President’s Budget Proposal Has S-corporations in the Crosshairs

Stan Rose, Tax Director
February 2016

If a federal budget proposal materializes, it could send S-corporations down the path of the 8-track player. A lot of proposed rules come across tax accountants’ desks, and the shrewd advisors will not worry too much over things that may never materialize. Instead, they laugh, cry or curse about the further evidence of a dysfunctional relationship between the country’s executive and legislative branches of government, and focus on what the proposals might mean to their clients. The president released his fiscal year 2017 budget proposal this month, and I’ll share one item of interest because it has come up several times. If it gains more traction on the legislative side of the Washington boxing ring, it is bad news for owner/operators of some S-corporations – and in this author’s opinion, could even set in motion the demise of the S-corporation.

Background

Some background is needed to understand what is proposed. A couple years ago, two new taxes came into existence: A 0.9% “additional Medicare tax” on compensation and self-employment income, and a 3.8% tax on investment income. More details regarding those taxes may be found here.

These taxes are imposed in addition to income tax, and they only apply to recipients with relatively high income. Many readers also are familiar with the long-existing FICA and Medicare taxes. FICA applies to the first $118,500 of wages at a rate of 6.2%, and Medicare applies to all wages at 1.45%. These are assessed on the employee and withheld from wages by the employer, who must match those amounts with funds of its own, causing the combined rates to equal 12.4% and 2.9%, respectively. Self-employed individuals are subject to the same tax, using those combined rates.

It is the self-employment tax and the new investment income tax and additional Medicare taxes that the president and some members of congress would like to see expanded. Why? Because for owners of pass-through entities, these taxes are not applied consistently. Certain S-corporation owners can avoid most of these taxes, while other S-corporation owners and all LLC and partnership owners (assuming applicable income levels) cannot escape them.

How the additional Medicare tax and net investment income tax are applied inconsistently

Let’s start with the two new taxes, and look at how they impact business owners. Assuming income is high enough for the rules to apply (visit this link to see the thresholds), the chart below shows how these taxes will be assessed on the “flow-through” income reported on the owner/recipients’ Schedules K-1, and the self-employment income of sole proprietors:

Medicare and Net Investment Income Tax Applicability to Flow-through and Proprietor Income

Partnership, LLC or Proprietorship (c) S-corp.
Passive owner 3.8% (b) 3.8% (b)
Active owner 3.8% (a) 0

(a) Consists of 0.9% additional Medicare tax plus 2.9% “regular” Medicare tax (1.45% employee share + 1.45% employer “match” are both components of the overall “self-employment” tax)
(b) Net investment income tax
(c) All proprietor income is considered “active”

As you can see, the flow-through income of S-corporation shareholders who are active in the business (generally owner/employees) completely escapes these new taxes. This stands in stark contrast to a passive owner of an S corporation (like an angel investor or family member owner who is not employed by the company), or a passive or active owner of a partnership or LLC, who all will be facing some combination of Medicare or net investment income taxes totaling 3.8%.

Active S-corporation owners are not totally unscathed, as any wages they draw from the same company are subject to regular Medicare tax, FICA tax, and potentially the 0.9% additional Medicare tax, which applies if income is high enough. But as long as that active S-corporation owner draws “reasonable” wages (and of course, Congress and the IRS helpfully refuse to define “reasonable”), the flow-through income, regardless of ceiling, is not subject to these new taxes.

How the self-employment tax is applied inconsistently

Some of the taxes discussed above apply only to relatively high incomes. However, even for lower-income taxpayers, S-corps have always enjoyed a more favorable tax status than LLCs/partnerships and proprietorships because S-corporation’s flow-through income is not subject to the 12.4% FICA portion of the self-employment tax; while LLC/partnership owners who are actively involved in the company and all proprietors, must pay that tax on the first $118,500 of self-employment income. That is depicted here:

FICA Tax Applicability to Flow-through and Proprietor Income

Partnership, LLC or Proprietorship S-corp.
Passive owner 0 (a) 0
Active owner 12.4% 0

(a) All proprietor income is considered “active”

With respect to the FICA tax, the S-corporation shareholder (wages notwithstanding) again comes out ahead.

The proposed change/commentary

The favorable treatment of S-corporations shown above is what the President and some members of Congress would like to change, by subjecting S corporation owners to the same taxes applicable to owners of partnerships and LLCs.

This is an interesting proposal, and one that easily could lead to the greatly diminished use of the S-corporation. Why do I say that? Consider the evolution of the most popular types of tax entities: C-corporations and partnerships have long existed. But C-corporations, when viewed along with their owners, are subject to two layers of tax: One at the entity level, and one at the shareholder level. Partnerships have always had only one level of tax, applied at the individual level rather than the entity. But until a few decades ago, partnerships’ owners were at risk of liability stemming from entity activity jeopardizing their personal assets. Use of corporations was safer, but more tax-expensive, compared to partnerships.

S-corporations were introduced in the 1950s, which combined the “one level of tax” treatment partnerships enjoyed with the robust liability protection for the owners that only corporations offered. In that way, it was the best of both worlds. It even allowed owners to avoid the self-employment tax that applied to active partnership income. The downside was, and is, that S-corporations have severe restrictions on who can own them (generally only individuals and certain trusts), how many can own them (100 shareholders or fewer), the types of stock they can offer (generally only one class of common stock), and the distributions they can pay (must be in proportion to ownership). These pros and cons left all three types of entities in strong use, each with strengths and weaknesses.

When “limited liability partnerships” (LLPs) and then “limited liability companies” (LLCs) came into existence in the 1990s, they became preferred forms of business because they have none of the S-corporation restrictions, and provide most of the legal protections formerly only enjoyed by corporation owners. They still, however, have been more expensive to active owners than S-corporations, due to the self-employment taxes, and more recently, the additional Medicare tax.

So – is it fair that S-corporations enjoy favorable tax treatment relative to partnerships and LLCs? Arguably, yes – because they are so limited in terms of ownership structure, types of owners, total headcount of owners, and distributions. Partnerships and LLCs have much more freedom, but at a price. (Proprietorships enjoy freedoms, too – they do not have to file separate tax returns.) If the tax savings that apply to S-corporations are removed, and only the comparatively unfavorable characteristics remain, there may be very few roles in the future that the S-corporation will play.

That has not happened yet, though, and this is one of the reasons why S-corporations, for all their complexity and restrictions, remain a very efficient tax vehicle for business of all sizes.

If you have any questions, please contact your Baker Newman Noyes tax professional at 1.800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.