Issue Senate Proposal Pits IRS Against Small Businesses
Hit Will Include
Doctors, Dentists, Architects, Engineers and
S Corps with 3 or fewer key employee's will be
If you own an S Corporation,
you need to read this article.
Please read this important article written by Dean
Zerbe from Forbes.com.
Pits IRS Against Small Businesses."
their catchall spending, tax break "extenders" and tax hike
bill fell far short in a test vote, the Senate's Democratic
leadership put forward a new version. This one softened both a much
discussed tax increase on hedge fund and private equity managers and
a little noticed $11 billion payroll tax increase on small business
owners, which I called attention to in a column last week. That
change, already passed by the House and promoted as a "loophole
closer," would increase the Social Security and Medicare taxes
paid by the owners of S corporations, which engage in professional
services and have three or fewer key employees. Those hit would
include doctors, dentists, architects, engineers and consultants of
So what's my verdict on this new and improved version of the S corp
tax? It reduces the projected tax increase just a bit-from $11.2
billion over 10 years to $9.15 billion over 10 years, according to
the Joint Committee on Taxation's scoring. But it sets up a new,
unworkable test that would exacerbate the problems small businesses
already have with the Internal Revenue Service.
Here's an example of how the proposed tax change would work. Judy and
Jane each own 50% of an S corporation that provides professional
services-namely marketing advice and website design for small
business folks who sell through eBay, Amazon.com and other Internet
outlets. They have invested time, money and effort into developing
their business and have one nonowner employee, Joe, a young website designer.
Judy and Jane pay themselves each a salary of $70,000, an amount
their accountant views as an appropriate wage for their position.
They pay ordinary income tax as well as 15.3% in payroll taxes (that
includes both the employer and employee portion of Social Security
and Medicare taxes) on that $70,000. Their hard work and
entrepreneurship pays off in 2011, and the S corp makes a profit of
an additional $60,000 that they either distribute to themselves as
the owners or decide to retain in the company for future growth.
Either way, since
the S corp is a "pass-through," the $60,000 isn't subject
to corporate income taxes; instead, the profit is passed through to
the owners and each is taxed on $30,000 of ordinary income on his own
1040. Under current law that $30,000, as profit, isn't subject to
The House-passed tax change, which was contained in the Senate bill
that failed a test Wednesday, would subject that $30,000 to an
additional 15.3% tax. Why? Because the company is a professional services
corporation with three or fewer (in this case two) key employees
whose skill and reputation are responsible for the earnings of the S
corporation. The supposed reason for this change (other than the
obvious need to raise billions), is to prevent self-employed
professionals from forming S corps and taking almost all their
earnings as profits to avoid the payroll tax. (If they operated as
unincorporated self-employed folks, reporting their business on a
Schedule C of their 1040, all their earnings would be subject to the
But as you can see from the case of Judy and Jane, the House-passed
change would also penalize those who pay themselves reasonable
salaries and are building a legitimate business, with its own value,
including a roster of clients.
As word of this
proposed change has spread and small businesses have voiced their
concerns, Senators Olympia Snowe (R- Maine) and Mike Enzi (R-'o.),
have taken the lead in an effort to have it removed from the Senate
bill entirely. Instead, in the new version they offered Wednesday,
Democratic leaders attempted to soften it by adding a test, which
they said Would make it "more administrable." Under this
test the extra payroll tax will apply only in those cases where 80%
or more of the income of the S corp is attributable to the services
of three or fewer key employees. Or to think of it another way, if
more than 20% of the S corp earnings can be attributed to the efforts
of Judy and Jane's one employee, Joe, than the new tax isn't imposed
on their $60,000 in profits.
This new test would create an unholy mess between small business
owners and the IRS. There's already a test in the law: whether Judy
and Jane have paid themselves reasonable salaries. At $70,000 each,
you would think so.
But now an IRS auditor and the women's accountant can haggle over an
additional issue: whether more than 20% of their profit-more than
$12,000 of the owners' $60,000 in nonsalary earnings-can be
attributed to the efforts of Joe, their website design employee. If more
than $12,000 in profits can be attributed to Joe, then none of the
$60,000 is subject to a 15.3% tax.
Congress needs to be finding ways to limit and reduce the friction
between small businesses and the IRS-not creating a new problem. As I
suggested in a previous column, these frictions have been growing to
the point where a small-business taxpayer bill of rights is sorely
As I gave speeches after my column of last week was published, it
became clear that this tax has hit a raw nerve. Many business owners
recognized that this new tax hits them. But just as many were
concerned that while it doesn't hit them today, Congress will expand
it tomorrow, forcing even more S corp owners to pay an additional
15.3% even as the top rates on ordinary income are about to climb. So
this provision sparks concern on two levels: fear of the IRS and fear
of higher taxes.
What do you think about this provision? Must it be killed outright?
Is there a way to make it fairer-and more narrowly targeted at any
real abuses? Would the IRS be able to better targets corp owners who
grossly underpay themselves simply by publishing some reasonable
salary standards? What else can be done to ease the administrative
burden on small business owners?
If you have any questions or concerns, please call us
at (813) 286-7373.
Heidi Wisneski, Adm. Assistant
C&L Value Advisors LLC