Does Material participation “pass through” too?

[Smallmfgrbizguy]

Partner and I are 50-50 owners and founders of a successful manufacturing company we started in 2006 as an LLC filing federally as an s corp.

call it OldCo.

we both worked 40 hours a week for years, and easily met the material participation requirements.

we sold most of OldCo company 8 years ago (2015) to another LLC (NewCo) and it’s grown to dozens of employees, and our original OldCo continues to own 20% of that new company.  It is the only business and income that OldCo has.

I have had to work for our original OldCo company this last year, and have been paid a fair hourly wage, over 100 hours this year, so I believe that I meet the material participation requirements (since I am the only one working for our company)

my partner has done no work directly for our original OldCo company, BUT she worked for the NewCo LLC company (that OldCo owns 20% of) full time before retiring last fall. 

that new llc company is now selling the entire company!

We (OldCo) will get 20% of the proceeds of that sale.

Since I have worked over 100 hours so far, I don’t think I will have to pay the additional 3.8% tax, right?

But what about my partner?  

she hasn’t worked for our company directly, exactly (we don’t pay her a salary from OldCo) but… she worked full time for the manufacturing company, which is a pass through llc, that we owned 20% of… so she has clearly Materially Particapated in that company that is selling, so… we don’t think she should have to pay the 3.8% additional taxes, either, right? Because, although she may not be directly materially participating in OldCo, which is going to give her the k1, she clearly materially participated in the company that is selling, so I think she clicks the box that says “yes” to material participation, when filling in TurboTax next year, and therefore avoids the 3.8%, right?

[tagteam]

For material participation tests see the following:

https://www.irs.gov/publications/p925#en_US_2022_publink1000104582

[Mike9241]

@Smallmfgrbizguy did you read the special rules in the NIIT form 8960 instructions for those regarding disposition of your interest in in the S-Corp Disposition of Partnership Interest or S Corporation Stock.....
In general, an interest in a partnership or S corporation isn’t property held for use in a trade or business and, therefore, gain or loss from the sale of a partnership interest or S corporation stock is included in your
net investment income. 
Adjustment The amount of the gain or loss from the disposition for regular income tax purposes is included on Form 8960, line 5a, as a gain or loss. If you materially participated (as defined under the passive activity loss rules) in a trade or business activity of the partnership or S corporation (or one of its subsidiaries) and that trade or business activity isn’t the trade or business of trading in financial instruments or securities, then you must calculate the adjustment to report on line 5c. The adjustment described below only applies to dispositions of equity interests in partnerships and stock in S corporations and doesn’t apply to gain or loss recognized on, for example, indebtedness owed to the taxpayer by a partnership or S corporation. For more information on how to calculate the adjustment to report on line 5c, see Proposed Regulations section 1.1411-7.

Note. If the tax basis of the interest in the partnership or S corporation for NIIT purposes is different than for regular income tax purposes due to certain adjustments associated with income from CFCs or QEFs, the amount of gain or loss may exceed the amount reported for regular income tax purposes.

Required statements. Attach a statement to your return for the year of disposition. Your statement must include: • The name and taxpayer identification number of the partnership or S corporation of which the interest was transferred, • The amount of the transferor's gain or loss on the disposition of the interest for regular income tax purposes included on line 5a, • The information provided by the partnership or S corporation to the transferor relating to the disposition (if any), and • The amount of adjustment to gain or loss due to basis adjustments attributable to ownership in certain CFCs and QEFs

proposed reg

https://keitercpa.com/wp-content/uploads/2014/01/Final-Regulations-Clarify-Net-Investment-Income-Tax... 

also

https://www.thetaxadviser.com/issues/2014/apr/clinic-story-10.html 

also

https://www.forbes.com/sites/anthonynitti/2013/11/27/irs-issues-final-net-investment-income-tax-regu... 

[Smallmfgrbizguy]

THANKYOU!! I was so focused on the Material Participation side of things, I didn't think to read this form... and how things may be impacted regardless of our Participation qualification (or not!) Interesting (and complicated... this isn't actually simple to parse through either, but I feel farther along! THANKYOU!!