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Stock sales early in the year could be expensive

I write and speak about the tax law. Enough so, and in different forums, that many people tell me I know a lot about the subject.

What I like the most is stuff I don’t know. My ignorance intrigues me.

I also do a lot of research and write many, many articles in professional tax journals. I don’t even know if anyone reads them. But I honestly don’t care. I write for myself. To learn things.

To quote an old Dylan song, “I’ve got a head full of ideas that are driving me insane.” Writing helps me focus on how to convert the insanity into thoughts that are useful to myself, and sometimes to others.

Einstein was a smart fellow. He said research is what we do when we don’t know what we’re doing. Einstein spent his adult life doing research. I guess he thought there was much he didn’t know. And, more important, wanted to know.

The cool thing about researching things is how it shows you all of the stuff you don’t know or understand. It feeds a sense of wonder of the world and its mysteries. It’s the only way I’ve found to stay young.

I love the questions I get that I cannot immediately answer. Today I address a question I received from someone who sat through one of my webinars on tax law. He had a question he never had a chance to ask so he emailed me after.

I suppose many instructors would ignore the question. The webinar is long over. But it was such a basic question, yet one I didn’t know the answer to, that I jumped on it.

Congress passed a surtax on investment income in 2013. This surtax was designed to fund the Affordable Care Act (colloquially, “Obamacare”).

We know that Republicans hate Obamacare. However, they seem to like the revenues from the 3.8% investment tax. Therefore, there has been no push to eliminate it.

This tax applies to “high income” people who have investment income such as dividends, interest and capital gains. The sale of stock produces a capital gain.

S corporations are special status corporations that allow income to pass through to the owners, avoiding a corporate-level tax. This pass through status also triggers a special investment surtax rule for stock sales.

If a high-income owner sells stock in an S corporation, the gain is treated as if it came from a sale of the assets of the corporation. This is only for applying the investment income surtax.

If the assets of the corporation are used in a business, the gain from the stock sale may be deemed business income not subject to the investment income surtax. However, the seller has to prove that he or she helped produce this business income.

The proof comes from a showing that the shareholder “materially participated” in the business for the year of sale. We have seven tests, most based on hours spent, to determine material participation (MP).

So here’s the question: What if the stock is sold in January of 2021? Recall that the MP tests are based on hours spent. The most basic one requires that more than 500 hours be worked during the year.

My webinar friend’s client started and grew a business in an S corporation. He worked full time. Over 2,000 hours each year. He sold the stock for a $4.2 million gain.

The investment surtax would be $159,600. That’s worth some research. There was a business. The seller-owner materially participated in every year. What about the year of sale?

A January sale makes it quite difficult, no impossible, to exceed 500 hours of participation. Could the timing of the sale really be a $159,600 mistake?

Thankfully, no. Just because the business was started in 2011. The owner materially participated from 2011 through 2020 – 10 years. There’s a special rule that says if you MP in five of the 10 preceding years you also MP in the current year.

That’s $159,600 of relief. My nature is to ask what if the business started in 2017. That produces only four years of MP. The lack of five years of MP history creates a $159,600 “January effect.” Really. How ’bout them apples?

James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at