TAX NEWS - June 2010

US Tax: Senate Proposal Pits IRS Against Small Businesses

Democrats' attempt to soften S corporation payroll tax hit sets up a burdensome test.

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 ( EBAY - news - people ), Amazon.com ( AMZN - news - people ) 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.