The Potential Employment Tax Increase for Shareholders of S Corporations

Association of Convenience and Petroleum Retailing (NACS) and National Systems Contractors Association (NSCA)
Aaron P. Nocjar
June 2010

For the better part of 2010, Congress has been wrestling with a potential employment tax increase (of approximately 15 percentage points) on earnings from certain businesses operating in S corporation form – the most common form of business organization used today.  Earlier in the year, the House passed a bill containing such an employment tax increase in “The American Jobs and Closing Tax Loopholes Act of 2010” (H.R. 4213).  Since then, the proposed employment tax increase has faced a rocky reception in the Senate, partly due to an avalanche of organized opposition.  This article will describe the most recent version of such employment tax increase, which would be effective for taxable years beginning in 2011.

A business conducted in S corporation form generally does not pay an entity-level tax.  Rather, the shareholders of the S corporation generally take into account (and pay individual income tax on) their pro rata share of the S corporation’s income, regardless whether such income is distributed to the shareholders or retained for reinvestment in the business.  This individual income tax treatment is separate and apart from employment taxes.

While a shareholder pays income tax on its annual pro rata share of S corporation income, such shareholder does not pay employment taxes on such income, even if that income represents income generated via the provision of services by such shareholder on behalf of the S corporation.  However, a shareholder does pay employment taxes on salary payments made by the S corporation to the shareholder.  So, in an effort to reduce employment taxes, a controlling shareholder-employee might cause the S corporation to provide a modest (but still reasonable) salary to such shareholder while leaving the majority of the S corporation’s income to be distributed to such shareholder or retained for reinvestment purposes, both free from employment tax.

The employment tax provisions in H.R. 4213 would restrict the type of taxpayers that could continue to use this employment tax mitigation strategy.  Section 413 of H.R. 4213 provides:  “In the case of any disqualified S corporation, each shareholder of such disqualified S corporation who provides substantial services with respect to [certain]  professional service business[es] shall take into account such shareholder’s pro rata share [of S corporation income] attributable to such business in determining the shareholder’s [employment taxes].”  In addition, the shareholder’s pro rata share of S corporation income that should be included in determining its employment taxes “shall be increased by the pro rata share of [S corporation income attributable to such business] of each member of such shareholder’s family…who does not provide substantial services with respect to such professional service business.” 

Like any tax provision, the real magic is in the definition of the terms used within the operative provisions described above. 

First, what is a “disqualified S corporation”?  A “disqualified S corporation” is (i) “any S corporation which is a partner in a partnership which is engaged in a professional service business if substantially all of the activities of such S corporation are performed in connection with such partnership” or (ii) “any other S corporation which is engaged in a professional service business if 80 percent or more of the gross income of such business is attributable to service of 3 or fewer shareholders of such corporation.”  So, if an S corporation does not fall within this definition, it and its shareholders would not be subject to the proposed employment tax increase.

Second, how does an S corporation determine whether “80 percent or more of the gross income of [an S corporation’s professional service business] is attributable to service of 3 or fewer shareholders of such corporation”?  What does it mean for gross income to be “attributable to” service of any shareholder?  What if an employee-shareholder and an employee-non-shareholder work to generate gross income for the S corporation?  Does all (or any portion) of such income get allocated to the employee-shareholder for this standard?  What if the S corporation conducts more than one business, where one business is a professional service business and the other one is not?  How is the S corporation supposed to allocate gross income between the two for purposes of this standard?  What if a shareholder provides services on behalf of multiple businesses conducted by the S corporation?  How would the S corporation track the services provided by such shareholder on behalf of each business?  Could an S corporation simply add a fourth shareholder-employee with a small pro rata share of S corporation income to avoid meeting this standard?

Third, what does it mean for an S corporation which is a partner in a partnership that is engaged in a professional service business to have “substantially all” of its activities “performed in connection with such partnership”?  What if the S corporation holds interests in multiple partnerships?  How is “substantially all” of the S corporation’s “activities” measured?  Is the amount of time the S corporation spends on the partnership business in relation to all other businesses the controlling factor?

Fourth, what is a “professional service business”?  A “professional service business” is “any trade or business (or portion thereof) providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.”  So, if an S corporation (or a partnership in which the S corporation is a partner) does not engage in any of the listed businesses, such S corporation and its shareholders would not be subject to the proposed employment tax increase.

Most “product” (as opposed to “service”) businesses might take some comfort in this definition.  However, what does it mean to have a trade or business of providing services in the fields of “investment advice or management”?  If an S corporation merely acts as a holding company for several “product” businesses conducted in wholly-owned subsidiaries, could the S corporation be viewed as providing investment advice or investment management services with respect to its interests in the subsidiary “product” businesses?  If so, the income from such subsidiary “product” businesses could become subject to employment taxes in the hands of the shareholders of the S corporation holding company under this proposal.         

Fifth, what does it mean for a shareholder to provide “substantial services” with respect to a professional service business?  Note that, even if (i) an S corporation (or a partnership in which the S corporation is a partner) engages in a “professional service business” and (ii) the S corporation is a “disqualified S corporation,” a shareholder of such S corporation would be subject to this increased employment tax proposal only if it provides “substantial services” with respect to such business.  The proposal and its background materials do not define “substantial services.”  Is this standard to be measured based on relative hours worked during the year in a particular business?  Are special types of services to control whether such standard is met?  How is an S corporation (or its shareholders) supposed to track the services provided “with respect to” a particular business when the S corporation engages in multiple businesses, some of which do not constitute professional service businesses?

Sixth, a shareholder who is treated as providing “substantial services” also will have the pro rata share of any family-member-shareholder attributed to it to the extent such family-member-shareholder “does not provide substantial services.”  So, the same measurement issues surrounding “substantial services,” described above, would apply to all family-member-shareholders as well.  For family-run S corporations, this rule effectively means that either 100 percent or 0 percent of S corporation income would be subject to the employment tax increase – no middle ground would exist.  Further, if two family-member-shareholders provided “substantial services” but three other family-member-shareholders did not, how would the S corporation allocate the S corporation income attributable to the three other family-member-shareholders to the two family-member-shareholders that provide “substantial services” for purposes of the employment tax proposal?  Answering some of these questions could sow seeds of discontent within an established, family-run S corporation.   

What can one make of all of this? 

1.  Passive shareholders of an S corporation should avoid this proposed employment tax increase, regardless of the business conducted by the S corporation.  However, such shareholders still would need to substantiate that they, in fact, do not provide “substantial services.”

2.  Shareholders of an S corporation engaging in only “product” businesses should avoid this proposed employment tax increase.  Nevertheless, if such an S corporation is structured as a holding company, the definition of “professional service business” as including “investment advice or management” could subject the shareholders of “product” businesses to such employment tax increase. 

3.  Shareholders of an S corporation engaging in professional service businesses or in multiple businesses at least one of which is a professional service business could be subject to this proposed employment tax increase.  The issues here would be (i) whether “80 percent or more of the gross income of such [professional service business] is attributable to service of 3 or fewer shareholders” and (ii) whether any particular shareholder provided “substantial services” with respect to such professional service business?
 
4.  If an S corporation were uncertain whether any business it conducted constituted a professional service business, it would need to track shareholder services provided on behalf of such S corporation in order to determine whether any 3 or fewer shareholders generated 80 percent or more of gross income from any business conducted by such S corporation.

5.  Such an increase in employment taxes might alter the economics of the deal struck between shareholders.  It seems that this issue could arise, for example, between two shareholders who joined together to conduct a professional service business, where one shareholder was to serve primarily as the service-providing shareholder and the other shareholder was to serve primarily as the capital-providing shareholder.

6.  Even if such proposal were not enacted this year, the proposal still would have legislative momentum for future years due to the facts that (i) such proposal is estimated to raise $9 billion over 10 years and (ii) it already has been passed by the House and, at least, seriously considered by the Senate.  A consistent organized opposition will be needed to derail this tax train.