Corporate Structure and Taxation – Implications of the “Obamacare Tax”
In our July 11th Blog and October 8th Blog, we covered the positives and negatives associated with various corporate entity structures from an ownership, taxation, and M&A perspective. In this segment, we will cover the implications of Section 1411 of the Internal Revenue Service (“IRS”) Code, most commonly known as the “Obamacare Tax,” on shareholders of an S or C Corporation. As a background, this Code became effective for tax years after December 31, 2012 and, with respect to individuals, imposes a 3.8% tax on the lesser of (i) net investment income for such taxable year or (ii) the excess of modified adjusted gross income over the threshold amount ($250,000 for those filing jointly and $200,000 for individuals).
The Details Matter
The key component to the equation above for shareholders of an S Corporation is net investment income. Net investment income includes gross income from interest, dividends, annuities, royalties, and rents, but does not include distribution income from ownership in an S Corporation assuming that three tests can be met. These tests include (i) the S Corporation is engaged in a trade or business, (ii) the S Corporation is not in the business of trading financial instruments or commodities, and (iii) the shareholder “materially participates” in the S Corporation as defined by various tests in Section 469 of the IRS Code (also known as not being “passive income”). Another important change to the IRS Code is the additional 0.9% Medicare tax on wages after December 31, 2012, which apply to wages above the same thresholds listed above.
Putting It All Together
There are two key takeaways from the above that shareholders should be aware. The first is the benefit of the S Corporation status (assuming the above “tests” are passed) as compared to a C Corporation. Both dividends and capital gains to C Corporation shareholders are subject to the 3.8% tax, whereas distribution income for S Corporation shareholders that meets the above requirements is excluded.
The second is the potential impact of different forms of income to the shareholders of an S Corporation. Wages above the thresholds described above would be subject to the additional 0.9% Medicare tax. However, if a shareholder of an S Corporation were to pay themselves “reasonable compensation” as described in the IRS Code and our previous Blog, and take additional compensation as distribution income, there is potential to maximize take home pay while complying with the new IRS Code. In the case of an LLC structure, these rules generally follow those of an S Corporation; however, there is added complexity depending on the chosen tax election given differing treatment of partnership income with respect to the 0.9% Medicare tax as well as self-employment taxes. In summary, working closely with a tax accountant to regularly evaluate taxable income in various forms and navigate these tax complexities is the best course to ensure all IRS Codes are met in full while maximizing take home pay.
Contributors: Marc Marlin and Robert Dowling