Exploiting The Medicare Loophole

Section 1411 imposes a 3.8 percent surtax on investment income of high earners that mirrors Medicare taxes on earned income. The enactment of the net investment income tax highlights gaps in the employment tax rules for passthrough entities — particularly limited partnerships, S corporations, and limited liability companies. This article considers how businesses can be structured to allow active high-income owner-employees of passthrough entities to avoid all three of the 3.8 percent Medicare taxes (SECA, FICA and section 1411). Part I considers the anachronistic limited partner exception to the SECA tax and the well-known S corporation loophole under the FICA tax, as well as the failure of section 1411 to reach active business income that avoids these employment taxes. Part II considers the recent Renkemeyer case, which has reignited the employment tax debate and threatens to upend structures used in investment and real estate funds to shelter management fees from all of the 3.8 percent taxes. Although repeal of section 1411 remains high on the Republican tax-cutting agenda, Part III suggests the need to reform (not repeal) section 1411 to backstop the employment tax rules for active passthrough businesses, regardless of organizational form. The proposed approach would curtail opportunities to avoid the 3.8 percent taxes, raise substantial revenue, and promote the goal of parity in the taxation of earned and unearned income. By contrast, tax legislation enacted in 2017 leaves intact planning to avoid employment taxes and section 1411, while dramatically lowering the income tax rate on business income. As a result, business taxation has grown increasingly incoherent, regressive, and highly unstable.