To help fund the Affordable Care Act (Obamacare), an additional Medicare surtax is tacked on to your net investment income. Recall that as an S corporation owner, you are both employee and investor. When you trigger the high income threshold for the Medicare surtax, then you could pay 3.8% (2.9% Medicare plus 0.9% surtax) on some portions of your income.
The tax is calculated by multiplying the 3.8% tax rate by the lower of the following two amounts:
Again, whichever is lower (how nice of Congress?).
The IRS defines net investment income for the purposes of calculating the Medicare surtax as interest, dividends, capital gains, annuities, royalties, rents, and pass-through income from an passive business such as S Corps and partnerships. Yuck. Why did they have to pointedly name S corporations?
But! And this is a big but! Like a Nel Carter butt. If you materially participate in your S Corp this income is not included in the net investment income calculation. 99% of the small business owners out there who elect to be treated as an S Corp will also qualify as materially participating. In other words, your income is not considered passive which would otherwise be subject to the Net Investment Income Tax.
Here is the laundry list the IRS uses for testing material participation-
To materially participate in a business for a particular year, the shareholder must meet one of the following seven tests discussed in Temporary Regulations Section 1.469-5T(a)-
This list is an “or” list, therefore you only need to fit into one of the buckets to trigger the material participation designation. Interestingly, these regulations are titled Temporary Regulations but they have been around for a very long time. Like forever. Maybe even forever and ever.
Material participation is a common theme with the IRS, and in some respects it changes the color of money similar to an S Corp election. A silent investor in an S corporation will have passive income and might be subject to Medicare surtax on that income. That same investor now materially participates, and the same income is now considered non-passive (or quasi-earned but without self-employment taxes) and is sheltered from the Medicare surtax.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition