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Steve Looney Authors Article: Impact of the American Taxpayer Relief Act of 2012 on Choice of Entity

Published: March 6th, 2013

By: Stephen R. Looney

Although the American Taxpayer Relief Act of 2012 (the “2012 Act”) extends a number of expiring provisions retroactively for 2012 through 2013, in addition to making some “permanent” changes, the most hard fought provisions contained in the 2012 Act address changes to the tax rates applicable to certain higher income taxpayers.

This article will focus on the changes in income tax rates made by the 2012 Act, as well as on the 3.8% tax imposed on net investment income as part of the Affordable Care Act (“ACA”) which became effective January 1, 2013, and in particular how these rate changes may affect choice of entity decisions for closely held businesses.

Increase in Individual Income Tax Rates for Individuals.

The most debated and publicized portion of the 2012 Act concerns the individual income tax rates applicable to certain higher income individuals.  While President Obama and the Democrats pushed for higher tax rates for taxpayers making $250,000 or more, the Republicans wanted the higher tax rates to apply only to taxpayers making $1,000,000 or more.  The 2012 Act increases the maximum marginal individual tax rate of 35% to 39.6% for individuals having taxable income over $400,000 or for married couples filing joint returns having taxable income of over $450,000.

Consequently, the new tax schedules for 2013 are as follows:

Tax Rate

Single

Married Filing Joint

Married Filing Separate

Head of Household

10%

Up to $8,925

Up to $17,850

Up to $8,925

Up to $12,750

15%

$8,926 – $36,250

$17,851 – $72,500

$8,926 – $36,250

$12,751 – $48,600

25%

$36,251 – $87,850

$72,501 – $146,400

$36,251 – $73,200

$48,601 – $125,450

28%

$87,851 – $183,250

$146,401 – $223,050

$73,201 – $111,525

$125,451 – $203,150

33%

$183,251 – $398,350

$223,051 – $398,350

$111,526 – $199,175

$203,151 – $398,350

35%

$398,351 – $400,000

$398,351 – $450,000

$199,176 – $225,000

$398,351 – $425,000

39.6%

Over $400,000

Over $450,000

Over $225,000

Over $425,000

 Capital Gain Tax and Tax on Dividends.

Another hotly debated issue was the tax rate applicable to capital gains and dividends.  If Congress had taken no action, the maximum marginal tax rate on capital gains would have increased from 15% to 20% and the maximum marginal income tax rate on dividends would have dramatically increased from 15% to 39.6%.  The 2012 Act establishes a maximum marginal income tax rate on capital gains and on dividends of 20% for individuals having taxable income over $400,000 and for married couples filing joint returns having taxable income over $450,000. 

“Stealth” Taxes.

Although not receiving nearly the publicity as the increased 39.6% tax rate for certain higher income taxpayers discussed above, the effective tax rates on certain taxpayers (taxpayers filing individually having adjusted gross income of $250,000 or more and couples filing joint returns having adjusted gross income of $300,000 or more) will also be increased as a result of the reinstatement of the pre-Bush tax cuts phase-outs on itemized deductions and personal exemptions.  Since many taxpayers are unaware of this increase in their effective income tax rate, these phase-outs are referred to as “stealth” taxes.

First, the so-called “Pease” limitation on itemized deductions has been reinstated, so that taxpayers meeting the income threshold discussed above must reduce the amount of their itemized deductions by 3% of the amount by which the taxpayer’s adjusted gross income exceeds the applicable threshold (i.e., $250,000 or $300,000, as the case may be).  Under this provision, itemized deductions cannot be reduced by more than 80%.

Additionally, the phase-out of personal exemptions in effect prior to the Bush tax cuts has been revived, so that the total amount of exemptions of a taxpayer are reduced by 2% for each $2,500 by which such taxpayer’s adjusted gross income exceeds the applicable threshold (i.e., $250,000 or $300,000, as the case may be).

Again, the effect of these phase-outs on itemized deductions and personal exemptions is to raise the effective tax rate on taxpayers making $250,000 or more or $300,000 or more, as the case may be, so that it cannot fairly be said that income taxes have only been increased for those taxpayers having taxable income of more than $400,000 with respect to individuals, and having taxable income of more than $450,000 with respect to married taxpayers filing joint returns.

End of Payroll Tax Holiday.

Another change made by the 2012 Act which will have the effect of increasing taxes on all individuals, is the end of the so-called payroll tax holiday which was in effect for 2011 and 2012.  Under this provision, the employee’s portion of the FICA tax was reduced from 6.2% to 4.2% for 2011 and 2012. Similarly, the self-employment tax on self-employed individuals was reduced from 12.2% to 10.2% for 2011 and 2012.

Increase in Wage Base for FICA and Self-Employment Taxes.

Another source of tax increases will be the rise in the Social Security wage base from $110,100 in 2012 to $113,700 in 2013.  The OASDI portion of FICA and the self-employment tax (6.2% on both the employer and the employee under the FICA tax and 12.4% on self-employed individuals under the self-employment tax) is only imposed up to the maximum wage base.

Additional Medicare Tax on Employee Wages and Self-Employment Income.

Although not a part of the 2012 Act, the ACA raises the hospital insurance (Medicare) portion of the FICA tax and the self-employment tax beginning January 1, 2013 on employee wages and net earnings from self-employment for couples filing joint returns having adjusted gross income of more than $250,000 (and for other taxpayers having adjusted gross income of more than $200,000) from 2.9% to 3.8%.  There is no cap on the amount of wages or self-employment income to which the Medicare portion of the FICA tax and the self-employment tax are subject.  It should also be noted that unlike other self-employment taxes for which self-employed individuals may claim a deduction of 50% on their individual income tax returns, no deduction is allowed for the additional .9% (3.8% – 2.9%) Medicare tax imposed on taxpayers having adjusted gross income in excess of $250,000 for married couples filing joint returns and in excess of $200,000 for other taxpayers.

New 3.8% Tax on Net Investment Income.

The ACA imposes a new 3.8% tax on the “net investment income” of taxpayers having modified adjusted gross income of over $250,000 in the case of taxpayers filing a joint return and over $200,000 for other taxpayers (the “NII Tax”).  “Net investment income” includes gross income from interest, dividends, annuities, royalties, and rents other than such income which is derived in the ordinary course of a trade or business.

Additionally, the term “net investment income” includes: (1) any other gross income derived from a trade or business if such trade or business is a “passive activity” within the meaning of Section 469, with respect to the taxpayer; and (2) any net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business that is not a passive activity under Section 469 with respect to the taxpayer.

Consequently, now a partner, including a limited partner, LLC member and an S corporation shareholder, will be subject to the new 3.8% Medicare tax on his or her distributive share of the operating income of the partnership, LLC or S corporation, as the case may be, if the activity generating such income is passive under Section 469 with respect to such partner, LLC member or S corporation shareholder.

The new NII Tax is effective beginning January 1, 2013.

Choice of Entity Statistics

Over the past decade a majority of entities have been formed as so-called pass-through entities, such as S corporations, limited liability companies (LLCs) or partnerships.  Additionally, although LLCs have gained increasing popularity over the last decade, the number of entities taxed as S corporations still exceeds the number of entities taxed as partnerships for federal tax purposes.  It is projected to stay that way for the foreseeable future, as set forth in the table below published by the IRS (Document 6292, Office of Research, Analysis and Statistics, Fiscal Year Return Projections for the United States:  2012-2019, Rev. 6/2012):

                        Statistics Regarding Choice of Entity

 

2011
(Actual)

2012
(Projected)

2016

(Projected)

2019

(Projected)

Form 1065

3,573,550

3,604,400

3,963,400

4,232,700

Form 1120S

4,545,454

4,603,700

5,582,000

6,098,600

Form 1120

1,965,523

1,902,900

1,107,600

1,167,000

 

Effect of 2012 Act Rate Changes and 3.8% Tax on Net Investment Income on Choice of Entity

The change in tax rates occurring as a result of the 2012 Act result in the maximum marginal tax rate applicable to individuals (39.6%) exceeding the maximum marginal tax rate applicable to corporations (35%) for the first time in a number of years.  As a result of the maximum marginal tax rate for individuals exceeding the maximum marginal tax rate for corporations, some commentators believe this could result in a resurgence of C corporations.  However, if such C corporations desire to distribute their earnings out to their shareholders, the maximum combined corporate and individual tax rate on such earnings is 48% and increases to 50.47% when taking into account the new 3.8% NII Tax (to which C corporation dividends will be subject).  Additionally, C corporations, unlike pass-through entities, will still be subject to double taxation on the sale of their assets, again at a maximum marginal combined tax rate of 48%, or 50.47% when taking into account the 3.8% NII Tax.  This does not take into account state income taxes, to which many C corporations are subject and from which pass-through entities are exempt.

This double tax on C corporations still compares very unfavorably to the maximum marginal tax rate of 39.6% to which S corporation shareholders and members of other pass-through entities are subject.  Consequently, in most circumstances, it will still be more tax efficient to operate a business as a pass-through entity rather than as a “C” corporation.

Application of Social Security Taxes and Net Investment Income Tax to S Corporations

Shareholder-employees of S corporations are generally not subject to Social Security taxes on their distributive share of the income of an S corporation or on dividend distributions made to them by their S corporation, provided the S corporation pays reasonable compensation to them.  Thus, there is an opportunity for significant employment tax savings by maximizing the amount of distributions and minimizing the amount of wages paid to shareholder-employees of S corporations.

Additionally, so long as a shareholder of an S corporation materially participates in the business of his or her S corporation, the dividend distributions received by such shareholder should not be subject to the 3.8% NII Tax.  Thus, non-wage distributions from S corporations are one of the few paths to receive income untouched by the FICA tax, self-employment tax or the new NII Tax.

Although it may be possible for an LLC member or limited partner to materially participate so that his or her distributive share of income would not be subject to the NII Tax, that would likely result in that member’s or partner’s distributive share of the income of the LLC or partnership being subject to the self-employment tax, including the increased 3.8% Medicare tax imposed on the self-employment income of higher income taxpayers.  Thus, S corporations appear to be the best vehicle in which to operate a business to minimize both employment taxes and the NII Tax.

Conclusion

Taxpayers and their advisors need to be aware of the array of new taxes and tax rates applicable to higher income taxpayers, including the maximum marginal 39.6% tax rate on individuals, the maximum marginal capital gain rate and dividend rate of 20%, the phase-outs of itemized deductions and personal exemptions and the new 3.8% NII Tax, in order to properly plan to minimize taxes, including selection of the most tax efficient vehicle in which to conduct their closely-held businesses.  In many instances, an S corporation will be the only path to avoid the FICA, self-employment and NII Tax on the profits of a business distributed as dividends to its owners.

About the Author:  Steve Looney is the Chair of the firm’s Tax Department. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional practices. He is a former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at slooney@deanmead.com.