New Professional S Corp Tax Is Dumb by Stephen Nelson

The week before the recent Memorial Day weekend, Nancy Pelosi and her friends passed the American Jobs and Closing Loopholes Act of 2010. In a few days, probably, the U.S. Senate will also pass this grab bag of new taxes and spending.

The misnamed act is packed full of questionable legislative decisions, but for small personal service businesses, the new law prohibiting some businesses from using the S corporation rules seems particularly sloppy and dishonest. In a nutshell, the new S corporation law, Sec. 413(m), suffers from three huge flaws:

S Corporation Disqualification Only Applies to Professionals

The first and probably the biggest flaw is that the new law applies only to professional service S corporations. True, Democrats expanded the usual list of professions to include investment managers, investment advisors, brokerage firms and athletes. But even so, the targeted discrimination of the new law makes no sense.

Note: According to the most recent IRS statistics available for the 2007 year, roughly four million small businesses file as S corporations. Of this number, less than 900,000 are even in the general categories that might subject them to disqualification.

Do congressional Democrats want to close the S corporation loophole? Fine. But the loophole should be closed not just for white collar service businesses. The loophole should be closed for all S corporations. Or for all small S corporations.



Note: Democrats plan to raise slightly more than $1,000,000,000 a year from this tax increase. Our own internal calculations indicate that targeted S corporations will pay an extra $5,000 to $10,000 a year in extra self-employment taxes. Simple arithmetic suggests that approximately 140,000 S corporations get hit by the new disqualification taxes--roughly three and a half percent of the S corporation population.

S Corporation Disqualification Another Tax Increase on Investment Income

Another curious fact concerning the new S corp disqualification law: The law doesn't just close the loophole that allows S corporations (as compared to sole proprietorship and partnerships) to avoid payroll taxes on business income. The new law apparently also levies payroll taxes (or more specifically self-employment taxes) on all the elements of S corporation profit.

For example, if an S corporation earns bank account interest, dividend income on a brokerage account, or earns rental income on property, this investment income gets tagged with payroll tax.

Note: Individuals don't pay payroll taxes on their interest, dividend and rental income. Or at least they don't pay the taxes today. (In 2013, some higher income taxpayers will pay a Medicare surtax on some of their income.) Accordingly, this part of the new law is just a tax increase, plain and simple.

Tip: If you run an S corporation, you'll want discuss with your tax advisor the possibility of minimizing investment income within your S corporation if this new law, as expected, passes the Senate.

New S Corporation Law Lacks Clear Rules

A final and perhaps a semi-funny flaw in the new law? The law was too vaguely drafted to begin using only a few months from now (which is what the bill requires). And as soon as the sloppy vagueness is cleaned up and can be put under a microscope by attorneys and accountants, the law is arguably too poorly drafted to deliver the desired impact.

But let me explain. What committee chairman Charles Rangel and the House of Representatives wrote is itself a loophole-ridden law that disqualifies S corp only when "substantially all" of their activities constitute the performance of professional services. So, pop quiz, Charlie: What's https://www.google.co.uk/finance the precise definition of "substantially all?" 95%? 90%? 70%?

The chairman of the House Ways and Means Committee, the principal tax legislating body of the federal government, obviously knows or should know that the phrase "substantially all" means different things in different parts of the tax code. So what does the phrase mean in Sec. 413(m)? Taxpayers and their accountants will need to know. And as soon as they do know, any S corporation with a bit of energy and ingenuity will easily arrange their affairs to avoid disqualification.

And, sadly, the "substantially all" phrase isn't the only vagueness in the new law. The new law also says that firms only get disqualified when the business principally relies on the reputation and skill of three or fewer employees. What does that even mean? Certainly, the new rule doesn't just apply to one-, two- and three-employee S corporations. Otherwise the law would say that.

But does the law mean that in a law firm, for example, as long as you have four lawyers you're not disqualified but if you have only three lawyers you are disqualified? Who knows?

Suppose, for the sake of illustration, that the rock music groups ZZ top (three members) and Van Halen (four members) both operate as S corporations and employ dozens of employees. Musicians as performing aricles represent another target of the new tax law. So is ZZ Top hammered and Van Halen excused? Who knows?

As occurs frequently, the act directs the Secretary of Treasury to write detailed regulations that carry out the purposes of the law and "fill in the blanks". Nothing is wrong with that. But Wayne Lippman Sports Fan the new law takes effect starting in 2011. The IRS, unfortunately, won't have time to write the new regulations in time for tax payers to plan or adjust their operations. In fact, taxpayers may need to file their tax returns for 2011 before the IRS issues final regulations about how the new rule works.

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