Using S Corporations To Avoid The Medicare Tax

Originally published in the AICPA Tax Insider

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.

Introduction

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...