Net investment income tax: C corporation shareholders who are also employees

By Terrance J. Pak, J.D., MBA, Irvin Calif.

Editor: Mark G. Cook, CPA, CGMA

Individual shareholders who are also employees of C corporations were dealt a blow with Chief Counsel Advice (CCA) 202118009, which addressed whether they are subject to the net investment income tax on dividends received from the corporation. Specifically, CCA 202118009 found that a taxpayer who was both a shareholder and an employee of the dividend-issuing corporation did not qualify for the exception to the net investment income tax for dividend income derived from a trade or business.

This discussion first provides a brief overview of the net investment income tax and describes what types of income are included as net investment income. The discussion next moves to a summary and analysis of CCA 202118009 and how the holding may have an impact for tax planners.

Overview of the net investment income tax

The net investment income tax, also known as the unearned income Medicare contribution tax, was introduced as part of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152. The net investment income tax affects individuals, estates, and trusts, for tax years beginning on or after Jan. 1, 2013. As its name suggests, the net investment income tax is a tax primarily assessed on taxpayers' unearned income; however, despite its name, the revenue raised by the net investment income tax does not go toward the Medicare trust fund but toward the general fund (see paragraph 6 of REG-130507-11). According to an April 28, 2021, Congressional Research Service Report, the Joint Committee on Taxation estimates that the net investment income tax will raise approximately $27.5 billion of revenue in 2021, and that the majority of the tax is paid by higher-income households (see Congressional Research Service, "The 3.8% Net Investment Income Tax: Overview, Data, and Policy Options" (April 28, 2021), available at

To determine whether a taxpayer owes any net investment income tax, the taxpayer must first determine his or her modified adjusted gross income (MAGI) and, second, determine how much, if any, net investment income was incurred for that year (Sec. 1411). The net investment income tax is equal to 3.8% of the lesser of the taxpayer's (1) net investment income for the tax year, or (2) the excess, if any, of the MAGI for the tax year over the "threshold amount" (Sec. 1411(a)(1)). The threshold amount varies depending on the taxpayer's filing status: $250,000 for joint returns and surviving spouses, $125,000 for separate returns, and $200,000 for all other individuals (Sec. 1411(b)).

As provided in Sec. 1411(c), net investment income consists primarily of the sum of the following three categories of income, reduced by any properly allocable deductions for each:

  1. Gross income from interest, dividends, annuities, royalties, and rents that is not derived in the ordinary course of an active trade or business;
  2. Gross income from a trade or business that is a passive activity or a trade or business of trading in financial instruments or commodities; and
  3. Net gain attributable to the disposition of nonbusiness property and property other than property held in a trade or business (Sec. 1411(c)).

As can be seen from these categories, net investment income does not include income earned from employment or self-employment.

Category 1 income, which is the primary subject of CCA 202118009's analysis, includes gross income from dividends (Regs. Sec. 1.1411-4). Dividends generally include any item treated as a dividend by the taxpayer for regular income tax purposes, including dividends from closely held C corporations. Importantly, dividends generated in the ordinary course of business, except for dividends earned on an active business's working capital, would not be included in Category 1 income (Secs. 1411(c)(2) and (3)).

A clear view into the IRS's position on dividends from closely held C corporations

The central issues in CCA 202118009 were as follows: (1) whether dividend income received by an individual shareholder from a C corporation, in which the shareholder is an employee, is subject to the net investment income tax; and (2) whether the conclusion is affected if the C corporation is a closely held corporation within the meaning of Sec. 469 as described in Sec. 465. The IRS concluded that the dividends were indeed subject to the net investment income tax, irrespective of the fact that they came from a corporation in which the shareholder was also an employee and that the corporation was closely held within the meaning of Sec. 469 as described in Sec. 465.

In the case described by CCA 202118009, the taxpayer was a shareholder of a C corporation. The corporation paid several of the taxpayer's personal expenses from corporate accounts, and these payments were later recharacterized as dividend payments to the taxpayer. At the time these dividend payments were issued, the taxpayer was an employee of the corporation and was involved in the day-to-day operations of the corporation's manufacturing trade or business. Additionally, CCA 202118009 also notes that the taxpayer appeared to own a majority of the corporation's shares, but the CCA falls short of confirming whether this was actually true.

The taxpayer contended that, because the taxpayer materially participated in the corporation's manufacturing trade or business as an employee, the dividend income that the taxpayer received was derived from the ordinary course of a trade or business and, thus, was not subject to the net investment income tax.

The Chief Counsel's Office rejected the taxpayer's argument, stating that, to qualify for the ordinary-course-of-a-trade-or-business exception, the dividend income must be derived in a trade or business conducted (1) directly by the taxpayer (or through a disregarded entity owned by the taxpayer) or (2) through a passthrough entity. The IRS concluded that "being a shareholder in a C corporation in and of itself is not a trade or business."

The Chief Counsel's Office further noted that a shareholder generally would not be able to "offset dividend income from a C corporation with any deductions for expenses the C corporation incurred in carrying on its business" because these expenses would not be properly allocable deductions under Sec. 1411(c)(1)(B). The Chief Counsel's Office reasoned that if the income was earned in the ordinary course of a trade or business, such expenses would be properly allocable deductions under Sec. 1411(c)(1)(B), which would clearly not be the proper result under Sec. 1411 or the tax law generally.

In addition, the Chief Counsel's Office found that Sec. 469(h)(i) did not change this result. Because C corporations, including closely held corporations, are not passthrough entities, income from them cannot qualify for the ordinary-course-of-a-trade-or-business exception to net investment income. Thus, even if the corporation is closely held and subject to the Sec. 469 passive activity rules, income from the corporation will be subject to the net investment tax even if the shareholder is treated as materially participating in the business for passive activity purposes.

Are there any exceptions?

The IRS's position in CCA 202118009 seemingly makes no room for a C corporation shareholder who wishes to qualify for the exception simply by virtue of the fact that the taxpayer is also employed by the corporation, regardless of what percentage of the corporation the taxpayer owns.

However, for the sake of illustration, suppose a taxpayer is the sole shareholder and sole employee of a C corporation, and all income earned by the corporation is through the efforts of the sole shareholder. Perhaps, in this case, it can be argued that the corporation's trade or business is conducted directly by the taxpayer. However, although such a position can certainly be taken, it still fails to address the IRS's argument regarding the inability of a shareholder to offset dividend income with any deductions for expenses the C corporation incurred. Maintaining the above position but failing to address this argument will most likely merit a challenge from the IRS.


Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-623-0478 or

Contributors are members of SingerLewak LLP.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.