New Heathcare Medicare Tax Hurts Limited Liability Company Members

The Healthcare-triggered Medicare tax increases hit higher-income taxpayers with varying degrees of severity. But one group of higher-income taxpayers--small business owners--may not be too badly hurt. Yes, the new laws do increase the Medicare tax burden of many entrepreneurs operating as limited liability companies, or LLCs. But not business owner gets beat up...

A Quick Review of How the Medicare Tax Increases Work

Medicare taxes related to healthcare reform bite small businesses in two ways. First, when an individual taxpayer earns in excess of $200,000 or when married taxpayers earn in excess of $250,000, the Medicare tax rate goes from 1.45% to 2.35%. In other words, once a taxpayer's income rises above the threshold, the rate bumps up by roughly .9%, or $900 per $100,000 of income.

The Medicare surtax also bites in a second entirely new way: The new Medicare surtax (unlike the old Medicare tax) now hits unearned income when the taxpayer's income rises above the threshold amounts.

Once you understand the logic, you're ready to understand how the Medicare surtax hits small businesses operating as limited liability companies.

Limited Liability Companies Treated as Sole Proprietorships

An LLC taxed as a sole proprietorship might only see modest increases in its Medicare tax expense as a result of Obamacare. Here's why: Sole proprietorships (including limited liability companies taxed as sole proprietorships) already pay Medicare taxes on all of their business profits.

Accordingly, a sole proprietor would only see his or her Medicare tax bill rise when income rises above the threshold and get hit with the 3.8% rate rather than the usual 2.9% rate.

Limited Liability Companies Operating as Partnerships

A limited liability company operating as a partnership may see its Medicare tax burden increased. But the situation is confusing.

If an LLC partnership operates a trade or business, the LLC members active in the business already pay Medicare taxes on their shares of the partnership profit. In this case, the Medicare tax works the same way as it does for a sole proprietorship.

You can refer to the preceding paragraphs for a detailed description of the arithmetic, but basically the only people who get hit are partners with income above the thresholds at the rate of $900 per $100,000 of income. That's noticeable, but almost more irritating than truly burdensome.

Where an LLC partnership really gets whammed, however, is when the limited liability company passively holds investments or when there are passive, nonworking members in the LLC.

In these cases, income that previously was not subject to Medicare taxes would be subject to the unearned 3.8% tax rate if the taxpayer's income rises above the threshold. Ouch.

LLCs Taxed as S Corporations a Loophole?

The new Medicare surtax does not apply to ordinary income earned by active S corp shareholders active. This fortunate loophole--a small business friendly gimme from the Obama administration--means the S corp advantage still exists for active shareholders.

But a caveat: An S corp's unearned income retains its "investment income" character as it flows through to shareholder. This means that even working shareholders may pay the 3.8% Medicare tax on that portion of S corporation profit that represents dividends, interest, dividends, capital gains or rent earned inside the S corporation.

More information

Seattle tax accountant Stephen L. Nelson specializes in providing tax planning and preparation services to entrepreneurs. This article represents an abridged version of a longer column that Nelson wrote, "How Obama Healthcare Tax Affects Limited Liability Company," which is available at Nelson's LLC FAQ.