Recently, proactive CPAs have been alerting the public about the new Surtax on Net Investment Income and the additional Medicare Tax on earned income. However, the public remains without much reaction and is advised to be actively planning for the changes.

Starting in 2013, the income tax burdens of unincorporated sole proprietorships and passthrough entities including partnerships, LLCs and S corporations have increased. Given these recent tax changes, it is important to re-evaluate the choice of business entity types with the goal of minimizing or legitimately avoiding these taxes.

Reviewing the IRS statistics about 2011 tax returns filed, there are approximately 4.7 million U.S. taxpayers with adjusted gross income (AGI) of $200,000 or greater. Also, 31.4 percent of returns filed reported AGI between $50,000 and $200,000 which are close to the threshold amount. (See Footnotes 1.) These are the taxpayers who are most likely to see a significant increase in their federal tax liability for 2013.

These new taxes create an interesting situation that showcases the S corporation as the preferable entity in minimizing total tax liability when owners materially participate in the trades or businesses.

The Patient Protection and Affordable Care Act (ACA) changes the relative costs and benefits of operating under the various business types and creates a situation where unincorporated businesses should consider incorporating and electing S corporation status. Among its many provisions, the ACA has two new taxes that affect individual filers: a 3.8-percent tax on Unearned Net Investment Income (Investment Tax) and a 0.9% Medicare Surtax on earned income.

A 3.8% Investment Tax applies to the lesser of net investment income or the excess of modified adjusted gross income (AGI) over the threshold amount. The threshold amount is $250,000 for MFJ, $125,000 for MFS, and $200,000 for any other filing status. Net investment income includes interest, dividends, net capital gains (other than from business assets), annuities, royalties, and rents, unless such income is derived in the ordinary course of a trade or business that is not a passive activity. Exceptions apply.

Beginning in 2013, there is an additional Medicare tax on the employee’s portion of FICA and self-employment income equal to 0.9% of wages received or self-employment income earned that is in excess of $250,000 for Married Filing Jointly, $125,000 for Married Filing Separately, or $200,000 for Single or Head of Household. Employers are required to withhold the additional Medicare tax if the employer pays wages to an employee that exceeds the threshold amounts. If the threshold amount is exceeded because the taxpayer has more than one employer and/or has self-employment income, the additional tax is calculated on the Form 1040.

A high-income taxpayer with both earned income and investment income may be required to pay both taxes. Some types of business income would escape both taxes. Given the wide variation in the tax treatment of business income, it is important for sole proprietors and owners of flow-through businesses to understand the effect these taxes have on business income.

Under current law, the top individual income tax rate in 2013 has been increased to 39.6%. A taxpayer in the top bracket would owe a total of 43.4% to the IRS (39.6% plus 3.8%) on the amount of net investment income. It should also be noted that California income tax would be added to this 43.4% federal tax.

For S corporations, none of the S corporation flowthrough income is classified as Self-Employment income, so it is not subject to the Self-Employment tax or the Medicare Surtax. If the shareholder materially participates in the business, the income is also exempt from the 3.8% Investment Tax. Then with S corporations, taxpayers can legitimately avoid all three (3) types of taxes altogether.

Only the shareholder’s salary from the S corporation is subject to the regular payroll tax and the Medicare Surtax when, along with other earned income, the $200,000 (single) or $250,000 (married filing jointly) thresholds are met. According to IRS Statistics of Income data, over 60 percent of all S corporations have only one shareholder. (See Footnotes 1.) So at the very least, earned income of 60 percent of S corporations is not subject to the SE tax, the Medicare Surtax, or the Investment Tax. About 30 percent of S corporations have two shareholders. If both shareholders materially participate in the business, the 30 percent of S corporations can also avoid those taxes.

However, S corporation shareholders who do not materially participate in the business would be subject to the Investment tax. Therefore, sole proprietorships, partnerships, and LLCs with active owners have a strong financial incentive to incorporate their businesses and elect S corporation status.

S corporation shareholders may further minimize employment taxes by paying themselves a reasonable salary even when it is significantly less than the net income from the business. Using S corporation status to minimize employment taxes has been validated as a tax planning strategy.

For S corporations, the variety of reasonable compensation cases brings up the question of how much compensation is too little.

The IRS fact sheet FS-2008-25 acknowledges that there are no specific guidelines for what constitutes reasonable compensation in the code or regulations. This requires nitty-gritty factual analysis. FS-2008-25 lists a variety of factors that the courts have considered in determining reasonable compensation. They include the following:

• training and experience; • duties and responsibilities; • dividend history;

• time and effort devoted to the business; • payments to non-shareholder employees;

• the timing and manner of paying bonuses to keep personnel; • compensation agreements; • the amount comparable businesses pay for similar services; and • using a formula to determine compensation.

The choice of criteria to determine reasonable compensation is often subjective.

Now, I would like to introduce a very recent tax court case (Aug. 12, 2013. See Footnotes 2.) The court case involved a full-time real estate broker who was the sole shareholder of an S corp. When the corporation was set up, the taxpayer reported a salary of $24,000 plus commissions. However, none of the salary was paid. The taxpayer’s Form 1040 only had $231,454 in ordinary income from the S corp. The taxpayer argued that compensation should be $24,000, while IRS proposed a compensation of $100,755, calculated based on median wages for the area by a valuation expert. IRS also asserted the taxpayer’s failure to file and failure to deposit penalties in addition to the FICA/Medicare taxes.

The compensation agreement of a salary of $24,000 was disregarded by the tax court, because the amount was not actually paid. Also the court stated that the compensation was not at arm’s length, but rather adopted as mere window dressing. The IRS also had flawed valuation, but the court concluded that the reasonable compensation was $83,200 annually.

For investment and passive activity businesses, such as real estate partnerships, as well as entities where making special allocations of income/losses among the partners/LLC members is important, the corporate form may not be a viable alternative.

However, businesses with active income should give a second look at the corporate form of business to take advantage of the tax-favored status currently enjoyed by S corporations.

Also, the material participation rules should be reviewed carefully for Investment Tax purposes due to the complexity.

In preparation for potential reasonable salary issues for S corporations, it is strongly recommended to perform tactful research on salary comparisons based on job title, duties and skills, carefully document the compensation arrangement before the payment is made, and record it in the corporate minutes, and so forth.

During the entity selection process, business owners need to thoroughly consider all the facts, analyze the benefits and disadvantages of all entity types, then place them on the scales, and determine which factors outweigh others.