Lawmakers Put S-Corporations in Their Sights

Congressional Democrats have proposed financing student-loan legislation by expanding payroll taxes on subchapter S corporations and partnerships. The bill would levy Social Security and Medicare taxes on all business income if the firm is engaged in professional services, such as investment advice, or if 75% or more of the gross income of the firm is attributable to three or fewer shareholders.

Investment News’ Mark Schoeff Jr. reports that in Washington parlance, the phrase “pay for” has become a noun, “payfor.”  This term trends during the legislative process, as lawmakers seek “payfors” to offset spending or tax cuts contained in bills. A payfor is necessary under paygo rules that don’t allow legislation to be financed through deficit spending. Writes Schoeff:

Investment advisers could feel the impact of one payfor popular with congressional Democrats. They have proposed financing student loan legislation by expanding payroll taxes on subchapter S corporations and partnerships.

Under the bill, Social Security and Medicare taxes would be levied on all business income if the firm is engaged in professional services, such as investment advice, or if 75% or more of the gross income of the firm is attributable to three or fewer shareholders. The provision is estimated to generate about $9 billion in federal revenue over 10 years. [pullquote]”The bill will be fully paid for by closing a tax loophole that some of the wealthiest Americans use to avoid taxes”[/pullquote]

Currently, S corporation shareholders are assessed payroll taxes only on wages paid to shareholders, not on the income that is distributed to them.

“The bill will be fully paid for by closing a tax loophole that some of the wealthiest Americans use to avoid taxes,” said a statement from House Democratic leaders.

Democrats emphasize that the tax would fall on a “subset” S corporations and would only apply to couples who earn more than $250,000 or individuals who earn more than $200,000.

Even though Senate Republicans filibustered the student loan bill, it’s likely that the S corporation tax will become a staple Democratic “payfor” for the rest of the year – not only on the student-loan bill but also on other legislation.

“Bad tax ideas don’t die, they just get recycled,” said Phillips Hinch, assistant director of government relations at the Financial Planning Association. “I don’t see this going away.”

Mr. Hinch said that about 50% of FPA’s 23,400 members work in firms that employ five or fewer people. About 4% of the approximately 3.4 million S corporations, based on 2003 tax returns, are in the finance and insurance sector.

Currently, S corporation shareholders are assessed payroll taxes only on wages paid to shareholders