Because of the unlimited Medicare tax (formerly at the rate of 2.9%, but in 2013 moving to a combined 3.8% as a result of the .9% surcharge), there has long been an incentive to use S corporations to convert some portion of the earnings attributable to a business to dividend income which is not subject to Medicare tax as opposed to compensation that would otherwise give rise to self-employment income into income.
The IRS has always taken the position that distributions to the owner of an S corporation should be treated as compensation to the extent they are associated with the owner’s personal services or services to the company.
By contrast, earnings that come from the owner’s investment of capital and equipment or from the work of others can be treated as profit, not subject to self-employment tax.
The case law dealing with this issue has been unsettled due to the use of a “reasonableness test” which is inherently subject to dispute and conflict.
Many taxpayers have persisted in trying to violate the dictum that “pigs get fat and hogs get slaughtered” by being hogs. Repeatedly, we have seen that transactions where shareholders form S corporations and then seek to convert a majority of the distributable income into S corporation dividends.
The Service has successfully challenged a number of these attempts. See:
- David E. Watson, P.C. v. United States, 714 F.Supp. 2d 954, 955 (S.D. Iowa 2010), Doc 2011-530, 2011 TNT 7-14, aff’d, 668 F.3d 1008 (8th Cir. 2012), Doc 2012-3783, 2-12 TNT 36-12.
- Joly v. Commissioner, 211 F.3d 1269 (6th Cir. 2000), Doc. 2000-9384, 2000 TNT 61-20;
- Joseph M. Grey Public Accountant PC v. Commissioner, 119 T.C. 121 (2002), Doc 2002-21091, 2002 TNT 180-12, aff’d., N. 02-4417 (3d Cir. 2004), Doc 2004-7691, 2004 TNT 68-11;
- Greenlee, Inc. v. United States, 661 F.Supp. 642 (D.C. Colo. 1985);
- Olde Raleigh Realty Corp. v. Commissioner, T.C. Summ. Op. 2002-61, Doc 2002-12954, 2002 TNT 104-8.
But these cases are also instructive from a tax planning perspective. They demonstrate that if one is not too much of a “pig” that a large portion of the profits of a business can be excluded from self-employment income.
Thus, for instance, a not uncommon structure for certain very profitable professional firms looks something like this diagram.
This Subchapter S self-employment jig may now be up, however. Why you ask? Answer: Section 1411.
Remember that IRC § 1411 applies a 3.8% tax to all net investment income in excess of the various base amounts.
The question is whether “net investment income” under Section 1411 includes a distributive share of S corporation income. If so, the jig is up for the S corporation as a device for avoiding self-employment tax as the IRC § 1411 tax offsets the “saved” self-employment tax.
The statute was intended to catch this. However, it appears there is a “hole” in the computation of the taxable “net investment income” base that can be exploited.
Quaere: Will regulations under 1411 plug this hole? Perhaps not. Recently the IRS acknowledged they may not have the authority under IRC § 1411.[1]
[1] Amy S. Elliot, Tax Notes Today, November 7, 2012,http://services.taxanalysts.com/taxbase/tnt3.nsf/%28Number/2012+TNT+216-1?OpenDocument&Login
“Limited partnership structures are reappearing as taxpayers look to avoid the 3.8 percent section 1411 Medicare contribution tax on net investment income, Staudenraus said. “People are structuring into LPs with very, very skinny economics as a partner, and the whole reason they're doing it is so that they can take the position that they're not subject to [the Self-Employment Contributions Act] because they're a limited partner in a partnership, yet they're active so the carveout for material participation applies to them,” she said. She added that the government should address the material participation issue in its section 1411 reg project.
O'Shea said that although the government knows such planning is going on, officials “have said that they think it's beyond the scope of their project to shut that down, because that's really a problem with section 1402(a)(13).”