Lots of activity on tax policy with implications for S corporations this week.

On Monday, the White House held a forum on the expiring tax relief and its potential to hurt the economy if it is not extended. In preparation for the forum, Treasury issued a collection of issue summaries that focus on the importance of keeping tax rates low, including the top two individual tax rates most in danger of going up in the next Congress.

As friends of S-Corp know, the debate over the top two rates has focused on their application to businesses like S corporations and partnerships. Advocates for the lower rates like President Bush argue that keeping these rates low helps small businesses grow and create jobs.

Opponents argue that most taxpayers in those brackets are inaccurately depicted as small business owners when in reality business income makes up little or no portion of their total income. For example, a recent witness at the Finance Committee argued:

“In the top two tax brackets, seventy-eight percent of tax units report some form of business income. However, many of those people are not ‘small business’ people in the sense as you would normally think. Only 1.4 percent of tax units with some form of business income are in the top two brackets.”

Page six of the Treasury report provides a little clarity on this issue with a breakdown of taxpayers in the top two brackets and where they get their income. Perhaps the best statistic is:

  • Nearly 540,000 of the 1.4 million tax returns that benefit from lowering the top two tax brackets are flow-through business owners who receive more than 30 percent of their income from flow-though businesses.

In other words, more than one-third of the taxpayers paying the top two rates have significant business income. Here at S-Corp, we would point out that 540,000 small business owners probably understates the impact on small businesses since S corporation shareholders and LLC members who participate in their businesses often derive a salary from their business as well. While that income shows up as wages rather than profits, it comes from the business nonetheless.

Finance Looks at Flow-Throughs:

Today, the Finance Committee held a hearing entitled, “C, K, or S:B Exploring the Alphabet Soup of Small Business Choices in Advance of Tax Reform.” As the title suggests, the hearing focused on the various options investors have when forming a business. Perhaps the best thing to come from the hearing is a really comprehensive report from the Joint Committee on Taxation summarizing the state of business in America and the major trends in business types over the past three decades.

The report makes clear that S corporations are an increasingly critical part of the business community. In the past thirty years, the number of S corporations has grown from less than half a million to more than four million, eight hundred percent growth! Our contribution to the income and employment base of the country has risen by a similar amount.

Another section in the report (Table 10) outlines the distinctions between S corporation rules and those that apply to LLCs and partnerships. As S-Corp readers know, much of our work here at S-Corp is dedicated to improving the rules that govern S corporations and level the playing field between S corporations and LLCs.

Unlike S Corporations, LLCs have no limitations on the number or type of shareholders and have more flexible ownership rules. Bills introduced by S-Corp champions Senator Lincoln and Representative Kind (S. 3063 and H.R. 4840) move the S corporation rules in the right direction and we are working hard to get them enacted.

S-Corp Board Meeting

Finally, the S Corporation Board met this week here in Washington, DC. Flying in from all over the country, the Board met with officials from the Administration, Treasury, and Capitol Hill. Continuously visiting policy-makers in Congress and the Administration is the only way we can ensure that the special challenges facing S Corporations are understood and the Board did a great job of advocating on your behalf.

One immediate result of our meetings was the addition of Senator Olympia Snowe as a cosponsor of Senator Lincoln’s “S Corporation Modernization Act” (S. 3063). Senator Snowe is the Ranking Member of the Small Business Committee as well as a senior member of the Senate Finance Committee. She has a long history of advocating on small business issues and we are extremely grateful for her support.

S Corporation Payroll Tax 

A recurring theme in today’s Finance hearing was the disparate treatment of payroll taxes for S corporations and partnerships. The JCT report notes:

“Choice of entity also can affect the taxpayer’s flexibility to designate income as subject (or not subject) to payroll taxes. The evolution of present law with respect to limited liability companies, and the failure of the Code to clarify the payroll tax consequences for different contractual relationships made possible by these new forms, have created areas of significant uncertainty and potential planning opportunities with respect to payroll taxes. The situation is exacerbated by the fact that S corporations are subject to a different regime for determining labor income subject to payroll taxes than are partnerships, creating another potential planning option.”

Hearing witnesses also addressed this issue. When asked about changes they would recommend to simplify the tax code, three of four witnesses mentioned the differing treatment of payroll taxes between S corporations, partnerships, and LLCs.

The S Corporation Association has a long history of advocacy on this issue. Our core principle is to ensure that any changes enacted do not impose payroll taxes on S corporation income derived from capital investments. Payroll taxes should apply to wage income only — not returns on capital.

However, as last year’s bill introduced by Chairman Rangel revealed, maintaining that distinction is going to be a challenge. We expect this issue will be considered next Congress as a part of a broader tax reform effort and intend to continue to work with our friends in other associations and on the Hill to make sure Congress get this policy right.