The Patient Protection and Affordable Care Act, P.L. 111-148, and the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, contain many new tax provisions. Two of the more significant are the increase in the employee portion of the hospital insurance tax (Medicare Part A, “Medicare”) and the expansion of the Medicare tax to some forms of investment income (Sec. 1411). Because of these tax increases, tax practitioners will inevitably need to reevaluate some of the current strategies employed by their clients. Two areas that practitioners should examine for opportunities to reduce the impact of Medicare tax increases on their clients are the structure of privately owned businesses and holdings in passive investment activities.
Overview of the Revisions to the Medicare Tax
The changes to the Medicare tax are scheduled to begin in 2013. For single individuals earning more than $200,000, or $250,000 for married couples filing jointly, the tax rate will increase from 1.45% to 2.35%, a 0.9% increase. The Medicare tax rate for self-employed individuals will also increase from its current 2.9% rate to 3.8%. In addition to the tax increase on wages, net investment income will now be subject to the Medicare tax as well. Specifically, the tax is imposed on single individuals with modified adjusted gross income (AGI) in excess of $200,000 ($250,000 for married filing jointly; $125,000 per individual if married filing separately) (Sec. 1411(b)). Modified AGI for this purpose is AGI increased by any amount excluded from gross income under Sec. 911. This presents a potential material tax increase over the earnings threshold to taxpayers who have interest, dividends, annuities, royalties, rents, gross income from passive activities, or net capital gains. In addition, trusts and estates are subject to the 3.8% tax on the lesser of undistributed net income or the excess of AGI over the dollar amount at which the highest tax bracket begins for the tax year (Sec. 1411(a)(2)). Although the tax does not take effect until 2013, proper planning is vital to current high earners and those who may find themselves in the high earner category when the tax is imposed.
Structure of the Business
One of the more unusual provisions of the health care reform legislation is that any income from the active participation in an S corporation is not subject to the 3.8% Medicare tax. While self-employment income from a partnership will be subject to the 0.9% tax increase on wages and dividends and investment income from C corporations will be subject to the 3.8% tax, any active income from an S corporation is exempt from the new tax provisions. With this slight tax advantage, there is a planning opportunity for taxpayers who are considering making an S corporation election or who already employ that type of entity.
The wages of high earners, no matter how or where they earn the compensation, will be subject to the 0.9% increase in the Medicare tax. High earners that are shareholders in an S corporation and also material participants in the S corporation will want to maximize their taxable active income and minimize their wage income to reduce their exposure to the additional 0.9% increase in the Medicare tax. Shareholders that provide personal services to the entity cannot eliminate wage compensation altogether; however, they can adjust their wages as long as they continue to meet the reasonable compensation standard under Sec. 162(a)(1).
A good rule of thumb for reasonable compensation is that it should be equivalent to the amount paid for like services by a like enterprise under like circumstances (Regs. Secs. 1.162-7(b)(3) and 1366-3(a)). The shareholder’s role in the corporation (including position, hours, and duties), the company’s financial condition, the company’s compensation policies for all employees, and how the shareholder/employee’s salary compares with salaries for similar positions at similar companies are all key factors to consider when establishing reasonable compensation. However, all the facts and circumstances of each individual situation are considered in determining what is reasonable compensation for a particular shareholder/employee.
The IRS is well aware of this planning strategy because S corporation shareholders have often manipulated wages in both directions to minimize built-in gain tax, reduce payroll taxes, shift income, or, as in this case, change the character of shareholder income. However, if a company maintains documentation showing how the shareholders’ compensation was determined and why it was a good business decision, the taxpayers will have a much stronger position when presenting their case to the IRS.
Taxpayers must also remember that there are issues other than the Medicare tax to consider before making an S corporation election. For example, if the company is considering a public offering, the shareholders want the ability to specially allocate income or loss, or the company has built-in gains, it may not make sense to pursue the S corporation election. Not all taxpayers have facts and circumstances that make a change to their form of entity or their compensation worthwhile; however, the legislation does provide an additional potential tax advantage to doing business as an S corporation.
Planning for Passive Investment Income
Since the passage of the Tax Reform Act of 1986, P.L. 99-514, taxpayers with investments that consistently generate losses have been concerned about whether they are considered an active or a passive investor under Sec. 469. A taxpayer generally cannot deduct any losses generated from passive activities against income from nonpassive activities when calculating AGI. This can significantly limit the benefit of losses from passive activities until the taxpayer produces income from other passive activities or disposes of the interest in the loss-producing activity. However, with the new Medicare tax on investment income, passive investors will also be affected when an activity consistently produces income. As defined by Sec. 469(h)(1), material participation occurs when a taxpayer’s involvement in the activity is regular, continuous, and substantial. Temp. Regs. Sec. 1.469-5T(a) provides the following seven tests to determine whether a taxpayer is materially participating:
- The taxpayer participates in an activity for more than 500 hours during the tax year.
- The taxpayer’s participation is substantially all the participation of all individuals in the activity.
- The taxpayer participates in an activity for more than 100 hours per year, and no one else participates more than the taxpayer.
- The activity is a significant participation activity, meaning the taxpayer participates in the activity for 100 hours during the tax year and the taxpayer’s aggregate participation in all such activities is over 500 hours.
- The taxpayer materially participated in an activity for any five of the ten immediately preceding tax years.
- The taxpayer materially participated in a personal service activity for any three preceding tax years.
- Based on all the facts and circumstances, the individual materially participates on a regular, continuous, and substantial basis.
There are no specific rules for changing the level of participation in an activity. If one of the tests is met, the taxpayer can report the activity as a nonpassive activity. However, the IRS has the right to recharacterize income as either passive or active based on a review of all relevant facts and circumstances, so appropriate documentation is important. Now, before the tax goes into effect, is the time for taxpayers to reevaluate their level of participation in an activity and decide whether a case can be made for changing their participation level or how the income or loss is reflected, and to document the reasons they have taken a particular position. Anyone who owns a business and is involved in its day-to-day operations will clearly have active investment income and be able to avoid the investment tax for wages and other active business income. However, taxpayers will still be subject to the 3.8% tax on any of the other types of investment income described above. To change their participation, shareholders may take on additional job responsibilities, take a permanent employee position with the company, or perform other activities that fall within the rules for material participation. This does not mean simply putting up a nameplate on an office; legitimate new activities that constitute material participation must occur, and proper documentation is very important to substantiate the change.
The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act instituted several tax changes, including an increase in the employee portion of the Medicare tax. Not only is there a 0.9% tax increase on wages, but investment income is now taxed at 3.8%. If taxpayers begin to plan now, they may be able to minimize the impact of the tax by changing their participation in investment activities or, in the case of taxpayers who are employees/shareholders of S corporations, minimizing their employee wages while still meeting the reasonable compensation standard. As long as taxpayers operate within the limits of the law, there are some opportunities to reduce the personal impact of the new changes to the Medicare tax.
Editor: Frank J. O’Connell Jr., CPA, Esq.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.