Partners, S Corp. Shareholders and Biden’s 2022 Revenue Proposal: No More Business as Usual

June 14, 2021 | Louis Vlahos | Tax

What A Ride

No one anticipated that the Administration’s proposed tax increases would fly through Congress easily – at least no one residing in a state in which the recreational use of marijuana has not been legalized. Query, however, whether anyone foresaw the rollercoaster-like developments of the last several days.

The G-7

As the White House insisted that the President was committed to increasing the corporate income tax rate from 21 percent to 28 percent, the finance ministers of the Group of 7,[i] including the U.S., committed themselves to a 15 percent minimum corporate income tax.

Whereas Republican lawmakers were already against an increase in the federal corporate tax rate, and whereas Democratic Senator Manchin has stated clearly that he would not support a rate higher than 25 percent, the G-7’s announcement has other Democrats wondering whether they should table discussions of corporate tax hikes for now lest they compromise the ability of domestic businesses to compete with foreign rivals.

Biden-Capito Talks

Meanwhile, weeks of talks between the President and a group of Republican Senators, led by Senator Capito, ended after the two sides were unable to reach any accord, either on the breadth of a federal infrastructure plan or on how to pay for it.

During their discussions, however, Mr. Biden is said to have suggested a slightly smaller version of his original infrastructure plan ($1.7 trillion as opposed to $2 trillion), and even to have floated the idea of a minimum 15 percent tax on corporations (in lieu of the tax increase originally proposed?) to help pay for his plan.

The Progressives: “No Filibuster” & “Yes Reconciliation”

The more “progressive” wing of the Democratic Party has grown ever more impatient with the President’s efforts at trying to reach a bipartisan consensus.

The members of this group are pushing Mr. Biden to abandon his hopes of a deal with the Republicans. Rather, they are urging Senate Majority Leader Schumer to call for the elimination of the Senate’s filibuster rule, which requires sixty votes to end discussion on a bill and bring it to a vote.[ii] They are also pressing the Party’s leadership to prepare for a vote along strictly partisan lines.

In fact, Senator Schumer[iii] has announced that he is preparing to use the budget reconciliation process to move the President’s proposals forward without Republican support. Unfortunately for him, he also learned last week that he will be able to pass only one more reconciliation bill during 2021[iv]; the Senate Parliamentarian had previously told Mr. Schumer that he could use the process two more times this year.

Both these measures – eliminating the filibuster and using the budget reconciliation process – would require unanimity among Senate Democrats, but Senator Manchin wants no part of either option; instead, he is insisting upon a bipartisan solution.[v]

Another Shot at Bipartisanship?

In fact, a bipartisan group of ten moderate Senators (including Mr. Manchin) announced late last week that they had agreed on a “compromise framework” that focused on “core, physical infrastructure,” was much less expensive (under $1 trillion)[vi] than the President’s proposal and did not include tax increases.[vii]

Query whether the President and the Democrats, generally, will be receptive to a compromise that calls for such a significantly scaled-back version of their original plan. Unlikely.[viii]


This announcement coincided with the release of data by the Department of Labor indicating that the consumer price index for the period ended last month experienced its fastest increase since 2008, thus setting off concerns over inflation, especially when considered with the President’s proposals to increase federal spending by trillions of dollars.

The Republicans, as expected, have jumped all over this news. However, there are also centrist Democrats who quietly view the President’s spending plans and proposed tax increases as problematic.[ix]

Tax the Rich

The foregoing developments may have cast some doubt upon the Administration’s chances for enacting its proposed infrastructure plan and the related tax increases by which to pay for it.

Last week, however, “ProPublica” (a not-for-profit investigative journal) published what it described as “a vast cache of IRS information,” covering several years’ worth of detailed tax return information, according to which many of the wealthiest individuals in the country[x] have paid little-to-no federal income tax even as their fortunes have multiplied in value.[xi]

Inexplicably – at least to me – neither the White House nor the press,[xii] and not even AOC, has taken the offensive with this gift from the gods. (Perhaps because of the President’s first trip overseas?)[xiii]

Where Will It Lead?

Query how this “cache” was acquired. Indeed, even within the government, such information may be disclosed only under very strict conditions, to ensure its use for limited purposes and to preserve its confidentiality.[xiv]

In any case, the information is now in the public realm. Will its release serve as a catalyst for uniting the Democrats in Congress behind the President’s efforts to tax the “wealthy”? Will it weaken the force with which many Republicans have opposed those efforts?

Much remains to be seen, but the prospects of an impactful bipartisan bill are probably quite remote, which means that taxpayers and their advisers need to remain focused on the key elements of the Administration’s tax plans.

In prior posts, we looked at the proposals for increases in the corporate and individual income tax rates, the forced recognition and taxation of built-in gain (a deemed sale at specified times), the limitation of the like kind exchange,[xv] and the treatment of profits interests as ordinary compensation income.[xvi]

Today we turn to a topic that has not yet received the attention it deserves, but with which the owners of every closely held business (and their key employees) should be aware: the extension of the Self Employment Contributions Act (SECA), Medicare, and net investment income taxes. Before considering the President’s proposals for these taxes, it would help to review their current application.

Net Investment Income Tax Recap

Beginning in 2013, individuals with incomes over a threshold amount became subject to a 3.8 percent tax on their net investment income.[xvii] The threshold is $200,000 for single returns and $250,000 for joint returns.[xviii]

Net investment income generally includes: (1) interest, dividends, rents, annuities, and royalties, other than such income derived in the ordinary course of a trade or business; (2) income derived from a trade or business in which the taxpayer does not materially participate; and (3) net gain from the disposition of property other than property held in a trade or business in which the taxpayer materially participates.[xix]

Stated differently, net investment income does not include an individual’s share of partnership, LLC or S corporation income or gain if the individual materially participates in the entity’s business.[xx] However, if the individual owner is merely an investor in the business, or if their participation therein is insignificant, their share of income or gain from the entity is treated as investment income.

Thus, it is not unusual for the owners of a single pass-through entity to experience different tax consequences during the ordinary course of the entity’s business or upon the sale of such business, depending upon the extent to which each individual owner participates in the business.

Employment Tax Recap

The tax on net investment income does not apply to earnings from self-employment.

Such earnings, along with wages paid to an employee, are subject to employment taxes under either SECA or the Federal Insurance Contributions Act (FICA), respectively. Both SECA and FICA taxes apply at a rate of 12.4 percent for social security tax on employment earnings, or wages, as the case may be (capped at $142,800 in 2021), and at a rate of 2.9 percent for Medicare tax on all employment earnings (not subject to a cap).[xxi]

In the case of wages, half the social security tax (6.2 percent) component of FICA is borne by the employer, and half by the employee; similarly, for the Medicare tax, half (or 1.45 percent) is imposed upon the employer and half upon the employee.[xxii]

In the case of self-employment earnings, the individual taxpayer bears the entire 15.3 percent for both taxes but can deduct 50 percent of the tax in determining their adjusted gross income.[xxiii]

An additional 0.9 percent Medicare tax[xxiv] is imposed on the self-employment earnings and on the wages of high-income taxpayers; specifically, a taxpayer with income above the same thresholds that are used for the tax on net investment income: $200,000 for single filers and $250,000 for joint filers.[xxv]


General partners and sole proprietors pay SECA tax on the full amount of their net trade or business income, without regard to how actively they participate in the business.

Limited partners are statutorily[xxvi] excluded from paying SECA tax with respect to their distributive shares of partnership income, although they are subject to SECA tax on any “compensation” they receive from the partnership for services rendered to the partnership.[xxvii] This treatment is grounded, ostensibly at least, in the limited partner’s inability to participate in the management of the business.

The treatment of LLC members has been less clear. Years ago, the IRS proposed regulations[xxviii] under which a member would be subject to SECA tax if they had personal liability for an obligation of the LLC, if they had statutory authority to bind the LLC, or if they participated in the LLC’s business for more than 500 hours during the year. The regulations have never been finalized.[xxix]

In the absence of guidance, cautious advisers generally determine whether a member’s share of an LLC’s income is subject to SECA by looking at whether the member’s activities are more like those of a general partner or of a limited partner.[xxx]

S Corporations

S corporation shareholders, as such, are not subject to SECA tax – unlike the partnership, the S corporation is viewed as a separate taxpayer for this purpose and its activities are not attributed to its shareholders.

However, an S corporation is required to pay its owner-employees “reasonable compensation” for services rendered to the corporation, on which they are subject to FICA tax.[xxxi]

Nonwage distributions to shareholders of S corporations[xxxii] are not subject to either FICA or SECA taxes.

The Administration’s Proposal

The President’s proposal calls for significant changes to the application of the net investment income tax and to the imposition of the SECA tax to the owners of S corporations or tax partnerships (each a pass-through entity).

Specifically, the proposal seeks to ensure that all the pass-through business income of an individual with more than $400,000 of adjusted gross income for the taxable year is subject to the 3.8-percent Medicare tax, either through the tax on net investment income or through the SECA tax.

This outcome would be achieved by amending the definition of “net investment income” to include the individual’s gross income and gain from any pass-through business that is not otherwise subject to employment taxes; in other words, S corporation shareholders who are active in the corporation’s business but who do not draw down sufficient compensation, and limited partners (plus their LLC member equivalents) who materially participate in their partnership (LLC).[xxxiii]

S Corps

Thus, the 3.8 percent tax on net investment income would apply to a high-income[xxxiv] taxpayer’s share of S corporation business income – including the taxpayer’s gain from the sale of S corporation stock, as well as their share of the gain from the sale of the corporation’s business – even where the shareholder materially participates in the business.

Of course, the shareholder’s wages from the S corporation – which are deducted in determining the corporation’s net income – will be subject to the 3.8 percent Medicare tax in any case.

Shareholders with respect to whom the corporation’s business is a passive activity are already subject to the tax on net investment income with respect to their share of S corporation income.[xxxv]


In addition, the proposal requires that limited partners and LLC members who provide services to, and who materially participate in, their partnerships and LLCs would be subject to SECA tax on their distributive shares of partnership or LLC income to the extent that this income exceeds certain threshold amounts.[xxxvi] Their status as “limited partners” will no longer avail them.


Other limited partners and members would not be subject to this tax, though they would remain subject to the tax on net investment income.


Similarly, S corporation shareholders who materially participate in the organization’s business would be subject to SECA taxes on their distributive shares of the business’s income to the extent that this income exceeds the same threshold amounts.[xxxvii]

The fact that these shareholders fail to be paid reasonable compensation by their S corporation will no longer avail them.

Material participation standards would apply to individuals who participate in a business in which they have a direct or indirect ownership interest. Taxpayers are usually considered to materially participate in a business if they are involved in it in a regular, continuous, and substantial way.

The proposal would be effective for taxable years beginning after December 31, 2021.

What to Do?

The foregoing provisions, if enacted, would represent a sea change in the taxation of pass-through entities and their “high-income” owners. Many S corporation shareholders, partners, and LLC members who previously may have been able to reduce their employment tax exposure – either by controlling the compensation paid to them by the corporation or by downplaying the extent of their participation in the partnership/LLC business – would find themselves in a very different tax environment.

Depending upon where the income tax rate for C corporations ends up, many of these individual owners may consider incorporating their tax partnerships,[xxxviii] or revoking their S corporation elections, as necessary, to avoid the pass-through treatment for, and taxation of, undistributed profits.[xxxix]

Others may try to control their recognition of income in any taxable year, and thereby control their exposure to the above taxes.[xl]

The Inexorable March of Time

Of course, what a taxpayer may do will ultimately be dependent upon what Congress is able to pass.

It is already the middle of June. That doesn’t leave too many days before Congress takes its summer recess in August; it will return in September. The federal government’s next fiscal year begins on October 1, 2021; legislation will have to be passed before then to fund the operation of the government.

In other words, there is not a lot of time for the Administration’s infrastructure plan and its supporting tax initiatives (including the employment tax provisions described above) to be fleshed out, drafted, debated, and enacted before the House and one-third of the Senate start to think about the mid-term elections in 2022.

The next two months should be a doozy.

[i] The world’s seven largest free market economies: Canada, France, Germany, Italy, Japan, the U.K., and the U.S.; the “G-7.”

[ii] .

[iii] Who is up for reelection in 2022; there are rumors that a more progressive Democratic candidate may challenge him in the primaries.

[iv] The first was the $1.9 trillion American Rescue Plan, enacted in March of this year.

[v] Some fellow Democrats are now calling Mr. Manchin the “new Mitch McConnell.” Unfortunately for the Democrats, there are certainly other Senators in their party who share his views, or who are skeptical about components of the President’s plan (for example, the deemed sale of property at death). He happens to be the most vocal. I wonder if the others are concerned about being canceled.

[vi] I imagine that even rich Uncle Pennybags, from the Monopoly game, would feel light-headed upon hearing these figures.

[vii] Though it is not entirely clear how they propose to fund their alternative plan.

[viii] AOC has suggested that the Republicans are “hustling” the White House; specifically, that they are delaying any legislative action to prevent the Democrats from achieving any success before the mid-term elections.

[ix] According to The Hill, “29 moderate Democrats in the Problem Solvers Caucus have signed off on a $1.2 trillion infrastructure framework that closely hews to the” bipartisan Senate group’s efforts.

[x] We are talking Bezos, Musk, Buffet, Bloomberg, Soros, Zuckerberg, Icahn, Murdoch, Ellison, Page, . . . you get the drift.

[xi] ; see IRC Sec. 6103: .

It is amazing that this story has not grabbed the headlines in every major American newspaper every day since its release.

[xii] I recall the self-righteous indignation that was displayed when Trump’s income tax payments were publicized. .

The following is from endnote ‘xxi’ from my article on the internet at :

“Don’t get me wrong. Mr. Trump was not suited for the White House. The press, however, cannot allow itself to behave as it has these last four years. Back to my quoting from movies, as is my wont. In “Meet Joe Black,” media executive William Parrish says the following:

‘I’d hoped to create something, something which could be held to the highest standards. And what I realized was I wanted to give the news to the world, and I wanted to give it unvarnished. The more we all know about each other, the greater the chance we will survive. . . . Now if we give [John Bontecou] license to absorb Parrish Communications, and he has his eye on a few others after us, in order to reach the world you will have to go through John Bontecou. And not only will you have to pay him to do this, far more important, you’ll have to agree with him. Reporting the news is a privilege and a responsibility, and it is not exploitable.’”

It seems we have a lot to learn from the movies, though perhaps not from the actors.

[xiii] But see Rep. Tom Suozzi’s proposal last Friday for a “Patriot Tax” at: .

[xiv] See, e.g., IRC Sec. 6103.

[xv] .

[xvi] .

[xvii] IRC Sec. 1411(a)(1).

[xviii] IRC Sec. 1411(b).

[xix] A dividend distributed by a C corporation and gain from the disposition of shares of stock in a C corporation are treated as investment income.

[xx] IRC Sec. 1411(c).

[xxi] IRC Sec. 1401.

[xxii] The employer withholds the employee’s 6.2% FICA and 1.45% Medicare taxes from their wages and remits them to the government.

[xxiii] IRC Sec. 164(f).

[xxiv] IRC Sec. 1401(b)(2).

[xxv] It is no coincidence that the tax rate on net investment income is 3.8%. It equals the sum of the 2.9% Medicare tax on self-employed individuals plus the 0.9% additional Medicare tax on higher earners.

Indeed, it is appropriate to view this tax as a form of employment tax.

[xxvi] IRC Sec. 1402(a)(13).

[xxvii] So-called “guaranteed payments” under IRC Sec. 707(c).

[xxviii] REG-209824-96.

[xxix] In fact, the Taxpayer Relief Act of 1997 expressly prohibited the IRS from doing so. P.L. 105-34.

[xxx] Basically, the spirit of the frozen proposed regulations.

[xxxi] Rev. Rul. 74-44. That is to say, if an S corporation makes a distribution to a shareholder-employee who is under-compensated for the services they render, the IRS may recharacterize part of the distribution as compensation.

[xxxii] IRC Sec. 1368.

[xxxiii] Without regard to what such participation may do to their standing as a limited partner under state law.

[xxxiv] From whatever source; it is not limited to the taxpayer’s share of S corporation income under IRC Sec. 1366.

[xxxv] IRC Sec. 1411(c).

[xxxvi] The exemptions from SECA tax provided under current law for certain types of partnership income (e.g., rents, dividends, capital gains, and certain retired partner income) would continue to apply to these types of income.

However, the current statutory exception to SECA tax for limited partners would not exempt a limited partner from SECA tax if the limited partner otherwise materially participated in the partnership’s business.

[xxxvii] In order to determine how much of an individual’s income from a partnership, LLC, or S corporation would be subject to SECA tax under the proposal, the individual taxpayer would add together their share of (a) ordinary business income derived from S corporations for which the owner materially participates in the business, and (b) ordinary business income derived from either limited partnership interests or interests in LLCs that are classified as partnerships to the extent a limited partner or LLC member materially participates in its partnership’s or LLC’s business (this sum is referred to as the “potential SECA income”).

Beginning in 2022, the additional income that would be subject to SECA tax would be the lesser of (i) the potential SECA income, and (ii) the excess over $400,000[xxxvii] of the sum of the potential SECA income, wage income subject to FICA under current law, and 92.35 percent of self-employment income subject to SECA tax under current law.

[xxxviii] See Rev. Rul. 84-111. See also the check-the-box rules at Reg. Sec. 301.7701-3.

[xxxix] Though the accumulated earnings tax would have to be considered.

[xl] Query what anti-abuse rules would accompany the enactment of the Administration’s proposals.

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