Tax Prior to the Health Care Act. Prior to the 2010 Health Care Act, wages were subject to FICA at the rate of 6.2% on the employer and 6.2% on the employee (although the employee rate was reduced to 4.2% in 2011 and 2012) up to a threshold amount of wages ($110,100 in 2012). The Medicare tax was imposed at the rate of 1.45% on both the employer and the employee with all wages being subject to Medicare. For those with net earnings from self-employment (
NESE), self-employment tax was imposed at the rate of 12.4% (reduced to 10.4% in 2011 and 2012) up to the annual threshold and 2.9% on all net earnings from self-employment tax with no threshold.
2010 Act – Impact on Medicare Tax January 1, 2013. The 2010 Health Care Act increased the Medicare portion of the self-employment tax by .9% (to 3.8%) on earnings (wages or net earnings from self-employment) in excess of $250,000 for taxpayers filing jointly and $200,000 for other taxpayers for tax years beginning after December 31, 2012. The Act also subjects investment income to the Medicare tax. This is the first time in history that investment income has been subject to the Medicare tax. As of January 1, 2013, the 3.8% Medicare tax is imposed on investment income to the extent that modified adjusted gross income exceeds $250,000/$200,000. For example, if modified adjusted gross income is $270,000 and investment income is $40,000 of that total, then $20,000 of the investment income will be subject to the Medicare tax.
Net Investment Income (
NII). NII includes interest, dividends, royalties, and rents other than those derived in the ordinary course of a trade or business that is not a passive activity and does not constitute trading in financial instruments or commodities. NII also includes any net gain attributable to the disposition of property other than that held in a trade or business in which the taxpayer materially participates. Items of interest, dividends, annuities, royalties, rents, and gains, which pass through a partnership, LLC, or S corporation to its owners will retain the character of investment income and be subject to the Medicare tax.
Sole Proprietorships. Business income of sole proprietors and owners of single member LLC’s who
materially participate in the business should be excluded from the definition of NII. Net gains from the sale of business assets for such owners should also be excluded. If an owner does not materially participate, income and net gains from sales of assets will be included and be subject to the tax. In addition, even if the income is not included in NII, to the extent the sole proprietor’s income exceeds $200,000/$250,000, the sole proprietor will be subject to the Medicare surtax on self employment income.
Estates and Trusts. For estates and trusts, the new Medicare tax applies to undistributed NII of the estate or tax that is subject to the highest tax bracket (income in excess of $11,350 in 2011). As a result, distribution planning will become even more significant in 2013.
Partnerships. A general partner’s distributive share of income is generally included as net earnings from self-employment. A limited partner’s distributive share of partnership income is generally excluded from NESE (unless the limited partner meets one of the IRS tests including the personal liability test, the authority test, or the 500 hour participation test). To the extent a partner’s distributive share is treated as NESE, such income will be subject to the additional Medicare tax on NESE. To the extent that a distributive share is not NESE, it is likely subject to the 3.8% Medicare tax.
S Corporations. Rev. Rul. 59-221 held that S corporation pass through income does not constitute net earnings from self-employment . A variety of cases have focused on whether S corporation earnings should be salary. To avoid a re-characterization of distributions as wages, shareholder employees should be paid reasonable salaries. Income passed through to an S corporation shareholder who materially participates should be excluded from NII. Shareholders who do not materially participate will be subject to the new 3.8% Medicare tax. Similarly, the net gains on sale or redemption of a
passiveshareholder will be included in NII and subject to the 3.8% Medicare tax.
Use S Corporations to Operate Business. For shareholders who materially participate in the business, it appears that such shareholders can avoid both the Medicare tax on earned income and on net investment income. The caveat is that such a shareholder should take a reasonable salary from the S corporation. For the materially participating shareholder, distributions will be exempt from both the self-employment tax on NESE and from the Medicare tax on NII. Net gains on the sale or redemption of the shareholder’s interest in the S corporation should also be exempt.
Elect S status for LLC. The member of an LLC classified as an S corporation who materially participates should be exempt from the self-employment tax and from the Medicare tax on NII. An S election can be made by filing Form 2553 with the IRS within 2 ½ months after the beginning of the tax year.
S Corporation as Member of LLC. Where the S corporation limitations on shareholder eligibility or one class of stock are an issue, an S corporation owned by the principals participating in the business may be a member of the LLC.
LLC with Corporation as Sole Manager. If the corporation is the sole manager, individual members of the LLC may qualify for the limited partner exception from the tax on NESE. Members who materially participate in the LLC should not be subject to the 3.8% Medicare tax on NII.
Limited Partnership with Sole S Corporation General Partner. If the corporate general partner has sole control (with certain exceptions subject to vote of limited partners), the limited partners should qualify for the limited partner exception to the tax on NESE unless they materially participate; however they may be subject to the Medicare tax on NII. The S Corporation general partner will have the ability to make distributions to its owners and potentially avoid both taxes.
Member Managed LLCs Should Only Be Used When All Members are Service Partners. A member in a member managed LLC has the apparent authority to contract on behalf of the LLC regardless of material participation or personal liability. Accordingly, a member manager will be treated as a general partner subject to the self-employment tax on NESE.