In May, the House of Representatives passed legislation (Section
413 of H.R. 4213) that would subject non-wage earnings of certain S
corporation shareholders to the self-employment tax for the first
time. This proposed legislation is intended to prevent service
professionals from routing their income through an S corporation to
avoid paying Social Security and Medicare taxes.
Current Law Excludes Certain Income from Payroll Tax
The Internal Revenue Service currently uses a reasonable
compensation standard to ensure S corporation shareholders pay the
correct amount of self-employment taxes. The excess earnings, after
payment of the reasonable compensation, is taxable to the
shareholders as ordinary income but is not subjected to Social
Security and Medicare taxes. These non-wage earnings can either be
distributed among the shareholders or retained by the corporation
for future growth.
Proposed Bill Subjects Non-Wage Income to Payroll Tax
The proposed bill would increase the self-employment taxes paid
by the owners of S corporations that engage in professional
services. The provision applies to service businesses or an S
corporation that is a partner in a professional service business.
Affected businesses could include doctors, dentists, consultants,
attorneys and many others.
The reason for the proposed change is to prevent professionals
from forming S corporations to avoid self-employment taxes. Under
current law, the earnings of sole-proprietorships and partnerships
are already subject to payroll taxes, while S corporation earnings
To soften the bill, Democratic leaders have added a proposed
test to help determine which S corporation owners would be required
to pay the self-employment tax. Under this test, the additional tax
will apply only when 80% or more of the S corporation's income
is principally based on the reputation and skill of three or fewer
individuals. Many commentators criticize this test as unworkable
and believe it will lead to conflict and haggling between the IRS,
taxpayers and their accountants.
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The Internal Revenue Service has recently published an IRS Large Business & International Directive, which updates an earlier directive to field agents addressing the examination of capitalization and repair costs issues.