S Corporation Loophole Closed For Some Small Businesses
Do you run a small professional service business as an S corporation
? For example, are a consultant, contractor or other professional using an S corporation to save payroll or self-employment taxes? If so, you've got a tax planning conundrum to deal with before the end of 2010.Unfortunately, you probably need to decide how to react to the small-business-unfriendly "American Jobs and Closing Tax Loopholes Act of 2010." This new law disqualifies some small professional service S corporations from using an S corporation to save payroll taxes starting in 2011.
At the very least, you'll need to determine if the new law applies to you and means you'll need to budget for another business tax increase in 2011. And some S corporations hit by the new law may want to plan their way out of paying the tax.
Note for tax practitioners: The actual statute appears or will appear in Sec. 413(m) of the Internal Revenue Code.
Denied the Benefits of an S Corporation?
The new law really targets professional service corporations that fit one of two profiles:
Target #1: The Single Professional S corporation. In other words, if someone works as an independent contractor providing professional services, in the past this individual has been able to save on self-employment taxes through an S corporation arrangement. For example, a contract employee
(say an engineer or accountant) pulling down a $100,000 a year and taxed as a sole proprietor pays approximately $15,000 in self-employment tax. However, if the contract programmer incorporates his or her business and then elects S status, he or she only pays employment taxes on the part of the profit labeled as wages. By calling only the first $40,000 of profit "wages," therefore, the contract programmer pays only $6,000 in employment taxes--which means roughly $9,000 of savings.
Note: Self-employment taxes run roughly 15% on roughly the first $100,000 of self-employment earnings and then roughly 3% on amounts above that.
Target #2: The S corporation "Partner". If someone is a partner in a firm that provides professional services, the partner's share of the firm profits is subject to self-employment taxes. What aggressive taxpayers sometimes did to avoid these taxes is own their equity in the partnership through an S corporation. In other words, the professional owned an S corporation and the S corporation owned a slice of the partnership equity. With this arrangement, if the partnership paid the partner (the S corp) $300K but then the S corporation paid its single shareholder-employer $80K, the professional saved about $9K annually in self-employment taxes.
Loopholes in the Closing Loopholes Law
The law doesn't work perfectly to disqualify only S corporations like I describe above. The actual "in-the-tax-law" triggers for disqualification flow from two complicated tests:
Test #1: If an S corporation is a partner in a professional service business, the S corporation is disqualified if substantially all of the activities of the S corporation are related to being a partner.
Test #2: If the principal asset of a professional service S corporation is the reputation and skill of 3 or fewer employees, the S corporation is disqualified.
Accordingly, some professional services that aren't really the target of the law get hit (for example, small two- and three-person accounting, consulting, engineering and law firms.)
Furthermore, even professional services firm blatantly exploiting the self-employment tax loophole may be able to avoid disqualification if they fail the "substantially all" test referred to in the preceding paragraphs. We'll need to wait to see how the IRS defines the phrase "substantially all" to know for sure, but it's quite likely that "substantially all" will mean that 95% or more of the of the activities constitute professional services.
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