An overview of Medicare and its application to choice-of-entity planning considerations
Christopher Lee, CPA, MSA and Rachel Parsia, CPA, Surgent | October 2021 Footnote
Editor's note: Updated September 30, 2021
As baby boomers began turning 65 several years ago, tax practitioners received many questions regarding Social Security and Medicare. Health care planning often arises as one of the main points of confusion for taxpayers. The answer to client questions involves educating them about the components of Medicare and what planning opportunities are available to support their goal of maximum benefits at the least cost.
As with most tax-planning strategies, lead time is required for implementation and for the benefits to be realized. As such, baby boomers are left with fewer realistic planning opportunities. However, with The Great Resignation upon us, many millennials have begun handing in their notice and exploring their entrepreneurial spirit.
With new businesses forming, this makes for a great opportunity to educate taxpayers on the components of the three-legged retirement stool — Social Security, private savings and pensions. This will enable businesses to start on the right foot with a long-term view in place, buttressed by the correct operating entity structure.
An overview of Medicare
Before discussing entity-planning considerations, it is important to gain a basic understanding of Medicare. Medicare provides health insurance for individuals 65 and older, individuals younger than 65 with certain disabilities and individuals with end-stage renal disease. There are four types of Medicare coverage: Part A, Part B, Part C and Part D.
- Medicare Part A provides hospitalization insurance including inpatient care at a hospital or nursing home, home health care or hospice care. Often referred to as “premium-free Part A,” most individuals are not required to pay a monthly premium for Medicare Part A coverage.
- Medicare Part B provides necessary medical services such as doctor and outpatient care, including preventative care services. Most individuals pay a premium amount for Medicare Part B coverage as well as an income-related monthly adjustment amount (IRMAA) if their modified adjusted gross income (MAGI) exceeds certain thresholds.
- Medicare Part C provides Medicare Advantage Care plan coverage through private companies approved by Medicare. Although these policies are provided by private companies, they must follow rules set by Medicare. Typically, Medicare Advantage Care plans offer additional vision, dental or hearing coverage. These plans frequently bundle Part A and B coverage, and sometimes Part D coverage, into one Medicare Advantage Care plan. Some plans may charge a monthly premium in addition to the Medicare Part B premium, and some plans may pay all or part of the individual’s Medicare Part B premium. Usually, these plans provide for in-network practitioners, set copayments for visits and annual limitations on out-of-pocket expenses, similar to insurance policies previously held by taxpayers.
- Medicare Part D provides Medicare prescription drug coverage. Medicare Part D plans may categorize drugs into certain tiers that have different costs associated with them.
As an alternative to Medicare Advantage Care plans, Medigap plans exist to provide supplemental coverage to the individual’s original Medicare benefits. Under a Medigap plan, individuals pay both a monthly premium for the Medigap plan and a monthly premium for Medicare Part B. Medicare benefits only pay 80% of approved medical costs, leaving the insured liable for the remaining 20% of uncovered costs, with no annual out-of-pocket maximums. Medigap assists in covering these potentially substantial out-of-pocket costs. Individuals covered under Medicare Advantage Care plans are not eligible for Medigap plans.
One important reminder regarding all Medicare programs is that they are not considered high-deductible health plans, and thus, covered individuals are not eligible to contribute to tax-advantaged Health Savings Accounts (HSAs). Although individuals enrolled in Medicare may no longer contribute to an HSA, they may still withdraw funds tax-free and penalty-free if the funds are used for qualified medical expenses, including Medicare premiums. HSA funds may not be used to pay Medigap premiums.
Medicare taxes and choice of entity
Generally, Medicare Part A is funded through the Medicare tax, which is calculated at a 2.9% rate, shared equally between employers and employees. In contrast to the Social Security tax, taxable compensation for the Medicare tax is not capped annually.
Beginning in 2013, the Medicare tax was increased by 0.9% for both employees and self-employed individuals and partners/members of a partnership/LLC who participate in management of the business. This obligation is solely the responsibility of an individual taxpayer and is calculated on Form 8959: Additional Medicare Tax. The additional 0.9% rate applies to taxpayers with taxable income in excess of $200,000 for single filers and $250,000 for married filers.
The differentiation in what is considered taxable compensation for Medicare tax purposes, primarily, revolves around an individual taxpayer’s status as an employee or proprietor/partner. For employee-owners of C Corporations and S Corporations, the Medicare tax applies only to compensation for services to the corporation, which generally refers to wages as reported on Form W-2: Wage and Tax Statement. Neither taxable dividend distributions nor the distributive share of pass-through income from an S Corporation are subject to Medicare tax.
In the case of proprietors/partners — that is, self-employed individuals and partners/members of a partnership/LLC participating in management of the business — the distributive share of income is generally treated as self-employment income and subject to the Self-Employment Tax (SE Tax). The SE Tax consists of both the employer and employee shares of Social Security tax at 12.4%, up to the annual maximum income limitation ($142,800 for 2021), and the employee and employer shares of the 2.9% Medicare tax, which has no annual taxable income limitation.
Typically, the choice between operating business activities in a C Corporation structure as opposed to a pass-through entity structure largely falls on the applicability of the qualified business income (QBI) deduction under Section 199A. When choosing the optimal pass-through entity structure, the decision usually relates to the number of owners, the type of owners, the flexibility regarding allocation of distributive share items, the merger and/or acquisition potential related to the business operations, the ease of formation, the liability protection desired and the ease of operation. However, Medicare taxes are an additional consideration that can often be overlooked.
The main interplay between Medicare taxes and choice of entity structure falls primarily on the taxable base, and because of the disparity in the taxable base, planning opportunities exist. S Corporation shareholders are subject to Medicare taxes and the additional 0.9% Medicare taxes only to the extent of taxable compensation, usually in the form of W-2 wages. The distributive share of an S Corporation’s earnings is not subject to the SE Tax, which includes the Medicare tax, leaving the Form W-2 wages to function essentially as the upper limit of the taxable compensation base subject to Medicare taxes.
This contrasts with self-employed individuals or managing partner/members of entities taxed as partnerships who are subject to the Medicare taxes on all earnings of the business activity. As noted, all earnings of the self-employed individual are subject entirely to Medicare taxes, and potentially, the additional 0.9% Medicare tax. This treatment is similar for the guaranteed payments and distributive share of income from partnership entities.
The salary that employee-owners in an S Corporation set for themselves to manage Medicare taxes paid should be determined by considering benefits for both Social Security and Medicare. Medicare benefits are determined by the number of quarters worked rather than by what is actually paid into the program. As opposed, Social Security benefits pay much like a lifetime annuity that has flexible beginning dates, differing amounts depending on taxpayer’s first receipt of benefits, and decreasing net marginal benefits for taxes paid into the program. Thus, a cost-benefit analysis can be performed to determine the maximum benefits associated with taxes paid into Social Security and benefits that can be expected.
Taxpayers considering a check-the-box election and a subsequent S-election should keep in mind that there are restrictions regarding when S-elections can be made and revoked. Generally, elections and revocations are effective for five taxable years.
Reasonable compensation issues
The Internal Revenue Code establishes that any officer of a corporation, including S Corporations, is an employee of the corporation for federal employment tax purposes. Though there is discretion afforded to employee-owners, S Corporations should not attempt to avoid paying employment taxes for reasonable compensation by having such owner compensation be treated as cash distributions, payments of personal expenses and/or shareholder loans. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages, and if salaries are found to be unreasonably low compared to dividends paid, such dividends may be reclassified as compensation with all employment taxes imposed along with any related penalties and interest. Courts have frequently determined employee-shareholder reasonable compensation cases by looking at the time devoted to the business, dividend history and salaries paid for similar services by comparable businesses, among other factors.
Go forth and advise well
With new businesses forming in record numbers, the choice of entity decision-making process should consider Medicare in addition to all other factors. It is not uncommon for the effect of Medicare taxes to be left off the choice of entity analysis and, as trusted advisers, it is important to assist clients and provide them with all relevant information in their analysis. Advising clients now in these matters would go a long way in establishing long-standing relationships. These can grow in a mutually beneficial manner with a client’s continued business.
Christopher Lee, MSA, CPA, is a manager of tax and advisory content for Surgent. Additionally, he serves as associate faculty for the Indiana University Kelley School of Business teaching a variety of courses in the accounting department. Prior to joining Surgent, Chris was a tax manager with PwC serving both public and private companies as well as high-net-worth families in all areas of taxation including federal, state and local, international and estate planning matters.
Rachel Parsia, CPA, is a senior manager of tax and advisory content for Surgent, where she co-authors a variety of tax CPE courses. Prior to joining Surgent, she worked in the tax department of a Big Four accounting firm and a $12 billion global industrial technology leader. Rachel has experience in federal tax, international tax and tax forecasting.
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