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Potential Tax Increase for Small Businesses-S Corporations Beware

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Proposed legislation (H.R. 4213) that was passed by the House before Memorial Day is being considered by the Senate. This legislation, if signed into law, will affect the shareholders of S corporations in professional service industries such as doctors, accountants, attorneys, etc.

S corporations, a popular form of entity ownership for individuals, especially in the rofessional service industry, generally pay no tax but pass their profits totheir shareholders who report the related income and pay tax on these profits on their personal income tax return. Professionals find S corporations attractive because they are able to receive part of their earnings in the form of distributions. Unlike wages, distributions from an S corporation are not subject to payroll taxes.

Although S corporation shareholders are required to take a “reasonable compensation” the IRS has found that many shareholders are taking nominal wages and receiving most of their S corporation earnings in the form of distributions, thereby avoiding payroll taxes.

The proposed legislation is attempting to close this loophole by subjecting S corporations engaged in a professional service business to payroll taxes where the principal asset of the company is the reputation and skill of three or fewer employees.

The payroll tax in question consists of Social Security and Medicare taxes. For 2010, the Social Security tax is 6.2% of the first $106,800 of wages and the Medicare tax is 1.45% with no cap on the amount of wages taxed. Although both the Social Security and Medicare taxes are paid by the employee, the employer must also make a payment equal to the amount paid by the employee. However, because self-employed individuals must pay the employee and employer’s portion of the payroll tax, the proposed bill would effectively result in a new tax of 15.3% to certain S corporation shareholders.

The proposed legislation is estimated to raise $11.2 billion in additional revenue.

 
 
 
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