Despite borrowing massive amounts of money, the government still needs to find ways to raise revenue to pay for new programs and spending. The current democratically controlled Congress is looking to potentially implement new social programs and a climate bill. As a way of funding these initiatives, they are considering an expansion of the Net Investment Income Tax (NIIT).
The NIIT is proposed to raise revenue since it is seen as politically more palatable, given that it typically only impacts a small group of wealthier taxpayers. Critics, however, say the plan in its current form would also hurt small family businesses.
History of Net Investment Income Tax (NIIT)
The Patient Protection and Affordable Care Act (ACA), as amended by the Health Care and Education Reconciliation Act of 2010, contained a provision that may have taken many taxpayers by surprise several years ago. The provision is known as the new NIIT.
Internal Revenue Code Section 1411 was enacted to help fund health care through a tax on certain sources of unearned income of individuals, estates and trusts. This new law took effect for tax years ending after December 31, 2012, and taxpayers have been dealing with the new tax for several years.
While many tax changes were enacted as part of the 2018 Tax Cuts & Jobs Act (TCJA), repeal or lessening of the Net Investment Income Tax was not part of it. Thus, the NIIT is still a burden for taxpayers to whom the Act applies, and a proper understanding of the law is important.
Net investment income falls into one of three categories and is generally made up of passive investment income. This includes interest, dividend, annuity, royalty, and rental income, unless those items were derived in the ordinary course of an active trade or business such as income from real estate professionals.
Capital gains from dispositions of property, other than property held in an active trade or business, are also subject to the tax. In addition, any income from a trade or business that is classified as passive activity is subject to tax. This would include income reported to you on a Schedule K-1 from the business activity unless you are an active participant in the business.
Who Pays NIIT Now?
Under the ACA, Internal Revenue Service Code Section 1411 imposes a 3.8 percent tax on a taxpayer’s net investment income. Investment income includes both passive sources like dividends, capital gains, interest, royalties and rents as well as passive business income.
The NIIT will apply to a taxpayer only if their modified adjusted gross income exceeds $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for unmarried taxpayers and heads of household. The amount subject to the tax is the lesser of a taxpayer’s net investment income or the amount by which modified adjusted gross income exceeds the threshold amount that applies. Thus, a taxpayer will not be subject to the additional tax on net investment income unless their modified adjusted gross income exceeds the respective threshold amount that applies to them.
Take, for example, a married couple with a modified adjusted gross income of $270,000 for 2018, of which $100,000 is net investment income. They would pay the additional tax on only the $20,000 amount by which their modified adjusted gross income exceeds their threshold amount of $250,000. That is because the $20,000 excess is less than their net investment income of $100,000. Thus, the couple’s net investment income tax would be $760 ($20,000 × 3.8%).
When it comes to the taxability of business income under the NIIT, because the law only captures passive business income, most owners of pass-through entities must pay the NIIT; however, active owners of S-corporations are exempt. Likewise, if someone qualifies as a real estate professional, their income is considered active and so their rental income is also exempt.
There are several types of income that are exempt from the net investment income tax. Items excluded from income for regular income tax purposes are generally also excluded from net investment income. This would include such items as tax-exempt interest, gains subject to the like-kind exchange rules and the excluded gain from the sale of your principal residence. Additional items of income not included in the definition of net investment income are distributions from qualified retirement plans such as individual retirement accounts and Roth IRAs, and wages and self-employment income.
Who Would Pay Under the New Proposed Law?
The current version of the House bill makes two major changes. First, the NIIT expands to capture all business income. Essentially, S-corporation shareholders, limited partners, and pass-through entity owners that are currently exempt would be impacted.
Second, when it comes to removing the exemption on this business income, the income threshold rises from $200k to $400k for single filers and from $250k to $500k for taxpayers filing jointly. The effect of this would be to exclude most business owners from the tax, but make filing more complex for those impacted.
Under the new rules, the Tax Policy Center projects that in 2023 the tax hike would fall on those in the top 1 percent of household incomes or those making approximately $885k or more. Further, even among the top 1 percent, more than 50 percent of the tax increase would be borne by the top 0.1 percent for those making $4 million and up.
Impact No Small Businesses
Overall, about 14 percent of taxpayers report some form of business income on their federal tax returns. The amount reported, however, is usually not a material amount for most as a percentage of their income. For example, only approximately 5.5 percent of taxpayers with reported business income had this as the source of 50 percent or more of their total income. As a result, the impact will be mostly on a small percentage of small businesses. At the same time, as business income is far more variable than employment income, someone could easily fall in and out of the tax range.
What can a taxpayer do to minimize the potential net investment income tax burden?
Several strategies do exist that can help minimize the overall effect of the tax. Investments in tax-exempt bonds or securities that are more capital appreciating versus dividend-paying can help reduce the exposure to the tax. Capital loss harvesting has always been a strategy to help reduce capital gains tax on any net capital gains a taxpayer may have but can be even more valuable now as it may also help reduce net investment income tax. Since income from passive activities is subject to the tax, an effort should be made to increase participation in an activity in order to make a passive investment non-passive in nature.
There are several strategies that can help reduce a taxpayer’s modified adjusted gross income, such as installment sales, Roth IRA conversions and Above-the-Line deductions and exclusions. Installment sales allow the taxpayer to spread the gain on the sale of an asset over a period of years rather than receive a lump sum. Since the gain is distributed over multiple years, income is lowered.
Unlike other qualified retirement plans, Roth IRAs have no minimum required distributions. This makes a Roth conversion an effective strategy for reducing a taxpayer’s modified adjusted gross income. Another way to decrease the modified adjusted gross income is to increase above-the-line deductions. These include items such as contributions to qualified retirement plans and IRA deductions, Health Savings Account deductions, and student loan interest deductions. Any additional strategies that will help to reduce modified adjusted gross income will also generally reduce a taxpayer’s exposure to the NIIT.
Conclusion
Overall, the House bill looks to raise the threshold of where the NIIT expansion applies by the type of income it captures. We will have to wait and see if there are changes as the bill makes its way through – if it even passes at all. No matter what happens, there will certainly be tax increases of some kind.
The enactment of the ACA will create additional tax burdens for taxpayers. Certain types of passive investment income will be subject to the 3.8 percent tax on net investment income. Taxpayers should consider the various strategies available to reduce both net investment income and modified adjusted gross income. Keep in mind that the NIIT will not apply unless a taxpayer’s modified adjusted gross income exceeds the applicable threshold amount. The NIIT is a reality for taxpayers, but proper planning may help to reduce or eliminate the potential tax burden it may create.
Content provided by LBMC tax professional Ben Alexander.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.
