People have complained about the loophole, gosh, probably since President Eisenhower’s administration created it.
The triggering event? President Biden and the House Democrats’ tax proposal to subject working S corporation shareholders to the net investment income tax. But the situation is complicated. Messy.
So, I’m going to talk here about the slow death of the S corporation. Why it occurs. And what you can do if the death matters to your business. Or to the businesses of your clients.
One other thing to say as we start. I’m going to use rounded, really simplified examples here. That’ll make this discussion shorter. Easier to digest.
And then one high level point to start with? The death occurs because the new tax on S corporations ignores inflation. But let’s dig into the details.
How S Corporations Save Tax
To start, you need to understand how S corporations save entrepreneurs payroll taxes, including Social Security taxes, Medicare taxes, and then the Medicare surtax and net investment income tax (which are more commonly known as the Obamacare taxes).
Say an entrepreneur pays him or herself a fair salary. On that income, she or he pays Social Security taxes, and possibly Medicare and Obamacare taxes.
But say the business the entrepreneur runs generates another $100,000 of business profit in addition to those wages
On that additional non-wage income, the entrepreneur still pays income taxes.
But with an S corporation she or he doesn’t pay payroll taxes. And that is how S corporations save business owners taxes.
In comparison? If the entrepreneur operates as a sole proprietorship and makes the exact same amount of money? She or he essentially pays both income and payroll taxes on all the profit.
Furthermore, the same basic accounting occurs if an entrepreneur works as a partner in a partnership. In that situation, the partner pays both income and payroll taxes on all the profit.
Note: We have a long discussion about how S corporations save taxes here: The Million Dollar S Corporation Mistake.
How Biden Tax Plan Starts the Slow Death of S Corporation
What President Biden proposes? And what the House Ways and Means Committee puts into writing? A rule that says an entrepreneur pays the 3.8 percent Obamacare tax if the entrepreneur’s income rises high enough.
Specifically, the rule says that if an entrepreneur files as a single person, she or he pays the 3.8 percent Obamacare tax once modified adjusted gross income hits $400,000. And if an entrepreneur files as a married person, she or he pays the 3.8 percent Obamacare tax once modified adjusted gross income hits $500,000.
A clarification: A taxpayer pays the Obamacare tax on the amount by which modified adjusted gross income exceeds the threshold. A single person with a modified adjusted gross income of, say, $410,000, pays no 3.8 percent tax on that first $400,000. Only on a part of that last $10,000.
Who Gets Hit Initially with New S Corporation Tax
Very correctly, Mr. Biden and House Democrats point out that in 2021, those modified adjusted gross income thresholds mean basically only taxpayers in the top one percent get hit.
For the record, I double-checked. The Democrats are absolutely right.
Today? The new tax on S corporations ignores roughly 99 percent of the taxpayers in the country.
Note: A great paper that discusses and coincidently profiles who the Biden tax plan targets appears here: Capitalists in the Twenty-first Century.
The thing that people miss? And something, frankly, entrepreneurs, business owners and professional advisors need to pay attention to?
Slowly but efficiently, inflation expands the number of people subject to the Obamacare tax over time.
Why? Because tax law fails to adjust those $400,000 and $500,000 thresholds for inflation.
And what that means is, more quickly than you might guess? A larger and larger group of S corporation shareholders pay the Obamacare tax.
Furthermore, eventually, inflation will eliminate the payroll tax savings an S corporation has traditionally delivered.
Specifically, once inflation pushes up a shareholder-employee’s reasonable wages to the Social Security maximum taxable earnings limit and pushes up that person’s household taxable income to the Biden net investment income tax trigger? The S Corporation no longer saves business owners payroll taxes.
The process takes time. But the effect shows up sooner than you might guess.
The Original Obamacare Tax Example
To give you a concrete example, you only need to look at the original Obamacare tax formula.
The original flavor of the Obamacare tax formula hit single taxpayers earning more than $200,000 of modified adjusted gross income. And it hit married taxpayers earning more than $250,000 of modified adjusted gross income.
In 2010 when Obamacare passed, people talked about those income thresholds representing top one percent situations. That sounds about right.
And note that in 2010 when Obamacare passed, the Social Security tax applied only on the first $106,800 of earnings.
Above that earnings level, any additional wages got hit with either the standard 2.9 percent Medicare tax or the 3.8 percent Obamacare tax.
The 2.9 percent tax applied to earnings over the $106,800 maximum taxable earnings threshold but under the $200,000 threshold.
Then above $200,000? That 3.8 percent Obamacare tax rate kicked in.
But the thing is? That bit of tax law also doesn’t adjust that $200,000 or $250,000 value for inflation. And that means the 2.9 percent bracket has shrunk in size due to inflation.
With a dozen years of inflation since the Obamacare law passed, many more people pay the Obamacare tax. Next year, the Social Security maximum taxable earnings limit will probably equal roughly $147,000. That’s my guess. That means the 2.9 percent payroll tax bracket shrinks to roughly $53,000. So almost half the size of the $93,000 bracket that existed when Obamacare passed.
All that income previously taxed at 2.9 percent? Tax law now levies instead either a 15.3 percent Social Security tax or the 3.8 percent Obamacare tax. And in a few years? Well, very possibly by the time Mr. Biden leaves office? The 2.9 percent Medicare bracket won’t even exist.
In a few years, in other words, the 15.3 percent tax may apply to the first $200,000 or more of income a person earns. And the 3.8 percent Obamacare tax will apply to any amounts in excess of that $200,000.
The Slow-Motion Death of the S Corporation
Now let’s return to the slow-motion death of the S corporation…
And a first point just so nobody overreacts: The death of the S corporation? It will take time. Lots of it.
I’m talking, and we’re worrying, about something that occurs incrementally over the next couple of decades or longer.
But it’s certainly worth noting that in coming years the S corporation tax savings steadily shrink. Especially for successful entrepreneurs.
Specifically, as inflation requires shareholder-employees to bump their salaries and so pay more and more of the 15.3 percent Social Security tax? And as more and more shareholder-employees pay the 3.8 percent Obamacare tax? Well, yeah, you need to think about all this. And probably starting as soon as the law passes. If it passes.
Note: Nonworking S corporations may already be subject to Obamacare taxes on their shares of S corporation profits as explained here: Avoiding Net Investment Income Tax.
Actionable Insights for Bid Tax Plan S Corporation
In fact, if you’re an entrepreneur or business owner, I think you want to consider three issues:
First, if your business needs wages to qualify for the still generous Section 199A deduction Congress plans to provide through 2025? The S corporation option may still save you tax. The current Congressional Democrats’ tax proposal, which could easily change between the time I write this and the time you read it, gives business owners up to a $400,000 or $500,000 Section 199A deduction. So, a 199A deduction on roughly $2 million to $2.5 million of income. An S corporation may therefore make sense temporarily if only to create wages for the Section 199A deduction. (That deduction allows taxpayers to avoid paying tax on the last 20 percent of their business income.)
Second—and this is an however—if your situation revolves around a business or venture that may or will run decades? Yeah, you probably want to revisit your entity choice. Something else may make more sense. Let’s be honest. The historical reason to be an S corporation? So you save payroll taxes. The historical problems with an S corporation? You also lose flexibility and give up other tax benefits. Accordingly, if you lose or will lose payroll tax savings as compared to what you planned or hoped? Yeah, you need to consider other options. Like a limited liability company treated as a partnership. Or a traditional C corporation.
Third, and I am not going to go into details here, but you of course do have other ways to mitigate or sidestep the taxes Congressional Democrats and Mr. Biden propose hitting S corporations with. Your tax advisor, in fact, has a long list of planning techniques she or he can dust off and then use to dial down the taxes you ultimately pay. You may just need to be a bit more proactive. And go to a little more work.