Is It Time To Dump Your S Corporation?

Update

Neither party made any progress on passing any form of extender’s bill today. There is talk that the House will try the cloture route again as early as Wednesday, but without a new bill being introduced today, that’s unlikely. We’ll update again tomorrow, as events unfold.

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The “Tax Extender” Bill is up for vote in the Senate today. Over the weekend, I reviewed all the amendments since the House approved it in late May. Are you ready for this? There have been 197 amendments (some of them just place-holders until their unveiling this week) since it hit the Senate floor.

You probably have heard about the bill because it extends unemployment payments, extends some expiring tax deductions and tax credits and includes a complicated “interest charge” that might have little to do with you. But what you probably haven’t heard about, at least in the mass media, is how this will effect S Corporations. For our clients, this is one of the most significant pieces of
legislation to hit S Corporations since maybe the 1986 Tax Reform Act.

Since there are over 4.5 million S Corporations in existence today, this really is a big deal.

In plain English, the new tax will make all S Corporation income subject to self-employment tax if the S Corporation meets certain criteria:

• Provides professional services, as defined under the expanded definition in this Act,
• Substantially all of the income comes from professional services, and
• More than 80% of the professional service income is provided by 3 or few shareholders

This is the version that, at least at this point and with information available right now, that the Senate will vote on. It is not the version that the House approved. So, if it passes the Senate, then the House will need to vote again and approve. Then it goes to the President for signature or veto.

There are a number of important distinctions in this bill as it relates to S Corporations:

• If you have other income that would not normally be considered ‘active’ income and thus not subject to self-employment tax, this bill won’t make that income subject to self-employment tax. (think rental, royalties, etc)
• This is only applicable to ‘professional services.’ This is where it gets confusing though.

  The new bill definition of professional services includes: “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.”

  This is more expansive than the previous professional services corporation (PSC) that C Corporations use. There’s bound to be a lot of confusion there.

• The term “consulting” continues to be a subjective definition. Basically, the only guidance we have on what this takes is:

  Reg 1.448-1T(e)(4) states:
  For purposes of paragraph (e)(4)(i)(H) of this section, the performance of services in the field of consulting means the provision of advice and counsel. The performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or brokerage services, or economically similar services. For purposes of the preceding sentence, the determination of whether a person’s services are sales or brokerage services, or economically similar services, shall be based on all the facts and circumstances of that person’s business. Such facts and circumstances include, for example, the manner in which the taxpayer is compensated for the services provided (e.g., whether the compensation for the services is contingent upon the consummation of the transaction that the services were intended to effect).

• The term “substantially all” has been defined as 95% or more of the efforts related to professional services. If this same definition is applied here, there could be an easy out.
• If more than 21% of your professional service income comes outside the efforts of 3 or less shareholders, your S Corp is exempt.

Until we have regulations and court cases, we’re left to fill in the blanks on much of this. But some of the open questions will be:

• What are professional services?
• Can we use the same “substantially all” definition to exempt a company from this rule?
• Do the ‘others’ that provide income need to be employees?

Stay tuned to USTaxAid.com for more information! We will be covering this, along with the Health Care Bills and the HIRE Act and how to position your business to pay the least amount of tax possible in our Tuesday, July 13, 2010 Coaching Course. Sign up today!

Related posts:

• Professional Service Corporation Tax Traps
• Are You Ready For a C Corporation?
• 3 Strategies with Corporation Taxes
• When is Your C Corporation Tax Return Due?
• One Big Reason Why You Might Want a C Corporation