With the current record deficit spending, bailouts, and the country’s exploding debt, combined with the decline of government tax revenues, the current administration is focusing on increasing tax revenues anywhere it can be found. According to the Office of Management and Budget, Treasury Department, in 2009 individual income tax receipts are down 22% from a year ago and corporate income taxes are down approximately 57%. Social Security tax receipts are likely to drop for only the second time since 1940, and Medicare taxes are on pace to drop for only the third time ever. For those S corporations, beware, you are on the IRS’s radar and have been for a while.
Current Law
S corporations are on the IRS’s radar because of the way pass-through income is taxed to the shareholder. Shareholder-employees of S corporations are only subject to FICA on their wages, and S Corporation earnings passed through to shareholders are taxed as ordinary income and not subject to FICA or self-employment tax. One popular strategy is to not pay wages and to make payments to officers as distributions rather than wages, effectively avoiding employment-tax liabilities. Another popular strategy is to roll up partnership or LLC businesses to an S corporation.
The IRS continues to audit returns based on this issue and requires shareholder-employees to pay themselves a reasonable and fair wage. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes. Compensation should be based on similar criteria that non-shareholders salaries are based. Factors would include prevailing market rates; hours worked, and the individual’s skills, abilities and knowledge.
Proposed Change
Paying a reasonable and fair wage is not enough to some politicians. Representative Charlie Rangel, Chairman of the House Ways and Means Committee, has proposed in 2007 House Bill H.R. 3970, tax reform that would fundamentally change the way S corporation shareholder-employees are taxed for Social Security purposes. Under this proposal, an S corporation primarily engaged in a trade or business consisting primarily of the performance of services, any shareholder who provides substantial services with respect to such trade or business would be required to consider pass-through income as net earnings from self-employment, therefore subject to self-employment taxes.
