The rules associated with the nature of investments and the income generated have always been complex. Subsequent to 2013 and the activation of the provision of the Affordable Care Act following those rules became more important. The ACA put significance to the nature of income. Passive income, such as interest, dividend, capital gain, and some business earned income, is now subject to a 3.8% tax (if you meet certain AGI targets). The classification of income, passive or active, and its incumbent importance to the issuance of this new tax has now given the Internal Revenue Service a new reason to turn their computers and auditors loose on our returns.
There is a difference between passive and active income. There is also a difference between types of active income. The importance for the investor today is knowing up front what type of investment you’ve made and how it should be treated.
Limited Partnership: In general, if you’ve made an investment in a partnership, and the most you can lose as a result of the failure of the partnership is the original investment, then you are a Limited Partner. If that same investment has a guaranteed return on your investment, then the part of earnings, normally referred to as a Guaranteed Payment, is treated as passive income, or interest, and is taxed under the ACA for the additional 3.8% tax. It is also important to note that these investments have only one type of expense that is deductible against the income from the investment-interest expense.
- Interest expenses as Investment Interest Expense-if you borrow money to purchase the investment the interest expense is Investment Interest Expense.
- Interest expense as a direct reduction of the earnings from the investment may be allowable, especially if your employer has arranged for an internally financed loan for you to acquire the investment.
- In most cases a down payment is still required, but if the down payment is funded by the company as well, then this amount of income to you is considered earned income and subject to social security and ordinary income tax.
- If you work for the partnership and in the ordinary course of your job you have expenses which are not reimbursed by the partnership, in no instance are these expenses deductible against the limited partnership earnings.These expenses must be deducted as an out of pocket business expense on Schedule A and are subject to a 2% of AGI threshold.
- Losses associated with the investment may not be deducted currently unless you have earnings from other passive investments.You do not lose the ability to take a deduction for the loss, it is tracked via Form 8582. These losses may be deducted against certain other passive income.
- Losses in excess of basis are not allowed, but suspended until basis is restored regardless of losses from other investments.
General Partnership: In general, if you’ve made an investment in a partnership and you may also have to guarantee loans of the partnership, then you are a General Partner. None of these earnings are subject to the ACA’s additional passive income because the investment is considered subject to self-employment tax.
- Interest expense associated with indebtedness to acquire the investment will normally be deductible against the ordinary income of the investment.Interest expense in excess of the earnings could result in a deductible loss for the year.
- If you receive the down payment to make the purchase from the entity either through a direct investment or through a reduction in the purchase price versus the fair value of the investment, this down payment is ordinary income to you and will also be subject to Self Employment Tax.
- You may deduct any annual loss created by the investment against other sources of income.The deduction may not exceed your basis in the investment, but you may now include the amount of recourse debt you’ve guaranteed as a portion of your overall basis. Because it is possible that the loss from the business may still exceed the sum of your original investment and the amount of recourse debt, it is important to know the excess loss is suspended until your basis is restored.
- If you incur expense personally on behalf of the partnership, you may deduct any out of pocket expense against this type of partnership income, but the operating agreement should have provisions which explain and give a general outline that these would be considered ordinary and normal business expenses the partnership would have deducted had they paid for the expenditure.
General and Limited Partner: It is possible to be a general and a limited partner. In this instance you are considered a general partner for tax purposes. Your earned income from the partnership is considered subject to self employment, even that earned from the limited partnership, because you are considered under the Internal Revenue Code to have influence over the recognition of income. The rules of being a general partner therefore apply.
If you have any questions, do not hesitate to give us a call at the office, 314-993-4285.