Self-employment income may be included in an individual’s net investment income, or may raise modified adjusted gross income beyond the net investment income threshold.
Business owners may be able to reduce exposure to the net investment income tax by establishing a qualified retirement plan, and characterizing a portion of business earnings as pretax contributions to the plan.
The Columbia Management Learning Center is dedicating a series of blog articles to this important and timely “Navigating the New Tax Regime” topic.
Sam is a loyal, hardworking employee who earns a good wage and participates fully in his workplace 401(k) plan. But in order to earn a little extra income, he has turned his wood carving hobby into a money-making side business. How does his entrepreneurial endeavor affect his exposure to the net investment income tax (NIIT), and what might the business owner do about it?
Self-employed individuals and those who receive miscellaneous income that is reported on Form 1099-Misc need to understand that income from a trade or business will be included in net investment income (NII) if the business is a passive activity for the owner or he or she is in the business of trading in financial instruments. If the business activity is not passive, then most of the income will be excluded from NII. (A business owner would have to meet one of seven IRS tests to demonstrate material active participation, for example, working more than 500 hours during a year or, as a sole proprietor with no employees, providing the only activity in the business, regardless of number of hours). There is an exception for income from the investment of working capital. Working capital generally refers to capital set aside for the future needs of a trade or business. The investment of working capital can give rise to portfolio income that is considered NII.
On the flip side, income where the owner is actively involved in the business can increase his or her modified adjusted gross income (MAGI), which could cause the individual to exceed the MAGI threshold for NIIT purposes. Fortunately, small business owners can consider strategies that might help them lessen the potential impact of NIIT — which involve reducing their NII and/or MAGI — without altering their overall income.
First, as a way to reduce NII, a small business owner could increase his or her participation in the business in order to change passive income to active business income (which, for the most part, is excluded from NII).
Second, as a business owner with earned income, he or she would be entitled to establish a qualified retirement plan for the business — for example, a 401(k)/profit sharing plan, a cash balance defined benefit plan or even a simplified employee pension (SEP) IRA. Such plans allow participants (the small business owner in this case) to characterize some business earnings as pretax contributions to the plan, thereby currently lowering the business owner’s MAGI.
This strategy would be a viable option for Sam, thereby allowing him to not only make the maximum contribution to his employer’s plan, but also to his unrelated plan for his side business. For example, Sam could defer $17,500 of his salary to his employer’s 401(k) plan, and depending on the revenues from his business, contribute as much as $51,000 to his business’s SEP IRA plan.
Of course, investors should always consult their personal tax advisors and/or legal counsel before making any investment or financial planning decisions.
Related reading: Retirement plan design for the new tax regime
Next in this series:
- Trust accounts and net investment income tax
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