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.
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|Change in Revenues||9.4||15.4||16.9||18.4||19.8||21.1||22.3||23.8||25.2||26.6||79.9||198.9|
In addition to the individual income tax, high-income taxpayers face two taxes on certain types of income above specified thresholds. The first—the Additional Medicare Tax—is a 0.9 percent tax on 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 single and head-of-household filers. The 2.9 percent Medicare Hospital Insurance tax also applies to all wages and self-employment income; as a result, high-income individuals are subject to a total Medicare-related tax on wages and self-employment income of 3.8 percent.
The second tax faced by high-income taxpayers—the Net Investment Income Tax (NIIT)—is a 3.8 percent tax on qualifying investment income, such as interest, dividends, capital gains, rents, royalties, and passive income from businesses not subject to the corporate income tax. Taxpayers are subject to the NIIT if their modified adjusted gross income (MAGI) exceeds certain thresholds: $250,000 for married taxpayers who file joint returns, $125,000 for married taxpayers who file separate returns, and $200,000 for everybody else. (For purposes of the NIIT, MAGI is the total of adjusted gross income and income earned abroad, which is typically excluded from taxable income.) For some taxpayers, qualifying investment income is greater than the amount by which MAGI exceeds the applicable threshold; in such cases, the tax applies only to the excess MAGI.
For virtually all labor and capital income that is derived from the activities of sole proprietorships, general partnerships, and C corporations (businesses that are subject to the corporate income tax) and that is above the income thresholds, the combination of Medicare-related taxes and the NIIT results in a uniform 3.8 percent marginal tax rate. (The marginal tax rate is the percentage of an additional dollar that is paid in taxes.) That income includes the net profits of sole proprietors and general partners, which are subject to Medicare-related taxes, and the interest, dividends, and capital gains paid by C corporations to their bondholders or shareholders, which are subject to the NIIT.
Income generated by other forms of businesses—specifically, limited partnerships (wherein certain partners are not liable for the debts of the business in excess of their initial investment) and S corporations (which are not subject to the corporate income tax because they meet certain criteria defined in subchapter S of the tax code)—may be excluded from both taxes under certain circumstances. If a high-income taxpayer is a passive investor in such a business (that is, if he or she does not actively participate in its operations), his or her share of the firm's net profits is subject to the NIIT. Most limited partners and some S corporation owners are passive investors and thus fall into that category. But if a high-income taxpayer is actively involved in running such a business, as some limited partners and most owners of S corporations are, his or her 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.)
The Treasury Department has estimated that in 2013, 58 percent of S corporation income and 18 percent of partnership income was nonqualifying investment income. The Congressional Budget Office estimates that of the nonqualifying S corporation income, roughly three-quarters was received by S corporation owners who had incomes above the NIIT thresholds (approximately 600,000 taxpayers in 2012). Because the NIIT thresholds are not adjusted for inflation, the amount of nonqualifying investment income above those thresholds—an amount subject to neither the Additional Medicare Tax nor the NIIT—has grown faster than total individual income since 2012, and that pattern is projected to continue.
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 participation in the business's operations.
Effects on the Budget
The staff of the Joint Committee on Taxation estimates that implementing this option would increase revenues by $199 billion between 2019 and 2028. That estimate is subject to uncertainty. For example, it relies on CBO's economic projections of the economy over the next decade under current law, which are uncertain. In addition, it relies on projections of businesses' organizational structures, which were made more uncertain by recent changes to tax law. Also, the estimate reflects certain anticipated behavioral changes by taxpayers, and accounting for those behavioral changes adds more uncertainty to the estimate.
An advantage of this option is that it would allow businesses with different organizational structures to be treated in a more uniform way for tax purposes. Entrepreneurs would therefore be more likely to select the form of organization that best suited their business rather than the form that minimized their tax liability. The option would also reduce the incentive for high-income owners of S corporations to reduce their Medicare-related taxes by accepting a salary that is less than the value of the labor they contribute. Finally, it would encourage people to base decisions about actively participating in running an S corporation or limited partnership on whether such participation would strengthen their 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 the businesses that are affected by it. For example, if actively involved owners of an S corporation subject to the NIIT expanded their business, their after-tax return would be lower under this option than under current law. In some cases, it would probably be too low to justify the expansion. That argument implies that the NIIT should apply to fewer (or no) sources of income, not more.
An alternative approach would be to impose the Self-Employment Contributions Act tax (of which the Hospital Insurance tax is a part) and the Additional Medicare Tax on business income that is not subject to either the Additional Medicare Tax or the NIIT. In that scenario, 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, this option's goal of taxing business income more uniformly would be accomplished, and there would be no reason to subject that income to the NIIT. (See "Tax All Pass-Through Business Owners Under SECA and Impose a Material Participation Standard.")