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Thursday, July 29, 2010 S Corporations in the Cross Hairs
According to my accountant, rumors in the accounting community are flying lately that the IRS has eliminated the ability for professionals who operate their business as an S Corporation to receive distributions from their companies in lieu of a wage or salary.
On May 28th, 2010, The House passed The American Jobs and Closing Tax Loopholes Act of 2010 which contains a provision that proposes to raise over $11 billion by tacking on payroll taxes to certain service professionals who currently split income as wages and draws.
And by certain service professionals, Congress specifically means those in "health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services." If this change becomes law, it can add a 15.3% surcharge to the distribution portion of the income that S Corporation owners pay themselves. The Senate has taken this issue up in its June session.
S Corporations are entities where the net income from the corporation passes to the shareholders and gets taxed at the shareholders marginal rate of taxation. S Corporation
owners typically receive income from their businesses in two forms:
1) A salary or wage and 2) A distribution.
The salary/wage income component is subject to Social Security, Medicare and unemployment taxes. The distribution component, however, is not subject to these payroll taxes, which in many cases allows the business owner to avoid 15 percent or more in payroll taxes. Here lies the problem.
So what should professionals do today who are potentially affected by this change? We will see what happens with the legislation, but if you fall into this category, you must take immediate steps to get in compliance with the existing laws relative to the compensation you receive from your businesses. The IRS requires S Corporation owners to pay themselves a "reasonable salary" from their business. Unfortunately, there is no clear standard from the IRS that the business owner can rely upon to make this determination.
This is where a consultation with your accountant may be in order. Because here is the thing: Professionals with S Corporations that pay themselves a nominal salary are going to get selected for audit.
Due to the increased emphasis on employment tax issues by the Service, businesses must take the following immediate steps to ensure their compensation formulas are in compliance:
1. Document the compensation plan in your corporate records. S Corporations should hold a board meeting at the beginning of the year with resolutions prepared that approve the compensation plan for the officers.
2. Professionals should pay themselves a reasonable salary on the same cycle that their employees are paid on. No more grossing up the salary at year end.
3. Professionals can have a compensation study performed that identifies what other similar professionals are being paid with consideration given to each of the following factors:
a. National and local economic conditions.
b. Size of the practice.
c. Geographical factors.
d. Amount of time the professional devotes to the practice.
e. Experience level of the professional.
f. Whether the professional acts in a managing capacity or actually performs the work.
The bottom line is that across all levels of government we are in an environment of increased regulation and enforcement. For the professional that means higher income taxes, increased chances of audit and higher levels of scrutiny in all areas of business.
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Hegwood & Associates assist clients with Estate Planning, Wills, Trusts, Pet Trusts, Special Needs Planning, Asset Protection, Elder Law, Veterans Benefits and Probate/Estate Administration in Houston, Texas as well as Webster, League City, Seabrook, Kemah, Pasadena, Friendswood, Dickinson, Bacliff, La Porte and Deer Park in Harris County and Galveston County.
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