When Congress created the S corporation in 1958, the IRS ruled that only S corporation shareholders who are active in their business should be subject to payroll taxes, and then only on amounts received for their labor.

Fast forward fifty years. While the payroll tax has grown dramatically, the application of payroll taxes has always applied to labor income only – not capital income.

Last week, all this changed. House Ways and Means Committee Chairman Charlie Rangel [D-NY] introduced legislation that turns 50 years of tax policy on its head.

The bill, the Tax Reduction and Reform Act of 2007, would lower the corporate tax rate and eliminate the individual AMT. However, one of the many revenue increases included, is a provision that would raise $9.5 billion over ten years by expanding the application of payroll taxes on S corporation shareholders who also work at the business.

This tax increase would be limited to those businesses primarily engaged in service businesses, and only on the income related to that service business. Nonetheless, it represents a payroll tax increase on taxpayers that are already fully complying with the law – setting the stage for future efforts to apply payroll taxes to all S corporations, including manufacturers and farmers.

S-Corp members appreciate the concern that certain taxpayers are paying less than their fair share of payroll taxes. The IRS already has the tools, however, necessary to identify these taxpayers and require them to pay the correct level of tax. And while applying these tools may be time intensive and costly, the alternative is to raise payroll taxes on small and family-owned businesses that are fully complying with the law and paying all the taxes they owe.

Even when limited to service sector businesses, this proposal violates decades of established tax policy and imposes a new tax on a significant portion of America’s small and family-owned business community.