Although we’ve been waiting for an “extenders” bill for some time, the one now before the Ways and Means Committee contains some controversial provisions that have generated quick and vociferous opposition.

The extenders, part of the American Jobs and Closing Tax Loopholes Act of 2010, is much more than just a jobs bill or an extenders bill. It contains nine chapters, more than 400 pages, and a summary that alone is 27 pages long. However, it is the “pay-fors,” naturally, that have generated opposition. These include a provision changing the taxation of carried interest, a number of international tax items placing restrictions on the use of the foreign tax credit, and a proposal to subject certain S corporations to payroll tax.

It is the provision on S corporation employment taxes that might affect many smaller accounting firms. Social Security taxes are imposed on compensation and self-employment income up to the Social Security Wage Base, currently at $106,800, and the Medicare tax is imposed on all self-employment and compensation income. Some service professionals have been avoiding Medicare and Social Security taxes by routing their self-employment income through an S corporation, noted the Ways and Means Committee in its explanation of the provision.

“These taxpayers then pay themselves a nominal salary and take the position that the remaining earnings are exempt from employment taxes,” the committee said. The bill would address this abuse in 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.

Specifically, the provision targets S corporations engaged in a “professional service business,” which it defines as “any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.”

“There is the potential for taking out smaller salaries subject to payroll tax, and taking out the rest as distributions,” noted Rick Thompson, a tax partner at Sikich LLP.

“Years ago, some S corporation shareholders were being really abusive by not taking any salary and claiming everything as a distributions,” he added. “If the IRS saw no officer compensation on a return but saw distributions, it would send a notice telling the shareholder to pay the payroll tax. The fact that the new provision targets smaller S corporations indicates that the perceived abuse is primarily at lower levels. It’s unusual to see people playing around with salaries at higher levels.”

The U.S. Chamber of Commerce observed that this provision would apply to capital investments made by businesses engaged in the service sector, hurting their ability to invest and create jobs. In a letter to the House of Representatives, executive vice president for government affairs Bruce Josten observed that by targeting service-sector S corporations, the measure would increase taxes on small business owners who are fully complying with the law, and would add to the Tax Code’s complexity by creating new categories of business activity that would have to be defined and litigated.

And in a letter to Ways and Means Committee Chairman Sander Levin, D-Mich., Padgett Business Services president Roger Harris said that the proposed measure unfairly singles out smaller businesses. “If the Committee believes there is improper behavior, it should be discouraged in all situations, not just in the smallest of businesses,” he stated.

In addition, the provision has the potential to discourage investment in small S corporations, Harris noted. “As the legislation is written, the shareholders’ pro rata share of income is considered self-employment income based on the number of skilled employees and the type of business operated by the S corporation,” he said. “This would treat shareholders that invested in the business the same as those that are active in the business. This tax treatment would discourage investment in businesses with less than three skilled employees as opposed to one with more than three.”

“The problem is, it’s targeted only to small businesses in certain fields,” Harris commented. “This is the first time in my memory that the tax law has penalized someone for being small. Most of the time tax laws are written with large businesses in mind, and carve out exemptions for small business.”

“The problem is that people are abusing the regulations that are already in place,” he added. “If they follow the rules and take the salary the law says they should, there would be no problem.”

There are currently regulations that require active S corporation shareholders to pay a reasonable salary, but there is little guidance to help business owners and their advisors determine what that reasonable salary should be, Harris said. “We feel that the Committee would better serve S corporations if they provided guidance, and perhaps safe harbors, to the small business community on how to determine reasonable salary,” he said.

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