New Bill Requires Certain S Corporation Shareholders to Pay Self-Employment Tax
In May, the House of Representatives passed legislation (Section 413 of H.R. 4213) that would subject non-wage earnings of certain S corporation shareholders to the self-employment tax for the first time. This proposed legislation is intended to prevent service professionals from routing their income through an S corporation to avoid paying Social Security and Medicare taxes.
Current Law Excludes Certain Income from Payroll Tax
The Internal Revenue Service currently uses a reasonable compensation standard to ensure S corporation shareholders pay the correct amount of self-employment taxes. The excess earnings, after payment of the reasonable compensation, is taxable to the shareholders as ordinary income but is not subjected to Social Security and Medicare taxes. These non-wage earnings can either be distributed among the shareholders or retained by the corporation for future growth.
Proposed Bill Subjects Non-Wage Income to Payroll Tax
The proposed bill would increase the self-employment taxes paid by the owners of S corporations that engage in professional services. The provision applies to service businesses or an S corporation that is a partner in a professional service business. Affected businesses could include doctors, dentists, consultants, attorneys and many others.
The reason for the proposed change is to prevent professionals from forming S corporations to avoid self-employment taxes. Under current law, the earnings of sole-proprietorships and partnerships are already subject to payroll taxes, while S corporation earnings are not.
To soften the bill, Democratic leaders have added a proposed test to help determine which S corporation owners would be required to pay the self-employment tax. Under this test, the additional tax will apply only when 80% or more of the S corporation’s income is principally based on the reputation and skill of three or fewer individuals. Many commentators criticize this test as unworkable and believe it will lead to conflict and haggling between the IRS, taxpayers and their accountants.
Contact Frank, Rimerman + Co. LLP
If you are an S corporation shareholder, this bill (if passed) may affect your taxes. The tax advisors at Frank, Rimerman are available to assist you.