Congress is looking to restore some fiscal restraint. It could do so by reigning in spending, but let’s be practical—they’re going to raise taxes. Congress is trying to drink your milkshake.
The American Jobs and Closing Tax Loopholes Act of 2010 (which is currently working its way through Congress) has a provision that subjects all profit in a professional S corporation to self employment tax of 15.3%. Examples of professional services include accounting, legal, architectural, consulting, engineering, etc.
Here’s the kicker—the tax applies only to professional S corps that are based principally on the reputation and skill of three or fewer employees. So the business can have more than three employees and still be subject to the full self employment tax, as long as three or fewer employees are the firm’s principal asset. Thus, each year the business must assess (through valuation?) whether the principal asset of the firm is three or fewer key employees.
Example: Timmy and Jimmy have a law firm that is a professional corporation. They have filed an S corporation election and are therefore taxed as an S corporation. The corporation has $200,000 in profit before officer salaries. Timmy and Jimmy each take a $60,000 salary, so the remaining profit is $80,000. Under current law, Timmy and Jimmy pay their share of FICA taxes of $4,590 ($60,000 * 7.65%) and the corporation matches their FICA contributions of $4,590 each. This is the rough equivalent of each owner paying self employment tax of 15.3% (7.65% * 2). The remaining profit of $80,000 is exempt from self employment tax (assuming Timmy and Jimmy are paid a reasonable salary).
Under the new law, the $80,000 remaining profit is also subject to self employment tax of $12,240 ($80,000 * 15.3%).
What if the corporation hires a receptionist and a couple paralegals so it has more than three employees? The result will not change because the principal asset of the firm is based on two employees—Timmy and Jimmy.
THIS LAW HAS NOT YET PASSED. IT IS VERY UNPOPULAR, BUT WHEN HAS THAT STOPPED CONGRESS?
The IRS already has power to challenge unreasonably low compensation of S corporation owners, can reclassify profit distributions as wages, and collect FICA taxes on them.
If passed, this new law will dramatically increase the tax burden on small businesses by increasing their taxes and imposing the new requirement to perform a quasi-valuation each year to determine if three or fewer employees are the business’ principal asset. This will harm their ability to grow their businesses and create new jobs.
…I’m Finished (spoiler alert)…