Net Investment Income Tax (NIIT)

We got a new tax proposal on October 28th! And everything is different!

Net Investment Income Tax (NIIT) presents a big planning opportunity.

Nearly all of the changes we saw in the September 13th tax proposal are gone.  We can forget about updated tax brackets, the 25% maximum capital gains rate, the refundable child tax credit extension past 2022, the death of the back door Roth and the defective grantor trust, and edits to estate tax rules. It’s all gone!

Instead, based on our reading of the latest proposal, we are left with the following material changes to current tax laws:

  • Net Investment Income Tax (NIIT) on S Corp Profits – If MAGI exceeds $500,000 for a joint filer or $400,000 for a single filer, S Corporation profits will be subject to the 3.8% NIIT.  There is a phase-in range that creates some pretty interesting range calculation patterns.
  • High-Income Surtaxes – Taxpayers will be assessed a 5% surtax on any MAGI over $10 million and an additional 3% surtax on any MAGI over $25 million.  This surtax does not differentiate between ordinary or capital gains income.
  • Qualified Small Business Stock treatment – We go back to 50% rather than 100% capital gains excluded on the first $10 million.

Let’s discuss Net Investment Income Tax (NIIT) specifically, when does the 3.8% NIIT apply, and how is it calculated?

Here is an example.

Let’s assume you own a successful business, where you, as an employee of that business, collect a w2 wage via payroll that is considered reasonable by the IRS. In addition to that, either at the end of the year or throughout the year, you take out profits on top of that. Now, let’s put some numbers here; please understand this is a sample example only,

  • You are a single filer.
  • Your w-2 pay is $100,000
  • Your profit is $300,000

First, let us make sure that we understand what MAGI is and how to calculate it. Your modified adjusted gross income (MAGI) is your adjusted gross income (AGI) after considering certain allowable deductions and any tax penalties. It’s not a number you’ll find on your tax return — you have you calculate your MAGI yourself. For many taxpayers, the numbers are the same. Now that we got that out of the way, let’s get back to our example.

In that example, we see that the MAGI for this filer who is filing single is $400,000 because their MAGI does not exceed $400,000, they are not subject to 3.8% Net Investment Income Tax (NIIT). Let’s take this one step further, and say that the company had a great year, and at the end of the year, this business goes to file their tax returns, and they are pleasantly surprised (at least at first) that they had another $100,000 of net profits.

So really what they have here is $100,000 0f w2 and now $400,000 of profits, all we did here is add $100,000 of profits, and now the entire $400,000 is subject to the 3.8% Net Investment Income Tax (NIIT).  NOT just the extra $100,000 but the full $400,000 is subjected now to the 3.8% Net Investment Income Tax. We went from none of it being included at $300,000 to all of it being included at $400,000. For individuals that file jointly, it’s the same process, but the magic number is $500,000 vs. $400,000.

So what can you do, as an investor and a business owner, to try and minimize your tax exposure?

  • Make sure you review your income throughout the year and model the current and potential income changes and if it could subject you to Net Investment Income Tax. We do this quarterly with all of our clients to ensure we don’t have any surprises at the end of the year.
  • If the projections show that you most likely will be subject to Net Investment Income Tax, consider ways of lowering your income. One example would be creating a 401k plan for the company. Important to note, if you are the only employee or you and your spouse, consider creating a self-employed 401k plan. If you have employees, consider an actual 401k plan or possibly a SEP.
  • Consider opening an HSA account.

Many other strategies could be implemented, and these are to name a few. The bottom line is if you have a business and you are an S- corp not paying attention or not having the right team in place can potentially be a costly mistake.

Once again, this bill has not been passed; at this point, this is all hypothetical until it is signed into law. However, having the right tax strategy and the right team that is constantly monitoring your strategy for you has always been a wise decision.

If you have any questions or need further clarification, please don’t hesitate to reach out to us and schedule a call by clicking the button below.

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Information provided in this document is for informational and educational purposes only. To the extent any investment information in this material is deemed to be a recommendation, it is not meant to be impartial investment advice or advice in a fiduciary capacity and is not intended to be used as a primary basis for you or your clients’ investment decisions. It is not tax advice Always consult your financial advisor, accountant before making any investment or tax decisions.