While businesses in general may be in shock over the tax increases they see due to the Obama healthcare reform, for the typical limited liability company, the new law may not pack that big a punch. Sure. The new laws increase in the Medicare tax burden of many LLCs. But the rules are tricky and often subtle.
A Quick Review of How the Medicare Tax Increases Work
The Obama/Pelosi tax increases bite in a couple of ways. First of all, if an individual earns more than $200,000 or if a couple earns more than $250,000, the Medicare tax rate goes from 1.45% to 2.35%. In other words, once a taxpayer’s income rises above the threshold, the rate bumps up by roughly .9%, or $900 per $100,000 of income.
But a clarification: Employers pay Medicare taxes, too, and at the rate of 1.45% of wages paid. And it’s important to understand the two-part nature of Medicare because sole proprietorships and partners (and limited liability companies taxed as sole proprietorships or partnerships) pay both rates.
In other words, an employee might pay either a 1.45% tax or a 2.35% tax. But a sole proprietor and partner would pay either a 2.9% or a 3.8% tax.
The Medicare surtax also bites in a second entirely new way: The Medicare tax, which in past hit only earned income, now hits unearned income (interest, dividends, capital gains, royalties, rents and so forth) if the taxpayer’s income rises above the threshold amounts mentioned earlier. In the case where the Medicare tax hits unearned income, the rate is 3.8% or $3800 on $100,000 of unearned income.
With an understanding of the arithmetic, one can begin to talk about how the Medicare tax works with limited liability companies.
Limited Liability Company Taxed as a Sole Proprietorship
An LLC taxed as a sole proprietorship might only see modest increases in its Medicare tax expense as a result of Obamacare. Here’s why: Sole proprietorships (including limited liability companies taxed as sole proprietorships) already pay Medicare taxes on all of their business profits.
Accordingly, a sole proprietorship would only see its Medicare tax bill rise if the proprietor earns enough income to push above the threshold and get hit with the 3.8% rate rather than the usual 2.9% rate.
Example: An unmarried sole proprietor makes $300,000. In this case, the new Medicare tax adds $900 to his or her taxes.
Limited Liability Companies Operating as Partnerships
A limited liability company operating as a partnership may see its Medicare tax burden increased. But the situation is confusing.
If an LLC operating as a partnership operates an active trade or business, the LLC members active in the business already pay Medicare taxes on their shares of the partnership profit. In this case, the Medicare tax works the same way as it does for a sole proprietorship.
You can refer to the preceding paragraphs for a detailed description of the arithmetic, but, to summarize, for active partners in a partnership operating a trade or business, the Medicare tax increases and surtax probably aren’t that big a deal. The only people who get hit are partners with income above the thresholds at the rate of $900 per $100,000 of income. That’s irritating if you have to pay it, but probably more in the category of annoyance.
Where an LLC taxed as a partnership really does get hit, however, is when the LLC isn’t operating an active trade or business–for example, a real estate investment partnership. Or when the LLC passes through unearned investment income like dividends, interest, capital gains, and so on.
In these cases, income that previously was not subject to Medicare taxes would be subject to the unearned 3.8% tax rate if the taxpayer’s income rises above the threshold and at the 3.8% tax rate. That rate does seem (at least to this accountant) pretty darn substantial: The tax equals $3800 per $100,000 of income. Ouch.
Note: If you think that a $3800 tax on $100,000 of income doesn’t sound bad, remember that if all the Obama tax increases have gone into effect this taxpayer (perhaps you?) has already paid perhaps $40,000 of federal income taxes and maybe another $10,000 of state income taxes. With the new $3800 Medicare tax, then, the federal and state governments take almost $54,000 of the $100,000 of income. Yikes.
Limited Liability Company Taxed as an S Corporation
The new Medicare tax does not apply to operating income earned by shareholders active in the S corporation. Accordingly, if you own and operate an S corporation, your share of the S corp profits won’t be subject to the new Medicare tax even if you are over the thresholds amounts. This means that the principal advantage of the S corporation tax regime still exists–at least for working shareholders.
However, if someone doesn’t actively work in the business, then their share of the S corporation income gets whacked with the 3.8% tax.
One other wrinkle: An S corporation’s unearned income retains its “investment income” character as it flows through to shareholder. This means that even working shareholders may pay the 3.8% Medicare tax on that portion of S corporation profit that represents dividends, interest, dividends, capital gains or rent.