The good news embedded in Mr. Biden’s proposals? Most S corporation shareholders avoid a tax increase. But let’s dig into the details…
Biden Proposes to Levy Obamacare Tax on S Corporations
The major piece of Mr. Biden’s S corporation tax proposals? To levy the 3.8 percent Obamacare tax on some S corporation shareholders with adjusted gross incomes more than $400,000.
But some quick backstory so everybody starts on the same page…
Two flavors of the Obamacare tax exist: “net investment income tax,” or what we’ll called here the “NIIT” and then “self-employed contributions act tax,” or what we call here and what the Biden proposal calls the “SECA”.
If an S corporation shareholder holds a passive interest in an S corporation, she or he may already pay one flavor of the 3.8 percent tax, the net-investment-income-tax (or NIIT), on the S corporation’s profit. In this case, the 3.8 percent Obamacare tax kicks typically when a taxpayer’s total income equals $250,000 if married or $200,000 if single.
Currently, however, if an S corporation shareholder holds a nonpassive interest, she or he avoids the other flavor of the 3.8 percent Obamacare tax: the 3.8 percent SECA on up to 92.35 percent of the S corporation’s profit. Mr. Biden proposes these shareholders also now pay the Obamacare tax.
Just to be clear, then, a passive “investor” shareholder might currently pay a 3.8 % tax on a $100,000 S corporation profit. And Mr. Biden proposes a working shareholder-employee should pay a 3.8% tax on $92,350 of a $100,000 S corporation distributive share of the profit.
And one other thing to mention because date confusion exists. The proposal suggests an effective date of January 1, 2022.
Average S Corporation Shareholder Continues to Enjoy Benefits
Perhaps the most important point to make here: The average S corporation should continue to enjoy significant tax benefits from an S corporation. And, the same benefits enjoyed in the past.
The most recent IRS data available (from 2017) suggest that S corporations roughly pay their shareholders about $40,000 of wages and then also generate another $50,000 of profits, or distributive share.
If this small business owner operated as a sole proprietor or a partner, she or he would pay the 15.3 percent SECA tax on 92.35 of the $90,000 of business income, or roughly $12,000.
When the owner instead operates as an S corporation and pays $40,000 in wages and then the other $50,000 in distributions, she or he instead pays the 15.3 percent tax on the $40,000 of wages, or roughly $6,000.
In 2017, then, the average S corporation shareholder-employer maybe saved about $6,000. Probably that savings amount has increased since then. Or at least it increased before the effects of the Covid-19 pandemic.
But the main point: Mr. Biden leaves S corporation tax saving in place for most S corporations.
High Income S Corporation Shareholder-employees Lose Savings
High income S corporation shareholders, however, face a different situation.
Say an S corporation shareholder enjoys $1 million of income from an S corporation she or he works in. Further assume the shareholder earns $250,000 in wages and then receives the remaining $750,000 as a distributive share of the profits.
Under current law, the shareholder employee pays roughly $25,000 in payroll taxes on the $250,000. But the shareholder avoids paying any payroll taxes on the other $750,000.
Mr. Biden proposes this shareholder-employee pay the 3.8 percent tax on $600,000 of the $750,000. So, roughly $23,000 of new taxes.
In this example, the shareholder-employee still saves roughly $6,000 of taxes. The taxpayer avoids paying the 3.8 percent Obamacare tax on $150,000. But the pre-Biden tax rules let this same person save nearly $30,000 annually. Under those rules, the taxpayer avoids paying the Obamacare tax on $750,000.
And now I want to say something for the tax accountants…
This Next Part Only for the Tax Accountants
The May General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals document, known as the “Green Book,” gives a detailed description of how the calculations work:
In order to determine the amount of partnership income and S corporation income that would be subject to SECA tax under the proposal, the taxpayer would sum (a) ordinary business income derived from S corporations for which the owner materially participates in the trade or business, and (b) ordinary business income derived from either limited partnership interests or interests in LLCs that are classified as partnerships to the extent a limited partner or LLC member materially participates in its partnership’s or LLC’s trade or business (this sum referred to as the “potential SECA income”).
Beginning in 2022, the additional income that would be subject to SECA tax would be the lesser of (i) the potential SECA income, and (ii) the excess over $400,000 of the sum of the potential SECA income, wage income subject to FICA under current law, and 92.35 percent of self-employment income subject to SECA tax under current law. The $400,000 threshold amount would not be indexed for inflation.
The thing to notice: Mr. Biden calculates someone’s “potential SECA income” by adding up their S corporation profits and then the similar profits from partnerships and LLCs that have not been subjected to an Obamacare tax. And then he applies the 3.8 percent SECA tax to the lesser of the SECA income or the amount by which the business-y part of the taxpayer’s adjusted gross income exceeds $400,000.
As a result? High income taxpayers do not pay as much tax as one might expect from reading the news reports.
Some High-Income Folks Avoid Losing Out
An example shows why this occurs…
Consider this situation. A taxpayer earns $500,000 in investment income (which would already be subject to the 3.8 percent NIIT). Further, say she or he also earns another $500,000 from an S corporation in which she or he materially participates. (Perhaps the shareholder recently retired so earns no wages but still per the regulations counts as materially participating.)
How much S corporation income does Mr. Biden propose taxing at 3.8 percent? I think $100,000. And here’s my accounting…
This fictitious taxpayer’s “potential SECA” income equals $500,000.
The sum of the potential SECA income (so $500,000), wage income subject to FICA (so zero), and 92.35 percent of self-employment earnings (so, again, zero) also equals $500,000.
The tax applies to the amount by which this $500,000 exceeds $400,000. So only the last $100,000. And thus the tax equals $3800.
Four Final Things to Note
Four other points to make a quick note of here…
A first thing to note: Back-of-the-envelope calculations suggest the most a working shareholder saves with an S corporation runs about $15,000 annually under the Biden plan. The most a non-working shareholder who still materially participates (perhaps using the rule in Regulation 1.469-5T(a)(5) or 1.469-5T(a)(6)) saves with an S corporation runs about $30,000.
These savings amounts sound good. But some high-income taxpayers may prudently decide the costs of operating as an S corporation don’t make sense given limited benefits. (I’d think about lower Social Security benefits, lower retirement contributions, stricter ownership rules, reduced flexibility in allocating profits among owners, and then potentially extra costs to liquidate.)
Second, this quick but really important note. Keep in mind that Mr. Biden proposes bumping the top tax rate from 37 percent to 39.6 percent. S corporations and their shareholders need to plan for this. For example, their S corporations may need to adjust upward the tax distributions they make.
Third, and I’ll try to keep this nonpolitical, but this proposal to subject S corporations to the Obamacare tax diverges from the promise that former President Obama and Congressional Democrats made when they worked to sell the Affordable Care Act (also known as Obamacare) to voters–including voters who owned small businesses. Accordingly, while for decades S corporations avoided payroll taxes on some their profits, this proposal if it passes may signal the end is in sight for the S corporation loophole. However…
A fourth final point: Because the S corporation loophole has survived attacks for decades, and regularly been defended by both Democrats and Republicans, many knowledgeable tax practitioners we talk with think Congress won’t in the end make this change.
We wrote a blog post about how Mr. Biden proposes bumping up taxes on Small C corporations at our Nelson.CPA website: Avoiding Biden Tax Increases on Small Corporations. Small business owners who want to consider all their options may want to skim that.
The Treasury Green Book referenced above is available here. It is well worth a careful read if you’re a tax accountant.