Work Enough to Avoid 3.8% Investment Income Medicare Tax

February 9, 2015 — How many hours do you need to work for a trade or business to avoid the 3.8% Investment Income Medicare tax?

Most believe it is greater than 500 hours per year. This is not necessarily true.

Internal Revenue Code (IRC) section 1411 assesses a 3.8% Medicare tax on certain types of investment income that exceed certain income level thresholds.

One of the types of investment income is passive activity trade or business income as defined in IRC section 469.

Basically, IRC section 469 indicates that income from a trade or business operated as a sole proprietorship, partnership/LLC or S-Corporation is passive if the taxpayer doesn't materially participate in the activity.

Material Margin Special Rules

Generally, material participation requires one to work more than 500 hours per year for the trade or business activity. There are several special rules that treat one as materially participating at a lower level of hours.

There are also special rules that specify if certain activities generate income they are not passive (and therefore not subject to the 3.8% Investment Income Medicare tax), but if they generate a loss they are passive.

One of the rules requires if one participates more than 100 hours in a year for a trade or business  activity, and all that person's "100 plus hour and less than 501 hour trade or businesses activities" don't exceed 500 hours in total, the income from the activity is not passive. Therefore, it is also not subject to the 3.8% Investment Income Medicare tax. This rule gets missed a lot. It should be fairly easy to get 101 hours. That is 2 hours a week.

One should review all trade or business activity income reflected on their tax returns and determine how many hours they need to work to "materially participate" or qualify for the above special 100 plus hours rule.

Note, if one has large passive losses, treating income activities as passive may result in more tax savings, than avoiding the 3.8% Investment Income Medicare tax.