On February 9, 2016, the White House released President Obama’s fiscal 2017 budget, which proposes to eliminate the statutory gap that currently allows owners of pass-through businesses to avoid paying self-employment tax or net investment income tax on certain income (the Proposal). If Congress approves legislation adopting the Proposal, the Proposal would be effective for taxable years beginning after December 31, 2016.
Self-employed individuals are generally subject to tax on their “earnings from self-employment” under the Self-Employment Contributions Act (SECA) regime. Like its statutory analogue for employees, the Federal Insurance Contribution Act (FICA), the SECA tax includes two components: a limited 12.4 percent tax allocated to Social Security (capped at $118,500 in 2016) and an unlimited 2.9 percent tax allocated to Medicare, which increases to 3.8 percent for high-income individuals. Self-employed individuals, including general partners and sole proprietors, are required by statute to pay SECA taxes on all income other than investment income.1 Under the exception described in Section 1402(a)(13)2, however, an individual is not subject to SECA taxes on his or her distributive share of income received as a “limited partner” in a partnership, other than certain “guaranteed payments” for services.
Separately, under Section 1411, individuals with a modified adjusted gross income in excess of $200,000 for individual/head of household filers ($250,000 for joint filers) are subject to a 3.8 percent “net investment income” tax (the NIIT). Enacted as part of the Health Care and Education Reconciliation Act of 2010, the NIIT is intended to extend the 3.8 percent Medicare tax under FICA and SECA to include passive income, as compared to active business income. Although “net investment income” subject to the NIIT is broadly defined to include most interest, dividends, capital gains, income from trading in financial instruments or commodities and income from businesses in which an individual does not materially participate, it does not include all income exempt from taxation under SECA.
The Proposal is intended to close the gap between the SECA and NIIT statutory regimes that currently allow owners of partnerships and other pass-through entities to structure their businesses so as to mitigate the Medicare tax under both NIIT on their investment income and SECA on their business income, through two complementary steps.
First, the Proposal would amend the definition of “net investment income” for purposes of the 3.8 percent NIIT to include any “gross income and gain from any trades or businesses of an individual that is not otherwise subject to employment taxes.” The Proposal would effectively eliminate the ability of a limited partner (including a member of an LLC) or S corporation shareholder to avoid NIIT on income allocated in respect of a partnership interest or received from S corporation stock.
Second, the Proposal would subject individuals who materially participate in a “professional service business” to SECA taxes on their distributive share of the business’s income, regardless of the form of business entity. The Proposal would thus reconcile the dissimilar treatment currently afforded to owners of certain S corporations and partnerships. For purposes of the new rules, a “professional service business” would be defined as an entity taxed as a partnership or S corporation substantially all the activities of which involve the performance of services in certain enumerated fields (including investment advice or management). An owner would be treated as “materially participating” in such a business, if the owner were involved in a regular, continuous, and substantial way, with 500 hours as a general threshold of materiality.