subject: Understanding Why S Corporations May Get Hit Under Obamacare [print this page] The 2010 Health-related legislation makes big changes to federal laws, including tax laws. But the change most significant for S corporations is the 3.8% Medicare surtax on investment income.
Before the recent law changes, S corp saved their owners employment taxes because unlike partnerships and sole proprietorships, S corporation profits weren't subject to Social Security and Medicare taxes.
The recent healthcare legislation (specifically the Health Care & Education Reconciliation Act (H.R. 4872) and the Patient Protection and Affordable Care Bill (H.R. 3590) rather significantly modifies all this. But the rules are complicated.
How the Medicare Surtax Works --- the Cliff Notes Version
How the Medicare tax works is pretty simple at least from a birds-eye view. If a married taxpayer's income exceeds $250,000 or if an individual taxpayer's income exceeds $200,000, the investment income is excess of the threshold is subject to a 3.8% Medicare tax. Investment income includes things like interest, dividends and capital gains.
Where the Medicare tax rules get really tricky, however, is when they're applied to S corporation profits.
Active S Corporation Shareholder-employers
Here's the good news--and perhaps a bit of surprise. The new Medicare tax does not apply to operating income earned by shareholders active in the S corporation. In other words, if you're working in an S corporation, your share of the S corporation's operating profits won't be subject to the new Medicare tax--even if you are over the thresholds amounts.
For now, the principal advantage of the S corporation tax regime still exists--at least for working shareholders. Unfortunately, the situation is a bit bleaker for people who invest but don't work in S corporations.
Passive S Corporation Shareholders
If someone doesn't actively work in the business (and the usual passive activity rules of IRC Sec. 469 apply), the S corporation income gets whacked with the 3.8% tax. And this means that non-working shareholders (passive investors, basically) will get hit under the Obamacare legislation.
You should consult with your tax accountant if the passive activity regulations apply to your return. But as a general rule, S corporation shareholders who are only and merely shareholders will potentially get hit with the new Medicare tax.
Hidden S Corp Hits in the New Medicare Tax
One other clarification should be made concerning the new Medicare tax. Once a taxpayer's income exceeds the threshold amount, investment income gets hit with the tax. But it's important to note that investment income earned inside an S corporation retains its character as the income flows through to investors. This means that even working shareholders may pay the new Medicare tax on the chunk of the S corporation's profit that occurs because of interest, dividends, capital gains or rental income earned by the S corporation.
For example, if an S corporation shareholder receives a $100,000 share of the S corporation's profit, but $40,000 of this profit share comes from dividends, interest and capital gains earned on investments in the S corporation, that $40,000 of investment income is subject to the new Medicare tax (assuming the shareholder's income rises above the thresholds mentioned earlier).
