Expand the Base of the Net Investment Income Tax to Include the Income of Active Participants in S Corporations and Limited Partnerships

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 8.3 12.8 13.9 15.3 16.1 16.8 17.7 18.7 19.8 20.6 66.4 160.0

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

The Affordable Care Act of 2010 (ACA) includes two new taxes on income above specified thresholds. One of those—the "Additional Medicare Tax" of 0.9 percent—applies to wages and self-employment income in excess of $250,000 for married taxpayers who file joint returns, $125,000 for married taxpayers who file separate returns, and $200,000 for people whose filing status is "single" or "head of household." In combination with the Hospital Insurance (HI) tax of 2.9 percent, which predates the ACA and applies to all wages and self-employment income, high-income employees and self-employed individuals are now subject to a total Medicare-related payroll tax of 3.8 percent. The other new tax—the Net Investment Income Tax (NIIT) of 3.8 percent—applies to investment income such as interest, dividends, capital gains, rents, royalties, and other passive business income of taxpayers whose modified adjusted gross income (MAGI) exceeds $250,000 for married taxpayers who file joint returns, $125,000 for married taxpayers who file separate returns, and $200,000 for everybody else. If qualifying investment income is greater than the amount by which MAGI exceeds the applicable threshold, then the tax applies only to the excess MAGI.

In combination, the Additional Medicare Tax and the NIIT cover virtually all labor and capital income derived from the activities of sole proprietorships, general partnerships, and C corporations (those businesses subject to the corporate income tax). Net profits received by sole proprietors and general partners are considered earnings and are subject to the HI tax and the Additional Medicare Tax; and the interest, dividends, and capital gains paid by C corporations to their bondholders or shareholders are subject to the NIIT. Income generated by other forms of businesses, however, can escape both taxes under certain circumstances. In particular, income earned by people actively involved in limited partnerships (wherein certain partners are not liable for the debts of the business in excess of their initial investment) or in S corporations (which are not subject to the corporate income tax if they meet certain criteria defined in subchapter S of the tax code) falls into that category. If a taxpayer is a passive investor (not actively participating in the operations of such businesses), his or her share of the firm's net profits is subject to the NIIT. Most limited partners are passive investors and thus potentially liable for the NIIT. But if a taxpayer is actively involved in running such a business (as many owners of S corporations are), the taxpayer's share of the firm's net profits is not subject to either the Additional Medicare Tax or the NIIT. (If the taxpayer receives a salary from the firm, however, that income would be subject to the Additional Medicare Tax.)

This option would impose the NIIT on all income derived from business activity that is subject to the individual income tax but not to the Additional Medicare Tax, regardless of the business's organizational form or the taxpayer's level of activity. If implemented, the staff of the Joint Committee on Taxation estimates, the option would increase revenues by $160 billion between 2017 and 2026.

An advantage of this option is that, for tax purposes, it would treat businesses with different organizational structures in a more uniform way. Entrepreneurs would be more likely to select the form of organization that best suits the business rather than the form that minimizes their tax liability. The option would also reduce the incentive for high-income owners of S corporations to reduce their HI tax and Additional Medicare Tax by accepting a salary that is less than the value of the labor they contribute. Finally, decisions about actively participating in running an S corporation or limited partnership would be based on whether such participation would strengthen the business, not on whether it would avoid an additional tax liability.

A disadvantage of the option is that it would probably reduce total investment by businesses. Some investments may be attractive only if the organization is structured in a way that allows owners to avoid the NIIT. For example, two identical businesses—one organized as a general partnership and the other as an S corporation—could consider an expansion that would result in the same before-tax rate of return for each company. Under current law, the general partners whose income exceeds the specified thresholds must pay the Additional Medicare Tax, as well as the HI tax, on their profits. If that tax lowered the rate of return on an investment to less than it would have been if the partners had invested in 10-year Treasury bonds, the partners would buy bonds instead of expanding the business. Because the owners of the S corporation are not subject to the HI tax, the Additional Medicare Tax, or the NIIT, their after-tax income—after expansion—would be higher than the general partners would have received if they had also chosen to expand their business. However, if the owners of the S corporation were subject to the NIIT, the after-tax return they could realize by expanding the company would be the same as that the general partners would get with a comparable expansion, and the S corporation would also forgo expansion. That argument implies that the NIIT should apply to fewer (or no) sources of income, not more.

An alternative approach would subject net business income that is currently not subject to either the Additional Medicare Tax or the NIIT to the Self-Employment Contributions Act tax (of which the HI tax is a part) and the Additional Medicare Tax. In other words, the owners of all businesses except C corporations would be deemed self-employed and would be taxed in the same manner. If that approach was enacted, the goal of this option would be accomplished and there would be no reason to subject that income to the NIIT. (See Option 23.)