Tax Extenders Bill Expands PayrollTaxes to Professional Service S Corporations


By Ron Kramer

On May 28, 2010, the House passed H.R. 4213, the American Jobs and Closing Tax Loopholes Act, which extends many temporary individual, business, energy and charitable incentives through the end of 2010. The Senate will take up the House extenders bill when it returns from Memorial Day recess after June7.

One of the revenue raisers contained in H.R. 4213, is the raising of payroll taxes (i.e. self-employment tax) on S Corporation shareholders primarily engaged in the performance of services. Tax writers expect to raise $11.2 billion in revenue from this proposal over the next 10 years. The new law would be effective for taxable years beginning after December 31, 2010.

The House bill targets what Congress (and the IRS) views as employment tax evasion by certain service professionals who conduct business in S corporation form, but claim only minimal salaries for services rendered to the corporation. In particular, the House bill focuses on firms in which the business is based on the skills and reputation of three or fewer professional service providers, or S corporations that are partners in such service businesses.

An S corporation is treated as a passthrough entity for Federal income tax purposes and each shareholder takes into account and is subject to Federal income tax on the shareholder’s pro rata share of the S corporation’s income. Also, a shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages from the S corporation. Currently, a shareholder of an S corporation generally is not subject to FICA tax on amounts that are not wages, such as the shareholder’s share of the S corporation’s income or distributions from the S corporation.

The IRS has held that an S corporation employee is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized by the taxpayer as other than wages. Treasury Regulations on employment taxes support this position and provide that the form of payment of compensation is immaterial, the only relevant factor being whether payments are actually received as compensation for employment.

Case law has also addressed the issue of whether amounts paid to shareholders of S corporations constitute reasonable compensation and, therefore, are wages subject to the FICA tax, or are properly characterized as another type of income that is not subject to FICA tax. In cases addressing whether payments to an S corporation shareholder were wages for services or were corporate distributions, the courts have recharacterized a portion of corporate distributions as wages if the shareholder performing services did not include any amount as wages to avoid liability for payroll taxes.

Under the House bill, a shareholder who provides substantial services with respect to certain professional service businesses will take into account for self-employment tax purposes all of his and her pro rata share of S corporation income that is attributable to the service business. The proposal also provides that the pro rata share of income of family members who are S corporation shareholders but who do not provide substantial services with respect to the professional service business, will be attributable to the shareholder providing services and will be subject to self-employment tax.

The new payroll tax rules will apply to:

  • Any S corporation which is a partner in a partnership which is engaged in a professional service business, if substantially all of the activities of such S corporation are performed in connection with such partnership, and
  • Any other S corporation which is engaged in a professional service business if the principal asset of such business is the reputation and skill of 3 or fewer employees.

Under the proposal, the term “professional service business’ means 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.

It is interesting to note that test (ii) above makes reference to the reputation and skill of 3 or fewer “employees”, not S shareholders. Accordingly, the new legislation could also be applicable to larger S service corporations if it is determined that its principal asset is the “skill and reputation of three or fewer employees. How the “principal asset” test will be determined and valued on an annual basis for S corporations subject to the new legislation is not clear.

The S corporation payroll tax provision appears to have been hastily written and subject to little debate. And, again, it’s a tax provision that raises revenue on the backs of small business. Most S corporations have three or fewer shareholders; therefore, Congress identified these service companies as a fertile source of revenue ($11. 2 billion over 10 years) to fund the widening budget deficit. We will continue to follow the progress of this provision as the Senate considers H.R. 4213 in the coming days. As yet, the Senate’s position on this issue is unclear.

Schneider Downs provides accountingtax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH. 

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

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