income tax. After spending two days rifling through, arranging, and scanning all of Bill’s documents, to your surprise, they paint a rather complete picture of a very involved manager on the Blue Line board of directors.
How the venture succeeded with Bill’s leadership is anyone’s guess, but you take this as an even more substantial sign of Larry’s hoagie-based acumen. Because Bill significantly participated, he will avoid the net investment income tax.
You call Bill to give him the good news, and he picks up on the fourth ring. There is a bit of panic in his voice, and he is out of breath. The only words that you can make out are “Thelma and Louise” and “gone rogue.” You ask if he wants you to call for help, but the call drops. Either he escaped his prized emu hens, or it is too late for Bill. You are relieved when he calls you thirty minutes later and gives you a life lesson as only Uncle Bill could:
When you are wrestling a full-grown emu, put it in a full nelson and hold on tight.
- See, e.g., Goshorn v. Commissioner, T.C. Memo. 1993-578 (finding that “ballpark guesstimates” made in hindsight are not acceptable substantiation). ↑
- Treas. Reg. § 1.469-5T(f)(4). ↑
- See Treas. Reg. § 1.469-5T(f)(2)(ii)(A). ↑
- Treas. Reg. § 1.469–5(f)(1). ↑
- See Treas. Reg. § 1.469-5T(f)(2)(ii)(A). ↑
- Treas. Reg. § 1.469-5T(f)(2)(ii)(B). ↑
- 373 U.S. 193, 202-03 (1963); see also Estate of Stangeland v. Commissioner, T.C. Memo. 2010-185. ↑
- Accord Iverson v. Commissioner, T.C. Memo. 2012-19 (owner of ranch with full time ranch manager found to be investor). ↑
- A nelson hold is a grappling hold which is executed by one person from behind the opponent, generally when both are on the mat face down with the opponent under the aggressor. One or both arms are used to encircle the opponent’s arm under the armpit, and secured at the opponent’s neck. Several different nelson holds exist, and they can be separated according to the positioning of the encircling arm(s).
A nelson is used to control an opponent or to turn them over onto their back and execute a pin. The term “nelson” is derived from “full nelson”, which dates back to the early 19th century. It has been suggested that it was named after Horatio Nelson, who used strategies based on surrounding the opponent to win the Battle of the Nile and the Battle of Trafalgar; it was also suggested that Bobby Nelson was the innovator and/or the name inspiration of the Nelson hold. See “Nelson hold,” Wikipedia, https://en.wikipedia.org/wiki/Nelson_hold. ↑Add to favorites