The expansion of the net investment tax would mostly target households earning $1 million or more

Looking for a politically palatable way to raise revenue to pay for reduced welfare spending and a climate bill, Senate Democrats are mulling a plan to expand the net investment income tax (NIIT). Predictably, critics say the plan will hurt small family businesses.

But a new analysis by the Tax Policy Center finds that in 2023, the burden of the House version of that tax hike would fall largely on the top 1 percent of households (those making $885,000 or more). More than half of the new tax will be paid by the top 0.1 percent, those making $4 million or more. Households making $1 million or more will pay about 85 percent of the expanded tax.

Who pays and who doesn’t

The NIIT of 3.8 percent was included in the Affordable Care Act of 2010 (ACA). Only applies to single filers making $200,000 or more or joint filers making $250,000 or more. The tax is levied on investment income such as interest, dividends, capital gains, rents and royalties, and, most importantly, business income, which the tax code treats as passive as opposed to active.

While many transit business owners are required to pay NIIT under current law, others do not. For example, active owners of S Corporations are generally tax exempt. There are more than 4.7 million of these businesses in 2017.

Similarly, real estate professionals do not have to pay NIIT on rental income.

Two big changes

The House bill would make two major changes. First, for high-income households, it would expand the tax to include all business income, whether or not the taxpayer is materially involved in the business, as long as that income is no longer subject to payroll taxes. In fact, S Corporation shareholders, limited partners, and other pass-through business owners who are now exempt will be affected by the NIIT.

Second, for this active income alone, the House bill would raise the income threshold to $400,000 ($500,000 for couples filing jointly). This would require two separate income thresholds, a feature that excludes the majority of business owners, but would also make filing more complicated (although those affected would likely have accountants doing the work).

High-income payers

Nearly 99 percent of households will be completely exempt from the new tax simply because they fall below that $400,000 threshold. TPC estimates that about 88 percent of the expanded NIIT will be paid for by the top 1 percent. About 54 percent will be paid by those in the top 0.1 percent.

The rest, about 12 percent, will be paid by those earning between about $372,000 and $885,000 (those between 95th and 99th income percentiles).

Trade group S charged: “NIIT expansion will raise taxes on small and family businesses.” Family owned? Often. small? Not necessarily. In 2005, the 0.3 percent of S Corporations with at least $50 million in annual income accounted for a quarter of all those firms’ earnings, according to my TPC colleague Donald Marron.

Effects on small businesses

Of course, we can argue endlessly about what a small business is. But we could probably agree that someone with an annual modified adjusted gross income of $1 million or more is not a struggling entrepreneur.

We know that about 14 percent of tax filers reported some business income on their federal tax returns, but only about 5.5 reported business income that accounted for at least half of their adjusted gross income. On average, business owners only report about $32,000 in business income. They will not have to spend time worrying about NIIT expansion.

We also know that about 85 percent of partnership and S Corporation income is earned by households making $200,000 or more, and half is made by households with $1 million or more in annual income. They may need to consult their accountants.

It remains to be seen whether the Congress will finally agree to the expansion of NIIT. But if it does, most family-owned small businesses won’t be completely affected.

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