New Proposed S Corporation Tax Bill Revised

As I blogged last week, Congress is considering taking away the employment tax benefits of being an S corporation for certain small professional services businesses.

The first bill that was proposed targeted S corporations engaged in professional service businesses if the principal asset of such businesses was the reputation and skill of 3 or fewer employees. This bill gave rise to some hue and cry over what these concepts meant. The charge was that these provisions were too vague to be readily interpretable.

Senator Baucus has now proposed that this language be changed to target S corporations engaged in professional services businesses if 80 percent or more of the gross income of such businesses is attributable to the service of 3 or fewer shareholders. So, Senator Baucus’s amendment removes the concepts of “principal asset,” “reputation and skill,” of “employees,” and substitutes for those concepts “80 percent or more of the gross income” “attributable” to “3 or fewer shareholders.”

 A redline of all of the initial proposal against the new proposal is here.

Old ConceptsNew Concepts
principal asset80% or more of gross income
reputation and skillattributable
3 or fewer employees3 or fewer shareholders

The Senate Finance Committee described the changes this way:

Changes to Employment Taxes on Earning of 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. A provision passed by the House and included in the original Baucus substitute would address this abuse in situations where (1) an S corporation is a partner in a professional service business or (2) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals.   This provision does not change the ability of S corporations to use some income to make business investments or deduct those small business investments.  To make the second alternative more administrable and more targeted, this amendment changes the language so that the policy applies only if 80 percent or more of the professional service income of the corporation is attributable to the services of 3 or fewer owners of the corporation.  This proposal, as amended, is estimated to raise $9.15 billion over 10 years.  

These are welcome changes from a clarity point of view, but these tax provisions are still problematic because they are targeting the smallest companies in America. Why are S corporations 80% or more the gross income of which is attributable to the services of 3 or fewer shareholders being targeted for increased taxes? Why not broad-based employment tax law changes? Evidently the desire and/or need for revenue trumps treating small businesses the same as larger businesses.

These opinions are my own.

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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