With the imposition of a new 3.8% “net investment income tax” (the “NIIT”) pursuant to Section 1411 of the Internal Revenue Code of 1986, as amended (the “Code”) on passive income and the imposition of an additional .9% on the uncapped Medicare portion of the self-employment tax under Section 1401 of the Code (the “SET”) beginning in 2013, individuals who act as private equity and hedge fund managers or advisors have been searching for ways to prevent the application of the NIIT and the SET to their distributive shares of the income from the fund. While certain fund managers may be able to escape the imposition of the SET on partnership income, the analysis is complex, and there is significant uncertainty with respect to how the Internal Revenue Service (“IRS”) and courts will interpret the relevant statutory provisions. However, it is clear that if income is subject to the SET, it will not be subject to the NIIT and vice versa. The following is a general overview of how the NIIT and SET could apply to individual fund managers, and does not purport to be an exhaustive analysis of the subject.
TAX ON SELF-EMPLOYMENT INCOME -
The SET has two components: a 12.4% tax on income from self-employment up to a cap, and a 2.9% tax on self-employment income that is uncapped. Self-employed individuals can deduct one-half of their SET in calculating adjusted taxable income. Starting in 2013, the SET applies to self-employment income at a rate of 3.8% for income over a “threshold amount.” The threshold amount is $250,000 for a joint return, $125,000 for a married taxpayer filing separately, and $200,000 for a single return. Notably, the additional .9% tax is not deductible for income tax purposes.
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