From: C&L Value Advisors LLC [hwisneski@clvalue.com]

Sent: Thursday, October 21, 2010 4:23 PM

To: Heidi E. Wisneski

Subject: News on S Corps from C&L Value Advisors LLC

 

In This Issue Senate Proposal Pits IRS Against Small Businesses

 

Those Hit Will Include

Doctors, Dentists, Architects, Engineers and Consultants.

 

Featured Article

S Corps with 3 or fewer key employee's will be affected. 

 

Forbes.com


Forbes.com

 

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If you own an S Corporation, you need to read this article.

 

Hello.  

Please read this important article written by Dean Zerbe from Forbes.com. 

 

 

"Senate Proposal Pits IRS Against Small Businesses." 

Wednesday, after 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 all descriptions.


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 payroll taxes.


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 payroll tax.)


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 needed.


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.

 

Sincerely,

 


Heidi Wisneski, Adm. Assistant
C&L Value Advisors LLC

 

This is information is being forwarded from Forbes.com - Dean Zerbe, 06.17.10, 9:30 AM ET. 

 

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