In light of the Patient Protection and Affordable Care Act1 and the Health Care and Education Reconciliation Act of 2010,2 small and family owned businesses have been reevaluating choice of entity considerations. This article summarizes the most common business entity forms and some of the major tax consequences of each in light of these new laws.
Changing Tax Landscape
Net Investment Income Tax (“NIIT”)
Since Jan. 1, 2013, a new 3.8% Medicare Surtax has been imposed on the lesser of a taxpayer’s “net investment income” or any income over certain threshold amounts.3 In general, net investment income includes portfolio-type income and income from passive activities.4 Under Internal Revenue Code §469,5 business activities are treated as passive activities unless the taxpayer “materially participates” in the activity.
With respect to pass-through entities such as S corporations, partnerships and limited liability companies taxed as partnerships or sole proprietorships, the determination of “material participation” is made at the individual or shareholder level, rather than the entity level.6 This means that items of income from pass-through entities may be active income to some owners and passive income to others.
Increased Medicare Taxes
Beginning in 2013, the employee portion of the Medicare tax, and the reciprocal Medicare tax imposed on self-employed persons, increased by 0.9% on compensation income in excess of the threshold amounts.7 The entire burden of the increase falls on the employee and self-employed persons, not on employers. (Employers and employees share equally the initial 2.9% Medicare tax imposed on wages, while self-employed persons obviously bear the entire burden of the maximum 3.8% Medicare tax). Thus, with these Medicare tax law changes, passive investment income and compensation income generally bear the same rate of Medicare tax above the threshold amounts.
Change in Tax Rates
With the expiration of certain tax breaks at the end of 2012, the top corporate rate became lower than the top individual rate for the first time since 2003. The top individual tax rates for 2015 are 39.6% for ordinary income and 20% for long term capital gains and qualified dividends. For corporations, the top tax rates for 2015 are 35% for both ordinary income and long term capital gains.
Choice of Entity
In light of the changes in the taxation of both individuals and corporations, a taxpayer can minimize his or her tax burden by carefully choosing the type of entity for a business.
For C corporation shareholders, the NIIT applies to all dividends paid to shareholders, as well as any gain a shareholder recognizes from the sale of his or her stock, regardless of the level of participation the shareholder has in the company. Furthermore, the NIIT applies to all income from a C corporation, even if the corporation’s business activities are active with respect to a particular shareholder.
Self-employment tax is not assessed on dividends paid to a shareholder from a C corporation or to any gain on the sale of stock. If a shareholder is also employed by the corporation, that shareholder’s earnings will be subject to the NIIT.
Although C corporations are taxed at a relatively lower rate when compared to individuals in the top bracket, typically this advantage is outweighed by the increased tax burden at the shareholder level. A corporation is subject to tax at a top rate of 35% on its earnings at the corporate level, and when the earnings are distributed to the shareholders in the form of a dividend, the earnings are taxed again at the shareholder level at the shareholder’s individual rate. With the added NIIT imposed on corporate dividends, every dollar a shareholder receives from a corporation will be taxed at rate as high as 35% and then again at the individual’s rate plus the 3.8% NIIT for high-income shareholders.
S corporations are pass-through entities for tax purposes and the NIIT applies to a shareholder’s distributive share of S corporation income allocated to the shareholder, but only to the extent the income comes from a passive activity, from trading in financial instruments, or is generated by the corporation’s investments. Because the material participation test is applied at the shareholder level, if a shareholder materially participates in the corporation (i.e., by being a shareholder as well as an employee of the corporation), his or her distributive share of the corporation’s income is not subject to the NIIT.8
Provided the S corporation pays its shareholder-employees a reasonable salary, a shareholder-employee’s share of the S corporation’s income is also not subject to the Medicare self-employment tax. Note however, any wages will be subject to employer and employee Medicare taxes that equate to having to pay the self-employment tax on that amount.
LLCs and Partnerships
For partners and members of LLCs taxed as partnerships, the treatment of income for NIIT purposes depends on whether the business is passive with respect to the owner and whether the owner is treated as a “limited partner.” Income that flows through to a partner is subject to the NIIT if it is derived from partnership activity that constitutes a passive activity with respect to the partner, income from trading in financial instruments, or income from the partnership’s investments. However, if a partner materially participates in the partnership’s business, the NIIT generally does not apply to any of the partner’s share of income from the partnership.9
However, a partner who materially participates in a partnership will likely be subject to the self-employment tax on the partner’s entire distributive share of the partnership’s income.10 Thus, in the case of partnerships, a partner with income above the threshold amount will be subject to the 3.8% Medicare tax on income above the threshold amount allocable from the partnership regardless of whether the partner materially participates in the partnership.
Most family businesses will choose to operate as either an S corporation, a partnership or an LLC taxed as partnership or as a sole proprietorship. With the enactment of the NIIT, the S corporation has emerged as a stronger competitor to the previously favored partnership and LLC for business owners who plan on actively participating in the business. An S corporation shareholder-employee can likely avoid both self-employment tax and NIIT on the shareholder’s distributive share of income (after being paid a reasonable salary), while a partner will likely be subject to one or the other of the Medicare taxes on all income derived from the business. Thus, in certain cases, particularly in cases involving a service business in which the owners will materially participate and capital assets are not an important part of the business, use of an S corporation may be preferable to utilizing an LLC or a partnership.
1 Pub. L. No. 11-148 (2010).
2 Pub. L. No. 111-152 (2010).
3 I.R.C. §1411(a)(2); The threshold amounts are $250,000 in the case of married individuals filing jointly, and $200,000 for taxpayers filing individual returns. I.R.C. §1411(b). There is no cap on the amount of income subject to the tax. Furthermore, the threshold amounts are fixed and are not indexed for inflation.
4 Specifically, “net investment income” is defined as the excess, if any, of: (1) gross income from interest, dividends, annuities, royalties, and rents, other than income generated in the ordinary course of a trade or business; (2) gross income from a trade or business that constitutes a passive activity under §469 or consists of trading financial instruments or commodities; (3) net gain (that is included in income) that is attributable to the disposition of property, excluding property held in a trade or business that does not constitute a passive activity under §469 or that does not consist of trading financial instruments or commodities. I.R.C. §1411(c).
5 All section references are to the Internal Revenue Code of 1986, as amended, or to Treasury Regulations proposed or promulgated thereunder.
6 Treas. Reg. §1.469-4(d)(5)(ii).
7 §3101(b)(2); §1401(b)(2).
8 I.R.C. §§469, 1411(c)(2)(A).
9 Except to the extent the partner receives guaranteed payments.
10 The only exception to this rule is for a “limited partner,” in which case self-employment tax will only be assessed on guaranteed payments to the limited partner for services rendered to the partnership, rather than the partner’s entire distributive share of income. The code sets forth a maximum level of participation a partner can have in a partnership in order to qualify as a “limited partner” for self-employment tax purposes. This maximum limitation of activity likely does not rise to the level of “material participation” for NIIT purposes; therefore, a partner’s income generally cannot be exempt from both self-employment tax and NIIT.