Will the Obama Health Care Reform Affect S Corporations?

Obamacare, specifically the Health Care and Education Reconciliation Act of 2010 (HR 4872) and Patient Protection and Affordable Care Bill (HR 3590), makes myriad changes to federal law. But the change that's perhaps most relevant to S corporations and their owners concerns the new 3.8% Medicare tax on investment income.

An S corporation shareholder might see his or her taxes rise by roughly $4,000 per every $100,000 of business profit because of just this tax. And note that other additional taxes are coming down the pike.

Before you rush off and join the tea party movement, however, you want to look a little closer at how this new tax affects S corporation shareholders and S corporation income. The news isn't all bad. And it could have been much, much worse...

Working S Corporation Shareholders

In a small-business-friendly move, the new Medicare tax does not apply to business income earned by shareholders active in the S corporation. In other words, if you're working in an S corporation, your share of the S corporation's operating profits won't be subject to the new Medicare tax--even if you are over the thresholds mentioned earlier.

Example: You own and operate an S corporation, paying yourself a salary of $200,000 and earning a distributive share of $300,000. Assume that all of your distributive share comes from business operation. In this case, you will pay the Medicare tax on the $200,000 of wages (as has always been the case), but not on the $300,000 of distributive share.

For now, then, the principal advantage of the S corporation tax regime still exists--at least for working shareholders.

Passive S Corporation Shareholders

Unfortunately, passive investors in an S corp don't get a pass on the new Medicare tax. If someone doesn't actively work in the business (and the usual passive activity rules of IRC Sec. 469 apply), the income gets whacked with the 3.8% tax.

Example: You invested in an S corporation but are not working and in fact have never worked in the business. If you make $250,000 in your regular job and your distributive share of the S corporation's profit is $100,000, you will pay Medicare tax on all of the $100,000 distributive share under Obamacare.

Tip: You need to confer with a tax advisor if you think the passive activity rules apply in your situation. But as a general rule, S corporation shareholders who are only and merely shareholders will potentially get hit with the new Medicare tax.

Hidden S Corporation Hits in the New Medicare Tax

Once a taxpayer's income exceeds the threshold amount, investment income gets hit with the tax. But it's important to note that investment income earned inside an S corporation retains its character as the income flows through to investors. This means that even working shareholders may pay the new Medicare tax on the chunk of the S corporation's profit that occurs because of interest, dividends, capital gains, or rental income earned by the S corporation.

Example: Your share of an S corporation's profit is $100,000 but only $80,000 of this $100,000 represents profits from the business operation. The remaining $20,000 of profit comes from dividends, interest and capital gains earned on investments held by the S corporation. In this case, no matter whether you're a working shareholder or a passive shareholder, you'll pay the Obamacare Medicare tax on the $20,000 of investment income that flows through to you if your income exceeds the threshold amounts.

Secret Benefit of S Corporations

One final note should be made about S corporation taxation and Obamacare. While capital gains are normally subject to the Obamacare tax if your income rises about the $200,000 or $250,000 thresholds, if you actively participate in an S corporation and the S corporation's assets are sold or the S corporation's stock is sold, you do get to avoid the Obamacare tax on the profits from those sales. This loophole means that S corporations provide their owners with big tax savings when the business gets sold.

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