S-Corp rule changes: any CPAs been hearing this at seminars? (semi-vanity)

My CPA has been warning me about something for a couple of months. I cannot find a url source for any of this. She says that in CPA seminars they have been telling her that s-corp rules will change with 2 years.

Here is the background. S-corps are used by most small businesses to limit personal liability and to take some income as dividend disbursements in order to avoid FICA/Medicare (13% after tax write offs).

According to the seminar leaders, the ways and means committee in the house is working towards making s-corp dividend disbursements subject to FICA/Medicare under the same rules as wages. The exceptions are: 1) this only applies to service based income. Doctors, lawyers, CPAs, tech companies. 2) the 102,000-250,000 FICA "bubble" will apply to this income as well.

The "bubble" is Obama's plan to remove the FICA wage limit, but make $102,000-$250,000 not subject to FICA. Everything below $102,000 (or whatever the cap is in that year) and everything above $250,000 will be taxed.

She is understandably worried about business in general. It's hard to imagine the effects on small service based businesses. Suppose a business nets $100,000. If they take $20,000 as wages, and $80,000 as dividends, they will be paying an additional net taxes of $10,400. That hurts.

To go a step further, consider a doctor making $500,000. For everything over $250k, they will have 13% extra taxes for FICA/Medicare + 5% for Obama's tax increase, plus the base of 35% taxes. That is 53% before state taxes. At some point, taking home $0.40 on the dollar isn't worth the increased liability.

Have any other CPAs heard these things? I've been searching the web and I can't find any articles about it. But I trust my CPA. She's my mom. She's successful and smart.

I find it hard to believe the government could get this passed into law because the impact on small businesses making less than $250k will be huge considering FICA implications.

From a recent ABA Tax Section presentation this fall: Payroll Taxes & S Corporation shareholders

An S Corporation is treated as a pass-through entity for Federal income tax purposes, and its income generally is taxed to the shareholders. A shareholder of an S Corporation who performs services as an employee of the S Corporation is subject to FICA tax on his or her wages, but generally is not subject to FICA tax on amounts that are not wages (such as distributions to shareholders). Nevertheless, an S Corporation employee is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wages. A significant body of case law has addressed the issue of whether amounts paid to shareholder-employees of S Corporations constitute reasonable compensation and therefore are wages subject to the FICA tax, or rather, are properly characterized as another type of income that is not subject to FICA tax.

In cases addressing whether payments to an S Corporation shareholder-employee were wages for services or were corporate distributions, courts have recharacterized a portion of corporate distributions as wages if the shareholder performing services did not include any amount as wages. In recent cases involving whether reasonable compensation was paid (not exclusively in the S Corporation context), courts have applied a multi-factor test to determine reasonable compensation, including such factors as whether the individual's compensation was comparable to compensation paid at comparable firms. The Seventh Circuit, however, has adopted an “independent investor” analysis differing from the multi-factor test in that it asks whether an inactive, independent investor would be willing to compensate the employee as he was compensated. The independent investor test has been examined and partially adopted in some other Circuits, changing the analysis under the multi-factor test. Payroll tax issues relating to S Corporation shareholders There has been very substantial growth in the number of S Corporations in recent years, which some attribute to the widespread use of S Corporations to avoid self-employment tax. The 2005 TIGTA report stated that “the S Corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses.” Individuals who perform services in businesses that they own commonly choose the S Corporation form to seek to reduce their FICA taxes. S Corporation shareholders may pay themselves wages below the wage cap, while treating the rest of their compensation as a distribution by the S Corporation in their capacity as shareholders. They may take the position that no part of the S Corporation distribution to them as shareholders is subject to FICA tax. Because the HI component of the tax has no wage cap, this S Corporation approach may be viewed as a tax planning opportunity with respect to HI tax at high income levels as well as below the cap. The entire amount of an S Corporation shareholder's reasonable compensation is subject to FICA tax in this situation, under present law. However, enforcement of the “reasonable compensation” standard by the government may be difficult because it involves factual 15 determinations on a case-by-case basis, requiring taxpayer audits and potentially involving costly, resource-consuming litigation. The 2005 and 2006 proposals aim to reduce the use of S Corporations to avoid the employment tax by recharacterizing wages from service businesses as some other type of S Corporation distribution. Under these proposals, an S Corporation is treated as a partnership and its shareholders as general partners, for self-employment tax purposes (under the 2006 proposal, this applies only to S Corporation service businesses). Either the 2005 or the 2006 proposal would achieve greater uniformity of employment tax treatment as between partnerships and S Corporations than does present law, reducing tax-motivated choice-of-entity decisions and improving the neutrality of the tax law. The narrower TIGTA proposal applies only to shareholders of S Corporations who, directly or through relatives, have a 50 percent or greater interest in the S Corporation. By contrast to the 2005 and 2006 proposals, the TIGTA proposal would be less effective in improving tax neutrality as between partnerships and S Corporations, though it would serve to reduce the relative attractiveness of S Corporations as employment tax planning vehicles. By treating the S Corporation shareholders similarly to partners of a partnership (taking into account the modifications made by the partnership portion of the proposals), the 2005 and 2006 proposals reduce the need to apply the cumbersome, difficult-toadminister “reasonable compensation” standard. Although the TIGTA proposal does not cover partners, it could be said that a proposal addressing only S Corporation shareholders' attempts to avoid the reasonable compensation standard is likely to be more enforceable and efficient than continuing to apply the reasonable compensation standard to those shareholders. The 2005 proposal has the effect of applying the self-employment tax collection system to S Corporation shareholder-employees, rather than the withholding regime that applies to them (along with other employees) under the present-law FICA tax rules. There are both drawbacks and advantages to this approach. One drawback is that withholding may be a more effective and faster collection mechanism than self-assessment as under the self-employment rules. Another is that the income tax deduction for wages or compensation paid by an S Corporation would have to be added back or disallowed for purposes of calculating self-employment tax of the S Corporation shareholder. Other disadvantages would arise from retaining the FICA withholding system from some compensation while imposing the self-effecting SECA rules on other compensation of the same individual. For example, preserving a withholding regime on S Corporation shareholder wages, and imposing self-employment tax only on the portion of the shareholder's distributive share that exceeds previously taxed wages, would require a mechanism to prevent double-counting from one taxable year to the next, which could impose additional administrative and recordkeeping burdens on the S Corporation. Imposing two separate employment tax regimes on S Corporation compensation payments to one individual could be criticized as complex. 16 2005 Joint Committee on Taxation staff proposal (“2005 proposal”) Under the proposal, for purposes of employment tax, an S Corporation is treated as a partnership and any shareholders of the S Corporation are treated as general partners. Thus, S Corporation shareholders are subject to self-employment tax on their shares of S Corporation net income (whether or not distributed) or loss. As under the present-law self-employment tax rules, specified types of income or loss are excluded from net earnings from self-employment of a shareholder, such as certain rental income, dividends and interest, certain gains, and other items. However, under the proposal, in the case of a service business, all of the shareholder's net income from the S Corporation is treated as net earnings from self-employment. A service S Corporation is an S Corporation, substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (similar to sec. 448(d)(2)). If a shareholder does not materially participate in the trade or business activity of the S Corporation, a special rule provides that only reasonable compensation from the S Corporation is treated as net earnings from self-employment. The 2005 proposal is effective for taxable years of partners or S Corporation shareholders (as the case may be) beginning after the date of enactment. One commentator has suggested that the 2005 proposal be expanded to closely held C Corporations (in addition to partnerships and S Corporations), in order to achieve parity in the way that the employment tax rules apply to all individuals who perform services in a business conducted through a business entity, particularly in light of the 2003 reduction to 15 percent in the top rate applicable to qualified dividends paid by a C Corporation.

I wasn’t there, but the point of the “it will happen” discussion was that it was going through ways and means.

A friend of mine said something like this: if this passed I make a list of my least performing employees and in my head identify if they were pro-Obama. Then I would sit down enough O supporters whose wages make up the difference in taxes and explain to them that I’m firing them because of tax increases that they supported. I would even give them a printout with the numbers so they could ponder what they did to themselves.

Oh, something will happen, bank on that. What it will be specifically no one knows, including Presidents-elect, Senators, Congressmen, and all their staffers. Much less some seminar speaker. Once the horse-trading starts, anything can happen. Or not happen.

I personally would never go into a detailed explanation of why someone is being fired with that person. Too much possibility of some BS discrimination lawsuit these days. “Economic times are bad, taxes are going up, I have to cut expenses. Good luck out there.” And even that may be too detailed. A printout?!? Let them figure it out, don't give them evidence to use in court. Legal fees are expensive, even if you win.

And I would never admit to an Obama supporter that I knew he was an Obama supporter, much less that that was a factor in my decision. Not that it wouldn't be a factor, just that I would never admit it. And there is always the possibility that he might be such a valuable worker that I would keep him, in spite of his foolishness.

I sent a link to my accountant and this is what he returned:

Guess what? laxcoach is probably more correct than not. While changes are not for sure, this issue is on the Radar and has been for some time, thanks to the idiots out there that are not taking a reasonable salary from their S-Corps.

Current Courts cases only define wages that are unreasonable and that amount appears to be “zero” if the shareholder is also taking dividends. The cases do not define what is reasonable or “more reasonable”. In the 7th circuit had the Exacto Spring Corp v. Comm. (196 F.3d 833 (7th. Cir. 1999), which adopted the independent investor test. Under the independent investor test, if a hypothetical independent investor would consider the rate of return on his investment in the taxpayer corporation “a far higher return than he had any reason to expect”, the compensation paid to the corporation’s CEO is presumptively reasonable. This case is good for S-Corps and their shareholders.

There has been discussion quite a while on how to fix the S-Corp FICA issue at the government level. For now, all we can do is try to be reasonable with shareholder wages. The taxpayers out there taking “zero” salary, working in the business and taking S-Corp distributions will get spanked, as well as their taxpreparer. The potential penalties are extreme and clearly not worth a zero salary FICA savings.

We have been monitoring government activity on this issue for years and I believe we will see more activity on this matter in the near future.

Both Congress and the 2008 annual report to Congress by the National Taxpayer Advocate have questioned the IRS for not focusing more audit attention to S-Corporations who are not paying employment taxes on their shareholder/employees. Congress has received proposed legislation from the House Ways and Means Committee to subject the distributive share from S-Corporations (and limited partnerships) that relates to the service business of S-Corporations to self-employment taxes.

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