The Affordable Care Act imposes an increased Hospital Insurance Tax (HIT, also known as the Medicare Tax), of 3.8% on "net investment income" and .9% on earned income, for taxpayers with income of more than $200,000 individually or $250,000 on joint returns. These levels are NOT indexed for inflation, so more and more taxpayers will be subject to additional HIT (particularly if inflation accelerates as many predict). The additional .9% HIT on earned income, when combined with the existing 2.9% HIT, creates an equal 3.8% tax on both earned income and passive income for these high income taxpayers. One-half of the HIT on earned income is paid by the corporation and is thus tax deductible.
S Corporation Distributions Currently Avoid Payroll Tax
One common payroll tax avoidance techniques, frequently used by dentists and other high income professionals, is to operate their business through an S corporation, and as a shareholder reducing their salaries in favor of S corporation distributions. This technique has been targeted more over recent years for IRS audits, particularly for those professionals who do not pay themselves "reasonable compensation" for the work they do. The IRS issued a GAO study on taxpayer noncompliance with S corporation tax rules in December 2009, showing how keenly focused the IRS is on S corporations as a source of additional taxes (see link to study, below).
Surprise! S Corporation Distributions Continue to Avoid Payroll Tax (if you Materially Participate)
Given the negative political environment surrounding S corporations, I expected S corporation distributions to be included in the Health Care Bill's definition of "net investment income." However, "net investment income" only includes investment income from "passive activity" like rentals, and trading in financial instruments (a Wall Street tax); S corporation distributions are NOT a passive activity for shareholders who "materially participate" in the practice. (Material participation generally requires a minimum 500 hours per year (10 hours per week) in the business activity, see link to IRS Publication below.) This means that most S corporation dentists will continue to benefit from treating practice income as distributions rather than salary. In fact, since the HIT imposes an additional .9% tax on salary that doesn't apply to distributions, incentives to use an S corporation and pay distributions just increased.
S Corporation Distributions to Absentee Owners are Subject to the HIT
The good news does not extend to absentee owners of dental corporations and other professional corporations; since they do not "materially participate" in the practice, S corporation distributions will be considered passive income and will therefore be subject to the HIT. This creates an odd incentive - these absentee dentists have historically limited their salaries to a "low but reasonable" amount, but they now will save money (starting in 2013) by converting their distributions back to salary! The savings results by using the deduction available to the dental corporation for its share of payroll taxes, a deduction that is not available to the HIT.
Look for Continued S Corporation Audits
There are rumblings that this loophole for S corporation distributions may be attacked with further revisions to the Health Care Bill - but without a filibuster-proof Senate, I think it unlikely that this attack will be successful. However, look for the IRS to continue to audit S corporations, particularly on the reasonableness of their compensation and adequacy of initial capitalization, as discussed in the GAO study. I have also added two links below on how the IRS determines whether your compensation is "reasonable." Given the growing audit environment, it is important for all S corporations, not just dental corporations, to observe all corporate formalities (see link to my Legal Guide on "Corporate Formalities" below).
Example 1: Individual earning $250,000
S corporation dentist (single taxpayer) materially participates in the dental practice. The dentist received $250,000 in total income: $120,000 in salary (full payroll taxes) and $130,000 in distributions (no payroll taxes). This dentist receives no passive income (since he materially participated in the business). The Health Care Bill imposes no new taxes on this dentist; in fact, being an S corporation has saved this dental corporation an additional $1,650 in payroll taxes.
Example 2: Joint Filer / Absentee Owner earning $1 million
S corporation dentist (jointly filing taxpayer) does not materially participate in three separate dental practices (absentee owner). He receives $1 million in total income: $250,000 in salary (payroll taxes), $600,000 in distributions (no payroll taxes), $100,000 in rent on the office condo of one of the practices, and $50,000 in other passive income. In 2013, this dentist will pay 3.8% on the excess income it received, a total additional tax of $28,500. If the dentist converts $250,000 of distributions to salary, A 1/2 of the 3.8% payroll tax becomes a corporate tax deduction; assuming the dentist has a 40% marginal tax rate, the tax is reduced to $26,600. Alternatively, if the dentist can demonstrate that he works at least 10 hours per week on these practices, the only additional tax will be $5,700 on the rental and other passive income - a savings of $22,800 ($45/hour).
Disclaimer - Legal Stuff
IMPORTANT: This Legal Guide is made available for educational purposes only. There is no attorney client privilege between you and the attorney author. This Legal Guide is not a substitute for competent legal advice from a licensed attorney that specializes in this area in your home state and with whom you have an attorney client relationship. Also, law changes frequently and varies from jurisdiction to jurisdiction. The information and materials provided are general in nature, and may not apply to a specific factual or legal circumstance described in the question. Copyright 2010 by Robert W. Olson, Jr. - all rights reserved.