Will Medicare or SE taxes increase for investors in pass-throughs?
New proposals could increase Medicare or SE taxes for pass-through entities.
INSIGHT ARTICLE |
The Obama Administration has proposed to change the rules that currently exempt many partners, limited liability company (LLC) members and S corporation shareholders from the 3.8 percent Medicare tax imposed by the Affordable Care Act. The Administration’s proposal would also ensure that all partners and S corporation shareholders who provide services for a professional service business pay self-employment (SE) or SECA tax on the compensation they receive from the company. In effect, these proposals would collectively result in partners, LLC members and S corporation shareholders paying FICA, SECA or the 3.8 percent Medicare tax on the entirety of their income from these entities. The Administration could also expand the SE tax proposals to recommend, as they have in the past, that such taxes be paid by limited partners who provide any material services to their firms, even if the firms are not engaged in providing professional services. Any of these legislative changes are unlikely in the short-term, and are sure to be controversial. But this may be a good time for potentially affected taxpayers to ensure they are fully utilizing the exemptions that currently exist, and to assess the implications of any proposal to repeal them.
Following are the basic categories of taxpayers affected.
S corporation shareholders who also provide services to their company are required to be paid reasonable compensation, which is subject to the Medicare portion of Social Security or FICA taxes, just like all other salaries. That is the reason why S corporation income itself, passed through to a shareholder, is not subject to SE tax, sometimes referred to as SECA (Self-Employment Contributions Act). In theory, the compensation-element of that income has already been paid as wages and taxed in that form.
S corporation income that represents a return on investment, not compensation for services, is not subject to either FICA or SECA taxes. For high-income investors (generally above $250,000 of AGI) S corporation income can be subject to the 3.8 percent Medicare tax imposed by section 1411. However, if the investor is sufficiently active in the business the tax does not apply. Generally that requires 100 hours of bona fide work in the business per year. That exemption was intentionally included by Congress in the original text of the Medicare tax provisions associated with the Affordable Care Act, which passed at the time with the strong support of the Administration’s party. The other party generally has opposed taxes like these. Thus, it may be questioned whether there will be political support, on either side of the aisle, for eliminating this exemption, as the Administration has proposed.
Limited partnerships and LLCs
In the case of a limited partnership, the statutory language of the tax code provides that none of the limited partner's distributive share is subject to self-employment taxes, even if the partner is enjoying that share of partnership income as compensation for services, as might be the case with a group of physicians, dentists, lawyers or accountants operating as a limited partnership and splitting their profits under some formula. However, there is uncertainty as to whether this exemption applies to members of LLCs or limited liability partnerships (LLPs).
In addition, the IRS and Treasury have long sought to deny by regulation, even for true limited partnerships (LPs), the availability of this exemption for distributive share income that truly represents compensation for services. They might even challenge the exemption in the courts in the case of a true LP that was a professional services firm, although the statutory language seems difficult to overcome. Interestingly, although the Administration has proposed to close this loophole through legislation, they have previously asserted that they have the power to close it by regulation, without the approval of Congress. However, when regulations to that effect were proposed they were so controversial that they were never finalized. In theory, however, they could be reissued in final form with the stroke of a pen.
For all LPs, LLPs and LLCs that generate a return on capital, not services, that income is theoretically subject to the Medicare tax for high-income taxpayers. However, as with S corporations, the clear statutory language of the Affordable Care Act provides that such amounts are exempt, as they are for S corporation shareholders, if the partner is sufficiently active in the partnership or LLC. Generally that requires more than 100 hours of bona fide participation. That exemption was also intentionally included in the statutory text of the law when it was enacted in connection with the Affordable Care Act. Thus, it may be questioned whether there will be political support for eliminating this exemption, as the Administration has proposed. In addition, some may argue that it should be considered only as part of a comprehensive reconsideration of the Affordable Care Act.
Taxpayers may wish to review whether they are fully utilizing existing exemptions in this area. In addition, taxpayers who are planning for the creation or modification of business structures should keep these rules in mind, along with the possibility that the rules may be subject to change.