What Is a Non-Section 1411 Trade or Business?

The Net Investment Income Tax (NIIT) is a 3.8% tax under Internal Revenue Code Section 1411 applied to specific investment income for taxpayers whose income surpasses certain thresholds. The tax is calculated on top of regular income tax and applies to individuals, estates, and trusts with high income. It is levied on the lesser of the taxpayer’s net investment income or the amount by which their modified adjusted gross income (MAGI) exceeds a statutory threshold.

This article explains the exception for income from a “non-Section 1411 trade or business,” which allows taxpayers to exclude earnings from certain business activities from this tax. Understanding which business activities qualify for this treatment is part of tax planning for many individuals and business owners. The rules differentiate between income that is passively received and income earned through active involvement in a business.

Defining Net Investment Income

Net Investment Income (NII) is the base for the 3.8% tax and falls into three main categories. The first category is traditional investment income, which includes gross income from interest, dividends, annuities, royalties, and rents. These income types are included in the NII calculation by default.

A specific rule applies to rental income. Rents can be excluded if derived from a trade or business that is not a passive activity for the taxpayer. This distinction provides a path for real estate entrepreneurs to avoid the tax on their rental earnings based on their level of participation.

The second category is income from a trade or business classified as a passive activity, which captures profits from businesses where the owner does not materially participate. This category also includes income from the business of trading in financial instruments or commodities, regardless of the trader’s involvement.

The final category subject to the NIIT is the net gain from selling property, such as stocks, bonds, and investment real estate. An exception exists for gains on property held in a non-passive trade or business. If an owner sells assets used in an actively managed business, the gain may be excluded from NII.

The Material Participation Safe Harbor

To classify a trade or business as a non-Section 1411 activity, a taxpayer must demonstrate “material participation.” This concept, from Internal Revenue Code Section 469, provides seven tests to determine if an activity is non-passive. Meeting one of these tests for a tax year is sufficient to exempt the income from that activity from the NIIT.

• The 500-hour rule: An individual participates in the activity for more than 500 hours during the tax year. For example, a partner in a consulting firm who documents 600 hours of work for the year meets this standard.
• The “substantially all” participation test: The taxpayer’s participation constitutes nearly all of the participation in that activity for the year. This is useful for a sole proprietor who is the only person working in the business.
• The 100-hour rule: An individual materially participates if they participate for more than 100 hours, and no other individual participates more. This test prevents classifying an activity as passive when the taxpayer is the primary, though not sole, participant.
• The significant participation activity (SPA) test: An SPA is a trade or business in which an individual participates for more than 100 hours but does not otherwise meet a material participation test. If the taxpayer’s total participation in all of their SPAs exceeds 500 hours, they are considered to materially participate in each of those activities.
• The five-out-of-ten-year rule: A taxpayer is considered to be materially participating if they materially participated in the activity for any five of the preceding ten taxable years.
• The three-year personal service activity test: This applies to fields like health, law, or engineering. If the taxpayer materially participated in that personal service activity for any three prior taxable years, their participation is deemed material for the current year.
• The facts and circumstances test: This test requires the taxpayer to participate for more than 100 hours and demonstrate that their participation was regular, continuous, and substantial in relation to the needs of the activity.

Special Rules for Certain Activities

Certain business activities, such as real estate and financial trading, are governed by unique rules that operate alongside the material participation framework. These provisions address the distinct nature of specific industries.

Individuals in the real estate industry can qualify as a “real estate professional” to treat rental income as non-passive. To qualify, a taxpayer must meet a two-part test. First, more than half of their personal services performed during the year must be in real property trades or businesses, and second, they must perform more than 750 hours of services in those activities.

Qualifying as a real estate professional does not automatically exempt rental income from the NIIT. The taxpayer must also demonstrate material participation in their rental activities by satisfying one of the seven tests for their rental operations.

A different rule applies to the business of trading financial instruments or commodities. Income, gains, and losses from this activity are always considered net investment income. This is true regardless of the trader’s effort or time, so even if they meet a material participation test, the income is subject to the NIIT. This rule is a potential trap for active traders who might assume their involvement would shield their business income from the tax.

Grouping Activities and Tax Reporting

A strategic decision before filing a tax return is the grouping election, which can impact a taxpayer’s ability to meet participation thresholds. This election allows a taxpayer to treat multiple trades or businesses as a single activity for the passive activity rules.

Under Treasury Regulation 1.469, a taxpayer can group activities that form an appropriate economic unit. This is for individuals who may not meet a participation test for any single business but would if their hours were combined. For example, an owner of three separate restaurants might group them into one activity to aggregate their hours and prove material participation.

This grouping election is binding for future tax years and must be disclosed with the tax return for the year it is first established. Careful consideration is important due to the binding nature of the election.

The final step is to report NII on Form 8960, Net Investment Income Tax, which is filed with the annual income tax return. The form separates different types of investment income and allows for deductions of allocable expenses. Income from passive business activities is reported on Form 8960, while income from a non-Section 1411 trade or business where the taxpayer materially participates is excluded from the form.