The extenders legislation currently under consideration (see related post) would shut down a method of avoiding employment tax (including self-employment tax) used by many individuals who earn money from personal services. A dentist, for example, who earns $90,000 in fee income might form an S corporation to receive that income, and pay himself a salary of $2,000 per month, taking the rest of the money as a distribution (dividend). He would still pay income tax on the entire $90,000, but avoid paying Social Security and Medicare tax on the amount above his salary $24,000. These arrangements are subject to challenge by the IRS, but the tax agency doesn’t have the resources to pursue all the individuals who use this technique.
If passed, the law would address this issue beginning in 2011. Shareholders of a “disqualified S corporation” will be required to treat their share of corporate income as self-employment income. Generally this would apply to an S corporation that is engaged in a professional service business principally based on the reputation and skill of three or fewer individuals, or that is a partner in a professional service business. Additional provisions prevent shifting of income to family members who don’t render substantial services to the S corporation and prevent avoidance of employment taxes by routing earnings through a limited liability company or limited partnership.
Tags: Employment Tax, feature, S corporations
