I know one thing that is certain. Taxpayers hate paying self-employment tax. Hate it, hate it, hate it. Maybe it's because they know the tax goes towards financing Social Security - and they know better than to plan on retiring on Social Security. Now for some professional S corporations it appears that they will lose this wonderful tax advantage.
If you are in the following professions and if the principal assets is the reputation and skill (yet to be defined) of three or fewer workers, you are going to get hit starting in 2011.
• Accounting.
• Law.
• Health.
• Actuarial science.
• Engineering.
• Architecture.
• Lobbying.
• Consulting.
• Brokerage services.
• Investment management.
• Sports.
• Performing arts.
Currently, the tax is 15.3% of the first $106,800 in profits and 2.9% above that.
The change will end a popular tax saver for personal service S firms. Our strategy was to take a modest salary and receiving the rest of the profit as a dividend. The S corporation profits flow through to the owners’ individual income tax returns as dividends. Those dividends are exempt from self-employment tax, but they are hit with income tax.
We saw this coming. A few years ago, Treasury inspectors found massive tax avoidance in this area. More than 35,000 one-owner S companies with profits of $100,000 or more paid no payroll taxes on the profits because the owners didn’t take a salary. The same was true for owners of about 40,000 S firms with profits in the $50,000-$100,000 range. Because of this the tax writers decided to take action to end any possibility of gaming the system.
No exception will be allowed for amounts left in the firm for working capital, at least for small professional service S firms. Dividends passed through to owners of larger S service firms or of S corporations that aren’t in professional service fields will continue to be exempt from self-employment tax but the writing's on the wall. The iceberg is visible ahead. And we can't just sit around waiting for it to hit like the Titanic.
We'll obviously keep a sharp eye on this.
Larry Kopsa CPA
