Insight The S Corporation Loophole in the 2013 Medicare Surtax and Disregarded Entity Owners

Compensation and distributions from an S corporation are both considered income on which an individual will pay income tax. But since 1959, S corporation distributions to owner-employees have not been subject to payroll taxes, as long as the owner-employee’s compensation was reasonable for the services rendered. With the introduction of the Medicare Surtax and an additional 0.9additional Medicare payroll tax in 2013, an S election will further reduce tax liability for business owners who materially participate in the day-to-day business of the S corporation. This article will discuss whether converting to an S corporation may be appropriate for your business.

Medicare Surtax

Beginning this year, a new 3.8% Medicare Surtax will be imposed on the lesser of net investment income or any excess over certain modified adjusted gross income thresholds. I.R.C. § 1411. For an individual, the thresholds are $200,000 for single individuals, $250,000 for married individuals filing jointly, or $125,000 for married individuals filing separately. The Medicare Surtax is also imposed on trusts and estates. I.R.C. § 1411(a)(2).

What is Net Investment Income?

Net investment income means income such as interest, dividends, distributions, annuities, royalties, and rents. Generally, net investment income comes from a business or trade activity in which the taxpayer does not “materially participate” – meaning the taxpayer is not involved in the operations of the activity on a regular, continuous, and substantial basis. I.R.C. § 469(h).

S Election Loophole for Owner-Employees

S corporation distributions to owner-employees are not considered net investment income, where the owner-employee materially participates in the day-to-day business of the S corporation (Material Participation Loophole). I.R.C. §§ 469, 1411(c)(2)(A). This means that distributions of S corporation earnings to an owner-employee are not subject to the Medicare Surtax, regardless of the owner-employee’s modified adjusted gross income. In contrast, both wages and distributions to an owner-employee of a business taxed as a partnership are subject to payroll taxes and the Medicare Surtax.

Who Can Be an Owner-Employee?

An S corporation must comply with technical restrictions on form and ownership. The S corporation must be a domestic entity (corporation, partnership, or single or multi-member LLC) with only one class of stock (or interest) and no more than 100 owners. Owners may only be: individuals, estates, certain trusts, or exempt organizations. Notably, partnerships and corporations cannot be owners of an S corporation. And owners must be U.S. citizens or residents. Complying with the technical ownership requirements is critical – an S election is automatically terminated if any of these requirements are violated, and the business will be prohibited from making another S election for 5 years without IRS consent.

Reasonable Compensation Requirement

Recall the taxpayer-favorable treatment of distributions in S corporations, discussed above. This tax advantage leads many S corporation owner-employees to bifurcate their earnings from the business – allocating as little as possible to compensation and taking larger distributions. Be forewarned that the IRS may be able to recharacterize distributions into payroll taxable compensation where the wages paid are not reasonable relative to the services rendered by that shareholder-employee. In addition, bear in mind that lower wages today may mean lower social security benefits down the road.

An Example

Imagine Paul and Chris own a successful restaurant business. Paul is a passive investor and Chris is the head chef in the restaurant. The restaurant pays Chris a salary of $180,000 a year, a reasonable wage for his services. After paying all of its other operating expenses, the restaurant has $100,000 in net income to distribute to Paul and $140,000 to distribute to Chris. Regardless of whether restaurant is taxed as a partnership or an S corporation, both Chris and Paul will pay income tax on their distributions and Chris will pay self-employment taxes on his salary of $180,000 (approximately $27,000). If the restaurant is taxed as a partnership, then Chris will also pay self-employment taxes on the full amount of his distribution (approximately $21,000), plus an additional 3.8% surtax on $120,000 of net investment income, which is the amount of his distribution in excess of the $200,000 MAGI threshold (approximately $4,560).

However, if the restaurant is taxed as an S corporation and pays Chris reasonable compensation for his services, Chris will not pay self-employment tax on his distribution. In addition, he can use the Material Participation Loophole to avoid the 3.8% surtax – meaning that he would pay approximately $25,560 less in taxes, simply by making an S election. For owner-employees of profitable businesses, like Chris, making an S election can equal substantial tax savings.

Single-Member LLCs 

An S corporation employee who owns the S corporation shares or interests personally, clearly qualifies for the Material Participation Loophole. This is Chris in the example above. But what about an employee who owns his or her interest in the S corporation via a disregarded entity like a single-member LLC – is that person subject to the Medicare Surtax? In other words, what if Chris owned his interest in the restaurant indirectly through a single-member LLC?

Nothing in the statute or the proposed regulations, released by the Department of Treasury explaining the Medicare Surtax, prohibits the “owner” of a disregarded entity (i.e., the single member in an LLC that is disregarded) from using the Material Participation Loophole. While there are strong arguments to support the owner of a disregarded entity using the Material Participation Loophole, this approach is not without risk.

In a 2008 private letter ruling, the IRS concluded that a single-member LLC that is disregarded under the default classification rules in the Treasury regulations was a permissible owner in an S corporation because for tax purposes the entity is not separate from the owner – the member reports the entity’s activities on his or her return. Beware that private letter rulings are not intended to be used or cited as precedent. If a single-member materially participates in the activities of the S corporation, he or she should be able to avoid the Medicare Surtax on distributions, which are reported on his or her tax return. Nevertheless, there is still some risk that the IRS will interpret the statute differently or propose regulations that would prohibit disregarded entity from using the Material Participation Loophole.

Conclusion 

So long as an owner-employee materially participates in the business of the S corporation and receives a reasonable wage for the services rendered, distributions to that person should not be subject to self-employment taxes or the Medicare Surtax. If you are contemplating making an S election, or if you have questions about the Medicare Surtax, please contact a member of our Tax, Estate Planning & Employee Benefits Group or call us at 208.344.6000.