It has been lauded. It has been vilified. And it has barely gotten off the ground. But although many of its provisions haven’t yet kicked in, the Affordable Care Act—or Obamacare, as it’s popularly known—is already having a profound effect not just on how health care will be provided, but also on how business will be conducted, especially in real estate.
Several of the Affordable Care Act’s provisions are well known, particularly the employer and individual coverage mandates and the creation of state-based health insurance exchanges. But lesser-known aspects of the legislation also could have a big impact on a company, its owners, and its investors. Below is a brief look at two of them, and options available to assess—or even blunt—that impact.
Limited Liability Companies
For many years, limited liability companies (LLCs) have been the legal entity of choice for real estate businesses. Among other advantages, they provide a great deal of tax flexibility, limit personal liability, and can be set up more easily than other types of entities.
But a health care reform–related tax that took effect this year casts LLCs in a new light—one that could dim their previous luster. As of January 1, 2013, a Medicare surtax of 0.9 percent applies to wages and self-employment income in excess of $250,000 (for married taxpayers filing jointly) or $200,000 (for single filers), bringing the total Medicare tax rate to 3.8 percent for earners above those thresholds.
Does this mean that continuing to run an active business as an LLC is costing more in taxes? The answer may be yes.
The question, then, is: What generates self-employment income from an LLC? It’s a long list, but the key triggers are:
- working more than 500 hours per year;
- having manager designation; or
- guaranteeing partnership debts.
Trying to reduce participation in the business—thus avoid self-employment income—would not help, since company owners could be hit with another new tax, the net investment income tax (NIIT), which is also at a 3.8 percent rate. But what about converting the business to an S corporation?
S corporations are pass-through entities with a single level of tax, just like LLCs. S corporations have their own limitations, such as restrictions on eligible shareholders, a single class of stock, pro-rata income and distributions, taxable distributions of appreciated property, and no step-up of assets inside the entity, to name a few. But in light of the new Medicare surtax, S corporations have certain advantages. For one thing, Medicare taxes apply only to wages, and the remaining flow-through income isn’t considered self-employment income and thus isn’t subject to self-employment taxes. The one thing to keep in mind is that wages from S corporations must be “reasonable,” according to the U.S. Internal Revenue Service (IRS).
Impact on Partners of a Typical Firm
Consider this example: Joe and Jane own a real estate development LLC as 50/50 partners. The LLC has various employees, subcontractors, and land. Joe and Jane are married, are actively involved in the company’s operations, and earn guaranteed payments of $125,000 each; remaining flow-through income is $1 million. Joe and Jane will pay the 3.8 percent Medicare tax on the flow-through income, totaling $38,000.
If Joe and Jane’s LLC were instead an S corporation that paid each of them $125,000 in annual wages, the Medicare tax would not apply to the flow-through income of $1 million. This would represent a tax savings of $38,000 a year.
This is just one scenario, of course, and converting to an S corporation may not be the magic answer for all LLCs, but the potential tax savings make it certainly worth considering. So, how easy is it to convert? Some states allow a simple one-step (or “formless”) conversion. The assets and liabilities of an LLC can also be transferred to a new corporate entity in exchange for stock and distribute the stock to its partners in liquidation.
However, one of the easiest routes to conversion is through the federal check-the-box election. This allows the firm to choose how the LLC will be taxed (as a partnership or a corporate entity) and provides an administratively easy way to do the conversion. Midyear conversions are permitted; both the check-the-box election and S corporation election can be made retroactive by 75 days. The conversion from LLC to S corporation will be tax free as long as certain requirements are met.
With a check-the-box election to tax the LLC as a corporate entity with a simultaneous S corporation election, the entity continues to be an LLC under state law. However, for federal tax rules only, the entity is taxed as an S corporation. Because nothing changes under state law, the LLC continues to operate as-is. There is no need for the company to change contracts, agreements, business cards, invoices, bank accounts, or loans. However, the business will file an S corporation federal tax return instead of being taxed as a partnership, and the owners will need to be paid a reasonable salary instead of draws.
Legal counsel should review the LLC agreement to ensure that the language conforms with S corporation requirements, in particular to see that income allocations and distributions are made according to ownership interests.
The Medicare surtax introduces a new wrinkle to the tax landscape for LLCs, and regardless of which avenue is taken—or even if the firm ends up deciding to do nothing—now is a good time to review entity structure as part of 2013 tax planning.
The New Investment Income Tax
Are you really a real estate professional? The IRS is increasingly auditing taxpayers with rental real estate activities in an attempt to reclassify associated losses as passive, which can generally be used to offset only passive income. This can lead to a large tax bill if you are faced with an audit. However, you can avoid this if you qualify as a “real estate professional”—that is, if you meet the IRS’s criteria to validate your status for tax purposes.
Deducting losses is not the only reason to take a hard look at the real estate professional status and passive-activity regulations. They are also applicable to the new 3.8 percent net investment income tax (NIIT) under the Affordable Care Act—imposed on income from a “passive” business—in effect for the 2013 tax year. The problem is that these regulations are a minefield for the average taxpayer.
To be classified as a real estate professional, you must spend more than 750 hours during the tax year in a “real property trade or business,” such as property development, construction, or rental business. You must also show that more than half of the personal services you performed during the year were in a real property trade or business.
To satisfy the time requirements, you must provide evidence of participation, usually in the form of a time log. The regulations don’t require a contemporaneously prepared log; however, the IRS and the courts increasingly disapprove of taxpayers who do not provide one. For this reason, it is critical to maintain a log or be able to create one using reliable sources such as calendars and appointment books.
Once you qualify as a real estate professional, you must still “materially participate” in the rental real estate business to avoid having the income or loss classified as passive. There are seven tests under the regulations that satisfy the material participation requirement, the most common of which requires you to have spent more than 500 hours participating in the business during the tax year.
The trap in meeting the time requirement for material participation, as opposed to real estate professional status, is that the material participation tests apply to each separate rental activity. Fortunately, you can elect to group all related activities into a single activity—with one caveat: Rental real estate activities cannot be grouped with other real estate activities. To be valid, this grouping election must be made on a tax return (filed on time) for the tax year it is to be effective.
While these rules have primarily been a concern for those with rental real estate losses, the newly enacted NIIT has made them a concern for those with gains as well. The NIIT will apply if your adjusted gross income crosses the applicable threshold amount, but only if the rental real estate trade or business is a “passive” activity.
To avoid passive classification, the rental real estate activity must qualify as a trade or business under Section 162 of the Internal Revenue Code, which can be difficult to establish. Assuming the activity constitutes a trade or business, you still must prove that you materially participated in the rental real estate business to avoid falling subject to the new 3.8 percent tax on passive income.
The average taxpayer’s ability to navigate these new regulations is dubious. The IRS is planning to provide new guidance that will help determine whether the NIIT applies, but what in its opinion constitutes a trade or business—which is critical to perform proper tax planning—is still fuzzy. And most of the guidance the IRS has issued on the subject to date appears to limit a taxpayer’s ability to avoid the NIIT.
Whether you’re thinking of converting your LLC to an S corporation or you want help understanding whether your business activities afford you “real estate professional” status in the eyes of the IRS, seek tax help. Because of the complexity and interplay of these regulations, it is critical to consult with experienced tax professionals and, in certain cases, with legal counsel.
Carleen Snyder, Karina Stadelman, and Greg Martin are partners with Moss Adams LLP, an accounting and business consultancy firm. They can be reached at www.mossadams.com.