The IRS claims that his 2013 return is wrong. The IRS wants to charge him nearly $500 for the 3.8% “net investment income tax” imposed under section 1411 of the Internal Revenue Code, as enacted by section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010, Public Law no. 111-152 (March 30, 2010).
Here is the only explanation provided by the IRS in the computer-generated notice:
The Health Care and Education Reconciliation Act of 2010 added a Net Investment Income Tax (NIIT) for tax years 2013 and subsequent [years]. The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates, and trusts. In general, net investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, and income from businesses in which the taxpayer is not an active participant.
The 3.8% tax applies when you have investment income and your modified adjusted gross income exceeds the following:
$200,000 for single or head of household[;]
$250,000 for married filing jointly or qualifying widow(er)[;]
$125,000 for married filing separately[.]
Since we changed your investment income, we also changed the amount of Net Investment Income Tax due.
No explanation of specifically what item of “investment income” was changed, or why it was changed. No amount given for the amount of the change in “investment income.” No showing of any calculation used to arrive at the amount of the tax supposedly owed.
The client is an attorney practicing law as a partner in a law firm partnership. It is not a limited partnership. He receives a K-1 schedule from the partnership, and he incurs and pays self-employment tax with respect to the income.
Of course, I ran the numbers and it turns out that I come up with exactly the amount of the tax that the IRS says is owed if I treat his K-1 income from the partnership as being subject to the Net Investment Income Tax.
This is clearly erroneous.
The IRS is erroneously treating his law firm income as “section 1411 trade or business income” -- as income from a business in which the taxpayer is not an active participant.
Yet, clearly, he is an active participant. And his 2013 return shows that he is paying self-employment tax on that very income -- including the section 1401(b) tax. Under section 1411(c)(6), “net investment Income” does not include any item of income taken into account in determining self-employment income for a year for which a section 1401(b) tax is imposed.
Further, nothing in his return indicates or implies that the trade or business of the law firm is a “passive activity” within the meaning of section 469. And nothing in the return indicates that the trade or business of the law firm involves “trading in financial instruments or commodities” as defined in section 475(e)(2). The trade or business of the law firm cannot be a business “described” in section 1411(c)(2) which, in turn, means that his share of the law firm income cannot be “net investment income” as that term is used in section 1411(c).
Thus, he has not incurred the NIIT for 2013.
Thus, the IRS is wrong.
And some people think federal income tax isn’t fun!