How Will Proposed New Taxes On S Corporation Shareholders Affect Startup Technology Companies?

By Joe Wallin and Brian Todd

As we’ve blogged about before, there is a tax planning opportunity available with S corporations that is not available with limited liability companies taxed as partnerships (LLCs). With an S corporation you may be able to save employment taxes that you would otherwise have to pay if you were operating your business through an LLC.

How? By paying yourself a reasonable salary and taking distributions beyond your reasonable salary in the form of dividends. This works if your salary is reasonable. Your tax savings depend on the amount of your salary and the amount of your dividends. If your salary exceeds the FICA wage base, the total tax savings is 2.9%–the total of the employer and employee side Hospital Insurance (HI) (aka Medicare) taxes beyond the FICA wage base.

These tax savings can be significant. To use an example:

In 2010, a taxpayer reported a salary of $360,000 from his consulting business and profits paid in the form of dividends in excess of the salary amount of $5 million. Tax savings: 2.9% of $5,000,000 is $145,000.

Of course, if you are running for public office and employ this tax saving tactic, your political opponents might describe it as a “deceitful ploy.”

In choosing the right type of entity through which to do business, this opportunity to potentially save on employment taxes is one of a number of factors entrepreneurs might consider in choosing an S corporation over an LLC. As we’ve blogged before, for entrepreneurs starting early stage technology companies who desire pass-through tax treatment, we believe the S corporation is preferable in form over the LLC for a number of reasons, including, in addition to potential employment tax savings, the following:

  • the ease with which employee equity plans can be deployed in an S corporation (stock options and traditional forms of equity compensation are easier to put to use in S corporations than comparable equity awards are in LLCs);
  • the tax-free reorganization provisions are available to S corporations; meaning, you can do a tax-free stock swap with an S corporation (say, if you are acquired by a publicly traded company in exchange for stock), but you can’t use the tax-free reorganization provisions with an LLC (and a LLC units for stock exchange would be taxable, even if you don’t get any cash to pay the tax in the transaction);
  • it is easier for an S corporation to do an equity fund raise than an LLC (the documents for raising capital through a corporation are more widely understood and accepted than complex LLC documents); and
  • it is generally easier to convert an S corporation to a C corporation to accept angel or VC funding (if that is required as a condition to obtaining the funding).

In Congress’s latest tax bill, there is a provision which would take away the potential for employment tax savings for certain types of S corporations. The provision eliminates the employment tax savings structure for each shareholder of any “disqualified S corporation” who provides substantial services with respect to a “professional service business.”

A “disqualified S corporation” is (i) an S corporation which is a partner in a partnership which is engaged in a “professional service business” if substantially all of the activities of such S corporation are performed in connection with such partnership, and (ii) any other S corporation which is engaged in a “professional service business” if the principal business of such business is the reputation and skill so 3 or fewer employees.

The term “professional service business” means any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of

  • consulting,
  • engineering,
  • investment advice or management,
  • brokerage services,
  • health,
  • law,
  • lobbying,
  • architecture,
  • accounting,
  • actuarial science,
  • performing arts, or
  • athletics.

The provision is summarized in the House Ways and Means Summary of the bill as follows:

Ensuring collection of employment taxes earned by certain service professionals. Social Security taxes are imposed on compensation and self-employment income up to the Social Security Wage Base (currently $106,800) and the Medicare tax is imposed on all self-employment and compensation income. Some service professionals have been avoiding Medicare and Social Security taxes by routing their self-employment income through an S corporation. These taxpayers then pay themselves a nominal salary and take the position that the remaining earnings are exempt from employment taxes. The bill would address this abuse in situations where (1) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals or (2) an S corporation that is a partner in a professional service business. The bill would also clarify that individuals that are engaged in professional service businesses are unable to avoid employment taxes by routing their earnings through a limited liability corporation or a limited partnership. This proposal is estimated to raise $9.618 billion over 10 years.

The good news for early stage technology startups in this? They probably do not need to worry too much because of the narrow scope of the bill. However, for startups in the designated fields (especially the broad catch all of “consulting” businesses), the bill could be problematic, if passed by the Senate.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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