Net Investment Income, Medicare Surtax and S Corps

By Jason Watson, CPA
Posted Monday, October 23, 2023

To help fund the Affordable Care Act (Obamacare), an additional Medicare surtax is tacked on to your net investment income. Recall that as an S corporation owner, you are both employee and investor. When you trigger the high-income threshold for the Medicare surtax, then you could pay 3.8% (2.9% Medicare plus 0.9% surtax) on some portions of your income.

The tax is calculated by multiplying the 3.8% tax rate by the lower of the following two amounts:

• net investment income for the year; or

• modified adjusted gross income over a certain threshold amount ($200,000 for single filers and $250,000 for married filing jointly).

Again, whichever is lower (how nice of Congress?).

The IRS defines net investment income for the purposes of calculating the Medicare surtax as interest, dividends, capital gains, annuities, royalties, rents, and pass-through income from a passive business such as S Corps and partnerships. Yuck. Why did they have to pointedly name S corporations?

But! And this is a big but! Like a Mama June butt. If you materially participate in your S Corp this income is not included in the net investment income calculation. 99% of the small business owners out there who elect to be treated as an S Corp will also qualify as materially participating. In other words, your income is not considered passive which would otherwise be subject to the Net Investment Income Tax. Yeah baby!

Here is the laundry list the IRS uses for testing material participation-

To materially participate in a business for a particular year, the shareholder must meet one of the following seven tests discussed in Temporary Regulations Section 1.469-5T(a)–

• The shareholder participated in the activity for more than 500 hours during the year;

• The shareholder’s participation in the activity constituted substantially all the participation of all individuals in the activity;

• The shareholder participated for more than 100 hours in the activity, and the shareholder’s hours were not less than those of any other participant in the activity;

• The activity is a significant participation activity for the year, and the shareholder’s aggregate participation in all significant participation activities exceeded 500 hours;

• The shareholder materially participated in the activity for any five of the past 10 years;

• The activity is a personal services activity where the shareholder materially participated in the activity for any three years preceding the tax year; or

• Based on all the facts and circumstances, the shareholder participated in the activity on a regular, continuous, and substantial basis.

This list is an “or” list, therefore you only need to fit into one of the buckets to trigger the material participation designation. Interestingly, these regulations are titled Temporary Regulations but they have been around for a very long time. Like forever. Maybe even forever and ever.

Material participation is a common theme with the IRS, and in some respects, it changes the color of money similar to an S Corp election. A silent investor in an S corporation will have passive income and might be subject to Medicare surtax on that income. That same investor now materially participates, and the same income is now considered non-passive (or quasi-earned but without self-employment taxes) and is sheltered from the Medicare surtax.

While we are here, let’s chat about being a passive business owner.