A Tempting Revenue Target – The S Corporation
As the government continuously wrestles with finding new sources of revenue, decreasing the tax gap and implementing tax reform, the subject of S Corporation taxation inevitably enters the picture.
There were an estimated 4.6 million S corporations in 2014 according to the IRS, more than double the number of C Corporations. A report released a few years back by the Government Accountability Office (GAO) showed clearly why shareholders of these S corporations might be a luring target for pols hunting for more revenue.
The report featured estimates of S corporation shenanigans, estimates based on special in-depth "National Research Program" audits the IRS conducted on 2003 and 2004 S corporation tax returns (the last years such information was available).
Over those two years, the GAO estimates, 68% of S corporations misreported at least one item on their tax return, with 80% of those misrepresentations being to the advantage of the corporation and/or shareholders. Further, estimates were that combined net profits were understated by $84.8 billion.
An S corporation doesn't pay corporate income tax on its own, but passes through its earnings, losses and tax credits to its owners' individual tax returns. The use of S corporations, as well as other "pass through" entities such as partnerships, has been rising, with the fastest growth taking place in small S corporations, often with just one owner.
S corporations have one key tax advantage. General partners of a partnership (including LLCs treated as partnerships) are subject to Social Security and Medicare taxes on all their earnings. So too are taxpayers who run their businesses as unincorporated sole proprietors and report their earnings on Schedule C of their individual returns.
By contrast, folks who own and run S corporations must cough up payroll taxes only on their salaries, not on what is passed through to them as profits.
Tax rules require S corporation owners to pay themselves reasonable salaries for the services they perform. But those rules are often ignored, particularly by one-owner S corporations, and they are tough and labor-intensive for the IRS to enforce.
The GAO estimates that in 2003 and 2004, S corporations underpaid wages to their owners by nearly $24 billion, thus not paying payroll taxes on that amount.
High-earning self-employed individuals have had an extra incentive to form S corporations and report big profits instead of high wages since 1993, when Congress lifted the cap on the amount of earnings subject to the 2.9% (combined employer and employee) Medicare tax.
As an example, in 1998, when he was a trial lawyer, former North Carolina Senator and later presidential candidate John Edwards reported a salary of only $360,000 as compared to net income of $5 million from his S corporation law practice. At 2.9%, he saved roughly $145,000 in Medicare taxes.
The S corporation payoff increased again under health care reform when the Medicare tax rate was increased by 0.9% on certain folks with higher salaries or self-employment income. Further, President Obama's economic advisers have continually discussed imposing the full Social Security tax on earnings above $250,000 (in 2015, only the first $1118,500 of employment earnings is subject to the 12.4% combined employee and employer Social Security tax.)
That would certainly raise the payoff from stepping up enforcement against S corporation owners who shirk payroll taxes or from closing the loophole they now exploit.
Even before payroll tax hikes for high earners were discussed and implemented, Congress' Joint Committee on Taxation suggested lawmakers could raise tens of billions over 10 years by subjecting the owners of S corporations involved in providing services (such as doctors, lawyers, accountants and performers) to Social Security and Medicare taxes on all their earnings.
For its part, the office of the Treasury Inspector General for Tax Administration has concluded sole proprietors are avoiding billions of dollars of payroll tax a year by incorporating as one-person S corporations. It has suggested a different crackdown approach: imposing payroll taxes on all earnings of any S corporation owner who owns more than 50% of the corporation.
And still others suggest that all net business income of S corporations be subject to full employment taxes like they are now for general partners of partnerships, regardless of ownership percentage.
For now, the tax benefits of operating as an S corporation are still with us, and therefore they remain a popular form of doing business. However, shareholders need to keep attune to the prevailing political winds. The bull's-eye seems to just keep growing, making change all the more tempting.
