The End of the S Corporation?

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I just read something on my tax wire that rocked me to the core. While Congress is looking at rolling back reducing the corporate tax rate, they are also looking at hammering small business owners. Here are a few of the items under discussion:

1) Eliminating the 6% production deduction. This was a deduction enacted back in 2005 that allows product-manufacturing businesses to deduct qualified manufacturing costs in an amount up to 6% of their net income.

2) Ending LIFO inventory valuation (that’s “last-in, first-out”) in favor of FIFO inventory valuation (“first in, first out”). This one will be spread out over 8 years so businesses aren’t completely flattened by the tax hit.

And, my personal favorite,

3) Requiring all S Corporation (and LLC-S) owners of service-based businesses to pay self-employment taxes on the distribution portion of their income in addition to payroll taxes paid on the salary stream.

The ability to stream income has been probably the most powerful feature of the S Corporation. Without it, I’m not sure if the S Corporation will make as much sense for most service-based businesses.

The planning implications here are huge. Moving to a C Corporation won’t always be the answer. With a C Corporation you can stream income but the dividends (the profit stream from a C Corp) are taxed at capital gain tax rates. Those are currently 15%, but are likely to go up to 20% or more with the new administration. So, no tax savings there. And, if you have more than one business, multiple C Corporations will lead to control group issues, lower tax deductions, etc.

I really don’t like this, for all kinds of reasons. The biggest is the most obvious: the majority of S Corporations are owned by small business owners, who are going to get slammed if these things pass. The ability to save money on taxes is one of the things I’ve always thought of as an incentive for people to begin businesses, and grow them. Take those incentives away, and I’m not sure where business owners will go from there.

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