New Tax Bill Will Affect the “Smallest of the Small” S-Corporations

On May 28 the “American Jobs and Closing Tax Loopholes Act of 2010” was passed by the House of Representatives in a 215-204 vote. This bill retroactively reinstates and extends one-year tax breaks for small business and individuals. Awesome, right? Not so fast! This bill also intends to close tax loopholes, as implied in the title of the bill.

The Senate took a small recess for Memorial Day and upon return, on June 8 to be exact, began discussion on substitute amendment H.R. 123, “American Jobs and Closing Tax Loopholes Act of 2010”.

The tax loophole the Senate is addressing is the use of S-corporations as a way to minimize Medicare and Social Security Taxes. Here is some background information:

Current tax law states that an S-Corporation shareholder must take a reasonable salary for the services he/she provides to the company. This salary is reported on their W2 and is subject to Social Security and Medicare. The current law also states that an S-corporation can distribute earnings amongst its shareholders. Distributions are not reported on the W2 and therefore not subject to Social Security and Medicare.

The Social Security wage base is currently $106,800. That means 15.3% of wages up to $106,800 is subject to Social Security and 2.9 % is imposed on all compensation for Medicare.

With the passage of this bill, all profits will be treated as if they are W2 compensation and will be subject to Social Security and Medicare.
This so called loophole has been one of the best tax savings strategies for small businesses, creating more than 4 million S-Corporations. S-Corporations have reported an increase of 35% from 2000 to 2006. This bill will most likely pass, socking an additional 15% tax on small business and raising $14.453 billion over 10 years.

This bill most likely came to the table due to Treasury inspectors finding massive tax avoidance in this area. More than 35,000 solo S-Corporations with profits of $100K or more paid no payroll taxes on profits because these owners did not pay themselves a salary.

This loophole patch is only going to affect the “smallest of the small.” It will also affect S-Corporations that are professional service businesses in the following fields known as HEAL A CPA BAIL, according to the acrostic mnemonic taken from Thomson Reuters:
Health- Engineering- Architecture- Law- Accounting- Consulting– Performing arts– Actuarial science–Brokerage Services– Athletics– Investment advice or management– Lobbying

Definition of a small S-Corporation is, “one that is principally based on the reputation and skill of three or fewer individuals.” Per the joint committee on taxation: “If the principal assets of the business are the reputation and skill of three or fewer employees.” Per Senate amendment, “If 80% or more of income is attributable to 3 or fewer owners.” Note: Shareholders of S-Corporations which are partners in a partnership are still subject to FICA if they are a small professional service business.

What does this mean if you are a small professional service S-Corporation? You may be looking at the possibility of revoking the company’s S election. However, keep in mind that taxable income for a regular corporation providing professional services is taxed a straight 35% and ineligible for graduated tax brackets.

On a brighter note, there were many great tax breaks extended for both businesses and individuals. Here are a few:

• The credit for increasing research activities. ( Code Sec. 41 )
• Fifteen-year straight-line cost recovery for qualified leasehold improvements, restaurant buildings and improvements, and retail improvements. ( Code Sec. 168(e)(3)(E) ). (Normal depreciation for leasehold improvements is 39 years).
• The credit for eligible small business employers equal to 20% of the sum of differential wage payments to activated military reservists. ( Code Sec. 45P )
• The election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction permitted for state and local income taxes. ( Code Sec. 164(b)(5) )
• The additional standard deduction for state and local real property taxes. ( Code Sec. 63(c)(1) )
• The above-the-line tax deduction for qualified tuition and related expenses. ( Code Sec. 222 ) For a tax year beginning in 2010, the bill would provide that the above-the-line tuition deduction is unavailable to a taxpayer for whom a credit for higher education under Code Sec. 25A (the Hope and Lifetime Learning Credits) would have provided a greater net reduction in tax liability, without regard to any disallowance or reduction in value of the credit as a result of the alternative minimum tax.
• The $250 above-the-line tax deduction for teachers and other school professionals for expenses paid or incurred for books, certain supplies, equipment, and supplementary materials used by the educator in the classroom. ( Code Sec. 62(a)(2) )