Taming The Three-Headed Monster: FICA, SECA, And NIIT Applied To Real Estate Activities

INTRODUCTION.

The ancient Greeks believed that a three-headed, dog-like beast named Cerberus guarded the underworld. Hercules was fabled to have tamed the beast in the most difficult of his 12 labors. The three-headed beast of the Code1 consists of the Federal Insurance Contribution Act (''FICA'') tax, Self Employed Contributions Act (''SECA'') tax and Net Investment Income Tax (''NIIT''). These provisions form a ''parallel'' income tax system that attacks from three directions. No income is subject to all three taxes (or even two), but almost all types of income are subject to at least one of the taxes. Avoiding all three can be a Herculean feat.

This article provides an overview of FICA, SECA, and NIIT in the context of real estate activities, with an emphasis on the application to flow-through entities. 2 We focus the analysis in Part II on the treatment of passive versus active investors. Passive investors may qualify for the ''limited partner'' exception to SECA, but it will be difficult for a passive investor to establish the ''material participation'' that is necessary to avoid NIIT. As discussed in Part III, the analysis is more complicated for rental income, which may be entitled to a carve-out from SECA, but a taxpayer is often required to establish status as a ''real estate professional'' to avoid NIIT.

1. BACKGROUND ON TAX REGIMES

   1. FICA Tax

      FICA is a United States federal employment tax imposed on both employees and employers to fund federal programs designed to provide benefits for retirees, disabled individuals and children of deceased workers. FICA consists of two parts: Old Age, Survivors and Disability Insurance (''OASDI''), which equals 6.2% of an employee's wages;3 and Hospital Insurance (''HI''), which equals 1.45% of an employee's wages.4 An employer must withhold and pay FICA tax on its employees' wages, and make a matching payment equal to the amount withheld.5

      Generally, all wages derived from employment are subject to FICA tax. The term ''wages'' is defined broadly to include ''all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.''6 As a general rule, payments or benefits from an employer to an employee are considered ''wages'' unless a statutory exception applies.7 However, wages subject to the OASDI portion of FICA taxes do not include amounts paid to an employee that are in excess of the OASDI taxable wage base.8 The OASDI wage base is recomputed each year. The 2015 OASDI wage base is $118,500, up from $117,000 in 2014. The HI portion of FICA taxes has no such wage base, and therefore all wages are subject to the HI portion. Starting in 2013, an ''additional Medicare tax'' of 0.9% applies to an individual's wages over $250,000 for married joint filers.9 Combined with the HI portion of FICA, the total tax is 3.8% for individuals over the income threshold.

   2. SECA Tax

      SECA imposes a tax on the self-employment income of every individual.10 Like FICA, SECA consists of a 12.4% OASDI portion and a 2.9% HI portion. 11 ''Wages'' that are subject to FICA are specifically excluded from self-employment income.12 As such, the same income may not be taxed under both FICA and SECA. The OASDI portion of SECA is taxed only up to a threshold,13 which is $118,500 for 2015.14 The taxpayer's FICA wages and selfemployment income are combined, such that the maximum amount of the combined income that is subject to the OASDI tax is equal to the threshold.15 There is no cap on the HI portion of SECA. The additional Medicare tax (0.9%) applies when the taxpayer's self-employment income exceeds the $250,000 threshold described above.16 The taxpayer may deduct 50% of the SECA tax,17 but the additional Medicare tax is not deductible.

      SECA imposes tax on net earnings from selfemployment, which is generally defined as gross income derived by an individual from any trade or business carried on by the individual (i.e., generally as a sole proprietorship).18 The Code has several carveouts, including most types of rental income, dividends, interest, and capital gains.19 Flow-through income from an S corporation also is not subject to SECA.20 However, owners of an S corporation that also perform services must be paid reasonable ''wages'' that are subject to FICA.21

      According to the IRS, members of a tax partnership may not be employees that receive wages for FICA purposes.22 Amounts paid to partners by a tax partnership (including a limited liability company (''LLC'') taxed as a partnership)23 for services rendered in their capacities as partners are treated as guaranteed payments. 24 Per the IRS, such payments are subject to SECA (and not FICA).25 The treatment of a partner's share of flow-through income is discussed in more detail in II.A below.

   3. NIIT

      Beginning January 1, 2013, ''high-income'' individuals, estates, and trusts are subject to a 3.8% tax on their ''net investment income.''26 NIIT applies to the lesser of a taxpayer's (1) net investment income or (2) modified adjusted gross income in excess of a threshold amount (generally $250,000 for married taxpayers filing a joint return or $200,000 for single taxpayers).27 Income that is subject to SECA under §1401(b) is not included in net investment income.28 In many respects, the 3.8% NIIT runs parallel to the combined 3.8% HI and ''additional Medicare tax'' of the FICA and SECA regimes.

      ''Net investment income'' is defined to include the following:

      1. Gross income from interest and dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of an ''active trade or business.''

      2. Other gross income derived from a trade or business other than an ''active trade or business.''

      3. Net gain attributable to the disposition of property other than property held in an ''active trade or business.''29

      An ''active trade or business'' is a trade or business that neither is a passive activity with respect to the taxpayer under §469 nor consists of trading financial instruments or commodities.30 Net investment income is reduced by the deductions that are properly allocable to that income.31 ''Allocable deductions'' are generally the deductible amounts paid or incurred to produce the items of income and net gain that are subject to NIIT.32

   4. Interplay of FICA, SECA, and NIIT

      FICA, SECA, and NIIT are mutually exclusive taxes that run parallel to each other. Each tax triggers (at least) an additional tax of 3.8% on different types of income of high-earning individuals. However, the circumstances in which such taxes are invoked are quite different. Generally, all income generated in the form of ''wages'' paid to an employee will be subject to FICA. The more complicated analysis involves income attributable to an owner of a pass-through entity.

      An owner may generally avoid SECA if he or she (1) owns S corporation stock (and the owner otherwise receives reasonable compensation that is subject to FICA), (2) owns a partnership interest that qualifies for the ''limited partner'' exception, or (3) is allocated income that is subject to a carve-out, such as the carve-out for rental income. If SECA does not apply, the owner might be subject to NIIT on such income. To also avoid NIIT, an owner generally must ''materially participate'' in the trade or business activity, which might be at odds with a SECA classification as a ''limited partner.'' There is a narrow avenue where an ''active'' owner may avoid all three taxes, but the path is less clear for an LLC, as compared to an S corporation. ''Passive'' individuals with significant income will frequently owe at least one of the three taxes. The interplay of these taxes is summarized in Part IV below.

2. PASSIVE AND ACTIVE INVESTORS IN NON-RENTAL ACTIVITIES

   The real estate industry involves numerous types of activities, such as real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing and brokerage. Rental activities in particular are subject to unique treatment under the Code, and flowthrough income relating to the same is discussed separately in Part III below. The following discusses when flow-through income relating to non-rental activities is subject to SECA or NIIT.33

   1. SECA

      There are several key exceptions to SECA for income attributable to an owner of a pass-through entity. The clearest exception is flow-through income from an S corporation, as described above. The second exception is less clear. Flow-through income of a ''limited partner'' is not subject to SECA.34 This ''limited partner'' exception was created before LLCs became widely used, and IRS attempts to provide guidance in the context of LLCs has been less than clear.

      A taxpayer's share of partnership income is generally subject to SECA.35 However, §1402(a)(13) excludes from SECA the distributive share of any item of income or loss of a limited partner. The question is whether an LLC member's distributive share will be eligible for ''limited partner'' treatment. On its face, §1402(a)(13) requires status as a state law limited partner, and absent that strict status, regardless of the passive nonparticipatory nature of an LLC's member relationship with the LLC, the exclusion from selfemployment tax would not be...