The Big Tax Increase Facing S Corporations

The important thing to realize is that the Obama Administration is keeping its promise about not raising taxes on businesses to pay for healthcare.  Rather it is closing existing tax loopholes that existed in an effort to force small businesses into paying $100 billion more in taxes over the next year.  But, this action is not a tax increase on business owners!

What is the government in DC doing now to punish business owners for having a business and employing others?

In HR 4213,( the House’s version of the new spending, physicians' reimbursement, extensions of expired tax breaks, etc…,) Congress is also creating a tax mess for small-business owners in the form of an $11 billion / year tax hike over the next 10 years.

The tax hit affects the owners of small S corporations in "professional service businesses"--doctors, lawyers, accountants, engineers, architects and so on.

The provision before Congress, however, doesn't target only those who are underpaying themselves (which the IRS can attack now, through audits) but all "disqualified S corporations."

What does disqualified S corporations mean? There are two tests, according to Forbes Magazine, either of which can be met to deem an S corp disqualified. First, an S corporation that is a partner in a partnership that is engaged in a professional service business if substantially all of the S corporation's activities are performed in connection with the partnership or any other S corporation that is engaged in a professional service business, if the principal asset of the business is the reputation and skill of three or fewer employees.

Does this sound like something that would affect Real Estate Investors who use an S-Corp for their business?

It is the second test that is the kick in the head for most small businesses. Forbes uses this example:  Think of a dentist's office, with one employee whose reputation and skill is a principal asset of the business--the dentist/owner. The office also employs two front desk/clerical workers and three dental assistants. So this office has six employees, but only one key employee. So the dentist would be hit by this new tax. (Even though he may have an investment in equipment, the principal asset of the business is still his reputation and skill.)

Imagine branding yourself in Real Estate as an expert on pre foreclosures or seller financing.  If you are using your name or business reputation and utilizing an S Corp for pass through revenue, you may be affected by this closing of tax loophole.

Note this new tax is imposed regardless of the dollars involved; it doesn't matter if, as an S corporation owner, you had $300,000 or $30,000 in nonwage profits--this tax will hit you.

Why is Congress raising taxes now on small-business owners? According to Forbes, It is to offset other items in this same bill that the House wants--not just the extension of tax breaks but spending such as the Build America Bonds provision, which provides $28 billion in highly subsidized bond authority to state and local governments (with Goldman Sachs getting millions in fees). If you didn't think you were bailing out California and New York, as well as the big banks, think again.

It has long been recognized that, just as with almost every provision in the tax code, there are folks who like to play fast and loose with the treatment of S corporation distributions. They take a very low salary and receive a good amount in distribution to avoid payroll tax. The current law seeks to prevent that abuse by requiring that an owner of an S corporation be paid "reasonable compensation."

But defining "reasonable" on a case-by-case basis has not been easy for the IRS and S corporation owners.   This bill has passed the house but has not yet passed the Senate. 

I strongly encourage readers who are concerned about this proposed new tax to contact their senators immediately--this $11 billion tax has gotten almost no publicity, and they need to hear from you directly.

About the Author:  Tom Bukacek is a real estate investor in Austin, TX, and Phoenix, AZ who focuses on pre foreclosures.  Tom is also the Marketing Director for the Entrepreneurs Incubator, a full service real estate investing marketing, systems, and mentoring company located in Austin, TX.  For more information on Tom, please visit http://www.entrepreneurs-incubator.com.