New Tax for S Corporations? May Affect Managed Services

After incorporation, many small businesses make a federal tax election know as a “subchapter S” election; these businesses are then typically referred to as an “S corporation”.  The benefit of an S corporation election is that the entity can “pass-through” corporate income, losses, deductions and credits to its shareholders. That is, the shareholders pay the applicable federal tax at their individual tax rates; the corporation itself does not pay a tax (except in some situations such as built-in gains and passive income).
 
Each S corporation determines its distributable (taxable) income by deducting all expenses, including salaries, and this distributable income flows to the individual tax returns of its shareholders.  This has always been considered a “distribution of earnings” that is not subject to payroll taxes.  However, this could change.
 
A troubling provision included in the House version of the extenders bill (H.R.4213 - American Jobs and Closing Tax Loopholes Act of 2010) would make many of these distributions subject to payroll taxes.  That is, S corporation distributions to a shareholder who “provides substantial services with respect to the professional service business“ could be hit with an additional 15.3% self employment tax!  That’s 12.4% for FICA and 2.9% for Medicare.  But note:  the 12.4% FICA tax only applies to the first $106,800 of combined wages, tips and, net earnings (including S Corporation distributions).  So if a shareholder’s salary is at least $106,800, the distribution would only be hit with the 2.9% Medicare tax.  This House version of this provision has been modified tentativelyby the Senate so that these distributions would be taxed only if 80 percent or more of the income is attributable to the skill and reputation of three or fewer shareholders.

Fair?  Not really. This provision would principally affect small businesses – which typically elect S corporation status.  Confusing? Sure.  This would only apply to a “professional service business” which is defined as a business in which:
 
“ … substantially all of the activities … involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.”

Great! I don’t see “managed services.”  But wait, what about “consulting”? Could managed services fall under the definition of “consulting”?  While the answer to this is not really clear from the statute, it is clear that this provision was written to raise revenue from small businesses.   And given that, it is quite likely that managed services will be pulled in when the IRS writes regulations to more clearly define the law.
 
The revenue from this new tax would be used to fund scores of “expiring” provisions, most of which have admirable goals. However, with this new payroll tax, much of the cost for extending these expiring provisions would be borne by small businesses. CompTIA clearly opposes this.  If this provision had applied to all S corporations, it would still be a bad idea.  However, because it applies only to service businesses, it’s a really bad idea – and would be very difficult to administer.
 
As the Senate is currently working to finalize its version of the extenders bill, CompTIA is re-doubling its efforts to be sure that the Senate does not include this small business tax increase in its expected legislation.    Fair?  Not really. This provision would principally affect small businesses – which typically elect S corporation status.  Confusing? Sure.  This would only apply to a “professional service business” which is defined as a business in which:
 
“ … substantially all of the activities … involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.”

Great! I don’t see “managed services”.  But wait, what about “consulting”? Could managed services fall under the definition of “consulting”?  While the answer to this is not really clear from the statute, it is clear that this provision was written to raise revenue from small businesses.   And given that, it is quite likely that managed services will be pulled in when the IRS writes regulations to more clearly define the law.
 
The revenue from this new tax would be used to fund scores of “expiring” provisions, most of which have admirable goals. However, with this new payroll tax, much of the cost for extending these expiring provisions would be borne by small businesses. CompTIA clearly opposes this.  If this provision had applied to all S corporations, it would still be a bad idea.  However, because it applies only to service businesses, it’s a really bad idea – and would be very difficult to administer.
 
As the Senate is currently working to finalize its version of the extenders bill, we're re-doubling our efforts to be sure that the Senate does not include this small business tax increase in its expected legislation.

Want to hear more?  Attend the Small Business Owners Special Interest Group at Breakaway on August 12 to discuss this and other small business issues.