What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax S Corporations Versus Partnerships: FICA, SECA, and NII Taxes The employment tax treatment of shareholders in S corporations is generally preferable to the self-employment tax treatment of partners. Adding the new hospital insurance surtax and net investment income tax to the mix, this article explains why some individuals are asking: Should my closely held business elect S corporation status? Monday, October 20, 2014 by Scott Vance and Jeanne Sullivan, Washington National Tax Scott Vance is a principal in the WNT Private Markets group practice. Jeanne Sullivan is a director in the WNT Passthroughs group, a former IRS senior technical reviewer (Passthroughs and Special Industries), and a former U.S. Tax Court clerk. As a general matter, a partner pays self-employment taxes on his or her full distributive share of income, while an S corporation shareholder pays employment taxes only on reasonable compensation. Although this distinction is widely known, 2010 legislation prospectively imposed hospital insurance surtaxes, hence increasing focus on employment and selfemployment taxes for tax years beginning after December 31, With new taxes in the mix, taxpayers with closely held businesses may be reconsidering the advantages of electing S corporation status. As a further part of the analysis, taxpayers should evaluate the potential application of the net investment income tax, also added as part of the 2010 legislation. Which Taxes Are at Issue? This article focuses on the following taxes: Sections 3101 and 3111 impose on employees and employers respectively a 6.2 percent tax for old-age, survivors, and disability insurance and a 1.45 percent tax for hospital insurance on wages as defined in section 3121(a). Significantly, section 3101(b)(2) imposes a hospital insurance surtax on employees of 0.9 percent, effective for wages received with respect to employment during any tax year beginning after December 31, 2012, in excess of specified thresholds. 1 These taxes are generally referred to as 1 This provision was added via P.L (The Patient Protection and Affordable Care Act of 2010), sections 9015 and The thresholds are $250,000 for married taxpayers filing joint returns, $125,000 for married taxpayers filing separate returns, and $200,000 for other individual returns. entity. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 S Corporations Versus Partnerships: FICA, SECA, and NII Taxes page 2 the Federal Insurance Contribution Act ( FICA ) taxes. Note that there are also payroll taxes under the Railroad Retirement Tax Act ( RRTA ) and Federal Unemployment Tax Act ( FUTA ). Section 1401 imposes on individuals a 12.4 percent tax for old-age, survivors, and disability insurance and a 2.9 percent tax for hospital insurance on self-employment income. Significantly, section 1401(b)(2) imposes a hospital insurance surtax of 0.9 percent, effective for selfemployment income during any tax year beginning after December 31, 2012, in excess of specified thresholds. 2 These taxes are generally referred to as the Self Employed Contributions Act ( SECA ) taxes. Section 1411 imposes on individuals, estates, and trusts a 3.8 percent net investment income tax ( NII tax ) on certain types of income and gain for tax years beginning after December 31, 2012, but only on net investment income that is over specified threshold amounts. 3 Note that the 3.8 percent rate equals the 2.9 percent hospital insurance rate plus the 0.9 percent surtax under the FICA and SECA regimes. How Do These Taxes Differ and How Do They Apply to S Corporation Shareholders or to Partners? It is important to distinguish among the taxes, as SECA taxes do not apply to wages subject to FICA taxes, and the NII tax in turn does not apply to amounts subject to FICA or SECA taxes. Additionally, certain income and gain is not subject to FICA, SECA, or the NII Tax. FICA Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). Starting with FICA, although there is some variation in the definition of an employee, section 3121(d)(2) generally defines an employee as any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. Under this definition, a person is treated as an employee if the employer has the right to direct and control the individual with respect to both the result to be accomplished by the work and the details and means by which that result is accomplished, and the employer is the person who 2 This provision was also added via The Patient Protection and Affordable Care Act of 2010, sections 9015 and The thresholds are similar to those in section 3101(b)(2). 3 This provision was added via P.L (Health Care and Education Reconciliation Act of 2010), section The thresholds are similar to those in sections 3101(b)(2) and 1401(b)(2).

3 S Corporations Versus Partnerships: FICA, SECA, and NII Taxes page 3 exercises that control over the work and the payment of wages. Section 3121(a) defines wages as all remuneration for employment. FICA taxes are not applicable to individuals who are self-employed. Comparing S corporations and partnerships readily illustrates this distinction. A shareholder of an S corporation can be employed by the S corporation and is subject to FICA on wages and other compensatory payments. However, the current view of the IRS is that a partner cannot be an employee of the partnership, and the partner is therefore not subject to FICA. 4 SECA Turning now to SECA, section 1402(a) provides as follows: The term net earnings from self-employment means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member Pursuant to section 1402(b) and (d), wages from employment are excluded from the ambit of SECA taxes. Furthermore, there are a variety of exclusions under section 1402(a)(1) through (17) including rentals from real estate and from personal property leased with the real estate, dividends, interest (unless the taxpayer is a dealer), and gain or loss on the sale or exchange of a capital asset. One of these exceptions bears some further comment; section 1402(a)(13) provides as follows: [T]here shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services The Code and regulations do not define limited partner for this purpose. The Joint Committee on Taxation has suggested that the preferential 4 See, e.g., Rev. Rul

4 S Corporations Versus Partnerships: FICA, SECA, and NII Taxes page 4 treatment derives from state law at the time section 1402(a)(13) was enacted, i.e., the then-general preclusion of limited partners from performing services for the partnership while retaining their limited liability. 5 No statutory changes have been made, however. Furthermore, while some courts have addressed the applicability of this provision to members of entities that are neither general partners nor limited partners, 6 no court has held that SECA taxes apply to a true limited partner in a state law limited partnership. Thus, the section 1402(a)(13) exception appears to have continued viability. In any event, the limited partner would still be subject to SECA on the partner s guaranteed payments for services. As suggested above, an S corporation shareholder may be employed by the S corporation and thus be subject to FICA on the shareholder s compensation (which must be reasonable). Perhaps because of the application of the FICA regime, as well as the language of section 1402(a) (which applies to partners but not shareholders), the IRS has concluded that an S corporation shareholder s distributive share of income and gain is not subject to SECA. 7 NII Tax Finally, consider the NII tax. While the statutory provision is rather brief, the regulations are extensive. 8 We will in this context provide a brief overview. The first step is determining what is included in net investment income ( NII ). Per section 1411(c)(1), NII is the excess (if any) of: (A) the sum of: (i) Gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which section 1411 does not apply (an excluded business); 5 See Options to Improve Tax Compliance and Reform Tax Expenditures, JCS (JCT Jan. 27, 2005) at See Renkemeyer, Campbell, & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011); Riether v. United States, 919 F.Supp.2d 1140 (D.N.M. 2012). 7 See, Rev. Rul , C.B See T.D (final regulations); REG (proposed regulations).

5 S Corporations Versus Partnerships: FICA, SECA, and NII Taxes page 5 (ii) Other gross income from a trade or business to which section 1411 applies (a section 1411 trade or business); and (iii) Net gain attributable to the disposition of property other than property held in an excluded business; over (B) the deductions allowed by subtitle A that are properly allocable to such gross income or net gain. A section 1411 trade or business is a trade or business that is a passive activity within the meaning of section 469 with respect to the taxpayer (passive business) or a trade or business of trading in financial instruments or commodities as defined in section 475(e)(2) (trading business). Status of a trade or business as an excluded business or as a section 1411 trade or business is driven in large part by section 469 principles. Thus, one must assess in many cases material participation of the S corporation shareholder or the partner in the activities of the trade or business. Appropriate grouping of related trades or businesses for this purpose can be a key step in the analysis. Furthermore, the final regulations provide a list of items excluded from NII, as follows: 9 Amounts paid in consideration for services rendered, even if such amounts are subject to section 72 Income subject to SECA Wages Distributions from certain qualified plans Unemployment compensation Alaska Permanent Fund dividends Alimony 9 See generally section (d)(4).

6 S Corporations Versus Partnerships: FICA, SECA, and NII Taxes page 6 Social Security benefits Inclusions from a CFC for which a section (g) election is not in effect What Does All This Mean for Choice of Entity between S Corporation and Partnership? To summarize several points discussed in this article: An S corporation shareholder may be an employee of the S corporation and thus may be subject to FICA taxes, to the extent of the shareholder s compensation (which cannot be less than reasonable compensation for the services). On the other hand, a partner may not be treated as an employee and thus is not subject to FICA taxes. An S corporation shareholder is not subject to SECA taxes on the shareholder s distributive share of income. On the other hand, a partner is subject to SECA taxes on the partner s distributive share of partnership income, subject to the section 1402(a)(13) exclusion for limited partners. The NII tax is potentially applicable in either the S corporation or the partnership context, to the extent of any amounts not already subject to FICA or SECA taxes. However, to the extent of material participation, the NII tax generally would not apply to either S corporation shareholders or partners (with the most prominent exception being per se passive rental activities). There have been proposals to change the employment tax treatment of S corporations and partnerships, including those by Ways and Means Committee Chairman Dave Camp 10 as well as the Obama Administration. 11 None, as of yet, have been enacted, however. 10 See Tax Reform Act of 2014, Discussion Draft, Section-by-Section Summary at pp The document is available at: mmary_final_ pdf 11 See General Explanations of the Administration s Fiscal Year 2015 Revenue Proposals (March 2014) at pp The document is available at: FY2015.pdf

7 S Corporations Versus Partnerships: FICA, SECA, and NII Taxes page 7 FICA, SECA, and the NII tax treatment of S corporation shareholders as compared to partners is only one factor taxpayers should consider when assessing choice of entity; ultimately, the decision must rest on a modeling exercise that explores the totality of the taxpayer s overall tax and business posture. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.