S Corp Owners Breathe a Little Easier … But Start Planning for the Future

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Tax extender legislation has been the hot topic this week (well there was that iPhone thing, too, I suppose). The latest version of the legislation again failed to get enough votes to pass, so for the time being, nothing changes. That doesn’t mean you can assume the idea is gone for good, though.

There are so many versions of the bill floating around it’s hard to figure out which was the final version. But, in the two most recent versions of the bill we were able to get our hands on, the news was discouraging for S Corporation owners. Despite the protestations by small business owners across the country, the new versions laid out an even more onerous tax increase. Here’s what was on the table:

6-25-21. Each shareholder who provides substantial services with respect to the professional service offered by the business must take into account their pro-rata share of all items of income or loss attributable to such business in determining the shareholder’s net earnings from self-employment. There’s nothing to define what “substantial” services means. But the intent is clear: your self-employment tax will be determined based on all of your income.

2. If you have passive family members (and by family we mean lineal, so parents, grandparents, children, grandchildren, etc.) who have invested in your business but are passive, non-participating shareholders, you must add their share of the profit/loss to your income when calculating self-employment. This one is troubling. That’s a nasty “gotcha” for those of you with parents or adult children in the same field, who want to invest in your business as silent partners. In some cases it’s a non-issue – remember, in many states the only people who can be shareholders in a professional services business are people who are also qualified. So if you’re a doc, all the shareholders have to be docs, etc. But in other cases, it’s not. Your best bet here is to accept funds as a loan only, and not as an equity purchase in your business.

3. S Corporations caught under this bill include all of those that “engage in a professional service if 80% or more of the gross income of such business is attributable to the service of 3 or fewer shareholders of the company.”

This could help some companies. If you’ve got a business where key employees (who are NOT shareholders) are also billing for their time, you’ll want to watch the numbers closely. Ideally you’ll want those non-shareholder employees to be billing for at least 21% of your business’s gross income. In the case of doctors, attorneys, CPAs, Engineers, etc., you’ll want to encourage your nurses, paralegals, interns and so on to bill as much as possible.

4. Professional Services include: health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.

Consulting was the big one here. We talked about what may (or may not) define consulting in the June 21st blog. It’s a loose, vague definition and will probably stay that way until the first few court cases are resolved.


Planning for the Future

Again, just because the bill failed this time doesn’t mean it’s gone for good. It may be safer to think of this as a reprieve, and put some planning in place to deal with a revival effort.

We’ve spent lots of time here at USTaxAid this week thinking up options. One thing we keep coming back to is diversification. It’s going to be more important than ever for you to develop multiple income streams.

First up is the 21% income idea. If you can ensure that 21% or more of your business’s income is earned by non-shareholder employees, you’ll escape the tax.

Another big part of diversification could also be finding the hidden assets in your business and leveraging them better. What knowledge do you have that is unique, and how could you package that knowledge for sale separately? eBooks, teleseminars, information products … what’s out there that you can use to augment your service income and increase your overall income without a lot of new effort?

One Comment

  1. I panicked when I first saw this proposal but it really is just clarifying what the IRS has been trying to enforce in their audits. We have always had to pay a “reasonable” wage. I love the 21% measure a lot. Most of us have staff that clearly bill more than 20% and we can prove it. This will give us Professionals more leverage in bringing our clients into compliance. Thanks again for your great updates.

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