Minimizing the 3.8 percent tax when selling a business
By Mark Sellner, CPA, JD, LLM (taxation)
February 15, 2018
Editor's note: This article was last reviewed and updated in July 2019.
The unearned income Medicare contribution tax was enacted as part of the Health Care and Education Reconciliation Act of 2010, with a delayed effective date of Jan. 1, 2013.1 The tax survived discussions of repeal in the Tax Cuts and Jobs Act of 2017, so it is still applicable.
Read on to understand this tax and considerations for its application.
The tax applies to:
- Net investment income of individuals when modified adjusted gross income exceeds certain threshold amounts.
- Undistributed net investment income of estates and trusts when adjusted gross income exceeds the highest estate and trust tax bracket.2
The tax does not apply to:
- Active trade and business income: The Technical Explanation of the provision states that, in the case of a trade or business, the tax applies to business income if the trade or business is a passive activity with respect to the taxpayer, or the trade or business consists of trading financial instruments or commodities, but that it does not apply to other trades or businesses conducted by a sole proprietor, partnership or S corporation.3
A closer look at what's taxable and what’s not when selling a business:
Sale of business assets
Upon disposition of a business, only net gain or loss attributable to property held by the entity, which is not property attributable to an active trade or business, is subject to the tax. However, income, gain or loss on working capital is not treated as derived from a trade or business, so is taxable.4
The tax applies to net investment income, including to net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business.5 When a disposition of an active equity interest in a partnership or S corporation is made, rather than a disposition of the underlying assets, an exception also applies.6
Sale of partnership/LLC or S corporation equity interests
The regulations issued state that, generally, an interest in a partnership or S corporation is not property held in a trade or business and concludes that, therefore, gain or loss from the sale of a partnership interest or S corporation stock will be subject to the tax.7
There is an exception for certain active interests in partnerships and S Corporations, so dispositions of those interests should be closely reviewed for exemption from the tax.8
Sale of partnership or LLC equity interests
A net gain on the sale of partnership interests or LLC member interests by a partner or member who actively participates in the business should be exempt, since a sale of equity interests in a partnership or LLC is treated as a sale of partnership or LLC assets directly.9 This result differs from the sale of interests in an S corporation, where there is a strong distinction between stock and asset transactions.
Sale of S corporation equity interests
Absent further guidance, the sale of S corporation stock, even by a shareholder who actively participates in the business, would appear to be subject to the tax. Fortunately, the law itself provides an exception. Section 1411(c)(4) states that, in the case of a disposition of an interest in a partnership or S corporation, gain is taken into account for purposes of the tax only to the extent of the net gain that would be taken into account if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest.
Sale by a qualified S corporation trust (QSST)
While income received by a qualified S corporation trust is taxed to the income beneficiary, if the QSST sells some or all of its S corporation stock, any gain or loss recognized on the sale will be that of the trust, not the income beneficiary. This is a disadvantage, since the 3.8 percent tax applies at lower levels of income for trusts than for individuals.
This is discussed in the preamble to proposed regulations, and in Prop. Reg. §1.1411-7(a)(4)(iii)(c) Treatment of Qualified Subchapter S Trusts (QSSTS).10
Section 338(h)(10) and Section 336(e) elections
In a sale of S corporation stock in conjunction with a Section 338(h)(10) or Section 336(e) election, the stock sale is disregarded and the transaction is taxable as a deemed asset sale.
Prop. Reg. §1.1411-7(a)(4)(i) states that the transaction will as a disposition of the underlying assets.
Installment sales
In an installment sale, the net investment income will be calculated in the year of the disposition. However, under Prop. Reg. §1.1411-7(d), the gain is deferred and recognized pursuant to the installment sales rules of Section 453.
Information reporting
Information required by Prop. Reg. §1.1411-7(g) is requested by the IRS to verify a taxpayer’s reported adjustment under Section 1411(c)(4) for the exception for certain active interests in partnerships and S corporations. This information will be used to determine whether the amount of tax has been reported and calculated correctly.
Payments for services, noncompete covenants, and personal goodwill
In the context of selling a business, Form 8594 Asset Acquisition Statement Under Section 1060 asks, even for a stock sale, whether ancillary agreements were negotiated with the sellers in addition to the related stock or asset sale agreement.
Employment or consulting agreements may attract the new 0.9 percent Medicare tax under Sections 1401 or 3101, but should not be subject to the 3.8 percent unearned income Medicare contribution tax, because payments would not constitute net investment income. Non-compete payments should not be subject to either tax since they are neither self-employment income nor net investment income.
The sale of personal goodwill, if respected, creates a capital gain that may be subject to the active trade or business exceptions to the 3.8 percent tax, if applicable.
Does a built-in gain avoid the 3.8 percent tax?
If the sale of an S corporation would have avoided the tax under the active trade or business exception, would that gain survive a tax-free merger of the S corporation into a C corporation and reduce the ultimate net investment income on a taxable sale of the stock received in the merger? Nothing in the statute, Technical Explanation or regulations addresses that issue.
The bottom line
An additional 3.8 percent tax on top of a 20 percent capital gains tax amounts to a 19 percent surtax. While it is appropriate to minimize the tax when possible, the Joint Committee on Taxation warned in March 2010 that the IRS will closely review transactions that manipulate a taxpayer’s net investment income to reduce or eliminate the amount of tax imposed by Section 1411.
Oddly enough, the Joint Committee also acknowledged that amounts collected under Section 1411 as a Medicare contribution tax are not designated for the Medicare Trust Fund. So, Congress can spend the taxes on other programs witout even giving Medicare an IOU.
Mark Sellner consults on business and executive tax matters, including the tax consequences of buying and selling a business. He is a member of the Minnesota Society of CPAs, a past CPA member of the Minnesota Board of Accountancy, and has served as an adjunct professor of business taxation at the University of St. Thomas School of Law. He formerly served as director of Graduate Studies in Taxation at the Carlson School.
1 IRC Section 1411 Imposition of Tax.
2 Under Section 1411(b), the threshold amount is $250,000 for married filing joint, $125,000 for married filing separate, and $200,000 in any other case.
3 Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as amended, in combination with the “Patient Protection and Affordable Care Act,” (JCX-18-10), March 21, 2010 .
4 Section 1411 (c)(3).
5 Section1411 (c)(1)(A)(iii) .
6 Section 1411 (c)(4).
7 Reg. Sect. 1.1411-4(d)(4)(i)(B)(1)
8 IRC Section 1411(c)(4)
9 Rev. Rul. 99-6.
10 REG-130843-13
