The Net Investment Income Tax is Broader Than You Think

published 10 February 2024

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The 3.8% net investment income (NII) tax is broader than most taxpayers think. It applies to single filers with modified adjusted gross incomes over $200,000, joint filers with modified adjusted gross incomes (AGIs) over $250,000, and married people filing separately with modified AGIs above $125,000. There are many definitions of modified AGI under federal tax laws, but for this purpose, modified AGI is defined as AGI plus tax-free foreign-earned income. The NII tax, which is added to the regular income tax, is due on the smaller of NII, or the excess of modified AGI over the income thresholds.

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Trade or business income derived through a passive activity is also NII, provided that the business income isn’t otherwise subject to self-employment tax. The test for determining a passive activity is material participation. For this purpose, a trade or business qualifies as a passive activity if the taxpayer doesn’t materially participate in the activity. In other words, trade or business income from an activity can be NII and subject to the 3.8% surtax for those taxpayers who don’t materially participate in the activity. Conversely, trade or business income from an activity in which one materially participates does not constitute NII. This rule applies to income from activities engaged in directly by individuals and to pass-through income from LLCs, limited partnerships and S corporations.

A recent federal court case addressed the NII tax in the context of trade or business income. According to the United States District Court for the Western District of Wisconsin, a businessman with his hands in many ventures may have to pay the NII tax on his share of business profits from three companies if he can’t otherwise convince the court that he materially participated in the firms’ activities. The court is requiring him to submit proof that he devoted sufficient hours to each of the businesses to satisfy the significant participation test of the passive activity regulations (Senty, D.C. Wis. [pdf]).

Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and edits The Kiplinger Tax Letter and contributes federal tax and retirement stories to kiplinger.com and Kiplinger’s Retirement Report. Her articles have been picked up by the Washington Post and other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.