When the Senate takes up the extenders package, one of the provisions (found in Section 413 of the amendment language) would for the first time impose the self-employment tax on S-corporation profits earned by firms with three or fewer shareholders, and in which 80 percent or more of the gross income is derived from “personal services” (health, law, lobbying, engineering, architecture, accounting, actuarial science, performance arts, consulting, athletics, investment advice/management, and brokerage services)
Under tax law, a corporation can elect treatment under “Subchapter S,” and become a so-called “S-corporation.” Unlike an ordinary corporation, an S-corporation does not pay taxes on profits at the company level. Rather, the profits flow through to the owners, who pay income taxes on them on their personal 1040 forms. Under current law, no self-employment taxes are owed on S-corporation profits. Those who own more than 2% of the company’s shares and perform services for the company must, however, pay themselves a “reasonable salary.” Like any salary, these earnings face Social Security and Medicare payroll taxation.
Because this tax structure is relatively-simple and avoids any potential for double taxation (always a problem with regular corporations), the S-corporation election has been increasingly-popular with tens of millions of small businesses since the 1950s. Many smaller professional and manufacturing firms are organized as S-corporations. According to the IRS, there were 4 million S-corporations in 2007, the latest year with data. These 4 million small businesses had 6.8 million owners. Of these, ATR has estimated from IRS data that approximately 1 million S-corporations are in the areas of “professional services”
These 1 million S-corporations have multiple owners. Assuming that the ratio of owners-to-companies holds up in the professional service sectors, this bill raises taxes on 1.7 million S-corporation owners
The recent healthcare law raises the Medicare portion of the self-employment tax for most small business profits from 2.9 to 3.8 percent. As a result of that, the House extenders bill means that the rate on most S-corporation profits will rise from 35 percent today (income tax only) to 43.4 percent by 2013 (3.8 percent Medicare payroll tax plus 39.6 percent top income tax rate that year). This is a 24 percent increase in the marginal tax rate most S-corporation profits face
In order to pay this new tax rate, most owners will simply take more money out of their companies. This is capital no longer available for wages, benefits, new jobs, plant and equipment, or other vital investments in our economy. Even as a class-warfare tactic, this tax hike doesn’t make any sense. The true incidence will be borne by workers (lower wages) and consumers (higher prices).