Beginning on January 1, 2013, the 2010 Healthcare Act will subject “net investment income” to a 3.8% Medicare tax for taxpayers with adjusted gross income over $250,000.00 in the case of joint filers ($125,000.00 for married taxpayers filing separately, and $200,000.00 for other filers). The imposition of the 3.8% Medicare tax on “net investment income” represents a historic shift in the type of income subject to employment related taxes as prior to the 2010 Healthcare Act, only income derived from active trades or businesses or labor was subject to employment related taxes, such as the Medicare tax.
The definition of “net investment income” includes income from interest, dividends, annuities, royalties and rents, other than income which is derived in the ordinary course of a trade or business, so long as the trade or business does not constitute a passive activity with respect to the taxpayer and does not constitute trading in financial instruments or commodities. In addition, “net investment income” includes any other gross income derived from a trade or business if such trade or business is a passive activity with respect to the taxpayer, and gain attributable to the disposition of investment property. For the sale of partnership interests and S corporation stock, the transferor must look through such pass-through entities and determine the net gain which the transferor would have taken into account (i.e. property which is not used in an active trade or business or in which the transferor does not actively participate) if the pass-through entity sold all of its assets for their fair market values immediately before the transfer of the interest or stock.
This new tax on net investment income will cause a renewed focus on the level of participation of S corporation shareholders and partners of partnerships (including members of LLCs taxed as partnerships) and on whether the activities of the ventures rise to the level of a trade or business or are primarily investment. Until additional guidance is provided by the IRS, practitioners may find it difficult to determine what income will be subject to this new Medicare tax. For example, if you have a member of an LLC, which is either disregarded for federal income tax purposes or taxed as a partnership for federal income tax purposes, but in which a member (or the sole member in the case of the single member LLC) does not materially participate, would such member’s allocable share of LLC income be subject to the new Medicare tax even if that member pays self-employment taxes on such income? The questions that arise with respect to the application of the new Medicare tax on “net investment income” are more problematic with LLC members because of the current lack of guidance on how to apply the self-employment tax rules to members of LLCs taxed as partnerships, irrespective of the level of participation of those members.
For reasons of clarity, it is likely that taxpayers that materially participate in a venture will have an increased interest in having eligible entities elect S corporation status to give those taxpayers greater flexibility and clarity on what amounts of their allocable income will be subject to employment taxes and/or the new Medicare tax. Also, for entities that are not eligible entities for purposes of electing S corporation status (or for which it is not practical to elect S status for other reasons), taxpayers that materially participate might be interested in holding their interests in such entities through S corporations, though the IRS has challenged similar structures for lack of business purpose. See Robucci v. Comm’r, TCM 2011-19. In addition, Code Section 269 and the Economic Substance Doctrine may also limit the ability of taxpayers that materially participate in a venture from forming S corporations to hold their interests in such entities.