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Orange County tax attorneys are watching new legislation that has passed the House and is pending in the Senate. Under the proposed law, small service firms classified as S corporations might see a big increase in payroll taxes.

HR 4213 is titled The American Jobs and Closing Tax Loopholes Act. It would impose payroll taxes (Social Security and Medicare) on S corporation income to shareholder-employees. The income is not subject to payroll tax now.

The bill would impose payroll taxes on income from S corporations where three or fewer professional shareholder-employees produce most of the corporation’s business. The bill names twelve service fields to which it would apply, including accounting, health, law and management. The bill would hope to raise $11 billion in the next ten years, beginning in 2011.

Internal Revenue Service audits of S corporations were… 

examined for income-reporting traits over a two-year period. The Government Accountability Office issued a report in 2009 based on the examination of the audits. The report concluded that professionals in S corporations underpaid their wages by about $20,000 per year. This meant they also underpaid payroll taxes. The report led to the current proposed legislation.

The owners of S corporations are almost always employees of the business entity. The S corporations generally pay no federal or state income tax at the corporate level on their net income. Instead, net income is taxed directly to the shareholders for federal and state income tax purposes. The corporate net income is not subject to payroll taxes, although it is subject to federal and state income taxes and generated through professional services.

There are no federal guidelines on how much S corporation net income should be paid as wages. Shareholder-employees of closely-held S corporations can avoid payroll taxes simply by taking minimal wages.

There are differences between the House and Senate versions, but if either becomes law, payroll taxes will increase for S corporations.

  • Source: Daily Business Review “Payroll tax increase imminent, no matter which version passes” July 26, 2010