Simple and logical changes in one’s life and business arrangements may have unforeseen and expensive tax implications. Balance and poise are needed to minimize the expense.

Consider the family owned business of Mrs. Franklin. Mrs. Franklin has spent the better part of her adult life creating and growing her successful aerospace industry manufacturing business. Mrs. Franklin is nearing retirement age but wants to pass the business down to her heirs and spend her time travelling. She will still advise in the business but wants to work less than 500 hours per year. The business is an S Corporation and its income passes through to Mrs. Franklin. The aerospace industry is abundant with opportunity and innovations abound, and Mrs. Franklin’s company strives to be relevant and on the forefront of technological advancement. The company annually invests several hundred thousand dollars into research and development that generates a Research and Experimentation Tax credit between $75,000 and $100,000 per year.

Mrs. Franklin and her company benefitted from the tax breaks afforded by the federal and state Research and Experimentation Tax Credits (R&E), offsetting nearly $100,000 of tax each year. As an incentive to encourage innovation, businesses can claim a credit for spending on labor and supplies used for research. The federal R&E credit passed through to the shareholders of the business each year, while Ohio R&E credit was applied to the company’s Ohio Commercial Activity Tax.

Net Investment Income Tax

The Medicare Surtax also known as the net investment income tax is a new tax effective January 1, 2013, imposed, in addition to income tax, on the net investment income—generally interest, dividends, annuities, royalties, rents, and capital gains—of individuals with income above certain levels (AGI > $200,000 approximately).

The 3.8% net investment income tax also applies to a pass-through trade or business if it’s a passive activity of the taxpayer. The material participation rules apply for purposes of determining whether a trade or business is passive. A business owner who participates in the business less than 500 hours during the year would be treated as not materially participating, and their share of the business income would be subject to the additional 3.8% surtax.

Mrs. Franklin’s semi-retirement planning may come at a steep price. If she works less than 500 hours this year her income from the business is subject to an additional 3.8% tax. This change could translate to an additional $11,400 in tax on $500,000 of passive business income. Additionally, the R&E credit that could have offset $75,000 in income tax can be limited under the passive loss limitation rules.

Research and Experimentation Tax Credit

The passive activity rules can impact Mrs. Franklin’s ability to benefit from the R&E credit as well. Credits that originate with a passive activity are subject to the passive loss limitations. To further reduce Mrs. Franklin’s ability to benefit from the R&E tax credit upon the disposition of her business interest, passive credits may not be deducted even if the disposition is fully taxable and was made to an unrelated party!1 Instead, the taxpayer may elect to increase the basis of the disposed property by any unused credits.

Mrs. Franklin’s tax advisor can assist her in meeting multiple objectives: planning the retirement move, succession planning, and transferring business assets to the next generation. Mrs. Franklin can actively participate in the business more than 500 hours per year to limit the additional 3.8% tax on her business income. As her investment in the business is reduced, Mrs. Franklin can reduce her participation. Additionally, the taxable income of the business is shifted to the next generation.

When Mrs. Franklin does reduce her activity in the business and is considered “passive”, she may be able to use the R&E credit to the extent she has taxable income from the business as long as she has overall passive income. If net passive losses exceed net passive income, passive credits are not allowable; however, Mrs. Franklin’s advisor can assist in tax planning to reduce passive losses from other activities that would exceed the passive income generated by the business. That may entail disposing of certain passive loss generating investments.

With careful tax and succession planning, Mrs. Franklin can limit her exposure to the Medicare surtax and enjoy the benefits of the Research and Experimentation Tax Credit.

1 However, IRC § 469(g) permits losses to be deducted upon disposition.