Let’s back up a bit. Our book loves to spill the beans so-to-speak with the net-net fun facts, and then dig a hole under the house for the foundation. Wow. All kinds of metaphors. There are three types of income- earned, portfolio and passive. There is also a small subset of passive income called non-passive income.
Capital gains are not a form of income per se. Capital gains simply defines how your portfolio income will be taxed. Subtle difference.
Portfolio income is not subjected to self-employment taxes, but as illustrated earlier it might be subjected to net investment income (NII) Medicare surtax.
Passive income is also not subjected to self-employment taxes. But similar to portfolio income, it might be subject to the Net Investment Income tax. So, if you own a rental house, the income generated from the rental house is considered passive income. As a side note, taxpayers used to label themselves as Real Estate Professionals under IRS definition to allow passive losses to be deducted; now we are seeing the same label to avoid Net Investment Income tax on rental income.
Additionally, if you wrote a book and receive royalty checks, that income is also passive and not subjected to self-employment taxes. But, if you write several books or make updates to an existing book (like this one) then you are materially participating in your activity and your income is earned income. And Yes, you would pay self-employment taxes on that income.
As an aside, expatriates, or expats for short, can exclude up to $104,100 for 2018 of earned income while working overseas. Many establish S corporations stateside for their contract gig- both the W-2 and K-1 income up to $104,100 are excluded from income tax.
Therefore as a shareholder in an S corporation you will receive a K-1. How this income is labeled can change depending on your involvement. Material participation makes your K-1 income non-passive, otherwise it is passive income. As mentioned earlier, this changes the color of money.
Where is this all leading to? Good question.
More Net Investment Tax, Self-Rentals and S Corps
It is common for a business owner who relies on machinery or equipment to have two business entities. One entity is an LLC that owns the assets. The other entity is an S corporation which leases the assets from the LLC to use in the business. This directly reduces the S Corp’s income, and might possibly reduce the amount of salary required to be paid by the business to the shareholders. Good news.
Here is an example-
This is an overly simplified example and leaves out depreciation, etc., but you get the idea. In addition, we used a 40% salary calculation which might be different in your situation. Regardless, the apples to apples comparison shows a nice little savings of $1,692. As mentioned in a previous chapter, the arrangement also allows you to have different partners in each entity allowing you to expand ownership in the operating entity while retaining full ownership in the leased asset (building).
More good news. The LLC’s activities are considered self-rental activities which means that you are creating a transaction with yourself. Provided that this arrangement is at market rates, the IRS accepts this relationship. Moreover, the self-rental income is not considered passive and therefore not subjected to the Net Investment Income Tax calculations.
We know what you are thinking... wait for it... Yes, this changes the color of money (how many times have we said this?).
Here is the code. Regulations Section 1.469-2 boringly read-
(f)(6) Property rented to a non-passive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property-
(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of Section 1.469-5T) for the taxable year; and
(ii) Is not described in Section 1.469-2T(f)(5).
Read that first paragraph again. Only attorneys and legislators could have taken a simple concept and made it unnecessarily complicated. Let’s summarize. If you have a self-rental situation with a business where you materially participate, that income is not considered passive income.
Self-rental situations are not just limited to buildings. You could lease your car to your S corporation. No, this isn’t the same as leasing a car from a dealership. This is where you own a piece of equipment, let’s say an automobile, and you lease it back to your business for your business’s use. Sounds exotic, but it is quite simple. More about this in a later chapter dedicated to fringe benefits and tax deductions.
This is about the equipment used in your trade or craft. Field engineers and landscapers are just a few that come to mind who benefit from a self-rental situation.
Wait! There’s more. There’s always more.
Interest income generated from loans to the S corporation are also excluded from the Net Investment Income Tax calculations to the extent of your allocable share of non-passive deduction. Huh? Example time.
Jim Smith and Sharon Jones own JS Toys as 60-40 partners. Jim received $1,000 in interest income from the business because he lent the business money. Jim owns 60% of the business. Therefore, Jim can exclude $600 from his net investment income since that is his allocable share of non-passive income. The remaining $400 would be subjected to the Net Investment Income Tax calculation. Yes, we accountants love a stupidly convoluted tax code- keeps you confused or bored, and keeps us employed.
Make sure this stuff is handled correctly. You might be paying a Medicare surtax gratuitously.
Here is a little teaser: you would never want to own real estate in your S corporation, or any appreciating asset for that matter. We’ll explore this in our next chapter.
Income Types Recap
Tilt. This can be confusing. Please contact the Watson CPA Group for more assistance and hopefully clarification.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition