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 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2023–
Decrease (-) in the Deficit -14.6 -22.1 -23.9 -24.2 -25.1 -25.9 -26.9 -27.8 -28.7 -29.7 -109.9 -248.9

Data source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2023.

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 those thresholds (bringing their overall Medicare tax rate to 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.

Income generated by certain types 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 actively involved in running such a business, as some limited partners and most owners of S corporations are, that person'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 is 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.