The S-Corp payroll tax issue is back in play. According to the Associated Press and others, Senate Democrats are planning to raise taxes on S corporation shareholders by $6 billion to offset the cost of extending low interest rates for student loans. According the AP:

Democrats are considering trying to make it harder for owners of so-called S corporations to avoid paying Social Security and Medicare payroll taxes on some of their earnings, said a Senate Democratic aide speaking on condition of anonymity to reveal an emerging party strategy.

Though decisions have not been finalized, the proposal would affect such companies with earnings of at least $250,000 annually and would raise roughly $5 billion to $6 billion over the coming decade, the aide said. Democrats might use it to help pay for an upcoming effort being pushed by President Barack Obama to keep college students’ loan rates from doubling this summer, to finance another initiative or for deficit reduction.

This Democratic plan, which has been under discussion among congressional and Obama administration aides, would tighten the definition of S corporation income on which payroll taxes must be paid. The idea is likely to face strong Republican opposition in the Senate, but Democrats believe there would be political value in forcing GOP senators to vote on the measure, win or lose.

This issue was last debated two years ago in the Senate. S-CORP led the successful fight to defeat the previous effort, and we have serious concerns about this one, especially given the lack of transparency that accompanied today’s announcement. What exactly is the proposal this time? They haven’t released anything and nobody knows, but the National Journal description gives a little more detail:

The bill will require S Corporations with three or fewer shareholders who declare income of at least $250,000 a year to pay employment taxes, Harkin said. An S Corporation is a specially structured entity that pays taxes under rules that allow earnings or losses to be passed through shareholders, reducing federal tax payments.

Two years ago, a group of 27 business associations, including the National Federation of Independent Business and the Chamber of Commerce, joined together to defeat a similar provision. Back then, the group wrote Congress with the following concerns.

[The provision] would raise taxes by $11.2 billion on privately-held businesses located in every state of this country. While it has been described as a “loophole closer” and a “payroll tax” it is neither. It is a new tax on small employers that will overturn more than fifty years of established tax policy. We share the concerns of Congress that certain taxpayers are underpaying their payroll taxes, but we believe Section 413 is overly broad and will result in more increased tax collections than increased tax compliance.

This new tax would hurt job creation. It would be imposed regardless of whether the affected firms make distributions to the targeted shareholders and partners, or retain that income to reinvest in jobs and capital equipment. Shareholders and partners of flow-through businesses are taxed on their firm’s income even when that income is not actually distributed. As a result, this provision will reduce the capital these employers have to create jobs and invest in their businesses.

Finally, this new tax is an excellent example of what happens when the legislative process is short circuited. It was never the subject of hearings or public review, it was made public just a few short weeks ago, and it has been attached to legislation that already passed both the House and the Senate. It is an accident of the legislative calendar that we are in a position to offer our views at all.

These same concerns appear to apply to the new effort. We don’t know exactly what the new provision is, but we do know that it’s likely to be overly broad, to apply to business owners who are already fully complying to the spirit and the letter of the law, to increase uncertainty (as well as taxes) at a time when businesses are already facing a remarkable level of policy uncertainty, and to take taxes dedicated for the Medicare Trust Fund and spend them on unrelated programs. None of that is good.

As you can imagine, S-CORP will be working closely with our allies to review this provision closely. From what we’ve read, we expect to oppose it, and we expect to have lots of allies join us. More to follow.