Why S Corporations Are Still Advantageous for Small Business Owners, Part 2 – Los Angeles Income Tax Planning and Income Tax Litigation Attorney Bruce Givner

by Bruce Givner on February 17, 2014

In the previous two posts, we have discussed how recent changes to the federal income tax rates have made small business owners reconsider their continued operation as S corporations. With the highest individual tax rate now at 39.6%, in addition to a 3.8% Medicare surtax as opposed to the highest corporate tax rate of 35%, the pass-through nature of an S corporation may no longer seem to confer the most tax-related benefits. In Part 2 of our series of posts on this subject, we will discuss another important reason why, despite the new tax rate changes, maintaining your entity as an S corporation remains advantageous for small business owners.

As mentioned in the preceding paragraph, along with the increase in the highest individual income tax rate, business owners also face a 3.8% Medicare tax on net investment income. At first glance, this seems to represent another added tax burden on the owner operator. However, a careful reading of Code Sec. 469 and Code Sec. 475(e)(2) will reveal why this may not actually be the case.

The tax on investment income applies to trade or business income resulting from passive activity or the trading in financial instruments or commodities as defined in the Code Sections mentioned above. Net investment income is generally defined as (1) the sum total of gross income from dividends, royalties, interest, annuities, and rents; (2) gains from the disposition of property; (3) gains from passive activities (those not including income generated in the ordinary course of a trade or business); and (4) less properly allocable expenses. Net investment income, therefore, does not include the following: salary, wages, bonuses, Social Security income, IRA or qualified retirement plan distributions, income taken into account for self-employment tax purposes, gains on the sale of an active interest in a partnership or S corp., and items that are otherwise excluded or exempt from income under the income tax law.

So what does all this mean? As defined above, net investment income refers to that income generated from passive activities. Thus, the income generated from a business in which you are materially participating is not subject to the 3.8% Medicare tax. This stands in contrast to shareholders of C corporations (unless they are closely held) who do not qualify for the exclusion due to the inapplicability of passive activity loss rules specified in Code Sec. 469 to C corporations.

Bottom line: shareholders of S corporations who are actively involved in the operation of the entity’s trade or business activity are not subject to the 3.8% Medicare tax on net investment income. Stay tuned for our final installment for yet another reason why S corporations remain advantageous to small business owners.

Givner & Kaye focuses on sophisticated income tax planning and compliance, tax litigation and procedure, estate planning, and asset protection plans for individuals and businesses in Beverly Hills, Calabasas, West Los Angeles, Hollywood, and other areas of Los Angeles, Orange, Ventura, San Bernardino, Riverside and Santa Barbara Counties. Call Los Angeles Estate Planning and Asset Protection Plan Attorneys Givner & Kaye at (310) 207-8008 today.

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