While recent deals have postponed financial disasters such as the “Fiscal Cliff”, “Default”, and “Government Shutdown”, each of these monsters are once again waiting just around the corner. As a result, Congress is back to the drawing board in an attempt to strike up a grand bargain to prevent the next scheduled crisis. The grand bargain compromise should include tax reform, which means that the S Corp tax status is being targeted once again.
S Corporations enjoy a special tax treatment unavailable to other corporations and partnership structures. As an S Corporation, distributions are treated like corporate dividends when it comes to Self-Employment Tax and Partnership distributions when it comes to tax on dividends. Because of this, shareholders are taxed on corporate income that flows through to them personally, but distributions from an S Corp are tax free to the extent they have basis. This can result in significant tax savings. On top of that, S Corp income is also one of the few items exempt from the ACA Medicare taxes of 3.8% on net investment income and .9% on payroll or self-employment income.
Democrats in the Senate are looking to change the way S Corp income is taxed for incomes over a million dollars a year. The result would likely be that S Corp income will become subject to Self Employment Tax once the taxpayer hits the million dollar mark. Since most taxpayers at that income level have already reached the Social Security limit, the effect would be a 3.8% Self Employment Tax on S Corp income. However, if an individual is not taking a salary and does not have other self employment income, the result could be an additional tax of up to 16.2% on S Corp income.
Attempts to levy Self-Employment taxes on S Corp income have been thwarted in the past by small business groups and members of both parties concerned about its effect on small business. However, the million dollar AGI floor could give this attempt legs. The popular mantra of “no new taxes” has been replaced over the past year by varying definitions of who can be taxed without too much political backlash. We will continue to monitor the tax reform negotiations and keep you updated on what direction the conversation is taking in DC.