Can S corporations avoid higher Medicare taxes?

S corporations facing increased Medicare taxes may want to take advantage of a planning opportunity.

Business owners might be able to reduce or eliminate the increased Medicare taxes that went into effect last year. This opportunity may be available to them if they own a business operating as an S corporation and their total income exceeds certain threshold amounts.

Since 2013, the Medicare tax on compensation and self-employment income has been increased from 2.9 percent to 3.8 percent. The 0.9 percent increase applies to the extent compensation or self-employment income specified is more than $250,000 for married individuals filing jointly and $200,000 for single individuals.

Since these threshold amounts are not indexed for inflation, an increasing number of taxpayers will be subject to the tax in 2014 and future years.

Accompanying the Medicare tax on earned income, a 3.8 percent Medicare tax that applies to net investment income (NII) also became effective in 2013. With few exceptions, most income is covered by one, but not both, of these taxes.

The net investment income tax applies to the lesser of NII or modified adjusted gross income over the specified threshold amounts.

NII is the sum of passive income – generally, interest, dividends, annuities, rents, royalties, capital gains and certain income from a passive trade or business – less applicable deductions. Trade or business income is included in NII only if the business activity is a passive activity or involves trading in financial instruments or commodities.

The net investment income tax applies to the entire distributive share of S corporation income allocable to a shareholder to the extent the income is derived from activity that is passive (or from trading in financial instruments or commodities) or represents the corporation’s investment income. However, shareholders who materially participate in the business of the S corporation avoid the NII tax on their entire distributive share of the S corporation’s business income.

If the shareholder is also an employee of the S corporation, the employee-shareholder is subject to employment taxes – including the Medicare tax on earned income at the new higher rate – on compensation for services that the shareholder provides to the S corporation. However, the self-employment tax does not apply to an S corporation shareholder’s distributive share of the corporation’s income.

If you are a shareholder-employee actively involved in a business operated by an S corporation, you can minimize earnings subject to the higher Medicare taxes by keeping your salary low and taking most of your profits through your distributive share of the corporation’s profits. The trick is to make sure your salary is reasonable in amount for the services you provide.

With the increase in taxes on earned income, the IRS has an added incentive to challenge the allocation of S corporation payments between salary and distributions. If the IRS determines that your salary is too low, a portion of the distribution might be recharacterized as wages.