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What really bugs me about this legislation is who it targets. Obama's entire campaign hinged upon a commitment to avoid imposing new taxes on the "middle class" and going after big money hoarders who evade taxes. Those who operate S-corps aren't the ones avoiding massive amounts of taxes. This is a backdoor way of increasing taxes on the upper-middle-class, and it really sucks.

True. Obama has changed few of Bush's policies and amplified the worst of them.

Aww, gee, well in that case I assume Obama will veto it, since in this video he makes a "firm pledge" that "no family making less than two hundred and fifty thousand dollars a year will see any form of tax increase":

http://www.youtube.com/watch?v=Q8erePM8V5U

This isn't a tax increase. People taking this informal tax "deduction" are counting on the IRS never reviewing their tax returns. As it stands today, and as it stood when Obama took office, if the IRS gave any of these shady returns a second look, the filers would wind up in tax court.

I don't pretend to understand the details here, but if it's just a question of better enforcing existing laws then why is there a bill?

If you don't pretend to understand the details, why do you feel comfortable making political arguments that rely on them?

Well, one complaint often leveled at bureaucracies is that the regulations are opaque and their application is arbitrary. Statutory clarification can thus help to lower the cost of compliance.

This isn't a deduction. A deduction is when you offset taxable income with deductible expenses. I also resent the fact that anyone would refer to these returns as "shady".

My accountant tells me that the reasonable salary requirement is typically interpreted as anywhere between a 60/40 and 80/20 ratio of salary to distribution income. "Abuse" in this case is when someone takes the vast majority of their income as a distribution in order to avoid paying SS and FICA tax.

The reason S-corps get a break here is because of the unique niche they occupy. A well capitalized business is a good business. The intended operation of an S-corp, and what is currently incentivized through the tax structures in place, is this: an S-corp owner takes a "reasonable salary" (as defined above), but enjoys pass-through tax status on the remainder of the income. They pay federal withholding on this amount, but benefit from a lack of SS or FICA taxes. The primary source of capitalization in a small business is the primary shareholder. That is, in tough times, the owner will have to contribute money back in to the business in order to sustain it. This is because the corporation itself cannot hold any assets.

Without this benefit, there's really no point in filing an S-corp election. You might as well just file as a C-corp. The tax differences are negligible.

You are missing the part where only the small number of people who have enough shares in the S-Corp to soak up 40% of their income get to take advantage of this loophole. The rank and file employees of an S-Corp, even if they're getting "first-employee" levels of equity, don't get to play this game.

You're also dancing around the fact that the IRS can already determine by fiat what "reasonable" salary is. I'm not an accountant. We're an LLC filing as an S-Corp. We have professional accountants. We have not been advised of any "60/40" rule. What I have been advised of is that tax courts interpret any compensation an employee of an S-Corp gets for services rendered as a wage, and wages are subject to FICA.

My hunch --- and that's all it is --- is that this 60/40 business is less about what the tax courts interpret the tax code as, and more about what will prevent your returns from getting caught in the IRS dragnet. That doesn't mean that taking 40% of your wages as distributions and skipping FICA on them is actually aboveboard.

The big differences between S and C corps is that C corps pay federal corporate tax and C corps have preferred stock.

I also have to add, at severe risk of getting smacked down by 'grellas, that I think your argument about "the reasons why S-Corporations get this break" is unsupported by evidence. In fact, when I read the "Opinion" sections of court cases involving decisions about distros versus wages (every one of which I found finds for Revenue and not the company owner), I see things like:

Dr. Sadanaga performed substantial services on behalf of petitioner. The characterization of the payment to Dr. Sadanaga as a distribution of petitioner's net income is but a subterfuge for reality; the payment constituted remuneration for services performed by Dr. Sadanaga on behalf of petitioner. An employer cannot avoid Federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation's net income, rather than wages. Regardless of how an employer chooses to characterize payments made to its employees, the true analysis is whether the payments represent remuneration for services rendered. Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990); Joseph Radtke, S.C. v. United States, 895 F.2d 1196 (?th Cir. 1990).

The question doesn't appear to be "does your company deserve a break". Rather, it's pretty straightforwardly: "is this money you're earning as compensation for your work, or is this money you're earning as compensation for the downside risk of an investment you hold".

I'm sorry that you feel like I'm calling you shady. I don't even know you. I don't think you are shady. But this business of allowing S-Corp owners to exempt themselves from half their FICA obligation just because of a quirk in how they file taxes is, as I see it, shady.

This legislation "targets" people who have deliberately structured their business to take advantage of a tax loophole that allows them to pay lower payroll taxes than owners of LLCs, partners in LLPs and partnerships, startups in C corporations, and sole proprietorships, all of whom are required to pay their fair share of FICA taxes.

Hate on Medicare and Social Security as much as you want, but as long as we have those programs, it is simply bullshit that company owners (not their employees, mind you, just the owners) can organize as an S-Corp, ratchet down their pro forma salaries, and collect the difference as "distributions".

As the parent poster slyly notes, this behavior is already unlawful. You'll find plenty of analyses on Google of people's attempts to skirt payroll taxes with distributions and then getting smacked down in IRS audits with 20% negligence penalties attached. The problem is that in order to catch those people, the IRS has to aggressively audit S Corps and take people to tax court, which is (a) a waste of everyone's time and money and (b) a nuisance for S-Corps who are playing by the rules.

All that's happening here is that a bright line is being created where a dim and flickering line was previously. That's a step forward. The notion that there was some social benefit to this quirk of the tax code is silly. If you try to defend it, you don't get to complain about the tax code being too complex anymore.

The purpose of an S-Corp is to allow the flexibility of an LLC while allowing companies to create real equity incentive plans for employees. It isn't a grant to small consulting companies to exempt them from FICA.

It might be a bad idea, but I have trouble considering this something targeting the "middle class". I'd generously define middle-class as, say, 20th to 80th percentile of incomes, which in the U.S. is a range of about $20k-$90k. I suppose you could use a wider range, and say that everyone except the bottom and top 10% is "middle class": then you get the even more absurdly expansive range of $10k-$125k for middle class (a group that obviously isn't anywhere near coherent as a "class", but oh well).

But it seems the S-Corp owners in question aren't even mainly in that ultra-expanded middle class. Is someone who's at, say, the 93rd percentile really in the "middle" of anything, or even at the upper end of the middle?

Y'know, I file Schedule C (ie, self-employed), and also pay the 15.3% rate of SS up to ~$106k (ie the employer's share in addition to the employees) - and like owners of S corps, that employer's contribution is deductible when calculating the taxable income, so that I'm not paying taxes twice on the same money.

Why, exactly, should someone who owns or part-owns an S Corporation - the essence of which is that it is a pass-through entity and thus has greatly simplified filing requirements compared to, say, a C corporation - be able to designate part of the money they receive as income, to be taxed at one rate, and part as profit, to be taxed at a different one? Does setting up an S corporation magically make you more enterprising or worthy than individuals who file schedule C?

I mean, I'd love to be able to say that in a good year I just 'earned' the same amount as I did the previous year, but that the same activity also yielded a 'profit' which should be taxed differently...even though this 'profit' found its way into my bank account, rather than being reinvested in tax-deductible stuff like new plant or equipment or suchlike.

I think the real question here is why you don't reorganize your business to take advantage of the benefits of an S-corp.

If he has no employee shareholders, exactly what is the benefit of structuring as an S-Corp?

I don't; that's a side issue about me personally (the actual reason being that that film production, which is the field I'm in, is generally insured by the producer so I don't have significant liability).

The question I'm asking, though, is why S corporation owners should not pay the same payroll taxes as anyone else. It's not like they don't get to deduct normal business expenses or necessarily create more economic value.

The fact is, S-corps provide several advantages, and if you think the tax is too high, you are free to forgo forming an S-corp and form a partnership instead. I don't see the coercion; "double taxation" isn't usually a complaint about extra taxes that are voluntarily paid in exchange for extra benefits.

By that logic, why shouldn't a larger corporation have to pay 15% of its entire gross income as payroll tax? Why shouldn't someone who is a W2 employee earning $500K per year?

Because you only pay payroll tax on payroll, not on expenses or capital purchases like equipment. A w-2 employee (and his or her employer) pays into social security up to $106,800 per annum. Same if you're self-employed; in that case one pays both the employee and employer contributions, but the latter are deductible for calculating taxable income payable to the IRS.

Here's what I don't understand about the people who are complaining. If you're self-employed, like me, you have unlimited liability for debts, torts and so on incurred as a result of work. Similarly, if I form a partnership with my buddy, either or both of us who are general partners also have unlimited liability. As an individual or a partner, I can also hire people, make business purchases and deduct those expenses for tax purposes. But if my employee or my business vehicle or whatever is the cause of liability, as a sole trader or general partner all that liability comes back to me (tax on partnerships is a little different again).

Now, if instead I or myself and my friend set up an S corporation, I/we enjoy the benefits of limited liability up to (or more realistically, 'down to') the value of the shares held which are usually nominally priced at $1 or suchlike. So if I have an irresponsible employee who is negligent or runs up debts in the company's name, my personal/family assets are protected from business-related liability claims. This protection is nothing to sneeze at, and indeed, I'm looking at reorganizing for that exact reason.

So why is it, exactly, that those who enjoy the considerable benefits of limited liability for their business operations should also be able to exempt part of their annual business gain from social security obligations, whereas a self-employed person, with unlimited financial liability, can not?

We are witnessing evolution in action here. Sole proprietorships and partnerships have become uncompetitive dinosaurs due to the explosion of litigation, and the system is in the process of reconfiguring itself to provide liability protection at a similar level of taxation. Given the risk of being involved in legal action, I don't understand why anyone would want to organize using an unprotected structure; fill out the paperwork and get yourself covered.

I don't understand why you aren't already organized as an LLC. Apart from some minor paperwork and nominal fees, there's no downside to it over a sole proprietorship. 'bd-at_rivenhill is right about this.

No special reason - just that freelancing and my financial situation has been simple enough that the 'ez' filing has generally been sufficient, and the potential for liability has been minimal.

I don't disagree with your logic, but I think you've simply chosen a non-optimal business arrangement. There is really no reason not to form an S-Corp or an LLC. In most cases, S-Corps are a better idea. Changing the tax code to prevent the taxing of distributions as capital gains simply amounts to raising taxes on small businesses.

One could argue that there is no feasible legitimate reason for an s-corp smaller than 3 employees, but one could equally argue that there is no reason to cap the payroll taxable income or that there is no reason to collect payroll taxes from young people who will surely never benefit from Social Security 50+ years from now (the program will likely be pure welfare by then which removes the justification for the regressive payroll tax to fund it).

You mean, apart from the fact that (a) the money you're "saving" on taxes can be taken from you with gigantic penalties by the IRS at any moment, because the tax courts apparently unanimously consider any compensation for services related to your employment a "wage" which is subject to FICA and FUTA, and (b) taxing all small businesses consistently lowers the long-term burden paid by the world's LLC's, sole proprietorships, LLP's, and C-Corps, all of whom are currently making up the shortfall of the people playing games with their S-Corporations.

That's what you meant, right? =)

Making up a shortfall? You're under the impression that if there were better enforcement of shady S-Corps there would suddenly be a law lowering taxes on the other types of business orgs?

I'm saying that there is some function mapping revenue to entitlement obligations, but I'm not interested whatsoever in arguing the merits, accuracy, or impact of that function.

Most "small businesses" are not S Corporations. An even smaller number are S Corporations that have been jiggered to allow owners to avoid FICA. And only fraction of the people employed by small businesses could ever take advantage of the loophole, since it's effectively usable only by owners.

Why should founders pay payroll tax on the firm's entire gross income up to the cap? That does not make any sense to me, since the founder already pays self-employment tax on whatever amount he/she takes as salary.

The "reasonableness" test is bullshit also. Last I checked, a salary is a predetermined amount of money that will be paid over a predetermined amount of time, for a predetermined amount of work. A reasonable salary for the owner of an S Corp should be whatever the company can guarantee they will be paid over the course of the next twelve months, or, in retrospect, their lowest monthly cash income over the last twelve months, times twelve, or a comparable employee salary, whichever is lower.

The fact of the matter is, as the owner of a company, you are at risk of not getting paid, or getting paid less than you would if you were employed somewhere else in the same position. 15% is a substantial amount of money to blow on a social program that will likely never benefit the individual paying into the system. Unless the government plans to begin compensating S corp owners that are making below a "reasonable" salary, to bring them up to a "reasonable" salary, something I also don't support, they should drop the onerous tax and allow small businesses to grow.

My sister is an accountant specializing in audits and forensic accounting. I've talked to her about this extensively. Any portion of the tax code that mentions "reasonableness" is indeed open to interpretation. The interpretation of this code is (much like criminal law), based on judicial rulings; case law. In the case of a "reasonable salary", the following stipulations apply:

* The IRS will not force your corporation in to an unprofitable scenario as a result of the salary requirement; i.e., if your corporation is yielding a net loss, they will not force you to take salary, but then again, your tax issue is already solved if you have a NOL

* The reasonable salary clause is targeted and applied specifically to S-corp operators who take a disproportionately large amount of their income in the form of a distribution, rather than salary

There is potential for abuse with the existing tax code, but the reasonable salary requirement was created specifically to address that. Enforcement of this clause isn't intended to be applied in the context of market salaries (which is how we usually think of them), but in the context of the ratio of salary to distributions.

Unfortunately for S-Corp advocates on HN, the "natural" FICA exemption already stops right around the "reasonable" salary of a computer professional.

Very true. Which is why, as a software consultant owner of a S Corp, my salary was always defined to be at least that minimum, to avoid any question.

Then why do you care about this issue?

he said "salary" not salary + distribution.

You're not following. What you do with your income after the FICA cap is largely (not completely, but largely) irrelevant. Pay everything past FICA as a distro; nobody's going to care.