Congress is hard at work extending a set of popular tax breaks. Those for individuals include tuition credits, sales tax credits, and real estate tax credits. For corporations, there are credits for the construction of housing developments, and a multitude of credits to encourage large corporations to hire new employees.
To help pay for this, the reconciliation bill making its way through Congress added little-noticed Sec. 413, in which Congress proposes additional taxes on Subchapter S corporations. Specifically, they propose that under certain conditions, 100% of S Corp income will be subject to FICA (aka Social Security) tax. Peter Blank at the non-partisan Kiplinger Tax Letter, which follows tax issues in Washington, told me the bill is “almost certain” to pass.
This may sound like obscure tax speak, but it affects a lot of small businesses. Some 62% of American corporations are S Corps. The S Corp gets special treatment because it is required to be small, and most S Corps have fewer than four employees and an average of 1.8 shareholders. Because it’s for small businesses only, an S Corp avoids the double taxation of a large corporation– the S Corp owner includes the corporation’s income as his own, and pays income tax on it.
The S Corp owner currently pays FICA tax on his/her salary, which is required to be equivalent to what the owner would have to pay someone else to do that job. Any additional income is subject to income tax, but not FICA (social security) tax. That’s because someone who takes the risk to start a business is presumably entitled to a return on his/her investment— the equivalent of a corporate dividend for a C Corp.
The proposed law would change that. For service businesses in certain fields, having three or fewer employees doing the primary work (and that’s most S Corps), all S Corp income would be subject to FICA tax, not just the salary.
In the past, FICA tax hasn’t applied to unearned income, which includes interest income, rents, dividends, royalties, stuff you sold during the year, etc. The health care bill opened the door to changing that, levying Medicare tax on the income of high-earning individuals. The changes proposed in HR 4213, however, would target low-earning individuals as well.
The rationale supporters use is that lawyers and doctors are abusing S Corps to avoid self-employment taxes, paying themselves a minimal salary and taking the vast majority as dividend. And surely there is some abuse like that.
But in this bill, Congress has defined professional services in such a way that it would include bookkeepers, athletic trainers, yoga studios, paralegals, struggling actors, acupuncturists, and a wide range of other occupations that lie within the “professional fields” specified. Then they’ve included the vague term “consulting.” Does that include freelance computer programmers? Gardeners? Health food nutritionists? Psychics? The IRS will make the final determination, but it will likely favor collecting more tax from more people.
Let’s take some real-life examples: a bookkeeper who made $20,000 last year through his S Corp. A man starting a business as an athletic trainer in a small town. A self-employed computer consultant whose specialty is such that he makes a living, but just barely. These are people who have taken (or who plan to take) the risk to become self-employed, who have used the S Corporation rules to ease the tax burden of being self-employed— that 15.3% surprise at the end of the year, no matter how little you earned. And Congress plans to raise their taxes.
There’s a bigger picture: so far this year, Congress has already passed one bill and will likely pass this one too, both of which expand FICA tax to non-wage income. With HR 4213, it’s no longer confined to just the rich. They’ve opened a door that will not easily be closed– we can expect more taxes on small businesses to pay for goodies for large corporations. And in this economy, there’s no room for entrepreneurs to raise prices.
Should the Fed take $3,000 in tax from a struggling small business that supports a family on $20,000, while giving more tax breaks to big corporations? If you don’t think so, ask your Senators and Representatives to change HR 4213. But I predict they won’t listen.