The American Institute of CPAs and the National Society of Accountants are voicing their opposition to a provision in the tax extenders and unemployment legislation that could increase the self-employment taxes paid by some professional services firms organized as S corporations.

The American Jobs and Closing Tax Loopholes Act of 2010 includes a provision, Section 413, intended to prevent service professionals from routing their self-employment income through an S corporation to avoid paying Social Security and Medicare taxes. The provision applies to situations where an S corporation is engaged in a professional service business that is principally based on the reputation and skill of three or fewer individuals, or an S corporation that is a partner in a professional service business.

The provision would also clarify that individuals who are engaged in professional service businesses are unable to avoid employment taxes by routing their earnings through a limited liability corporation or a limited partnership. This proposal is estimated to raise $11.249 billion over 10 years, and would help offset the cost of the various tax break extensions and unemployment benefit extensions in the mammoth bill.

AICPA Tax Executive Committee chairman Alan Einhorn sent a letter to Democratic and Republican leaders of the Senate Finance Committee and the House Ways and Means Committee opposing the provision. He noted that the provision is a major change in longstanding tax policy that should be discussed in public hearings and that it would lead to increased taxes and complexity for S corporations and their shareholders.

The AICPA said the Internal Revenue Service has the enforcement tools it needs to force any taxpayers avoiding payroll taxes to re-characterize S corporation distributions as salary, which would then be subject to employment taxes under FICA, the Federal Insurance Contributions Act.

In a June 14 letter to Senate Finance Committee Chairman Max Baucus, D-Mont., and Senate Finance Committee ranking minority member Charles Grassley, R-Iowa, the AICPA endorsed an amendment by Senators Olympia Snowe, R-Maine, and Michael Enzi, R-Wyo., that would remove Section 413 from H.R. 4213. 

The proposed Section 413, wrote Einhorn, “fails to take into account a fair and reasonable return on the human and investment capital of the owners; may reduce Social Security benefits for early retirees; may create unintended consequences to qualified and non-qualified retirement plans of owners that would now have both wages and self-employment income; and ignores the fact that the IRS currently has the appropriate enforcement tools it needs to re-characterize the distributions of S corporations as salary subject to employment taxes under FICA.”

Einhorn noted that the AICPA would like to work with Congress and the IRS to address the best way to collect S corporation shareholders’ and partners’ fair share of employment and self-employment taxes. “Such a provision should not be rushed through the legislative process without due process and deliberation,” he added.

The National Society of Accountants also sent a letter to U.S. senators supporting the Snowe-Enzi amendment.

“Section 413 would raise taxes by $11.2 billion on privately held small businesses located in every state of this country,” said the NSA. “While it has been described as a ‘loophole closer’ and a ‘payroll tax,’ it is neither. It is a new tax on small employers that will overturn more than 50 years of established tax policy. We believe Section 413 is overly broad and will result in more increased tax collections than increased tax compliance.”
The NSA added that the new tax would hurt job creation and would be imposed regardless of whether the affected firms made distributions to shareholders and partners, or retained that income to re-invest in jobs and capital equipment.

“Shareholders and partners of ‘flow-through’ businesses are taxed on their firm’s income even when that income is not actually distributed,” said the NSA letter. “As a result, this provision will reduce the capital these employers have to create jobs and invest in their businesses. Just as importantly, the new tax appears to be unenforceable. Section 413 would require firms — regardless of how many employees they have — to test each year to determine whether the ‘skill and reputation’ of one, two or three key employees is the firm's ‘principal asset.’ The enforcement challenges accompanying this new test and the valuation of intangible assets are too numerous to list.”

“The Internal Revenue Service currently uses a ‘reasonable compensation’ test to ensure S corporation shareholders pay the correct amount of tax,” the NSA noted. “Replacing this established test with a ‘principal asset’ test is a step backward for tax enforcement and should be rejected by the Senate.”

Like the AICPA, the NSA pointed out that the tax was never the subject of hearings or public review. “It was made public just a few short weeks ago, and it has been attached to legislation that already passed both the House and the Senate,” said the NSA. “It is an accident of the legislative calendar that we are in a position to offer our views at all. For these reasons, we respectfully request that you support Senators Snowe and Enzi and remove Section 413 from the bill.”

The NSA noted that in offering the amendment, Senator Enzi demanded to know why the provision was necessary, saying the IRS already has audit procedures in place to prevent tax evasion which, coupled with the recent codification of economic substance, should make the S corporation language needless. He added that the S corporation language would be a detriment to small businesses and would harm their ability to re-invest and create jobs.