If you’re an entrepreneur or small business owner, you want to know about how the Obamacare net investment income tax works. Accordingly, in this blog post, I’m going to provide a small business net investment income tax primer.
By the way, we aren’t going deep into the weeds in this blog post. There’s lots of complexity for small businesses related to the net investment income tax. But what you and I want to do here is have a discussion that gives you a good working handle on the issues you’ll face as a business owner.
Small Business Net Investment Income Tax Flows from Sec. 1411
Let’s start by pointing out that the net investment income tax flows from Internal Revenue Code section 1411.
This chunk of tax law says, essentially, that starting in 2013, some individuals, estates and trusts pay a 3.8% surtax on some or all of their net investment income.
Note: I’m not going to talk in this post about how the tax applies to estates and trusts. That’s a separate subject and probably not of much interest to small business owners and managers. However, if you use trusts, you’ll want to learn about this area of the law, too.
Investment income includes dividends, interest, royalties, rents not derived from a trade or business, trading, most capital gains, as well as net gains from disposition of passive activities (like an interest in a partnership) or disposition of a passive activity property (like investment real estate).
An important thing to note: The net investment income tax applies to your net investment income. If you have $100,000 of capital gains, $100,000 of capital losses, and $50,000 of interest, your net investment income equals $50,000.
You pay the taxes in this situation, potentially, on the $50,000.
Let me also tell you what income specifically is never hit with the net investment income taxes. The net investment income tax doesn’t hit income that’s already subject to self-employment taxes. The net investment income tax doesn’t apply to wages. The net investment income tax doesn’t apply to distributions from qualified retirement plans. And, important for business owners, the net investment income tax also doesn’t apply to gains you realize on the disposal of property (like unneeded equipment) used in a trade or business in which you’ve been active and met material participation tests.
Small Businesses Don’t Get Hit Until Owners Cross Tripwire
Even if you have net investment income, you don’t necessarily pay the net investment income tax. You need to cross a threshold in order to be subjected to the tax.
That threshold is $200,000 for a single taxpayer, $250,000 for married taxpayers filing a joint return, and $125,000 for a married taxpayer filing a separate return.
And then there’s a little wrinkle to how this works. The actual amount taxed equals the lessor of your net investment income or the amount by which your modified adjusted income exceeds a threshold.
Modified adjusted gross income equals adjusted gross income for most taxpayers. (The modifications that Sec. 1411 requires relates to Sec. 911 foreign exclusion income. )
One final important note to keep in mind as a long-term planning issue: The threshold amounts don’t get indexed for inflation. What this means is that while the net investment income tax only hits a tiny percentage of taxpayers now, someday not that far into the future, the tax will hit many more people.
Workers and retirees who today might consider themselves “merely” successful middle-class folks will very likely pay the tax a couple of decades into the future.
Self-Employment Tax vs. Small Business Net Investment Income Tax
A slight detour concerning self-employment income…
As you may know, self-employment taxes run 15.3% up to the FICA limit ($118,500 in 2016 and $127,200 in 2017), then 2.9% on any income between the FICA limit and the net income investment income thresholds just mentioned, and then run 3.8% after that.
On the face of it, 3.8% self-employment taxes look like 3.8% net investment income taxes.
However, self-employment earnings probably represent a better “flavor” of income as compared to net investment income for a couple of reasons.
First, self-employment tax gives you a tax deduction whereas net investment income taxes don’t. (1.45% of your self-employment tax is deductible on your tax return.)
Second, self-employment earnings may create an opportunity to contribute additional amounts to a pension plan which reduces your modified adjusted gross income, and later on, as noted, draws from a pension plan are not subject to net investment income tax.
The upshot of this detour? Small business owners may want to look to re-categorize income that would be subject to net investment income tax as income subject to self-employment tax. (You probably want to confer with your tax adviser for help with this, but basically what you’d do is look at the self-employment tax law contained in Internal Revenue Code Section 1402.)
Taxation of Pass-through Entities Like S Corporations and Partnerships
Businesses operating as S corporations and partnerships get some special tax breaks related to the net investment income tax.
If you own an S corporation or a share of an S corporation and you actively participate in the business (meaning you pass a material participation test in Treasury Regulation Sec 1.469-5T), you aren’t subject to net investment income tax on the income and any gains on disposition of property that’s derived in the ordinary course of the trade or business. (This will be the sort of stuff that appears on the K-1 you get from the S corporation.)
Example: Your family’s income exceeds the threshold before your income from an S corporation. Even though the S corporation allocates $100,000 of income to you via the K-1, you don’t pay any net investment income tax on that $100,000.
If you own share in a limited partnership and you’re a limited partner, many people think the same rule applies to you: In other words, that if you pass a material participation test in the regulations referenced earlier, you don’t owe net investment income tax on the income and gains derived in the ordinary course of business.
Example: Your family’s income exceeds the threshold before your income from a limited partnership interest in a partnership operating an active trade or business. You materially participate in the active trade or business. Even though the limited partnership allocates $100,000 of income to you via the K-1, you don’t pay any net investment income tax on that $100,000. Note that you probably also have a guaranteed payment from the limited partnership and this payment will be subject to self-employment tax.
Further, if you sell an interest in an S corporation or partnership and you’ve actively participated, you’re probably not going to owe much or any net investment income tax on the gain because much or all of the gain on the sale will be excluded from the net investment income tax. (This exclusion isn’t necessarily 100%, by the way. Some of the gain that occurs “inside” the S corporation or partnership may be subject to net investment income tax.)
Example: You sell an interest in a partnership or S corporation that generates $200,000 of gain and you’ve actively worked in the business. Even if the income shown on your tax return exceeds the threshold, you probably won’t pay net investment income tax or pay much tax on the $200,000 of gain.
A Final Bit of Clarification
If an S corporation or partnership invests in stocks or bonds or passive investments like real estate—the sort of stuff that would generate investment income if you owned it directly–that income and those gains will be subject to net investment income tax.
Whoever prepares the S corporation or partnership return, therefore, needs to do a good job of providing information about the net investment income earned by the entity and then passed through and allocated to the owners.