Thomas Wechter
Using S corporations to avoid the Medicare tax

Next year’s new tax on net investment income provides another incentive to form an S corporation.

June 14, 2012
by Thomas Wechter, J.D.

Both former House Speaker Newt Gingrich and former North Carolina Sen. John Edwards have been in the news lately—Gingrich for his campaign for the Republican nomination for president and Edwards for allegedly using campaign funds to hide his affair with a campaign worker. Not long ago, both men were in the news for their use of S corporations to avoid self-employment taxes and the Medicare tax. Both men conducted a personal service business through an S corporation, taking a minimum salary subject to self-employment taxes and the Medicare tax and distributing the remaining profits as dividends, which are subject to neither tax. With the Medicare tax applying to net investment income for the first time in 2013, the attempt to avoid these taxes may become even more widespread.


To understand the magnitude of the problem, one has to look only at the tax savings Gingrich and Edwards achieved. For 2010, by classifying nearly $2.4 million in earnings from personal services as profits through his S corporation, Gingrich avoided paying an estimated $69,000 in Medicare taxes. John Edwards, by reporting approximately $26 million from his work as a trial attorney as profits and dividends passed through his S corporation, avoided $754,000 in Medicare taxes.

The tax planning that Gingrich and Edwards implemented using S corporations is not illegal and is not even an abusive tax shelter, although it can be, and often is, successfully challenged by the IRS (see David E. Watson, P.C., 668 F.3d 1008 (8th Cir. 2012)). The choice of entity to conduct their business affairs was not only legal, but also contemplated under the plain meaning of the Medicare tax statute.

Medicare tax

Under current Secs. 3101(b), 3111(b), and 1401(b), a 2.9% Medicare tax is imposed on all wages and self-employment income. Beginning in 2013, the Medicare tax on wages and self-employment income increases to 3.8% on wages in excess of $250,000 for a joint return, $125,000 for a married taxpayer filing separately, and $200,000 for all others (Sec. 3101(b)(2) and Sec. 1401(b)(2)).

In addition, Sec. 1411, enacted under the Patient Protection and Affordable Care Act, P.L. 111-148, will impose a new Medicare tax of 3.8% on the lesser of net investment income or modified adjusted gross income exceeding $250,000 for married individuals filing joint returns, $125,000 for married taxpayers filing separately, and $200,000 for single individuals.        

Net investment income

“Net investment income” is investment income reduced by the deductions properly allocable to that income. Investment income includes gross income from interest, dividends, annuities, royalties, and rents, but excludes those types of income if they are derived in the ordinary course of a trade or business that  is not considered a passive activity for the income recipient and does not constitute trading in financial instruments or commodities. In addition, net investment income includes net gain attributable to the disposition of property other than property held in a trade or business to which the Medicare tax does not apply.

In the case of a trade or business, the Medicare tax applies if the trade or business is a passive activity for the taxpayer or the trade or business consists of trading financial instruments or commodities. Sec. 1411(c)(2)(A) defines a passive activity by reference to Sec. 469. Under Sec. 469, business activities are treated as passive activities unless the taxpayer materially participates in the activity. A taxpayer is not treated as materially participating in an activity unless his or her involvement in the operations of the activity is regular, continuous, and substantial (Sec. 469(h)(1)). The current regulations treat a taxpayer as materially participating in an activity if he or she meets one of seven tests during the tax year. The clearest of these tests is the taxpayer’s participation in the trade or business for more than 500 hours in the tax year (Temp. Regs. Sec. 1.469-5T(a)).

Incorporating the passive activity rules into the Medicare tax structure raises a number of  issues that it is hoped will be answered by new regulations. While guidance on applying the passive activity rules to the Medicare tax did not make the 2011–2012 priority guidance plan for projects affecting S corporations, the IRS has stated that guidance on the application of the passive activity rules to the Medicare tax is a “top priority” and can be expected soon.

Net gain from disposing of property—other than property held in a trade or business that is not a passive activity of the taxpayer or does not involve trading in financial instruments or commodities—is subject to the Medicare tax. Gain from disposing of C corporation stock should be includible in net investment income subject to the Medicare tax, but gain from disposing of an interest in a partnership or S corporation in which the partner or shareholder materially participates may not be includible in net investment income to the extent the net gain is attributable to property held by the entity that is used in the active conduct of a trade or business.

The Medicare tax applies to gain from the disposition of a personal residence to the extent taken into account in computing taxable income. Net gain from the sale of a personal residence that exceeds the amount that can be excluded from taxation would result in capital gain that increases net investment income. Currently, when homeowners sell their principal residences, they may exclude from taxation $250,000 in capital gain if single and $500,000 in capital gain if filing a joint return.

Congressional action

The U.S. Government Accountability Office (GAO) discussed treating a shareholder’s distributive share of income from an S corporation engaged in a personal service business as self-employment income subject to the Medicare tax (Tax Gap: Actions Needed to Address Noncompliance With S Corporation Tax Rules (GAO-10-195) (December 2009)). The American Jobs and Closing Tax Loopholes Act of 2010 (H.R. 4213) included a provision to treat a shareholder’s distributive share of income from a professional service S corporation as net earnings from self-employment subject to the Medicare tax where the shareholder performed substantial services for the S corporation. That provision passed the House of Representatives on May 28, 2010, but died in the Senate. On Sept. 16, 2010, the Job Creation and Tax Cut Act of 2010 (S. 3793) was introduced in the Senate with provisions similar to those in the American Jobs and Closing Tax Loopholes Act, but it did not include a provision to subject a shareholder’s distributive share of income from a professional services S corporation to the payroll and Medicare taxes. These provisions were not passed by the 111th Congress.

On Jan. 30, 2012, the Narrowing Exceptions for Withholding Taxes Act of 2012 (H.R. 3840) was introduced in the House with a provision based on the prior proposal to treat the distributive share of an S corporation shareholder from a professional service S corporation as included in the shareholder’s net earnings from self-employment subject to the Medicare tax.

Most recently, on April 24, 2012, congressional Democrats introduced the Stop the Student Loan Interest Rate Hike Act (S. 2343), using the imposition of the Medicare tax on professional service S corporation shareholders as an offset to the cost of forestalling a scheduled increase in the federal student loan interest rate hike. The proposal would be aimed at all S corporations that have three or fewer employees, each of whom makes at least $250,000 a year for joint filers and $200,000 for individual filers. The proposal targets S corporations whose principal asset is “the reputation and skill of three or fewer employees.” Republican members of Congress oppose this legislation and at this writing had succeeded in blocking a cloture vote in the Senate that would have allowed it to proceed to a full Senate vote.


With the application of the Medicare tax to net investment income to begin in 2013, there will be renewed interest in the use of an S corporation to avoid both the increased Medicare tax on wages and the new one on investment income. Of course, income from S corporations whose shareholders provide personal services would not be subject to the new Medicare tax because that income would not be considered investment income under Sec. 1411. A shareholder who was active in the business would probably be considered materially participating, and, as a result, that shareholder’s distributive share would not be considered investment income. Without a legislative change to the treatment of S corporations’ distributive shares, the use of an S corporation to avoid the Medicare tax will be available for all to take advantage of.

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Thomas R. Wechter, J.D., LL.M. (Tax), is a partner with Duane Morris LLP in the Chicago office and concentrates his practice in tax planning for individuals, corporations, and partnerships and in tax controversy matters in front of the IRS and before the Tax Court, U.S. Court of Federal Claims, and the district courts.