Tax Increase on S-Corporation Shareholders Defeated
May 17, 2012
Shareholders of small subchapter “S” corporations were spared from a tax increase when Senate Bill 2343 failed on a 52-45 vote yesterday. The bill would have required that certain shareholders of small S-corporations providing “professional services” in fields such as health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services pay self-employment tax, not only on their wages from the company, but also on any distributions of net profit of the company (dividends) received by virtue of being a shareholder.
The additional payroll tax would have been imposed only on small S-corporations, i.e. those where 75% or more of the gross income of the business is “attributable to service of three or fewer shareholders of such corporation,” a situation common in closely-held business where the shareholders actively provide services. The tax would have applied to shareholders whose adjusted gross income is $250,000 or more (for married taxpayers) or $200,000 or more (for individual taxpayers).
Many S-corporation shareholders currently characterize amounts received partially as compensation for services (subject to self-employment tax), and partially as a return on investment (not subject to self-employment tax). The proposed tax would have rejected such characterization and instead treated all amounts received by shareholders as compensation for services.
S-corporations are treated by the Internal Revenue Service as “pass-through” entities, meaning that company profits are allocated to shareholders as income regardless of whether the company distributes such profits to the shareholders. Thus, if SB 2343 had been approved, one effect would have been that some shareholders would owe payroll tax on money not actually received.
Although the Senate failed to approve SB 2343, a similar revision to the tax treatment of S-corporation shareholders has been proposed several times previously and is likely to appear again in another future bill. The IRS appears to be concerned with ensuring that S-corporation owners pay themselves reasonable compensation for services and will likely be monitoring potential abuses designed to avoid or unreasonably minimize payment of self-employment tax, making it important that S-corporation shareholders pay careful attention to the characterization, as well as the amount, of their compensation and dividends.
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