In spite of the growth and popularity of limited liability companies taxed as partnerships, S corporations remain a very popular option for doing business. Internal Revenue Service records show that S corporations remain the most popular way for a business to file tax returns.

In 2009, there were an estimated 2.5 million C corporation returns filed, a figure that has remained fairly stable over the last five years. Over that same period, the number of partnership returns filed has grown from 2.5 million to more than 3.5 million returns. While this is a greater percentage increase than the increase in the number of S corporation returns, S corporations, in absolute numbers, are pretty well holding their own. The number of S corporation returns filed in 2009 was about 4.5 million, an increase from 3.5 million five years earlier.

While S corporations must deal with a number of statutory restrictions, such as the number and type of shareholders and the types of stock, they also provide a number of advantages. They follow the general corporate structure of corporations in having stockholders, a board of directors, and officers - a form that is a familiar structure to many individuals.

Other than fairly standard bylaws, they do not require an operating agreement that can be costly to draft and even more costly to interpret down the road.

S corporations also have traditionally offered more certainty for owner/operators as to which distributions are employment-related and which are capital-related. Of course, any distributions are subject to risk of recharacterization by the IRS, but as long as employee compensation was reasonable, practitioners felt fairly comfortable with the ability to segregate what was compensation and what was a distribution on capital.

HEALTH CARE REFORM LEGISLATION

This advantage of the segregation of compensation and capital has been touted by commentators as a possible significant advantage for S corporations in determining how best to structure affairs in the face of the new Medicare taxes passed by Congress this year in the health care legislation.

The new Medicare taxes to be imposed fall only on incomes in excess of $200,000 for single filers and $250,000 for joint filers. S corporation employee/owners that can limit compensation to those amounts and take any excess in the form of distributions could avoid the new 0.9 percent tax on wages. Partnerships and partners have more difficulty in trying to distinguish one type of income from the other.

S corporations, as well as partnerships, may be utilized to play a role in trying to shield taxpayers from the 3.8 percent Medicare tax on investment income for taxpayers over those same $200,000 and $250,000 income levels. By using common estate-planning techniques to use S corporations to transfer investment assets to the younger generation, some or all of the Medicare tax on investment income might also be avoided.

PROPOSAL FOR FICA TAXATION OF K-1 INCOME

This rosy scene, however, comes with a dark cloud on the horizon. For some time, Congress has been considering making all of the K-1 income of S corporation employee/owners subject to self-employment taxes.

The extenders legislation currently being debated in the Senate (H.R. 4213) includes a provision that would impose the 15.3 percent self-employment tax on the dividend distributions paid to employee/owners of S corporations, on family members of employee/owners who are themselves shareholders, and on retained earnings in the S corporation. In efforts to overcome opposition to the provision, current versions of the proposal put a variety of limits on it. It would apply only to personal service corporations and only as long as 80 percent or more of the corporation's income is attributable to three or fewer owners.

If this provision is adopted and applied to a particular S corporation, it would effectively eliminate any advantage that the S corporation has over partnerships by shifting income from compensation to dividends. It would also impose a significant additional tax burden on these entities at a time when small business is being looked to as a generator of jobs growth.

SUMMARY

S corporations continue to be a popular form of doing business, in spite of the statutory restrictions imposed on them, due to their relatively simple structure and set-up requirements, the comfort level taxpayers generally have with the corporate structure, and the tax advantages that come from the ability to segregate compensation from distributions related to ownership.

Just as this latter advantage takes on even more importance with the passage of increased Medicare taxes, Congress is proposing to shut down this advantage with a broad self-employment tax on distributions to certain S corporation owner/employees and their family members, as well as retained earnings.

Such a change might not detract much from the attractiveness of the S corporation structure. It would eliminate one key advantage it has over the partnership structure, but then the two forms would be on more equal footing, and many taxpayers may still prefer their pass-through entity to operate in the more familiar corporate structure.

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