As S-CORP members will recall, this year began with a Joint Committee on Taxation (JCT) proposal to impose a nearly 3 percent additional tax on the full distributable share of profits for S corporation shareholders. The proposed tax would raise an astonishing $57.4 billion over ten years by applying to shareholders of S corporations as well as to partnerships. Then in May, the Department of Treasury’s Inspector General for Tax Administration in testimony before the Senate Finance Committee (May 25, 2005) also endorsed the proposition that the net earnings of S corporations should be subject to payroll taxes. This was in the context of suggesting ways to close the payroll tax gap to reform Social Security .

S-CORP reacted to these proposals by launching the S Corporation Alliance – a group led by S-CORP which includes dozens of other trade associations and expert advisors. Among the Alliance’s members are the National Association of Manufacturers, the National Federation of Independent Business, the Associated General Contractors, and the Chamber of Commerce. One of the first priorities of the Alliance has been to encourage other trade associations to sign on to a letter to Senate Finance Chairman Chuck Grassley and Ranking Member Max Baucus strongly opposing S corporation tax increases. This is an open letter; if your companies are members of any trade associations not listed on the letter, we encourage you to ask them to sign on, or to provide us with contact information so that we can reach out to them directly.

S-CORP has also been active on Capitol Hill, leading Alliance meetings with tax advisors to members of the powerful Senate Finance Committee to apprise them of the dangers of S corporation tax hike proposals, and to make them aware of the broad interests lining up against such initiatives should they advance. These efforts will continue throughout the fall. The importance of these Congressional education and outreach meetings was underscored just weeks ago, when — seven months after the Joint Committee on Taxation (JCT)’s proposal to hit S corporations with a massive new tax — the New York Bar Association weighed in supporting key elements of the JCT proposal. In a letter dated September 23rd (attached), the Chair of the NY Bar tells Congress’ tax analysts at the JCT that the organization supports broadening the application of payroll taxes to S corporation owners who ”materially participate” in the operations of the business. In S-CORP’s view, giving credibility or support to any elements of the JCT proposal is a dangerous step for the S corporation community.

That said, we should note that the NY Bar letter does point out that a proposal such as the JCT’s, which would simply raise payroll taxes on all S corporation shareholders, fails to distinguish between income derived from labor and income derived from capital, S-CORP remains concerned . As the letter states,  “(W)e believe that the JCT Proposal goes too far in the direction of extending self-employment taxes to income from capital, as opposed to income from labor, thereby widening the gap in treatment between otherwise similarly-situated employees and self- employed persons.”

Tax Legislation Update

Because any tax measure in Congress could contain revenue “offsets” such as the one proposed by JCT, S-CORP staff is actively monitoring all tax bills coming out of the congressional tax-writing committees. Right now, the focus of the tax -writing committees is on legislation to aid the victims of Hurricane Katrina and encourage job creation and economic incentives for the disaster area. A bill to “reconcile” the Congressional budget, which is slated to cut taxes by $70 billion over 5 years, was also scheduled to have been considered by September, but the measure has been pushed back, at least until the end of October and perhaps longer. The House Republican Leadership, which has gone through some significant changes themselves in the wake of Congressman Tom DeLay’s recent indictments, has announced that they still intend to move ahead with a process to reconcile the federal budget, but the timing on this effort is unclear. Senate Finance Committee Chairman Chuck Grassley (R-IA) shed some light on the challenges this measure faces when he said, at a recent Finance Committee hearing, that disagreements over a bill to provide health care to Katrina victims could endanger the “chances of our getting the reconciliation bill out of my committee if we don’t get this behind us.”

Additionally, both the House and the Senate still plan to consider and pass major pension reform bills this Fall, and tax measures are likely to be part of such a package too.

IRS Audit Update

Many S corporations were surprised this summer when the IRS announced it plans to audit some 5,000 S corporations to ensure compliance with federal tax laws. On September 20th, several weeks after this announcement was made, the IRS held an informational meeting to explain the progress of their National Research Program. In a panel called “Reporting Compliance Studies of Small Business,” there was considerable discussion of the IRS’ rationale for focusing the next round of audits exclusively on S corporations. As a document circulated by the IRS called “Why Study Subchapter S Returns” explained, the IRS views that such an audit is appropriate because:

  1. The last S Corp compliance study occurred in 1984;
  2. Since that time, the S Corp population has grown rapidly (S corps made up 59 percent of all corporate returns in 2002); and
  3. IRS plans to use the results of the audit study to “more accurately gauge the extent to which the income, deductions, and credits are properly reported” on S Corp returns.

IRS representatives indicated that audits will begin this month and continue for about three years.

The S corporation national audit is actually the second of five rounds of audits planned under the NRP. The first round focused on high income individuals, with an emphasis on those who file as sole proprietorships and farms. The third round, tentatively scheduled for 2008, targets C corporations, the fourth (2009) partnerships, and a final audit will focus on individuals filing under 1040 (2010). While S-CORP fully supports better IRS enforcement of the tax code, the multi-year timeframe of the NRP, coupled with its initial focus on high income individuals, sole proprietorships and S Corps, has created the impression that small and family owned businesses are the sole cause of the so-call “tax gap.” This impression, in turn, lends credibility to patently unfair tax proposals such as the JCT proposal to increase payroll taxes on S Corps and partnerships. The S Corp Alliance, together with our friends on Capitol Hill, will continue to monitor this issue. And again, this is why S-CORP has ratcheted up its advocacy and education efforts in Washington, working actively to help policymakers understand the very serious adverse consequences to all S corporations of these and potentially other S corporation tax hike proposals.