Net Investment Tax (Form 8960) and Sch K-1 Income

[Steve Stang]

I'm reviewing a 2013 filed tax return for an individual (lives in MA). I'm thinking that the previous tax preparer may have mistreated his Sch K-1 income from a sub-S Corp as passive resulting in higher surtax liability.

I don't often see these and I know the net investment income tax is new. I ran this by a CPA colleague and his opinion is that the sub-S income is "non-passive" and should be listed on Form 8960, Line 4b matching the entry on Line 4a resulting in a $0 amount on Line 4c.

The other preparer has included the K-1 on Form 8960, Line 4a, line 4b value of $0 resulting in a large, positive Line 4c value (about $48k).

If it means anything the taxpayer is a W2 employee and as of last year a 2% shareholder of the same employer (his first year as shareholder). His income is about $165k before the $48k K-1 distribution.

Am I wrong in thinking that this as a non-passive income item? If it is a non-passive item (my CPA colleague reminds me that all sub-S income is non-passive) then my Drake software defaults to "d - not a passive activity" resulting in a lower tax to the taxpayer.

Treating it as the original preparer did results in additional tax liability of several hundred dollars.

[Gary2]

The other preparer has included the K-1 on Form 8960

More likely, the preparer's software automatically carried the K-1 info to the 8960, but left the 4b entry as a manual adjustment (which is probably the right thing to do, though it should warn the preparer to look at this).

If it means anything the taxpayer is a W2 employee and as of last year a 2% shareholder of the same employer (his first year as shareholder). His income is about $165k before the $48k K-1 distribution.

Am I wrong in thinking that this as a non-passive income item? If it is a non-passive item (my CPA colleague reminds me that all sub-S income is non-passive) then my Drake software defaults to "d - not a passive activity" resulting in a lower tax to the taxpayer.

It does matter that he is an employee, because otherwise it would be a simple investment in an S-Corp, which would be subject to the NII tax (same as any other investment in corporate stock). I believe the active vs passive question is determined at the shareholder level, not the S-Corp level. Thus, your colleague's remark should be rephrased as "in most practical cases, all sub-S income is non-passive." (Don't ask me whether there are any exceptions for a spouse who owns shares but doesn't participate in the business.) Also, Portfolio income and S-Corps whose business is trading in securities are special cases.

[Steve Stang]

It does matter that he is an employee, because otherwise it would be a simple investment in an S-Corp, which would be subject to the NII tax (same as any other investment in corporate stock). I believe the active vs passive question is determined at the shareholder level, not the S-Corp level. Thus, your colleague's remark should be rephrased as "in most practical cases, all sub-S income is non-passive." (Don't ask me whether there are any exceptions for a spouse who owns shares but doesn't participate in the business.) Also, Portfolio income and S-Corps whose business is trading in securities are special cases.

Thanks for the response.

To clarify, the taxpayer's employer is a wholesale food broker/distributor. So the special circumstance for securities trading doesn't apply here.

If a 'simple' investment in an S-Corp triggers the NII tax, then would this situation where one does not "invest" money but is granted minority shareholder status in a business the taxpayer actively participates make this not subject to NII?

Any suggestion as to how to determine at the shareholder level what is active versus passive?

Assuming that the company deems it passive, then the entry in Line 4b should be zero, yes (resulting in the tax)?

Assuming that the company deems it non-passive (or active, I would think for us mortals), then that would, I think, make this not subject to the NII. I don't want to pick a fight with the other preparer - she already was annoyed when I asked - but I do want to make sure that the bases are covered for the taxpayer relative to tax planning - especially setting aside money to pay the tax bill.

Thanks.