S Corporation Payroll Tax Changes affect Florida Small Businesses

S Corporation payroll tax changes to affect Florida Businesses

by Jim Davis on August 18, 2010
Certain South Florida professionals providing professional services in small (closely held) S Corporations will see a significant increase in payroll taxes from recently proposed federal tax legislation.  H.R. Bill 4312 (The American Jobs and Closing Tax Loopholes Act) has passed the House of Representatives and is currently being debated in the Senate.  This newly proposed legislation would impose payroll taxes (Social Security and Medicare taxes) on S Corporation income taxable to the shareholder-employees of S Corporations.  Such income is presently not subject to payroll taxation.

Beginning in 2011, the Act would impose payroll taxes on income from S corporations, in general, where three or fewer professional shareholder-employees produce most of the S corporation’s business.  It applies to those S corporations whose business is in any one of 12 service fields such as law, accounting, health, management, etc.
Perhaps the genesis of the proposal stems from a 2009 Government Accounting Office report which was based on a national average.  The report concluded that professionals who were practicing in S corporations owned by three or fewer shareholders underpaid their wages by approximately $20,000 per year.  This resulted in an underpayment of payroll taxes that likely led to the currently proposed Act.

The impact of the new taxes could be significant in South Florida.  It has been estimated that 90% of all jobs in the United States are in some type of service industry, but South Florida has a higher percentage of service occupations than most of the country.  It has been reported that business professionals constitute perhaps 14% of the South Florida workforce and healthcare/educational services almost 13%.
To understand how the consequences of this proposed legislation will affect certain professionals, it is important to understand how they provide their services to the public.  Small professional service providers have the ability to choose the type of entity, such as a corporation, partnership or limited liability company, through which they will render services.  Each entity has different tax consequences to the owners.

Owners of S Corporations (shareholders) are almost always also employees of that entity (shareholder-employees).  They can elect that their corporation be taxed as “S Corporation” for purposes of federal and state income taxation.  An S Corporation generally pays no federal or state income tax at the corporate level on S Corporation net income which is after expenses and wages.  Rather, its net income is taxed directly to the shareholders for federal and state income tax purposes.  This “S Corporation net income” is not subject to payroll taxes even though it is subject to federal and state income taxes and even though it is generated through professional services.
Shareholder-employees of small S Corporations will typically pay out some of its net income to themselves as wages which are subject to payroll taxes.  But there are no federal guidelines as to how much of the S Corporation net income must be paid out as wages.  Therein lies the opportunity for abuse:  Some S Corporations pay only a modest amount of the S Corporation income as wages.  The remainder is treated as S Corporation net income and is not subject to payroll taxation.

If a corporation does not elect S Corporation status, it is taxed as a “C Corporation.”  Unlike an S Corporation, a C Corporation pays federal income tax on net income at the corporate level.  If the C Corporation net income is subsequently distributed to its shareholders as dividends, the shareholders are then subject to an undesirable and secondary income tax on the dividend distribution.  Consequently, a C Corporation will pay its shareholder-employees most if not all of its net income as wages in order to pay only one level of income taxes.  Since wages are subject to payroll taxes, virtually all of the earnings of professionals who are shareholder-employees of a C Corporation will be subject to payroll taxation.  This is an important distinction from an S corporation.
Service professionals may also choose to operate as a partnership or as a limited liability company instead of a corporation.  Both are typically treated for federal and state income tax purposes as a partnership.  Similar to an S Corporation, a partnership does not pay federal income taxes at the entity level and its net income is taxed directly to its partners.  However, unlike shareholders of an S Corporation, partners are required to pay payroll taxes on all of their partnership income on Schedule SE which is filed with their Individual Income Tax Return, Form 1040.

A shareholder-employee of a closely owned S Corporation can thus avoid the imposition of payroll taxes on a substantial portion of income generated from professional services of its owners merely by operating as an S Corporation and taking minimal wages.
The House version of the Act would impose payroll taxes on an S Corporation where the “skill and reputation” of three or fewer employees constitute the “principal” business of the S Corporation.  The present Senate amendment would impose the payroll taxes where 80% or more of the revenue of the S Corporation is generated by three or fewer shareholders.  The House version is qualitative whereas the Senate amendment is more quantitative.  It’s unclear which version if any will ultimately be enacted.  However, if either one is passed, it is clear that some professionals in South Florida who operate within the 12 targeted professions and in small, closely held S Corporations will see a significant increase in payroll taxes.

(As featured in the Daily Business Review, Monday, July 26, 2010)

Attorney Referral Service has Corporate and Business lawyers to help you plan for these new laws.