An expansion of the net investment tax would primarily target households earning $1 million or more

Senate Democrats are looking for a politically acceptable way to increase revenue to pay for a reduced Social Spending and Climate Act and are considering a plan to expand the Net Investment Income Tax (NIIT). Predictably, critics claim the plan would harm small family businesses.

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

Who pays, who doesn’t

The NIIT of 3.8 percent was incorporated into the Affordable Care Act (ACA) of 2010. It only applies to unmarried applicants earning $200,000 or more, or joint applicants earning $250,000 or more. The tax is levied on capital gains such as interest, dividends, capital gains, rent and royalties, and primarily on business income, which the tax code treats as passive rather than active.

While many pass-through business owners are required to pay the NIIT under current law, others do not. For example, active owners of S corporations are generally exempt from tax. In 2017, there were more than 4.7 million of these companies.

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

Two big changes

The House bill would make two major changes. First, for high-income households, it would extend the tax to all business income, whether or not the taxpayer has a material interest in the business, as long as that income is not already subject to payroll tax. Indeed, S Corporation shareholders, limited partners and other owners of pass-through businesses who are now exempt would be affected by the NIIT.

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

high-income payers

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

The remainder, about 12 percent, would be paid by those earning between about $372,000 and $885,000 (those between the ages of 95 and 95).th and 99th income percentile).

Trade group S Corp.org accused: “Expanding the NIIT would increase taxes for small and family-owned businesses.” Family-owned? Frequently. Small? Not necessarily. According to my TPC colleague Donald Marron, in 2005, 0.3 percent of S corporations with annual revenues of at least $50 million accounted for a quarter of all those companies’ revenues.

Impact on small businesses

Of course, we could 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 isn’t a struggling entrepreneur.

We know that about 14 percent of taxpayers reported some business income on their federal income tax returns, but only about 5.5 percent reported business income that made up at least half of their adjusted gross income. On average, business owners report only about $32,000 in business income. You don’t have to worry about the NIIT extension.

We also know that approximately 85 percent of partnership and S Corporation income was generated by households with annual incomes of $200,000 or more, and half by households with annual incomes of $1 million or more. They may need to check with their accountants.

It remains to be seen whether Congress will finally approve an expansion of the NIIT. But if this is the case, the vast majority of small family-owned businesses will remain completely unaffected.

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