Obamacare: One Element Driving Business Entity Choice

Obamacare: One Element Driving Business Entity Choice

[Editor's Note: This is an excerpt from 1-1 Tax Planning for Partners, Partnerships and LLCs § 1.02 (Matthew Bender) - Determining the Form of Business to Adopt.]

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Recent tax legislation relating to health care may significantly affect decisions regarding choice of entity and the type of income generated by business and investment entities. [Patient Protection and Affordable Care Act, Pub. L. No. 111-148 (2010), and the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152.]  The legislation imposes a new surtax (Medicare contribution tax) of 3.8 percent on investment income of certain taxpayers earned after December 31, 2012, and increases the FICA self-employment tax rate from 2.9 percent to 3.8 percent for many taxpayers. In effect, the Medicare surtax may result in a 3.8 percent tax on dividends C corporations pay to their owners.

These new taxes may encourage many entities to adopt the pass-through tax treatment provided by partnerships, LLCs and S corporations.  Although pass-through entities do not pay the Medicare contribution tax, individuals, trusts, and estates that are direct or indirect owners may be subject to taxation on the shares of income and gain they derive from these entities. Also, taxpayers must include the Medicare contribution tax in determining their estimated tax payments. [IRC § 6654.]

The 3.8 percent Medicare contribution tax applies to the lesser of a taxpayer's net investment income or the excess of its modified adjusted gross income (MAGI) over a threshold amount.  The threshold amount is $250,000 for joint filers or surviving spouses, $125,000 for a married individual filing separately, and $200,000 in other cases. [IRC § 1411(a).]

The MAGI equals a taxpayer's adjusted gross income (AGI) increased by the amount excluded from income as foreign earned income. [As defined in IRC § 911(a)(1) (net of disallowed deductions and exclusions); IRC § 1411(d).]

 A taxpayer's net investment income equals the excess of the sum of its:

  1. gross income from interest, dividends, annuities, royalties, and rents (other than income from the ordinary course of a trade or business not included in [2] below;
  2. gross income from a trade or business that is: [IRC § 1411(c)(2).] a passive activity (under IRC § 469) with respect to the taxpayer, or a trade or business of trading in financial instruments or commodities (under IRC § 475(e)(2));
  3. net gain from the disposition of property other than property held in a trade or business (other than a trade or business described in [2];

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  • allowable deductions properly allocable to such gross income or net gain.

In effect, the Medicare contribution tax applies to portfolio income and passive income as defined under IRC Section 469.

Although the surtax does not apply to income from a trade or business conducted by a partnership (other than passive income), income, gain, or loss on working capital is not considered to be derived from a trade or business and is subject to the surtax. [IRC § 1411(c)(3).] Gain or loss from a disposition of a partnership interest is included in a partner's net investment income only to the extent of the net gain or loss the partner would take into account if the partnership sold all its property for fair market value immediately before the disposition. [IRC § 1411(c)(4).]

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