The Build Back Better Act hits S corporation owners and active real estate investors a bit harder than some of us guessed.
In a nutshell? It subjects high income S corporation owners and active real estate investers to the net investment income tax. (Something they avoided to date.)
If you’re impacted, therefore, you want to understand the new law. And then you maybe also want to take steps to minimize the tax increase.
But let’s dig into the details…
How S Corporations and Active Real Estate Investors Taxed Prior to Build Back Better
To start, let me review how the net investment income tax (also known as the Obamacare tax) works today.
In the case of an S corporation earning $200,000 in profits, the business owner splits the profit into wages and a leftover amount called a distributive share. For example, an S corporation owner might split $200,000 of profit into $80,000 in wages and $120,000 in distributive share.
The business owner pays Social Security and Medicare taxes on the $80,000. But not on the $120,000.
Further, if she or he materially participates in the business? The owner pays no net investment income tax either.
Active real estate investors often, for purposes of net investment income taxes, enjoy a similar tax treatment. A high income taxpayer would usually pay net investment income tax on $100,000 of real estate investment income. But she or he probably sidesteps paying that tax if materially participating in an active real estate investment.
Build Back Better changes this, however. Starting in 2022, Build Back Better makes a high income taxpayer treat the S corporation or active real estate income as net investment income. That treatment potentially triggers the 3.8% net investment income tax on the S corporation distributive share or the active real estate investment income.
Net Investment Income Tax in a Nutshell
The 3.8% net investment income tax hits single taxpayers who earn more than $200,000 in modified adjusted gross income. It hits married taxpayers who earn more than $250,000 in modified adjusted gross income.
If some taxpayer pays the tax, the 3.8% tax gets levied against the lesser of the net investment income or the amount by which the taxpayer’s modified adjusted gross income exceeds those $200,000 and $250,000 thresholds.
For example, a single person who earns $210,000 in investment income pays the 3.8% tax on $10,000. Not on $210,000.
Most taxpayers can think about the net investment income “modified adjusted gross income” as equivalent to regular old adjusted gross income. But at the bottom of this blog post, I link to an example of what the new Section 1411 statute will look like if the version of the Build Back Better Act available when I wrote this blog post on November 15, 2021 is what Congress passes and the President signs.
And now lets talk about how Build Back Better impacts S corporation owners and active real estate investors. It’s a little bit tricky…
Which High Income Taxpayers Pay Tax
A single taxpayer treats her or his S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if her or his modified adjusted gross income exceeds $400,000.
Married taxpayers treat their S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if their modified adjusted gross income exceeds $500,000.
A married taxpayer filing a separate return treats her or his S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if her or his modified gross income exceeds $250,000.
Let me give an example so you see how this works.
Say a single person earns $410,000 in S corporation income and $90,000 in W-2 wages and therefore enjoys $500,000 of modified adjusted gross income. Build Back Better treats the $410,000 of S corporation income as net investment income. And therefore this taxpayer will pay the 3.8% tax on $300,000 of that $410,000 of S corporation income. Note that the taxpayer pays the 3.8% on the lesser of the $410,000 of net investment income or the amount by which the taxpayer’s $500,000 of modified adjusted gross income exceeds $200,000–which equals $300,000.
A Phase-In Range Applies for Build Back Better S Corporation Tax
And then another wrinkle to be aware of: A phase-in range applies.
Single taxpayers see the tax phase in as the modified adjusted gross income rises from $400,000 to $500,000.
Married taxpayers filing joint tax returns see the tax phase in as the modified adjusted gross income rises from $500,000 to $600,000.
Finally, married taxpayers filing a separate tax return see the tax phase in as modified adjusted gross income rises from $250,000 to $300,000.
For example, say a single taxpayer earns $450,000 from an S corporation she or he materially participates in. Say that $450,000 equals the taxpayer’s modified adjusted gross income. With Build Back Better, this taxpayer treats that $450,000 as net investment income. But she or he doesn’t pay the 3.8% tax on the full $250,000 in excess of the $200,000 threshold for net investment income tax. Rather, because $450,000 is half way through the $100,000 phase-in range, she or he pays the 3.8% tax on half of the $250,000, or $125,000.
Some Initial Tax Planning Thoughts and Comments
Right now? We don’t even know if the Build Back Better Act will pass. And we don’t know what the final bill will say. But a handful of tax planning thoughts merit consideration…
Wait to Elect S Status?
First, this suggestion: An entrepreneur starting a new trade or business probably wants to wait on making any Subchapter S election until the dust settles on the Build Back Better legislative process. It seems very likely that applying the net investment income tax to S corporation income changes the attractiveness the S corporation option for some high income taxpayers and for some high potential ventures.
Consider Converting to Partnership?
A second thought: High income taxpayers with existing S corporations probably want to explore the mechanics of converting S corporations into partnerships.
As compared to an S corporation, a partnership (including a limited liability company) might mean that a high income taxpayer pays self-employment taxes on all the business income rather than net investment income taxes on a chunk of the business income.
But that treatment however should result in a new self-employment tax deduction. And it might also result in larger Section 199A and pension plan deductions.
Further, a partnership allows more flexibility in the tax accounting. And in the ownership. These tradeoffs might make the partnership option attractive…
No Do-it-yourself Corporate Liquidations
A third thought: Liquidating a corporation, including an S corporation, and reforming as a partnership probably triggers a bunch of taxable events. Accordingly, most high income taxpayers should work with their tax advisors to assess the costs and benefits of liquidating an S corporation to reform as a partnership.
This would not be a do-it-yourself project, in other words. Well, unless you’re a tax attorney, CPA or enrolled agent with corporate tax knowledge.
Smooth Income to Avoid Tax
A fourth general comment: High income taxpayers whose adjusted gross incomes bounce around the phase-in range–probably the usual case for affected S corporation owners? Yeah, these folks will really want to smooth their income going forward.
For example, a single person with modified adjusted gross income that holds steady at $400,000 annually avoids the Build Back Better tax.
But a single person who sees her or his income bounce between $300,000 one year and then $500,000 the next year, gets whacked with about $10,000 of net investment income tax every other year.
Work Harder to Find Deductions
A fifth comment related to scavenging more deductions. The marginal federal tax rates for some affected taxpayers get very high.
Affected taxpayers might be paying a base federal income tax rate of 35% for example. Another 10% to 12% due to the phase-out of the Section 199A deduction (if they are a specified service trade or business). Then another maybe 8% to 10% due to the phase-in of the net investment income tax.
A 50% or higher federal rate may mean taxpayers want to reexamine all the usual tax sheltering tactics. So bigger pension deductions. Or de-passified real estate losses. Stuff like that.
Remember Section 199A May Require S Corporation
Finally, a sixth comment: Even with the new tax, an S corporation may still make sense for some high income non-specified-service-trade-or-business taxpayers. Why? Due to the Section 199A deduction. Accordingly, don’t automatically assume an S corporation no longer makes sense. (Note though the Section 199A deduction expires after 2025.)
Other Resources You May Find Useful
First, here’s the government web page where you can get downloadable copies of the Build Back Better bill and related official documents.
Second, just in case you’re not used to mashing up new legislation with old existing statutes, here’s a Microsoft Word document that shows how Section 1411 looks if the Build Back Better Act passes. Note that the new bits appear in green.
A third small point worth mentioning: If you’re an active real estate investor, you may want to verify you’ve been sidestepping the net investment income tax in the past. Details here about how you do that correctly: Real Estate Investors and the Net Investment Income Tax. By the way? If you’ve been paying net investment income tax on your real estate investment income but should not have been, amend your open old tax returns. And get the refunds.
Fourth, this tangential remark: Partnership entities face both risks and opportunities related to maximizing their Section 199A deductions. More details here about this subject: Salvaging Partnership Section 199A Deductions.
Finally, this plug for our CPA firm: If you own an S corporation and need tax planning help with the new net investment income taxes on S corporations, know that we are available to help taxpayers with this analysis. Contact information appears here: Nelson CPA.