Partners' income allocations and the new net investment income tax.

• Author: Taptelis, Louis

Starting in 2013, the Patient Protection and Affordable Care Act, Pi. 111-148, and the Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (health care acts), impose a new 3.8% income tax on net investment income (less applicable expenses) for high-income individual taxpayers. Since the U.S Supreme Court upheld the constitutionality of the health care acts (National Federation of Independent Business v. Sebelius, Sup. Ct. Dkt. 11-393 (U.S. 6/28/12)). It is important for owners of business entities structured as partnerships to consider their income streams and the tax effect on partners who are taxed as individuals. In particular, these partnerships may be in a position to arbitrage between the net investment income tax and self-employment (SE) tax for, their partners and potentially limit the effect of both taxes by altering the partnership's legal structure.

Background on Self-Employment Taxes

Many self-employed individuals and partners in a partnership are subject to the SE tax for "net earnings from self-employment" under Secs. 1401 and 1402. SE tax generally has two main components: (1) a 12.4% tax for "old age, survivors, and disability insurance" (Social Security tax); and (2) a 2.9% tax for "hospital insurance" (HI, or Medicare, tax). An annual cap limits the amount of income subject to the 12.4% Social Security portion of the SE tax ($113,700 for tax year 2013), but the cap does not apply to the 2.9% HI tax. To put partnerships on an equal footing with corporate employers, partners who are individual taxpayers may deduct 50% of both parts of the SE tax from gross income in determining their federal income tax liabilities; this deduction excludes the new 0.9% additional Medicare contribution tax on earned income for certain higher-income individual taxpayers.

This item does not focus on general income tax rules or the 12.4% Social Security portion of SE tax, but instead discusses the HI portion (including the 0.9% additional Medicare tax) and the net investment income tax and their effect on partners. The examples below focus on that part of the SE tax and on the net investment income tax.

Net Earnings From Self-Employment

Sec. 1402 generally states that, in determining net earnings from self-employment, a partner must include his or her distributive share of partnership ordinary trade or business income (subject to some exclusions for rental real estate income, interest, dividends, capital gains, etc.).

Example 1: Partner A, with adjusted gross income (AGI) in excess of $1 million, is a one-third partner in ABC general parmership and receives an ordinary trade or business distributive share allocation of...