New Medicare Tax Won’t Affect S Corporation Distributions

A key provision of the Patient Protection and Affordable Care Act of 2010 takes effect this year. That is, certain employees will be subject to an additional 0.9% Medicare tax on a portion of their earnings, bringing the maximum difference between wages and S corporation distributions to 3.8% instead of 2.9%. The workers in question are those with FICA wages and self-employment income that exceed:

  • $250,000 for married couples filing jointly,
  • $125,000 for married taxpayers filing separately, and
  • $200,000 for singles, heads of households and other filers.

The additional tax will be applied to FICA wages and self-employment income in excess of the applicable threshold.

In addition, a new 3.8% Medicare tax applies to net investment income to the extent that modified adjusted gross income exceeds the limits above. So the question becomes: Are the distributions received by an S corporation’s shareholder-employees thereby subject to the 3.8% Medicare tax?

The answer generally is no: Because, as shareholder-employees, these taxpayers typically materially participate in the business, the IRS won’t likely consider their distributions to be investment income under Section 1411 of the Internal Revenue Code.

However, if distributions are recharacterized as salary (see our post on that subject), that income could potentially be subject to the additional 0.9% tax.