The End of the S Corporation?
I just read something on my tax wire that rocked me to the core. While Congress is looking at rolling back reducing the corporate tax rate, they are also looking at hammering small business owners. Here are a few of the items under discussion:
1) Eliminating the 6% production deduction. This was a deduction enacted back in 2005 that allows product-manufacturing businesses to deduct qualified manufacturing costs in an amount up to 6% of their net income.
2) Ending LIFO inventory valuation (that’s “last-in, first-out”) in favor of FIFO inventory valuation (“first in, first out”). This one will be spread out over 8 years so businesses aren’t completely flattened by the tax hit.
And, my personal favorite,
3) Requiring all S Corporation (and LLC-S) owners of service-based businesses to pay self-employment taxes on the distribution portion of their income in addition to payroll taxes paid on the salary stream.
The ability to stream income has been probably the most powerful feature of the S Corporation. Without it, I’m not sure if the S Corporation will make as much sense for most service-based businesses.
The planning implications here are huge. Moving to a C Corporation won’t always be the answer. With a C Corporation you can stream income but the dividends (the profit stream from a C Corp) are taxed at capital gain tax rates. Those are currently 15%, but are likely to go up to 20% or more with the new administration. So, no tax savings there. And, if you have more than one business, multiple C Corporations will lead to control group issues, lower tax deductions, etc.
I really don’t like this, for all kinds of reasons. The biggest is the most obvious: the majority of S Corporations are owned by small business owners, who are going to get slammed if these things pass. The ability to save money on taxes is one of the things I’ve always thought of as an incentive for people to begin businesses, and grow them. Take those incentives away, and I’m not sure where business owners will go from there.
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Hi Megan, Thank you for this info - this is indeed a scary proposition. I’ve worked with several small business owners who benefit from having an S-corporation, and taking this away by increasing tax on the pass through distribution will decimate many small businesses.
We’ll also see a major impact on businesses owned by medical professionals, accountants, etc. who have made the S-corp election to steer clear of the professional services corporation tax rates of 35%+. Now if the distribution income is going to get hit with 15.3% SE tax on top of ordinary income tax rates, some professionals will be paying taxes on their S-corp income as high or higher than the PSC rates.
Megan - so this is just a subset of S corps that would get hit with the self employment tax, or does it look like all of them. You mentioned the personal service corporations in particular. Would small mom & pop retail stores, dance schools, etc. type businesses who elect S corp status be included?
Thanks for keeping us up to date on this!
It sure doesn’t seem to match the recent campaign promises to help the middle class.
Megan is on the road driving from Reno to San Diego today so I’ll jump in.
This is true for ALL S Corporations. The reason that she mentioned the PSC, I think, is because we’ve always been told to NOT do a C Corp for PSC because you end up with the higher tax rate unless you pull it all out in salary.
Well, if this comes true, the higher individual rate (estimated 39.6%) + 15.3% is lower than the PSC rate.
Don’t change anything today because of this. Just be aware that we all need to keep on our toes in the coming months ahead.
So if this happens then would a Single member LLC-sole propieror be a better option then an S? I am in the process of changing to LLC-S. Could you please give me your coments I am sure many others are wondering this too.
At this moment, the LLC-S is better. Even if this does pass, it will likely be 2010 before it’s effective. That means you can save a lot of tax between now and then. (Two full tax years)
Then, in 2010, you may find that you want to flunk the S election and go straight to a C Corp. (Rumours are that the Obama camp now understands the pressing international reason to cut the C Corporation tax. He’s talking about dropping it by 7% and raising individual by 5%)
I just re-read number 1. “1) Eliminating the 6% production deduction. This was a deduction enacted back in 2005 that allows product-manufacturing businesses to deduct qualified manufacturing costs in an amount up to 6% of their net income.”
Call me dense, but how does this promote “Made in America”?
In ObamaLand, if you own a business you are not middle class, you are rich by definition. So your taxes go up.
For a single person, services-type company I think you can make an argument for taxing the pass-through. It is all money you earned through your labor; dividing it up into money earned and “profits” that get taxed at a lower rate seems arbitrary and subject to abuse. Not that I agree with it…
_
Charlie
Hi Charlie,
It sure can be abused, and it certainly has been. That’s why the IRS takes a close look at S Corp returns to make sure the salary-to-profit ratio stays within reason - otherwise, everyone would want to take 90% profit and 10% payroll.
But if we live in a society which encourages entrepreneurship and self-reliance; and part of that encouragement consists of tax breaks for taking the risks associated with creating and operating a business, then it would seem counter-productive to remove the carrot and leave the risk.
—
Megan Hughes
www.businessfirstformations.com
Last week, my business had its best month ever.