Leaving aside any political or policy aspect of the Patient Protection and Affordable Care Act, P.L. 111-148, it is undeniable that the legislation (and the related Health Care and Education Reconciliation Act, P.L. 111-152) added significantly to the complexity of small business owners' federal tax reporting. While they made significant changes to the income tax regime, their changes to taxes designated for Medicare have been nothing short of monumental. These Medicare tax changes affect high-income employees, self-employed persons, and, for the first time, investors, including investors in small businesses. (The net investment income tax applies to individuals, trusts, and estates, but this discussion is limited to its application to individuals.)
Additional Medicare tax on wage income: Sec. 3101(b)(2) added a 0.9% employee Medicare tax on wage income in tax years beginning after Dec. 31, 2012, over the relevant threshold (e.g., $250,000 in the case of joint taxpayers). This increases the rate on the employee's share of the Medicare tax to 2.35% on wages above the threshold amount. The 0.9% tax does not apply to the employer portion of the Medicare tax. Wages, of course, are also subject (up to $118,500 in 2015) to the combined 12.4% Social Security tax that is split evenly between the employer and employee.
Additional Medicare tax on self-employment income: Sec. 1401(b)(2) added a 0.9% Medicare tax on net self-employment income over the relevant threshold (the same as for the tax on wage income). This increases the Medicare tax rate on self-employment income above the threshold amount to 3.8%. The threshold amount for the self-employment tax is reduced to the extent the taxpayer has wage income above the Sec. 3101(b)(2) threshold amount. Self-employment income is also subject to the 12.4% Social Security tax, which falls on the self-employed person only.
Medicare tax on net investment income: Sec. 1411 was added to the Internal Revenue Code and imposes a 3.8% Medicare tax on net investment income. Net investment income is income in the following three categories, less related deductions:
- Gross income from interest, dividends, annuities, royalties, and rents, other than those that are derived in the ordinary course of a trade or business that is not a passive activity under Sec. 469 with respect to the taxpayer or a trade or business of trading in financial instruments or commodities;
- Other gross income derived from a trade or business that constitutes a passive activity under Sec. 469 with respect to the taxpayer or a trade or business of trading in financial instruments or commodities; and
- Net gain attributable to the disposition of property other than property that is held in a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities.
In determining whether an activity is a passive activity under Sec. 469 for these purposes, material participation is determined at the taxpayer level. Determination of whether there is a trade or business (and its nature) is made at the entity level where the income is generated inside a partnership or S corporation.
The tax base is the lesser of (1) net investment income or (2) modified adjusted gross income over the relevant threshold amount (e.g., $250,000 in the case of joint taxpayers). Modified adjusted gross income is adjusted gross income with certain adjustments with respect to foreign earned income.
Two key additional features of the net investment income tax are worth noting. First, any income that is considered self-employment income is not considered net investment income. Second, passive income (e.g., interest) is net investment income even if it results from an investment of working capital.
The relative newness of these taxes, combined with other recent activity in the self-employment tax world, leaves enough questions that a brief summary might be helpful for those who do not operate in this space every day. This item analyzes how these taxes may apply to small business owners and their sole proprietorships, partnerships, and S corporations. (Because of the limited application of these taxes to shareholders of C corporations, ownership of those entities is not discussed here.) It also addresses the possible advantages from a tax perspective of being active or passive in a business, or whether limited or general partner status may be preferable. The analysis includes income from day-to-day operations (i.e., trade or business income), income from activities that are generally outside the ordinary course of business (including most types of passive income), and a sale of the business. However, the numerous and complex rules regarding rental activities and multiple activities for Sec. 469 purposes are generally outside the scope of this item.
Sole Proprietorship or Single-Member LLC
The owner of a sole proprietorship or a disregarded single-member limited liability company (LLC) is subject to self-employment tax on the net income of the operations, provided those operations amount to a trade or business under Sec. 1402 (which is assumed for purposes of this item, as is the owner's material participation under Sec. 469). This same income is not net investment income, because an item of income cannot be subject to both taxes.
Generally, passive income such as gains from sales of noninventory items, dividends, and certain types of interest is excluded from self-employment income. Interest, dividends, annuities, royalties, and rents are net investment income unless they are earned in the ordinary course of a trade or business that is not passive with respect to the taxpayer (other than a trade or business of trading in financial instruments or commodities). Other than for rents, whether such income is earned in the ordinary course of the trade or business is determined under Temp. Regs. Sec. 1.469-2T(c)(3)(ii). Rents are handled under the relevant case law.Gains from sales of property are not net investment income if the asset is held in the trade or business, but if, for example, a single-member LLC owns land solely for investment purposes, the gain from its sale is net investment income. If the entire trade or business is sold, either in a true asset sale or a sale of LLC units (which is treated as a deemed asset sale for tax purposes), the gains would be subject to the rules described in this paragraph.
Partnership, Including a Multimember LLC Taxed as a Partnership
A partner's distributive share of income from a trade or business carried on by a partnership (generally, partnership income described in Sec. 702(a)(8)) is self-employment income. Other than with respect to the limited partner exception described below, whether the partner materially participates in the partnership's trade or business is irrelevant for this purpose. As a general rule, Sec. 707(c) guaranteed payments to a partner for services are also self-employment income.
One of the most controversial wrinkles in the self-employment tax rules is with respect to limited partners. Neither limited partners' distributive share of trade or business income nor their Sec. 707(c) guaranteed payments for the use of capital are self-employment income (but Sec. 707(c) guaranteed payments for services are). The Code does not define a limited partner for this purpose. However, at a minimum, state-law limited partner status, or some comparable status, is required. In 1997, Treasury released proposed regulations (REG-209824-96; Prop. Regs. Sec. 1.1402(a)-2) that define a limited partner (for self-employment tax purposes) as a partner who does not:
- Have personal liability for debts or claims against the partnership by reason of being a partner;
- Have authority to contract on behalf of the partnership; or
- Participate in the partnership's trade or business for more than 500 hours during the tax year.
Under the proposed regulations, a partner would not, however, be considered a limited partner if the partner provides services (other than a de minimis amount) to or on behalf of the trade or business of a "service partnership"—a partnership substantially all the activities of which involve services in certain professional fields. In the proposed regulations, Treasury also indicated that an LLC member may be treated as a limited partner if he or she otherwise fits within the rules therein. The Tax Court in Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011), and the IRS in Chief Counsel Advice 201436049 have both, in recent years, supported the proposed regulations' emphasis on services performed for the partnership. In both these cases, resolution turned on the fact that the purported limited partner provided significant services to the partnership in the course of its trade or business.
For purposes of the net investment income tax, if a partner materially participates in the trade or business operated by the partnership, his or her distributive share of the partnership's trade or business income is not net investment income. A partner (other than a true state-law limited partner) may materially participate in one of several ways listed in Temp. Regs. Sec. 1.469-5T(a), including:
- Providing services to the partnership for more than 500 hours during a year;
- Providing services to the partnership for more than 100 hours during a year, if no other individual provides more services; or
- Providing services to the partnership on a regular, continuous, and substantial basis (as determined by an analysis of the facts and circumstances).
The net investment income tax and Sec. 469 allow an exception from a general rule that a limited partner is not treated as materially participating in any activity of a limited partnership. Partners that are limited partners for this purpose can materially participate only by satisfying the 500-hour rule described above or one of two tests that rely on material participation in prior years (Temp. Regs. Sec. 1.469-5T(e)(2)). The IRS tried several times to impose this same standard on LLC members (and partners in LLPs), but was rejected by the courts (see, e.g., Garnett, 132 T.C. 368 (2009)). Thus, LLC members and partners in LLPs can materially participate for net investment income tax purposes by satisfying any of the standards for material participation.
That certain partners may be exempt under certain conditions from both self-employment tax and net investment income tax might suggest they can enjoy the best of both worlds. However, accomplishing both simultaneously would not be easy, and any taxpayer who increases his or her activity to avoid the tax on net investment income should remember the larger overall tax burden on self-employment income.
A partnership's passive income, such as dividends, interest, and capital gain, is generally not self-employment income because it is separately stated under Sec. 702. Passive income that is interest, dividends, rents, or annuities is net investment income unless earned in the course of the partnership's trade or business. Even if it is earned in the course of the trade or business, though, it is net investment income if the partner does not materially participate. Gains from the sale of assets held in the trade or business likewise are net investment income if the partner does not materially participate in the trade or business. Gains from the sale of partnership assets not held in a trade or business are always net investment income.
The sale of a partnership interest is treated as the sale of a capital asset. Accordingly, this gain is not self-employment income. For net investment income tax purposes, a partnership interest is generally not considered property held in a trade or business, and so the gain is net investment income. However, if a partner materially participates in the partnership's trade or business, a special lookthrough rule applies. The amount of net investment income is the lesser of (1) the income tax gain from the sale (i.e., the Sec. 741 gain) or (2) the partner's allocable share of the inside gain from a deemed sale of the partnership's Sec. 1411 property (essentially, property not held in the trade or business). Gain under Sec. 731 (where the partner receives a distribution of cash in excess of his or her outside basis in the partnership interest) is subject to these same rules.
S Corporation
No part of an S corporation shareholder's distributive share of trade or business income is self-employment income, pursuant to Rev. Rul. 59-221. However, the law generally requires that a shareholder who provides services to the corporation receive reasonable compensation. If this is not done, a portion of distributions to the shareholder may be recharacterized as compensation. To the extent compensation received or deemed received from the S corporation exceeds the threshold, it would be subject to the 0.9% Medicare tax. If an S corporation shareholder does not materially participate in the S corporation's trade or business, his or her distributive share of trade or business income is included in net investment income. This is a more-than-welcome trade-off, though, as self-employment income is also subject to the 12.4% Social Security tax.
There is an opportunity for avoiding the bulk of both these taxes on the S corporation shareholder's distributive share of trade or business income. The income is not self-employment income under Rev. Rul. 59-221 and is not net investment income if the shareholder materially participates in the S corporation's trade or business. As discussed above, however, to the extent the shareholder provides services to the corporation (which may help to establish material participation under the net investment income tax rules) the shareholder would have to receive reasonable compensation from the corporation, and that would be taxable as wage income. The remainder of the shareholder's distributive share of trade or business income would avoid both taxes.
Passive income from the S corporation and gain from the sale of assets of the S corporation are not self-employment income under Rev. Rul. 59-221. Similar to the partnership rules, interest, dividends, annuities, royalties, and rents are net investment income unless received in the ordinary course of the S corporation's trade or business and the shareholder actively participates in the trade or business. Gains from sales of property held in the trade or business are not net investment income if the shareholder materially participates in the trade or business. Gains from sales of assets not held in the trade or business are included in net investment income whether or not the shareholder materially participates.
The sale of stock in an S corporation is a sale of a capital asset (unless a Sec. 336(e) or Sec. 338(h)(10) election is made). Accordingly, the gain is not self-employment income. The net investment income tax treatment of a shareholder's sale of stock in an S corporation is the same as that of a partner selling his or her partnership interest, as described above. If the shareholder materially participates, the gain from the shareholder's sale of stock is net investment income to the extent of the lesser of (1) the overall income tax gain or (2) the shareholder's allocable share of the inside gain from the deemed sale of Sec. 1411 property. If the shareholder does not materially participate, the entire gain is net investment income. Gain under Sec. 1368(b)(2) (where the shareholder receives a distribution of cash in excess of his or her basis in the stock) is subject to these same rules.
The net investment income tax rules follow the fiction created by a Sec. 336(e) or Sec. 338(h)(10) election. Thus, gain from the deemed sale of the corporation's assets is taxable under the general rules for net gains. There is no net investment income tax on the deemed liquidation of the S corporation if the taxpayer materially participated in the S corporation's trade or business (as determined immediately before the sale). If the shareholder did not materially participate, there is the potential for a second layer of gain that would be net investment income.
What May Lie Ahead
Treasury released proposed regulations on the net investment income tax in late 2012. In response to comments to those proposed regulations, Treasury released final regulations, along with a new set of proposed regulations, in late 2013 (T.D. 9644; REG-130843-13). In doing so, Treasury acknowledged that there is more work to be done with respect to the net investment income tax. Notably, there is no guidance in final regulation form on the calculation of net investment income on the sale of a partnership interest or stock in an S corporation when the taxpayer materially participates in the trade or business. The analysis above is from the proposed regulations released in late 2013 that provided a more taxpayer-friendly rule than the rule in the 2012 proposed regulations. Thus, while taxpayers are permitted to rely on the proposed rule for now, more guidance may be forthcoming in that regard (or the current guidance may become final).
There have been bipartisan congressional proposals to eliminate (or at least modify) the rule that an S corporation shareholder's distributive share of S corporation income is not self-employment income. This is not entirely unexpected, given the incongruity with other forms of small business ownership, not to mention the added complexity (and, presumably, enforcement difficulties) of the reasonable-compensation rule.
In late 2011, Treasury released proposed regulations that would significantly change the determination of whether a partner is a limited partner under the Sec. 469 rules, which in turn would affect the net investment income tax rules (REG-109369-10).The current regulations define a limited partnership interest as an interest that meets one of two tests. Under the first test, the interest is limited if the interest is designated as a limited partnership interest in the limited partnership agreement or certificate of limited partnership. Under the second test, the interest is limited if the partner's liability is limited by state law to a determinable fixed amount. The proposed regulations would classify an interest as a limited partnership interest if (1) the entity is considered a partnership under Regs. Sec. 301.7701-3 and (2) the partner does not have rights to manage the entity at all times during the entity's tax year under state law and the partnership's governing agreement. The preamble to the proposed regulations explains that the change is designed to reconcile the fact that the statute was predicated upon state laws at the time that limited the ability of limited partners in limited partnerships to be active in the management of the business, but that in recent years these laws have gradually been relaxed.
Finally, Treasury included in its 2014–2015 Priority Guidance Plan the issue of the application of Sec. 1402(a)(13) (excluding the distributive share of a limited partner's trade or business income from self-employment income) to LLC members.
EditorNotes
Anthony Bakale is with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com. Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
