The Net Investment Income Tax: Planning Opportunities for Small Business Owners

If you own an interest in an S corporation, partnership or LLC, it’s a good idea to review the potential impact of the net investment income tax (NIIT). There may be opportunities to reduce or even eliminate the tax.

How the tax works

The NIIT is a 3.8% tax on interest, dividends, annuities, rents, royalties, net capital gains and other investment income earned by high-income individuals (as well as trusts and estates). Several types of income are exempt, including income derived in the ordinary course of a trade or business that’s not a passive activity with respect to the taxpayer.

A high-income earner is an individual whose modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for joint filers, $125,000 for married filing separately). The tax applies to the lesser of your net investment income (NII) or the amount by which your MAGI exceeds the applicable threshold.

Planning opportunities

Whether income from a business is subject to the NIIT depends in part on whether you “materially participate” in the business. In some cases, increasing your participation may provide a tax advantage. Also, any income that’s considered self-employment income for self-employment tax purposes is not considered NII. 

IRS regulations set forth several tests for determining material participation. For example, you materially participate if you:

  • Participate more than 500 hours per year,
  • Participate more than 100 hours per year and as much as or more than any other person, or
  • Participate on a “regular, continuous and substantial basis,” based on all the facts and circumstances.

If you’re a partner in a partnership (including an LLC taxed as a partnership), your distributive share of the partnership’s business income, as well as any guaranteed payments for services, is considered self-employment income — and, therefore, exempt from the NIIT — regardless of your level of participation.

Certain types of partnership income aren’t considered self-employment income, including passive income (such as interest and dividends) and gain on the sale of a partnership interest. For this type of income, material participation may provide an advantage. If you materially participate: 1) your share of passive income the partnership earns in the course of its trade or business (as opposed to pure investments) is exempt from the NIIT, and 2) only a portion of your gain from the sale of your partnership interest will be considered NII.

Limited partners — including LLC members treated as limited partners — generally avoid self-employment tax (except on guaranteed payments for services). But typically they’re subject to the NIIT on their shares of partnership income. With careful planning, LLC members may be able to avoid the NIIT by increasing their participation in the business, but it’s difficult — if not impossible — to do so without triggering self-employment tax, which usually results in a heavier tax burden.

What if your business is structured as an S corporation? If you’re a shareholder-employee, and you receive reasonable compensation, you’re exempt from self-employment tax on your share of the corporation’s income. Plus, if you materially participate, you’ll also avoid the NIIT on your nonwage income.

Weigh your options

Partners, S corporation shareholders and, possibly, LLC members can avoid both self-employment tax and the NIIT on certain types of income by increasing their participation in the business. Your tax advisor can help you determine whether this strategy is right for you.

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