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Portfolio > Economy & Markets > Fixed Income

The New Investment Tax: Don’t Let Clients Be Snared by the Passive Activity Trap

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Your clients may have mastered the more obvious points of the new 3.8% tax on investment income that became effective this year, but with this complicated set of tax rules, what they do not know can hurt them. The tax is full of hidden traps that can leave your clients with a tax bill that is much higher than expected. The rules regarding the tax’s application to passive activity income can be some of the most surprising and confusing; well-diversified clients will need your advice in determining whether they are in danger of being caught up in the investment income tax’s clutches.

The New Investment Income Tax Defined

The 3.8% investment income tax is a tax on unearned income that became effective for tax years beginning in 2013. It affects more affluent clients, meaning taxpayers with adjusted gross income (AGI) of more than $200,000 for single filers or $250,000 for married couples filing jointly. This is an additional tax, meaning that it is added on to any other tax that is imposed on the income at issue.

Unearned income is income received from investments such as stocks, bonds and mutual funds. Net investment income includes dividends and interest received through investment in these vehicles but can also apply to income derived from a trust or, in some cases, the sale of a primary residence.

Passive Activities Defined

Under the proposed regulations, investment income that is subject to the 3.8% tax includes all income that is derived from passive activities. In many cases, your clients’ ownership interests in partnerships or S corporations may fall within this category, even if the allocations that your client receives based on such ownership represent income that the entity earned through its normal operations.

According to the IRS, a passive activity is any activity (in the context of a trade or business) in which the taxpayer does not materially participate. While there are several tests that are used to determine whether material participation is present, generally the client would have to be actively involved in the business on a regular and continuous basis to support a finding that the activity was not passive.

Many of the tests center upon the number of hours that the taxpayer devotes to the activity annually, or this number of hours relative to the hours spent by others engaged in the same business. A traditional facts and circumstances test is also often applied.

If the activity is found to be passive, all of the income derived from the activity will be subject to the additional 3.8% tax, assuming the client’s AGI exceeds the threshold levels.

The New Tax, Trusts and Passive Activities

In the case of a trust that owns interests in a pass-through entity, such as an S corp, the activities of the trustee are relevant in determining whether the investment is active or passive.

Recently, the IRS issued private letter ruling 201317010, in which it found that a trustee’s participation in a business in which the trust owned interests was not material even though the trustee was president of the company at issue. This was because the IRS determined that the trustee was participating in the company in his role as an employee and not in his role as a fiduciary of the trust. Further, the IRS found that the trustee’s activities were not “regular, continuous and substantial.” 

This PLR casts doubt on whether trusts that hold interests in pass-through entities will be able to escape the investment income tax even if the trustee holds a position within that entity.


Clients have been well prepared for the inevitability of the new investment income tax as it applies to income derived from their traditional investment-type vehicles. However, for this year and beyond, clients now need to be made aware of the repercussions of the new tax as it applies to income derived from passive activities, whether directly or through a trust.


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