Choice of Entity for Closely Held Businesses - The Affordable Care Act Further Complicates the Decision
When starting a new business, an entrepreneur faces an important decision: the type of entity to form to operate the business. The two most common choices for closely held businesses are “S” corporations and limited liability companies (“LLCs”).
In 2010, we wrote about the “S” corporations and LLCs and the various factors to consider when choosing between them (e.g., pass-through income taxation, employment taxes, flexibility of capital structure, allocation of profits and losses, types of owners, and the ability to distribute property in kind) in an article entitled "Choice of an Entity for Closely Held Business: S Corporations, LLC and Employment Taxes." This article focuses on just one of those factors, employment taxes, and discusses the effect of the new taxes imposed by the Affordable Care Act on the choice of entity decision.
Employment taxes often have been (rightly or wrongly) the deciding factor in choosing between an “S” corporation and an LLC. Where employment taxes are the deciding factor, entrepreneurs typically choose the “S” corporation because of the potential to realize employment tax savings when an owner-employee expects that her salary will be less than her share of the net earnings of the corporation. With an “S” corporation, only the salary paid to the employee-owner is subject to employment taxes, whereas active employee-owners of an LLC pay employment tax on their entire share of the LLC’s income.
In 2013, employment taxes are made up of Social Security tax equal to 12.4 percent of the first $113,700 of wages or self-employment income, and Medicare tax equal to 2.9 percent of the total wages or self-employment income. In the case of wages, the employer pays one half of these taxes. In the case of self-employment tax, the employee pays the entire amount.
Beginning this year, the following new taxes apply:
- The Additional Medicare Tax on Wages and Self-Employment Income
The Medicare tax rate is increased from 2.9 percent to 3.8 percent for wages and self-employment income above a threshold amount, $250,000 for married taxpayers and $200,000 for single taxpayers.
- The Net Investment Income Tax (“NIIT”), a/k/a the Medicare Contribution Tax
The NIIT is a 3.8 percent tax imposed on “net investment income” for taxpayers with income above a threshold amount, $250,000 for married taxpayers and $200,000 for single taxpayers. The calculation of the tax is complicated, but in general it applies to dividends, interest, royalties, and rents that are not derived from a trade or business, as well as capital gains from other non-trade or business property (such as a vacation home). Its application to “S” corporation and LLC income is also complicated.
As it relates to LLCs and “S” corporations, whether the NIIT applies to a member or shareholder depends in large part on whether the person materially participates in the business, or is simply a passive investor.
- Passive investors in an LLC or “S” corporation generally are subject to the NIIT on their respective share of the entity’s income, whether such income is passive-type income (e.g., interest) or income from the trade or business.
- Owners who materially participate in an LLC are not subject to the NIIT on most of their share of the entity’s income. However, they are subject to Medicare tax on that income. Therefore, with respect to income above the threshold amount, an LLC member will owe a 3.8 percent tax whether she is a material participant or not, the only difference being whether that tax is labeled as Medicare tax or NIIT.
- Like owners of an LLC, owners who materially participate in an “S” corporation are not subject to the NIIT on most of their respective share of the entity’s income. However, unlike materially participating owners of an LLC, they are only subject to Medicare tax on their wages from the corporation, not on their distributive share of income. Therefore, there continues to be a potential tax advantage to active owner-employees of “S” corporations because, unlike LLC owner-employees, they can avoid Medicare tax and the NIIT on their distributive share of “S” corporation income.
Numerous commentators and members of Congress have argued in favor of balancing the treatment of LLC and “S” corporation owners with regard to employment taxes. However, rather than bridging the gap, these new taxes further complicate the choice of entity analysis. Of course, despite the possible tax benefit for owner-employees of “S” corporations, an LLC, a “C” corporation, a partnership, or another type of entity may be the best choice for a particular business. Myriad other factors must still be considered.