Employment and investment taxes
Income taxes are only a part of the picture, especially for successful investors, executives, and business owners. This means looking at employment taxes and the net investment income tax.
Earned income
The taxes on earned income that are used to fund Social Security and Medicare are called employment taxes because they apply to salaries, wages and bonuses. The Social Security tax on earned income is capped ($168,600 in 2024 and $176,100 in 2025), but the Medicare tax has no limit. Both employees and employers pay Medicare tax at a 1.45% rate until earned income reaches $200,000 (single) or $250,000 (joint), and then the employee rate share increases to 2.35% for a total rate of 3.8%.
The business income from sole proprietors and partners is generally self-employment income with some key exceptions, meaning self-employment tax is due on both the employee and employer share of the Medicare tax. You can take an above-the-line deduction for the employer portion of self-employment tax.
Investment income
The net investment income (NII) is designed to impose tax on investment income at a rate that is equivalent to the top combined employment tax rate. The 3.8% tax applies to NII to the extent AGI exceeds $200,000 (single) or $250,000 (joint). NII includes rent, royalties, interest, dividends and annuities. There is an exception if the income is derived in the ordinary course of a trade or business in which you are not passive. On the other hand, all income from businesses in which you are passive is regarded as NII regardless of the type of income. In addition, income from trading in financial instruments is always NII.
Business owners
It’s important to consider the employment taxes and NII together, particularly for business owners. If you have to pay employment or self-employment tax on a stream of income, it is not included in NII. You never have to pay both taxes on the same income. Self-employment tax provides a better result because of the deduction for the employer share of tax. There may be limited situations in which neither tax will apply.
Owners of S corporations who are not passive in the business must take a reasonable salary and pay employment tax on wages, but they otherwise may not face self-employment tax or NII on their pro rata share of income of the S corporation.
The treatment of partners for self-employment taxes is more complex and is one to which the IRS is giving increased scrutiny. The issue revolves around an exception from self-employment tax under Section 1402(a)(13) for the distributive share of partnership income of a “limited partner.” Partners can potentially avoid self-employment tax on their distributive share of partnership income if they can establish that they are limited partners. But for this position to benefit the partners, they would also need to exclude their income from the NII tax by being active in the business.
Since the Tax Court ruled in favor of the IRS in Renkemeyer, Campbell, & Weaver, LLP v. Commissioner (136 T.C. 137) in 2011, it has become much more difficult for taxpayers to argue that they are both limited partners in a partnership while also being active enough in the business to avoid passive treatment. The Tax Court analysis established in Renkemeyer looks less at legal liability and more at whether activities the partner engages in are consistent with the general concept of a “limited partner.” The Tax Court has applied this analysis to LLCs and other entities organized as a partnership, and has recently reached an initial decision affecting entities that are established as limited partnerships under local law.
The Tax Court in late 2023 reached summary judgment in Soroban Capital Partners LP v. Commissioner, holding that it is not enough just to be considered a limited partner of a limited partnership under local law. The Tax Court held that the determination of eligibility for the limited-partner exception requires a “functional analysis test to determine whether a partner in a state law limited partnership is a ‘limited partner,’ as such.”
There are still several outstanding cases, and the Tax Court has not yet applied such a functional analysis. This is an evolving area of law, and taxpayers in similar situations should consider the issue carefully, particularly partners in a private equity partnership.
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