Small S-Corps - Beware

A long standing issue with the IRS has been the amount of salary s-corp owners take. An S-corp is a small corporation where the profits are passed to the owners and not taxed as traditional corporations. It has long been seen as a S-corp advantage that owners could take modest wages (like any other employee, the social security and medicare held and matched.)and then just pay income taxes on the profit which passes to them. The IRS has been working for years to get owners to take a realistic salary. A salary closer to what they would pay someone else to do the same work. The effect would bring more of the S-corp's income under Social Security and Medicare. Not content to let the IRS do it's job, Congress looks to be sticking their nose into the issue and making it worse.

As a way to pay for reinstating the expired tax cuts, Congress has added an amendment to H.R. 4213 -American Jobs and Closing Tax Loopholes Act of 2010. This amendment would subject all the profit of certain S-corps to Social Security and Medicare. The issue is "certain" S-corps. The Act targets small personal service corps where the principle asset is the skill and reputation of the owners and their staff. How small? 3 or fewer workers. 

If I was a S-corp, I would be subject to this amendment. My business is small and falls in the personal service category. But if I was the owner of a retail store with the same amount of profit, I wouldn't be subject to the tax. Or if I was a larger tax business with more employees, I would be exempt. And that is a problem. This amendment targets the smallest of business and adds an additional tax burden on them. An argument could be made that, for many of these businesses, the "salary" the owner takes is too low and if the IRS was to do a SE audit, they would be forced to take a larger salary and pay more Social Security and Medicare anyway. Maybe, but why are only certain S-corps being targeted? And why only very tiny businesses? It's like someone in Congress had this idea but didn't have the nerve to apply it to everyone and picked on the smallest and least likely to fight back.

I don't envy the IRS trying to enforce this one. The key is in "principle asset is the reputation and skill of three or fewer worker." Does this mean a tax business that has a bad reputation and turns out mistake laden returns is exempt from the amendment but a "good" business pays more tax? What about franchisees? Who's reputation will be used to qualify the business the person actually running the business or chain's? When does a new business have a "good" enough reputation and skill to qualify? Too many question.

Both house have passed a version of the law and are now trying to work out the differences. I hope that someone wakes up and cuts this. However, I doubt that will happen.