Under current law, limited partners who materially participate in a partnership’s business are not subject to self-employment tax. Members of an S corporation who materially participate in the S corporation’s business are subject to self-employment tax only on “reasonable compensation” received in their capacity as an “employee”. These individuals are also exempt from the 3.8% Medicare or “net investment income tax,” (NIIT) which currently applies only to certain passive income and gains.
The Biden Administration believes that the NIIT reflects an intention to impose the 3.8% tax on both earned and unearned income of high-income taxpayers. However, due to certain complexities in the tax rules, certain income escapes both self-employment tax and the NIIT. The complexities of the current tax system present an administrative challenge for the Internal Revenue Service (IRS). For example, the determination of “reasonable compensation” of S corporation members generally depends on facts and circumstances and requires a valuation analysis, which is expensive, and which can be contested by the taxpayer, adding to the cost of administration and enforcement. Uncertainty surrounding the treatment of limited partners and LLC members who materially participate in their businesses undermines the IRS’s ability to ensure payment of the self-employment tax.
In order to earn more tax dollars and to simplify the system, beginning in tax years after 2021, President Biden’s Greenbook proposes to subject all trade or business income of individuals earning over US$400,000 to either self-employment tax or NIIT.
Let’s review some basics:
What is Self-Employment Tax? How Does it Impact the American Abroad?
The self-employment tax is a social security and Medicare tax based on net earnings from “self- employment”. The dollar threshold trigger for paying self-employment tax is quite low – you must pay self-employment tax if your net earnings from self-employment are at least US$400. The self-employment tax rate is 15.3% imposed on the net earnings. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
If you are a “self-employed” US citizen or US resident, the rules for paying self-employment tax are generally the same whether you are living in the United States or living and working overseas. The mere fact that the parties label their relationship as an “employer-employee” relationship will not be determinative. If, in substance, the worker is an independent contractor (self-employed), he will be treated as such by the IRS and self-employment tax will be assessed. Obviously, this can get tricky when one is working overseas since the local employment laws and rules may have an impact on the situation. If there is any doubt as to your status, you should seek competent US taxation advice.
US taxpayers working abroad must note that all of the taxpayer’s self-employment income must be taken into account in figuring net earnings from self-employment, even income that is exempt from income tax because of the foreign earned income exclusion (FEIE). In other words, the FEIE does not reduce the taxpayer’s self-employment income for purposes of figuring the self-employment tax. Here’s an example, assume T is in business for himself in Dubai and runs a sole proprietorship providing consulting services. Assume his net earnings from self-employment are US$208,700. For income tax purposes, T can reduce his taxable income by the FEIE amount (for tax year 2021, the FEIE is US$108,700), meaning only US$100,000 will be subject to income tax. However, in determining his self-employment tax, T cannot use the FEIE amount to reduce his self-employment income. In this example, US$208,700 will be subject to the 15.3% self-employment tax.
What is the NIIT / 3.8% Medicare Surcharge?
The NIIT is, broadly speaking a 3.8% surtax on “net investment income”. It applies only to certain high-income individuals. We will discuss very soon, precisely to whom the NIIT applies.
What is Net Investment Income?
Net investment income must be distinguished from “earned” income (earned income is earned through one’s labor or services or because one is actively involved in a partnership or business). Investment income includes interest, dividends, capital gains, annuities, royalties and passive rents as well as income from businesses, such as trading of financial instruments and commodities and businesses that are considered “passive” with respect to the taxpayer.
The NIIT does not apply to distributions from qualified retirement plans (e.g., an employer-sponsored defined benefit plan, profit sharing plan, Employee Stock Ownership Plan, or so-called 401(k) plan and others) or distributions from an IRA. It also does not apply to payments made on a tax-exempt municipal bond. These NIIT exemptions make good economic sense. Congress does not want to discourage taxpayer’s from investing in their own retirement planning and it does not want to discourage taxpayers from investing in municipal bonds, since these debt obligations which are issued by states, cities, counties and other governmental entities, use the money for projects such as building schools, roadways, and other projects for the public welfare.
Who is Subject to the NIIT?
Not everyone is subject to the NIIT. A taxpayer must meet two basic requirements for the NIIT to apply. The taxpayer must have 1) Net Investment Income and 2) modified adjusted gross income (“MAGI”) over certain applicable thresholds. The thresholds are set out in the chart, below. Significantly, the thresholds are not indexed for inflation. Even if you are exempt from Medicare taxes, you may still be subject to the NIIT. Very simply, NIIT applies if you meet 1 and 2, above.
Individuals will owe the tax if they have Net Investment Income and also have MAGI over the following thresholds:
|Filing Status||Threshold Amount|
|Married filing jointly||$250,000|
|Married filing separately||$125,000|
|Head of household (with qualifying person)||$200,000|
|Qualifying widow(er) with dependent child||$250,000|
No NIIT for Nonresident Alien Individuals
Nonresident alien individuals are specifically exempt from the 3.8% NIIT. This is important, for example, for the nonresident alien individual owning investments or properties in the US and earning passive rents, dividends or capital gains with respect to the properties. Specific rules apply for dual-status individuals and those making a special election to be treated as a US “resident” for tax filing purposes. The IRS FAQ at number 5 gives further information. It can be accessed here.
Special Considerations for Overseas Americans or Those with Foreign Shareholdings
Calculating MAGI for purposes of the NIIT
The 3.8% NIIT is imposed on the lower of the taxpayer’s net investment income or the excess of MAGI over the income thresholds. Generally, MAGI is adjusted gross income with certain tax deductions added back into the number. You will not find MAGI on your tax return; it must be separately calculated. For Americans overseas to determine MAGI, they must add back all foreign earned income / foreign housing amounts that were excluded under the FEIE rules. In the case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their adjusted gross income.
Foreign Tax Credits Cannot Offset NIIT
Sadly, foreign tax credits cannot offset the NIIT due to a very technical reason reflecting how the US Internal Revenue Code is structured. All is not lost, however. If foreign income taxes are taken as an income tax deduction on the tax return, as opposed to taking them as a tax credit, some (or all) of the deduction amount may be deducted against the taxpayer’s net investment income. This is a matter to be carefully examined with your tax return preparer.
Posted July 1, 2021
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