About one-third of all US banks are organized as Subchapter S Corporations, so named because of the chapter in the Internal Revenue Code that governs them. The attraction is simple: S Corporations avoid the double taxation of earnings of C Corporations. C Corporations pay tax at the corporate level and their shareholders also pay tax on the dividend distributions. On the other hand, S Corporation taxes are generally only paid at the shareholder level on the pass-through of the corporate earnings.
In 2013, a provision in the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Tax Credit Reconciliation Act of 2010 changed things for S Corporations and many of their shareholders.
Starting in 2013, the Medicare tax of 2.9% rises to 3.8%. The tax previously applied to wage income only, meaning other S Corporation earnings passed through to its shareholders were unaffected. In 2013, the tax will now apply to both wage income and investment income for higher-income individuals. The new tax, termed the unearned income Medicare contribution tax, will have a significant impact on many S Corporation shareholders.
Net investment income
As of January 1, the higher Medicare taxes will be owed on all net investment income: interest, dividends, capital gains, annuities, royalties, rents, and pass-through income from passive business, such as S-corporations and partnerships. As a result, passive shareholders — those who have no role in the day-to-day operations of the bank — will be subjected to the new Medicare taxes on the income passed through from the S Corporation.
And, unlike Social Security, there is no cap on the amount of income subject to the new Medicare taxes. In fact, the tax is specifically designed to target wealthier taxpayers: it applies to single taxpayers with a modified adjusted gross income (MAGI) in excess of $200,000 and married taxpayers with a MAGI in excess of $250,000 if filing a joint return, or $125,000 if filing a separate return.
Banks vs. shareholders
It is important to understand the different ways certain income is taxed for an S Corporation compared to an individual. For example, net interest income earned by S Corporation banks from loans and investments is not considered investment income, because accepting deposits and making loans are part of a bank’s business. However, to a passive shareholder in the S Corporation, that interest income—as well as dividends, rents, and other gains—would generally be considered investment income and be subject to Medicare tax for those taxpayers above the MAGI limits discussed above.
The make-up and needs of each bank’s shareholder base is different. Therefore, the impact of this legislation will differ depending upon each shareholder’s circumstances (for instance MAGI levels, passive status, etc.). Banks should consider the extent to which shareholders may require additional distributions to cover potential additional Medicare tax due at the shareholder level. In order to sort through these issues, banks and their shareholders should contact their tax advisors to help understand and plan for the effects of this new tax.