A new US tax on investment income should be factored into the economics of some transactions.

US individuals are subject to a new 3.8% tax on “net investment income” as of January 1.

The tax applies to anyone earning more than $250,000 a year in adjusted gross income for married couples filing joint returns. The threshold is $200,000 for single persons. The income levels are not adjusted for inflation, so more people will become subject to the tax over time.

The tax applies to most interest, dividends, capital gains, rents, royalties and to other income from two types of businesses. The businesses are trading in financial instruments and commodities and any business in which the individual is considered a passive investor.

“Trading” means seeking to profit from short-term movements in prices. Electricity may be considered a commodity, but generating electricity for sale is not “trading” in electricity.

An individual owning an interest in a power project through a limited liability company or partnership may find his income subject to the tax because he is considered a passive investor. Unless he is engaged personally in the LLC or partnership business for a material number of hours each year, his role is normally considered passive. “Material” usually means more than 500 hours a year, but can be as few as more than 100 hours if his personal involvement in the business is not less than that of any other person.

The tax is on “net” investment income. Some directly-connected expenses can be deducted. An example is a fee that must be paid to a broker for arranging a sale that produced a capital gain.

A taxpayer who has net investment income but is over the income threshold at which the tax kicks in by a smaller amount than his net investment income is taxed only on the lower amount. For example, suppose a single person has adjusted gross income of $270,000 of which $90,000 is net investment income. He is only $70,000 over the threshold at which the tax starts to apply. The tax must be paid on only $70,000.

Partnerships will have to send more complicated forms to partners — so-called K-1s — each year breaking down the type of income the partners are allocated by the partnership.

Interest, dividends, rents and royalties retain their character when they pass through the partnership, but they will not count as investment income if received by a partnership in the ordinary course of its trade or business. Thus, for example, a partnership in the business of leasing solar panels to homeowners receives rent and interest on late rental payments. These amounts are not investment income to the partnership. Therefore, they are not investment income when they pass through to partners. However, any partner who is considered merely a passive investor would have to report all the income he is allocated by the partnership as investment income.

A partner selling his partnership interest at a gain must treat the gain as investment income. Capital gains from the sale of property held in a trade or business are not investment income. However, the Internal Revenue Service suggested in proposed regulations to implement the new tax in December that a partner generally is not considered to hold his partnership interest in a trade or business.

The proposed IRS regulations will require complicated calculations to determine the share of gain any partner has when selling his partnership interest that will be subject to the 3.8% tax. The calculations are supposed to put the selling partner in the same position as if he had sold his share of the partnership assets directly. The partnership may have a different “basis” in its assets than the partner has in his partnership interest. The adjustments are intended to calculate his gain as if the partnership made a deemed sale of its assets and allocated the partner his share of gain immediately before the partner sold his partnership interest.

The tax is in section 1411 of the US tax code.

by Keith Martin