By Stacie Clifford Kitts, CPA

Lately I’ve been reading commentary bouncing around the blogging community about S-corporations and self-employment tax. To understand the controversy, first we need to understand the tax benefits of a corporation electing  S-corporation status.

The IRS describes S-corporations this way: S corporations are corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.

Shareholders of S-corporations generally receive a W2 for their services as employees. The remaining profits of the corporation are passed-through to the shareholder (on Form K-1) to report on their individual income tax return.

Currently, S-corporation shareholders avoid self-employment taxes on the flow through income reported to them by their S-Corps.

However,  congress wants to change this tax structure and make the income passed through to shareholders from some types of S-corporations subject to self-employment taxes.

I absolutely love what Joe Kristan at the Tax Update Blog has to say about the proposal:

It’s hard to do something exceptionally stupid to a tax code already brim-full of dumb, but Sander Levin, Charlie Rangel’s replacement as head of the House Ways and Means Committee, is up to the job. Exhibit A: his new proposal to apply self-employment tax to some — but only some — professional S corporations.

It would penalize the smallest personal service providers to the benefit of their larger competitors.. A sole proprietorship would pay taxes at a rate at least 2.9% higher than a competitor whose “principal asset” is the reputation of more than three employees.

The bill also will require businesses and the IRS to determine what the “principal asset” of a personal service corporation is. The bill obviously requires the valuation of intangible assets — reputation and skill — but in a way not elsewhere attempted in the tax law. How do you do this?

Let’s take an entirely hypothetical S corporation CPA firm with nine shareholders. All have been practicing in tax or audit work since they had hair. They like to think they are all highly skilled, but the skill sets differ. Some are known more as rainmakers, some view themselves more as technicians. One has an enormous Google footprint, while others are more old-school in their business development methods. Which counts more?

In his extensive coverage of this issue, Joe asks The S corporation medicare tax grab: what is to be done?

The tax blog world is aghast at the weird revenue grab from small S corporation professional practices contained in HR 4213. TaxGrrrl, Kay Bell, Robert D Flach, and Monica Lawver (UPDATE – Russ Fox, too) have all raised the alarm for this awful bill (and have kindly linked to the Tax Update while doing so).

But it will take more than being appalled to prevent the worst-designed tax rule since Sec.409A from becoming law. We need to contact our congresscritters, especially in the Senate, immediately. The Senate will take up the bill as soon as tomorrow. If you have a professional practice, call and e-mail your congresscritters early and often and let them know that your livelihood is more important to you than NASCAR and the rest of the “motorsports” industry. If you hire professionals, tell Congress that you don’t want your local professionals to be discriminated against in favor of the big guys. The message is simple: The S corporation tax increase in HR 4213 is a mess and should not be enacted.

In his latest post How not to determine your S corporation compensation Joe explains:

-The IRS already has the ability to go after professional corporations that underpay employment taxes. ….

– If you want to use an S corporation to reduce your payroll taxes, remember that hogs get slaughtered, and treating only $24,000 of $200,000 of professional firm earnings as salary is on the porcine side.

My take? It always feels sleazy when our lawmakers sneak in some stupid provision that gets overlooked by the majority because the focus is steered toward other areas.  It does appear to be a  poorly written provision that will be a nightmare to implement.  It’s about as ridiculous as the booby tax that we debated last year in the posts:

Let’s Talk Fuller Lips, Larger Breasts, Slimmer Thighs, and H.R. 3590 (Patient Protection and Affordable Care Act.)

Still Talking About Fuller Lips, Larger Breasts, Slimmer Thighs, And H.R. 3590

Vanity Tax = Tax the Other Guy Legislation HR 3590

An Interesting Rewrite for the Vanity Tax H.R. 3590 Looks As if Congress Found a Vanity Product with Enough Sin to Justify a Tax