According to Accounting Today newsletter, the Democrats have resurrected their plan to tax the profits of an S Corporation as payroll. They proposed this a couple of years back, claiming that “millionaires” were using the loophole to avoid payroll taxes. While that is probably true, according to IRS statistics for 2003 (the most recent year available), 3.3 million S Corporation returns are filed. The average S Corporation grosses $1.2 million in receipts and has a profit of $52,000 — about the median family income for the country. IRS itself has encouraged small sole proprietorships to incorporate to save on taxes, and many small businesses (earning less than $50,000) have taken advantage of the S Corporation structure.
The advantage of the S Corporation is that profits are taxed as ordinary income to the taxpayer, with no corporate-level income tax. S Corp owners are required to pay themselves a salary, on which payroll taxes are deducted. But any profit from the corporation is not subject to either corporate taxes or payroll taxes. This was implemented to encourage small businesses, and it has been wildly successful. The Dems want to change that.
Few dispute the principle that a business owner is entitled to a salary, and also a return on his or her investment in the business based on profits generated. The Dems argue that some S Corp owners are taking too small a salary, thereby avoiding payroll taxes on more “profit” than they are entitled to. There’s no doubt that this happens. The primary reason is that IRS has refused to define what a “reasonable” salary is for an S Corp owner. Obviously, in the absence of an IRS standard, S Corp owners will tend to reduce their salary to reduce their tax burden. IRS could fix that problem with the stroke of a pen. They have refused to do so.
In a brilliant marketing move, the Dems are now referring to this as the “Newt Gingrich/John Edwards” loophole. But eliminating this so-called “loophole” will actually penalize millions of small businesses across the country, many of whom are barely scraping by as it is.