EXPLOITING THE MEDICARE TAX LOOPHOLE.

Author:Burke, Karen C.
 
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  1. INTRODUCTION II. ACTIVE LIMITED PARTNERS AND S SHAREHOLDERS A. Active State-Law Limited Partners B. Active S Shareholders C. Tiers of Entities III. POST-RENKEMEYER: FUNCTIONAL APPROACH A. LLC Revolution B. Functional Approach C. Investment and Real Estate Professionals IV. CLOSING THE MEDICARE TAX LOOPHOLE A. Expanding Section 1411 to Backstop Employment Taxes B. Material Participation Standard to Achieve Passthrough Parity C. Return-on-Capital Exclusion V. CONCLUSION I. INTRODUCTION

    During the ill-fated health care debate, the Republican leadership sought to repeal all of the Affordable Care Act ("ACA") taxes (1)--including Code section 1411, which imposes a 3.8% surtax on net investment income ("NII") of high-income earners. Eliminating the net investment income tax ("NIIT") as part of the ACA repeal was intended to lower the revenue baseline in order to make subsequent tax cuts appear to be less costly. The gimmick depended upon not accounting for the substantial revenue loss attributable to repeal of the ACA taxes. (2) Although health care legislation has stalled, repeal of section 1411 remains very much on the agenda. To avoid the political fallout from slashing taxes at the top while simultaneously eliminating health care coverage for low-income individuals, the Republican leadership reluctantly agreed temporarily to shelve repeal of section 1411 until a more propitious moment. (3)

    Enacted in 2010 and effective beginning in 2013, section 1411 provides a tax on NII ("Unearned Income Medicare Contribution") that is intended to increase fairness in the taxation of earned and unearned income. (4) Employment taxes on wage income ("FICA" (5)) and self-employment taxes on net earnings from self-employment ("SECA" (6)) are generally imposed at the same rate and subject to the same caps, except that the employer and employee are each liable for half of FICA taxes. The FICA and SECA taxes both consist of two components--the Old Age, Survivors, and Disability Insurance component ("OASDI") and the Medicare or hospital insurance component ("FICA-HI" and "SECA-HI"). (7) For taxpayers whose earnings equal or exceed the OASDI base ($128,400 for 2018), the excess is subject only to the uncapped hospital insurance tax. For taxable years beginning in 2013, the employee portion of the FICA-HI tax and the corresponding SECA-HI tax is increased by 0.9%, increasing the overall rate of the Medicare tax to 3.8%. (8) To mirror Medicare taxes on earned income, section 1411 imposes a parallel 3.8% tax on unearned income of high-income individuals. (9) The NIIT expressly targets investment income such as interest, dividends, and capital gains. (10)

    Although only one of the three 3.8% taxes (FICA-HI, SECA-HI, or NIIT) can apply to the same income and gain, not all earned and unearned income is subject to at least one of the taxes. The NII base does not include FICA wages and self-employment income taken into account under SECA. (11) The NII base also exempts income and gain from an "Excluded Business," i.e., a trade or business activity (other than a trade or business consisting of trading financial instruments or commodities ("Financial Trading Business")) that is not a section 469 passive activity with respect to the taxpayer. (12) Since most passthrough income is active and is disproportionately concentrated among high-income taxpayers, the section 1411 exemption for Excluded Businesses has important distributional and revenue consequences. (13) The enactment of section 1411 makes more urgent reform of the employment tax rules applicable to tax-transparent limited liability entities that combine passthrough taxation and limited liability with the ability of their members to actively participate in the entity's business operations. (14) Employment tax gaps permit high-income owner-employees to structure Excluded Businesses--often using multiple tiers of state-law partnerships, S corporations, and limited liability companies ("LLCs")--to avoid all three of the 3.8% taxes. (15) Since the late 1990s, the employment tax holiday for passthrough owners has persisted largely thanks to congressional action limiting Treasury's authority to clarify the employment tax status of limited partners and LLC members. (16) Beginning in 2013, the section 1411 tax provided an additional incentive for high-income earners to recharacterize income from trade-or-business sources as active rather than passive.

    This Article considers how passthrough entities can be structured to avoid all three of the 3.8% taxes and recommends reform (not repeal) of section 1411 to address the revenue loss and inequity resulting from such structuring. (17) Part I considers the anachronistic "limited partner" exception and the well-known S corporation loophole that permit active, high-income passthrough owners to avoid exposure to SECA and FICA taxes and, more recently, the section 1411 tax on unearned income. Part II considers a recent Tax Court decision (18) that has reignited the employment tax debate and, by implication, threatens to upend typical structures used to avoid all of the 3.8% taxes on management fees for services provided to investment and real estate funds. While rationalizing employment tax rules for passthroughs remains a worthwhile objective, Part III suggests a different approach: expanding the base of the NIIT to include active passthrough income and gain that would otherwise escape FICA and SECA taxes. This approach would ensure that high-income owner-employees could no longer avoid contributing to Medicare financing, thereby treating earned and unearned income more equally.

  2. ACTIVE LIMITED PARTNERS AND S SHAREHOLDERS

    Consistent with imposing a surcharge on passive investment income, section 1411 carves out an exception for most types of active business

    income. When Congress enacted section 1411, it clearly understood that income and gain from active passthrough businesses could potentially fall outside all three of the 3.8% taxes. Under section 1402(a)(13), state-law limited partners are exempt from SECA, except to the extent that they receive section 707(c) guaranteed payments for services. (19) Unlike partners, S corporation shareholders are not treated as self-employed but rather as employees of the S corporation. As such, they are subject to FICA taxes on wages paid by the S corporation to the extent of reasonable compensation, but not on amounts received in the form of dividends.

    1. Active State-Law Limited Partners

      General partners and sole proprietors have traditionally been subject to SECA on their net business income, except for clearly identifiable categories of capital income. (20) Prior to 1977, section 1402 did not distinguish between general and limited partners for employment tax purposes, regardless of services performed. (21) In 1977, Congress amended the statute to create an exception, under current section 1402(a)(13), for limited partners who are passive investors. (22) In the 1970s, limited partner interests were marketed to passive investors who paid SECA tax on their distributive shares, thereby qualifying for Social Security benefits. These arrangements offered passive investors an unwarranted tax benefit at the expense of the overall Social Security system, giving rise to "issues of tax morale and public perception." (23) Benefit eligibility based on investment income was "inconsistent with the basic principle of the [S]ocial [S]ecurity program that benefits are designed to partially replace lost earnings from work." (24) Congress responded by excluding a limited partner's distributive share from SECA tax, except for section 707(c) guaranteed payments for services actually performed. (25)

      The statutory reference to "limited partner" was intended to serve as a proxy for passive investors, reflecting state-law restrictions that generally prevented a limited partner from actively participating in management of a partnership's business without losing limited liability. Subsequently, state laws were liberalized to remove constraints on active limited partners, a development that paralleled the emergence of LLCs in the late 1980s. (26) These developments created uncertainty concerning the meaning of the term "limited partner" for purposes of the SECA rules. Moreover, by the mid-1990s high-income earners no longer considered accrual of Social Security benefits to outweigh the associated tax cost, prompting a backlash particularly against the uncapped Medicare component of SECA taxes. (27) Prior to 1983, the SECA tax rate was deliberately set lower than the FICA tax rate; in 1990, parity was established between the SECA and FICA tax rates. (28) In 1993, Congress lifted the cap on the FICA-HI and SECA-HI components of payroll taxes, so that the 2.9% Medicare levy now applies without limitation to all types of income included in the FICA and SECA bases. (29) Uncapping of the Medicare tax gave high-income owner-employees a powerful incentive to opt out of the system of mandatory contributions for social insurance. (30)

      The employment tax revolt by high earners coincided with an increase in the share of business income earned by passthroughs. Following the 1986 Act's temporary rate inversion, passthroughs gained in popularity at the expense of C corporations, so that, by 2013, 60% of all business net income was taxed only through the personal income tax. (31) While many passthroughs are small businesses, there is a substantial and growing percentage of large passthrough businesses. (32) In the post-1986 low income-tax rate environment, employment taxes loomed large as a percentage of overall taxes. Although employment taxes represent an increasingly important revenue source--accounting for roughly one-third of all federal tax revenue in 2015 (33)--aggressive passthrough planning for high earners and rising wage inequality have contributed to erosion of the Social Security tax base. (34) In response to uncertainty...

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