While the S corporation has a number of shortcomings, it historically has offered the best means for avoiding corporate level tax on the sale of business assets, provided the sale occurs beyond the corporation’s built-in gain recognition period.  A recent development provides yet another advantage for an S corporation over a C corporation: an opportunity for shareholders to avoid the imposition of a surtax on net investment income (“NII”).   Specifically, if the S corporation’s income is derived from a trade or business in which the shareholder-taxpayer materially participates, such income will not be subject to the surtax.

The Surtax

After 2012, the tax cost of operating an S corporation or of selling its business increased for higher-income taxpayers.  In addition to increased income and capital gain tax rates, a new 3.8% surtax is now imposed on the NII of an individual or trust.  In the case of an individual, the tax is imposed on the lesser of (a) the taxpayer’s NII for the year, or (b) the excess of the taxpayer’s modified AGI for the year over the “threshold amount” ($200,000 in the case of a single taxpayer).

But, what if the shareholder is a trust? This is not an uncommon occurrence; after all, the family-owned business is often the family’s most valuable asset, and it is often transferred to the next generation in trust (either by way of a gift, sale or bequest), so as to keep it within the family, or to protect it from spendthrifts, creditors, spouses, etc.

In the case of a trust, the tax is imposed on the lesser of (a) its undistributed NII for the year, or (b) the excess of (i) the trust’s AGI for the year over (ii) the dollar amount at which the highest trust tax bracket begins for such year.  For 2014, this dollar amount is only $12,150.

Thus, a trustee may be incentivized to make distributions of trust income to its beneficiaries so as to reduce the trust’s NII surtax. Alternatively, the trustee may consider invading the trust and distributing the income-producing corpus to a beneficiary whose AGI is under the threshold for the application of the surtax to individuals, or who is active in the business.

Of course, these options must be considered in light of the grantor’s purpose for the trust.  Any distribution has to make family and business sense first.  In any case, as we shall see, the distribution option will have limited application to most S corporation trusts, except during the 2‑year periods for which former grantor trusts and testamentary trusts may be S corporation shareholders.

Material Participation

Returning to the S corporation shareholder,  in general, a shareholder that is involved in the corporation’s business on a regular, continuous and substantial basis will not be subject to the 3.8% tax on the shareholder’s distributive share of S corporation business income, or on the gain from the S corporation’s sale of assets used in such trade or business, or on the gain recognized by the shareholder on the sale of the S corporation’s stock.  By contrast, in the case of a C corporation, an individual or trustee shareholder will be subject to the 3.8% surtax on any dividends received from the corporation and on any gain recognized on the sale of its stock, regardless of the shareholder’s level of participation.

The determination of whether an individual shareholder has materially participated in a business is fairly straightforward; in general, one of several alternative tests may be applied, including the annual participation requirement of 500 hours in the operations of the business.

Thus, the characterization of passive or non‑passive as to a particular activity may vary from one shareholder to another, with a “passive” shareholder being liable for the surtax on his or her share of the income or gain, while an “active” shareholder is not.

This potential difference in treatment among the shareholders of an S corporation should be considered in context. In many family businesses, only those members who are actually active in the business receive any economic benefit therefrom, usually in the form of salary or bonus. The passive members are dependent upon distributions from the corporation. It is often the case that the active members also control the corporation’s board and are its officers; among other things, they determine its distribution policy. Query whether the surtax will prove to be another source of friction between the “insider” and the “investor” shareholders?

In our next post, we will take a closer look at the application of the material participation test with respect to S corporation trusts.