Since the 2010 passage of the Affordable Care Act, the use of S corporations has seen a steady increase in popularity among tax advisers, despite the fact conventional wisdom provides that S corporations offer less operational flexibility than partnerships.
Although the latest attempt to repeal the ACA, the Graham-Cassidy bill, failed, President Donald Trump and others have vowed to press on.
Now that the ACA’s tax provisions are being targeted by both the Trump administration and the Republican-controlled Congress, the use of S corporations for small-business planning in place of LLCs taxed as partnerships needs to be re-examined.
Earnings from a business that has elected to be taxed under Subchapter S of the Internal Revenue Code are not subject to separate entity-level income taxes. Instead, shareholders are directly taxed on their allocable share of pass-through income, which results in a series of stock-basis adjustments. Distributions reduce the stock basis of shareholders, but are otherwise tax-free.
S corporations are subject to unique ownership restrictions and lack the significant flexibility partnerships have in allocating income.
S corporations are not permitted to have more than 100 shareholders, and only U.S. individuals, certain types of trusts, estates and charitable organizations are able to own shares. S corporations may only have one class of stock in which all shares must confer equal economic rights. Consequently, common partnership conventions such as the issuance of preferred units and profits interests, and the use of special or shifting allocations, are not possible. Lastly, S corporations do not automatically give shareholders basis credit for their pro rata share of the corporation’s liabilities.
Altogether, these rules make S corporations unsuitable for most real estate investments, private-equity funds and tax-credit deals.
The most common reason for forming an S corporation currently is the opportunity to reduce the 2.9 percent Medicare tax, along with the 0.9 percent Medicare surtax and the 3.8 percent net investment income tax. Both the Medicare surtax and the NIIT are part of the ACA.
The IRS has generally taken the position that partners, or members of LLCs taxed as partnerships, cannot be employees for payroll tax purposes. Partners actively involved in operations are therefore treated as self-employed, and must pay both portions of employer and employee payroll taxes (FICA and the 1.45 percent Medicare) on their shares of ordinary income. An additional 0.9 percent Medicare surtax is assessed on high earners. Critically, Medicare taxes do not have an earnings cap.
In contrast, with respect to an S corporation, FICA and Medicare are applicable only to payments made to shareholders as an employee of the S corporation. For profitable S corporations, the amount of income over reasonable compensation for S corporation owner/employees will therefore escape Medicare tax.
In contrast to payroll taxes, the NIIT applies to passive activity items such as gains, interest, rentals, capital gains, royalties and dividends, but not earnings from a trade or business in which the taxpayer materially participates.
Working together, Medicare and the NIIT are designed to impose a 3.8 percent tax on either passive or active income. Active income from an S corporation, however, is not subject to either Medicare or the NIIT.
Repealing the ACA will obviously reduce the top marginal rate benefit enjoyed by S corporation shareholders when compared to entities taxed as partnerships from 3.8 percent to 2.9 percent. Assuming tax reform does not address the payroll tax disparity between partnerships and S corporations, planning for Medicare rate relief could still make sense. The question for owners is whether they anticipate generating enough income to make a 2.9 percent savings worthwhile considering the other limitations S corporations have.
Michael P. Duffy is a tax attorney and CPA at the law firm of Partridge Snow & Hahn LLP in Providence.