New tax poses fairness issue for S corp owners

When the Affordable Care Act went into effect in January 2013, it came with an unexpected consequence that family business shareholders are still scrambling to understand. The new 3.8% tax on earnings hits shareholders who are considered passive investors in S corporations — generally those who work fewer than 500 hours a year in the company.

Some advisers are suggesting to clients that all passive investors become active ones by creating employment opportunities for them within the company. In our experience, this is a nearsighted approach.

If switching passive owners to active ones is not the solution for most families, then what is to be done? Broadly speaking, there are three alternatives: (a) change the corporate structure; (b) live with the difference; or (c) find some ways of equalizing the differences.

Options to equalize the tax burden may lessen the emotional toll on the family and the strategic consequences on the company. These options may not be perfect, but they are worth exploring:

1. Establish a family understanding of what to do with the “extra” distributions.


Active investors may choose to contribute any additional distributions they receive to fund the family foundation or a retreat for the broader family. This would be an informal family understanding and not a legally enforceable rule, but it could lessen the emotional sting of one branch profiting more than others.

2. Consider cross-gifting.

Active shareholders could consider making gifts to their nieces and nephews in the other branches.

3. Compensate passive investors through director fees.

It is important, however, that all board members be appropriately qualified to take a seat on the board.

4. Look at the broader portfolio.

If the company has multiple business entities, it may be possible to make distributions from the other lines of business.