So the Senate just adopted a stand-alone, six month Doc Fix. Adoption of this provision sends a couple signals for the broader extender package.

This action follows on last night’s failed 56-40 cloture vote on Baucus II. While this vote represented a significant improvement over the 45 votes in support of Baucus I, it still signaled to the Senate (and House for that matter) that the extenders plus package was not going to be completed this week. Hence the need for the stand-alone Doc Fix. Moreover, the adoption of this very large — and ultimately offset — spending item suggests that other non-tax parts of the extender plus package could get peeled off as well, calling into question the viability of the underlying tax parts.

As long as the majority insists on offsetting temporary extensions of current law with permanent, new tax hikes, this is going to be a problem and ultimately result in a much more burdensome tax code. Has anybody done a Net Present Value analysis of the relative values of the extenders and the tax hikes that offset them? Only in DC budget parlance are they at all equal.

Which brings us to the S corporation payroll tax hike envisioned by the Finance Committee. As we’ve mentioned, Baucus II is better than Baucus I, but it still fails the very basic test of being better targeted, less complicated and easier to enforce than current law.

Talks continue between the Finance Committee staff and those Senators concerned about raising taxes on small businesses in the middle of a recession — including S-Corp champions Snowe and Enzi. The trick is how to get at the tax avoiders without punishing compliant S corporations, because every dollar this provision takes from taxpayers already complying with the law is one less dollar they have to invest in their employees and businesses.

This debate will now spill into next week. We hope it gets resolved soon, because it’s almost time to take up the extension of the very tax provisions under consideration — they expire in six short months, after all.

Single Class of Stock and Payroll Tax Avoidance

Part of the frustration experienced by the S corporation community on the payroll tax issue is the lack of understanding of how S corporation rules effectively block payroll tax avoidance in multiple shareholder firms. It is extremely difficult if not impossible to effectively avoid payroll taxes year after year in an S corporation where no one shareholder controls the firm. Consider the following example:

A fictional John Edwards and his brother lawyer are both partners in a larger law practice. They agree to form an S corporation where each has a 50 percent share in the business and designate the S corporation as the partner in the law firm. John and his brother agree to pay themselves a nominal wage and take the rest as income on their K-1.

In year one, both John and his brother earn $1 million in legal fees. As the partner in the law firm, this money is paid to the S corporation. As agreed, they both pay themselves $200,000 in wages and take the rest as a distribution from the S corporation. By doing this, they successfully avoid HI payroll taxes on $1.6 million, or $46,400. [Editors Note: Here the IRS steps in, audits the brothers, applies a reasonable compensation test, and dings both of them for unpaid taxes and penalties.]

In year two, John wins a big case and has fees of $5 million, while his brother has legal fees of $1 million. Under their agreement, they would pay themselves $200,000 each and then distribute the rest as S corporation income. But S corporations can only have one class of stock, so any S corporation income would have to be divided up according to their ownership interest, or 50/50. This means John will have to share his $5 million legal fee with his brother. Both brothers would get $2.8 million in S corporation income, or total compensation of $3 million each, and avoid paying $81,200 in HI payroll taxes each.

So John Edwards’ clever scheme to avoid paying $81,200 in HI payroll taxes costs him $2 million in income.

Obviously, a real person would never enter into such an arrangement. And while the brothers could adjust their wages to get around the single class of stock limitation, those wages would be subject to payroll taxes and defeat the purpose of creating the S corporation in the first place.

This is an extreme example, but it makes clear the challenge of attempting to avoid payroll taxes in an S corporation with no one controlling shareholder. The HI tax is 2.9 percent, after all, so any effort by taxpayers to avoid this tax is going to be tempered by the cost of doing so. The simple rule is that, unless the earnings potential of all the active shareholders in the S corporation are remarkably stable over a number of years, it is next to impossible to structure an ownership agreement that can last.