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For many business owners, the additional 3.8 percent additional tax on net investment income (the “NII Tax”) is yet another layer of tax to contend with. Since this tax is imposed only on certain types of income, it does present some planning opportunities.

The NII Tax is a 3.8 percent tax on investment income to the extent that the taxpayer’s adjusted gross income (with some modifications) exceeds $250,000 (for married couples filing jointly). The term “investment income” for purposes of the NII Tax includes almost any income derived from passive business activities, including allocations of business income from S corporations, LLCs, and partnerships. Some advisors have recommended to their passive investor clients that they may want to become active in their business in order to avoid the NII Tax.

Although active owners of partnerships and LLCs will not be subject to the NII tax, they will most likely be subject to a Medicare tax that is also at a 3.8 percent rate. In general, allocations of partnership and LLC income to persons who are active in the business are subject to self-employment taxes, which include a Medicare component at 3.8 percent for taxpayers with income above the thresholds noted above. LLC and partnership owners will, therefore, in most cases pay the 3.8 percent NII tax if they are inactive in the business, or the 3.8 percent self-employment tax rate if they are active.

Given this conundrum, many business owners who are active in their business or who can become active have considered converting their C corporation or LLC to an S corporation. This conversion can usually be done on a tax-free basis, and can at least partially mitigate the issue with the NII/Medicare tax.

If the business is operated as an S corporation, salary payments to the owner would still be subject to the 3.8 percent Medicare tax (assuming the income thresholds were met), but allocations of business income to an owner who is active in the business would not be subject to either the Medicare or NII Tax. Care must be taken, however, in implementing this structure since the IRS will challenge compensation that is too low.

Although converting to an S corporation is normally tax-free, gain can be recognized under certain circumstances, so the conversion itself must be analyzed carefully. The benefits of the conversion relative to the NII and Medicare tax should also be weighed against other tax benefits that may be enjoyed by a business and its owners as an LLC or even a C corporation. All things being equal, however, the S corporation can be considered as a way to mitigate the business owner’s exposure to the NII Tax if the owner is active and expects distributions in excess of compensation for services.

This and other tax issues will be the topic of discussion at our upcoming Business Hour event – Top tax issues and planning ideas for 2015. Join us for a discussion on the latest tax updates, strategies, and insights by registering to attend our Business Hour or to watch the live webcast so you can start planning for 2015 taxes now.

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