S-Corporations are corporations electing to be taxed under Subchapter S of the IRS Code. Companies seek this designation to avoid paying federal income taxes as a corporate entity. Instead, the company’s profit and/or losses are divided and pass through to shareholders who then report them on their own individual tax returns.
Unfortunately, there are an increasing number of companies and business owners who are abusing this special tax designation for their own unfair advantage (almost 70% of companies claim S-Corporation status according to the IRS). Some of these companies are simply regular corporations and LLCs checking the box for standard corporate taxation, then electing S-Corporation Status.
While the government has been cracking down on abuses, limiting the amount of passive income that can be received and tightening the rules for ownership by an ESOP, they haven’t been successful in recouping the lost revenue from S-Corp employment taxes. Through this loophole, S-Corporation owners have continued to award themselves low wages to avoid FICA and Medicare taxes, instead passing that money through to themselves.
Recently, the Ways and Means Committee in Congress has been investigating this loophole and is considering ways to rectify the situation. The primary solution at this point is to subject all S-Corporation profit distributions to the self employment tax.
Considering the tax increases on the top income earners resulting from the American Taxpayer Relief Act and Patient Protection & Affordable Care Act (top C-Corp taxes are in the 35% bracket while the top individual tax are 39.6% plus 3.8% for the Medicare Surtax), the abuse of S-Corporations may actually correct itself as more businesses and owners return to and elect C-Corporations. Ultimately, the decision will be based on whether or not the savings or deferral of personal income taxes is enough to offset the taxes at the corporate level.
Regardless of the solutions set forth or eventually adopted, corporations will continue to seek out the most beneficial tax structure to minimize both personal and corporate liability, and the struggle between tax collection and tax maneuvering will live on.
At Lescault and Walderman, we help companies with entity selection in both the start-up and restructuring phases, but take a longer-term outlook that doesn’t flip-flop based on legislative loopholes. If you’d like more information on our services or are seeking advice and assistance on the best structure for your company, contact us at 866-496-2042.
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