Discussions regarding application of self-employment taxes to income passed through from S corporations have come and gone over the past few years. It appears that this issue is making a comeback. Income passed through from S corporations to their shareholders is not subject to self-employment tax even if these shareholders are actively engaged in the daily operation of the company. This is in direct contrast to income passed through to owners of un-incorporated entities. As a means to compensate for this disparity, S corporation shareholders who are actively engaged in the operation of the company’s business are required to be paid “reasonable” compensation which is subject to employment taxes. Recently, the administration and certain members of Congress have raised a concern that this disparity in treatment is tantamount to a tax loophole whereby S corporation shareholders reduce their overall tax bill by minimizing the compensation they receive and instead receive a higher allocation of income.
On April 24, Senate Majority Leader Harry Reid (D-NV) introduced S. 2343, the "Stop the Student Loan Interest Rate Hike Act of 2012." Congressional Democrats have indicated their intent to introduce a parallel measure in the House of Representatives.
The bill aims to keep the current interest rate of 3.4% on college students' loans from doubling on July 1, 2012, and would pay for this change by closing what's seen as an S Corporation employment tax "loophole." This legislation would subject income passed through from “professional service” S corporations to self-employment tax if the shareholder provides “substantial” services to the S corporation; the S corporation derives 75% or more of its gross revenues from the services of three or fewer shareholders; and the shareholder has adjusted gross income of more than $250,000 if married filing jointly ($200,000 in case of singles). The bill would also apply to S Corporation that is a partner in a professional service partnership.
What next? Subject all of S corporation income to self employment tax?