Taxpayers who own closely held businesses can maximize their tax savings by taking advantage of the self-employment tax “rentals exception” under which rentals from real estate and from personal property leased with the real estate (and the corresponding deductions) are excluded in determining net earnings from self-employment. The tax savings can be significant. This shift will help us control the 2013 additional Medicare Tax on earned income and the amount of earned income used for determining the earnings limit when receiveing social security benefits.
The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed workers—one for Old Age, Survivors and Disability Insurance (OASDI; commonly known as the Social Security tax), and the other for Hospital Insurance (HI; commonly known as the Medicare tax). For self-employed workers, the FICA tax normally is 15.3%—12.4% for OASDI and 2.9% for the Medicare tax. But for 2012, the self-employment tax rate is 13.3%—10.4% for OASDI, reflecting a two percentage point drop in the OASDI rate for employees, plus 2.9% for the Medicare tax.
There is generally a maximum amount of compensation subject to the OASDI tax, but no maximum for the Medicare tax. The Social Security Administration has projected that the Social Security wage base for OASDI will increase from $110,100 for 2012 to $113,700 in 2013.
For tax years beginning after 2012, an additional 0.9% Medicare tax is imposed on taxpayers (other than corporations, estates, or trusts) receiving wages with respect to employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately). See our previous blog posts for a more setailed discussion. The tax only applies to the employee portion of Medicare tax. An additional 0.9% tax also applies to net earnings from self-employment. This tax was added by the “Obama Care” which was largely upheld by the Supreme Court.
In addition, for tax years beginning after Dec. 31, 2012, an unearned income Medicare contribution tax is imposed on individuals, estates, and trusts. For an individual, the tax is 3.8% of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount. MAGI includes wages, salaries, tips, and other compensation; dividend and interest income; business and farm income; realized capital gains; income from a variety of other passive activities; and certain foreign earned income. The threshold amount is $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others. The tax generally doesn’t apply to an active (i.e., nonpassive) trade or businesse conducted by a sole proprietor, partnership, or S corporation.
Rentals exception. Certain items are specifically excluded in determining net earnings from self-employment. One of these exclusions is rentals from real estate and from personal property leased with the real estate (together with the deductions attributable to them). This “rentals exception” doesn’t apply to:
- rentals received in the course of a trade or business as a real estate dealer;
- rentals from real estate paid in crop shares if certain conditions are met; and
- payments made for rooms or other space where services (e.g., maid service) are also rendered to and primarily for the occupant’s convenience.
The “rentals exception” doesn’t apply to rentals received by an individual in the course of a trade or business as a real estate dealer. In general, an individual who is in the business of selling real estate to customers with a view to the gains and profits that may be derived from those sales is a real estate dealer, and the rents from the property are includible in net earnings from self-employment. Thus, a real estate dealer who receives rentals from real estate and from personal property leased with the real estate must include those rentals in self-employment income.
IRS has ruled that an individual who merely holds real estate for investment or speculation and receives rentals from the property isn’t considered a real estate dealer. Thus, an office building owner who provided normal building services and who was an investor, not a dealer, wasn’t subject to self-employment tax on the rentals. Similarly, the Tax Court has held that a taxpayer who acquired 10 parcels of real estate for the purpose of producing rental income wasn’t a real estate dealer. He didn’t offer or advertise any of the parcels for sale and, although he lost the properties to foreclosure, the lenders who foreclosed weren’t his customers.
Tax planning strategy. Taxpayers can withdraw money from their closely held business while dramatically cutting their self-employment income by simply leasing property they own to their closely held business. Rentals from real estate and personal property leased with it, and the corresponding deductions, are excluded in computing net earnings from self-employment, unless received by a real estate dealer in the course of his trade or business. This will provide additional benefits is circumventing the new Medicare “kicker” taxes and controlling earned income for social security benefit purposes.
If you have any questions regarding the “rental exception” and how it applies to you, please do not hesitate to contact us.