The Net Investment Income Tax (NIIT) is a 3.8% tax on investment income for individuals, estates, and trusts with income above certain statutory thresholds. While the NIIT applies to a broad range of investment-related income, a key exception exists for income derived from an active trade or business. This distinction is critical for business owners, especially when selling their business.
Understanding the Net Investment Income Tax (NIIT)
The NIIT applies to the lesser of:
- Your net investment income.
- The amount by which your modified adjusted gross income (MAGI) exceeds the threshold amount for your filing status.
The MAGI thresholds are:
- Married filing jointly: $250,000
- Married filing separately: $125,000
- Single or Head of household: $200,000
- Qualifying widow(er) with a child: $250,000
Net investment income generally includes interest, dividends, capital gains, rental and royalty income, and non-qualified annuities. However, the regulations specifically exclude income from a trade or business that is not a passive activity.
The “Active” vs. “Passive” Distinction
For NIIT purposes, the central question is whether the income is generated from a “passive” or “active” business activity. The IRS uses the material participation rules under Internal Revenue Code Section 469 to make this determination.
- Passive Activity: An activity is considered passive if the taxpayer does not “materially participate” in the trade or business. Income from passive activities, such as gains from selling an interest in a business where you are a silent partner, is generally subject to the NIIT.
- Active Trade or Business: An activity is considered active if the taxpayer “materially participates” in its operations. Income derived from an active trade or business is exempt from the NIIT.
What is Material Participation?
You materially participate in a business activity if you are involved in its operations on a regular, continuous, and substantial basis. The IRS provides several tests to determine material participation. Meeting just one of these tests for a tax year is sufficient to classify your involvement as active.
Common tests include:
- Participating in the activity for more than 500 hours during the year.
- Your participation was substantially all the participation in the activity by all individuals for the tax year.
- You participated for more than 100 hours, and your participation was not less than that of any other individual.
How the NIIT Exemption Applies to a Business Sale
When you sell your business, the gain is generally treated as capital gain. The applicability of the NIIT to this gain depends on your level of involvement in the business.
Scenario 1: Sale of an Active Business
If you materially participated in the business you are selling, the gain from the sale is considered income derived from an active trade or business. As a result, this gain is not classified as net investment income and is exempt from the 3.8% NIIT.
Example:
You are the sole owner of an S corporation that you actively manage, working over 1,000 hours per year. You sell the business for a significant gain. Because you meet the material participation test, the gain from the sale is not subject to the NIIT.
Scenario 2: Sale of a Passive Business Interest
If you are a silent partner or do not materially participate in the business, your involvement is considered passive. The gain from the sale of your interest in that business is classified as net investment income and is subject to the 3.8% NIIT, provided your MAGI exceeds the applicable threshold.
Example:
You invested in a partnership but have no involvement in its day-to-day operations. You sell your partnership interest for a gain. Since you did not materially participate, this gain is considered passive investment income and will be subject to the NIIT.
Key Takeaway for Business Owners
For business owners planning an exit, the distinction between active and passive participation is crucial for tax planning. Proper documentation of your hours and activities is essential to substantiate your claim of material participation. By doing so, you can ensure that the gains from the sale of your active business are not subject to the additional 3.8% Net Investment Income Tax, potentially resulting in significant tax savings.