Tax Reform 2021 – Build Back Better: Proposed Changes to Increase Net Investment (NII) Income Tax on S Corporation Shareholders and Limited Partners

Congress is proposing to expand the scope of existing income subject to the Net Investment Income (NII) tax, which originated in 2013 under the Affordable Care Act. 

As the Joint Committee on Taxation notes in its analysis of the Build Back Better proposed tax legislation, a principal effect of this proposal “is that those S corporation shareholders, limited partners, and LLC members who currently are not liable for FICA or SECA tax (self-employment tax), respectively, on their pro-rata shares, distributive shares, and partnership income and gain, become subject to NII tax on this income and gain above certain income thresholds” beginning in 2022.  Where previously the tax applied to passive-type investment income, the proposal provides that high-income individuals will be subject to NII tax on net income or net gain even when they materially participate in a trade or business that generated the net income or net gain. Thus, more taxpayers will be caught by the new NII tax regime.  

As Table 6 on Page 79 of the Joint Committee on Taxation Report highlights, the current taxation of various types of income under FICA, self-employment tax (SECA), and NII tax regimes under current law is as follows:  

 

Type of Taxpayer FICA Self-Employment Tax (SECA) NII Tax No 3.8% Tax
Employees Wages      
S corporation shareholders - active Reasonable compensation     Distributive share in excess of reasonable compensation; net gain from sale of business property
General partners   Self-employment income    
LP, LLP, and LLC limited partners or members - active   Guaranteed payments   Distributive share of partners claiming limited partner exception from SECA; net gain from sale of business property
S corporation shareholders; LP, LLP, and LLC limited partners or members - passive     Distributive share; net gain from sale of business property  
Sole proprietors   Self-employment income    
Investors     Investment income and net gain from passive activities or trading businesses Investment income and net gain from active interests

 

The current proposal is designed to generally capture the income under the “No 3.8% Tax” column currently not subject to the current tax regime.  

Under the proposal, for individuals with modified AGI exceeding the “high-income threshold amount,” the NII tax of 3.8% would apply to the greater of “specified net income” or “net investment income” (as defined under present law).  Certain trusts will similarly be subject to the tax.  

For individual taxpayers, the “high-income threshold amount” is $500,000 in the case of a joint return or surviving spouse, $250,000 in the case of a married individual filing a separate return, and $400,000 in any other case.  

Specified net income is a new term under the provision.  It will include income derived in the ordinary course of a trade or business and is the sum of (i) gross income from interest, dividends, annuities, royalties and rents, (ii) other gross income derived from a trade or business, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property; it’s reduced by deductions properly allocable to such income.  

While intended to generally increase NII, the proposal appears to allow nonpassive losses to be used in the calculation of specified net income.  There is a limited income phase-in included in the proposal that reduces the impact of the tax based upon a ratio on the first $100,000 ($50,000 for marrieds filing separately) exceeding the applicable income.

The proposal also clarifies a few items regarding the determination of net investment income (and specified net income):

Wages received with respect to employment subject to FICA taxes are not subject to the NII.
Net operating losses are not included as a deduction properly allocable to net investment income.
Net investment income includes subpart F and GILTI inclusions in respect of stock of a CFC and QEF inclusions in respect of stock of a PFIC and codifies existing regulatory treatment of mark-to-market inclusions in respect of PFIC stock as net investment income.

If the proposed legislation passes in its current form, Section 1411 of the Internal Revenue Code will be a tiered tax regime for individuals based upon income earned; a taxpayer’s income level will determine if and how the tax applies.  

Income Earned Section 1411 Applicability
AGI < $250,000 Not subject to NIIT
AGI = $250,001 – $399,999 Subject to current NIIT rules
Modified AGI > $400,000 or $500,000

Subject to proposed NIIT rules

 

 

 

 

 

Like the new proposed surcharge tax discussed, this tax is scheduled to apply to tax years beginning after December 31, 2021.  For taxpayers looking to sell an active trade or business, this is another reason to close your transaction before December 31, 2021.

We will continue to monitor developments as these proposed changes move through the legislative process.  Additional articles and analyses will be provided in the coming weeks.  In the meantime, if you have any questions, please reach out to your Schneider Downs tax consultant or contact us at [email protected].    

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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