RIP S Corporations?


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Did Congress just put the first nail in the coffin for service providers who operate in S Corporations?

5-31-10

Congress quickly passed a new bill called the American Jobs and Close Tax Loopholes Act of 2010. The Senate still needs to pass it, but is expected to do so just as quickly.

It includes some tax extenders which were needed. And it extended unemployment benefits to November 30, 2010 for people whose benefits were running out.

And it pays for it all by hitting small business owners right where it hurts – in their S Corporation.

Here are the highlights:

  • If you have a professional services S Corporation, your distributions will now be subject to 15.3% self-employment tax. This is on top of the payroll tax you’re already paying for salary you take from the S Corporation.
  • The definition of ‘professional services’ is sufficiently vague to allow the IRS some wriggle room when the Code and eventually Regulations are written. This is an area we’re watching closely. At this point, assume if that if you provide any kind of professional service this is going to affect you.
  • It is only applicable to S Corporations who have 3 or fewer shareholders whose “reputation and expertise” are used in the company.

This is clearly a bill that is targeted at ONLY small business owners who are service providers.

Remember it’s not law yet. And if enacted it doesn’t become effective until January 1, 2011. There is a tiny window available for planning.

This week we’re going to look at how this works with other new taxes coming your way thanks to the Health Care Bill. And of course, what you can do about it.



7 Comments

  1. This congress needs to be strung up and run out of town. We need to march on D.C. with our guns.

  2. LBoy says:

    I am fairly new to this issue, but on the surface it does seem like the definitions are ambiguous and leave a lot to interpretation (so what’s new?).

    However, from a practical matter, it seems like this is really dealing with small prof services firms where owners are using this technique as a way to lower tax liability. This is only a material issue up to the FICA cap, so it would only hit people who are paying themselves signficantly less than the FICA Cap, but making material amounts in distributions. (yes, I realize the Medicare care tax and eventually Obamacare tax on high amounts kicks in, but those are relatively small percents on above average incomes.

    As to the seemingly arbitrary 3 person threshold, I can only guess that they are assuming people paying themselves sub market wages are mostly an issue with small businesses. Is it likely a lawfirm with 10 shareholders pay themselves less than market wages, and let the excess be distributed to other shareholders – for that matter is it likely that a 10 shareholder law firm have a lawyers that pay themselves (and are worth) less than the FICA cap?

    Having said all that, from the little bit presented, it does seem there is a lot of ambiguity to be addressed, and of course nobody likes the prospect of a greater tax burden.

  3. ckc says:

    I just don’t understand why they are after the small businesses. How awful.

  4. Re-reading the bill and commentary, it looks like the exemption isn’t for more than 3 shareholders as I first thought. It’s more than 3 people who have “reputation and expertise” that drives the business. So, they could be employees. But I wonder if they could also be anybody. For example, if I pay 3 big name people to promote me to their database as someone who is an expert in yada yada yada, does that qualify as someone whose reputation and expertise work in the business. In this case, they work in marketing it.

    I’m also still confused by the prof services definition. It seems like the Congress has come up with a brand new definition, including other groups and NOT defining ‘substantially’ like they have with the C Corporation.

    What on earth will the objective criteria be for ‘substantially’, ‘reputation’ and ‘expertise’ be? I see major compliance issues down the road unless the language tightens up a lot.

  5. Megan Hughes says:

    Hi Cathaleen,

    I couldn’t agree more. What’s frustrating is that in the bill summaries and analyses that I’ve read the same comment crops up: ‘some’ individuals or ‘a small number of individuals’ abuse the S Corporation rules by trying to take none or a minimal salary and flow the rest through.

    But CPAs, auditors, EAs – anyone who deals with the IRS knows very well that no salary item on an S Corp return is an audit red flag. So the IRS already has the tools in place to enforce taking a reasonable salary.

    I’m also frustrated that it’s just small companies being hit. There’s no reason that a company with 4 shareholders should be treated differently than one with 3 shareholders. There are some good reasons that docs, lawyers, CPAs, etc. want to practice alone or in a small group.

    And, of course, this isn’t income-limited. So it’s not just going to hit people earning $250k+ – it’s going to hit all S Corporation owners who are unfortunate enough to fall under the definition of professional service provider.

    I wrote to my Representative today, through OpenCongress.org. Maybe if enough business owners speak up someone in Washington will listen!

  6. Hopefully our professional associations are looking out for us. As usual, this will just hit the small businesses and very hard. The individual Realtors and small brokerages will really be hit as well as the rest of us CPA’s etc. We have always been told we have to pay on “reasonal compensation” but would not owe FICA on income produced by our staff and investments in other parts of our businesses (i.e. equipment/websites etc.)

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