Tax Reform and S-Corps

[Mileage Psycho]

I know some of you folks are in business and in many cases you might be an S-Corp and I bring this to you as an FYI as it could cost you some hard earned money. 

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Greetings -

We are in the final days before the U.S. House of Representatives introduces its first full draft bill that will rewrite the Tax Code. 

That said, we are concerned that Congress will once again introduce a tax reform bill that will change many things for the better, but at the same time make reform for S-Corporations more difficult. There are serious discussions of lowering the corporate tax rate for S-Corps down from the current rate of 39.6 percent down to 25 percent, which is a great thing. However, Congress' zeal to prevent "cheating" in the system is resulting in the development of a complicated scheme called the 70/30 rule.

The premise behind the 70/30 rule is that historically, economic output is made up of about 70 percent returns to labor and 30 percent returns to capital, so that ratio should also apply to the income of pass-through business owners.  This is simply wrong - while the overall economy may be divided 70/30, not every company conforms to that ratio.  Capital-intensive industries would be disadvantaged by the ratio, while law and accounting firms would benefit.

Here is a simple example to illustrate the shortcomings of 70/30: 

In year one, an investor buys a company for $10,000,000 that has a ten percent rate of return.  The $1 million in annual profits from the company are obviously a capital return and, since the investor doesn't work at the business, they should be eligible for the lower 25 percent pass-through rate.

In year two, however, the investor begins working at the company, earning reasonable compensation of $500,000 for his work.  Under current law, the investor pays individual income and payroll taxes on his compensation, and pays applicable pass-through rate on his $1 million in profits. 

Under 70/30, however, his total income of $1.5 million would be treated as $1,050,000 wages and $450,000 profits.  In other words, $550,000 of his profits would be re-designated as wages.  Under the rate structure outlined above, this would represent a tax increase of about $75,000 (25 percent pass-through rate versus 35 percent individual rate plus the 3.8 percent HI tax). 

This is obviously the wrong result and, if put into practice, would encourage owners of pass-through businesses to stop working.  The higher the ratio of their profits to wages, the greater the incentive.

This is obviously the wrong result and, if put into practice, would encourage owners of pass-through businesses to stop working.  The higher the ratio of their profits to wages, the greater the incentive.

It could also mean the difference between a tax cut and a tax hike on these employers.  In comments to Senate Finance Committee this summer, -------. as a member of the S-Corp Association, observed that applying a 70/30 approach to the House Blueprint's base broadening provisions could result in actual tax hikes for many S corporations.  Cutting taxes for large multinational C corporations while raising them on smaller Main Street businesses is not a recipe for successful tax reform, and it emphasizes the need for Congress to get the enforcement challenge right.  There are many approaches Congress could take, and we're working to help identify them, but it is obvious a fixed ratio like 70/30 is not the place to start. 

 

 

[Zambroski]

Why on earth would any reasonably sane and intelligent person with that kind of coin put themselves on a payroll status within this company rather than a contractor/advisor position under a multitude of other corporations or LLC's.  They wouldn't or they aren't listening to their accounting firms.  Or, they won the lottery and decided to do this...in which case, this whole enterprise is on borrowed time.  

[Highmark]

4 minutes ago, Zambroski said:

Why on earth would any reasonably sane and intelligent person with that kind of coin put themselves on a payroll status within this company rather than a contractor/advisor position under a multitude of other corporations or LLC's.  They wouldn't or they aren't listening to their accounting firms.  Or, they won the lottery and decided to do this...in which case, this whole enterprise is on borrowed time.  

Completely depends on the work being done at the company.   There are other reasons to consider such as HI and 401K contributions which both carry tax deductions.  Yes they can applied to the other entity you work for but you are just adding more accounting work for multiple companies.  Its also different between starting the company and just buying it to be managed from arms length.  

We work with one of the largest and most respected accounting firms in the country and I can tell you they always want to be very careful at under compensating management if those in charge are owners.   S-corps of any size having extremely low SG&A can be prime audit red flags.   Especially large changes in one year.   For example paying yourself $500K one year then dropping it to $30K the next.   The firm has informed us that they have customers who insisted on pushing the envelope and had gotten audited and fined because of this.      

 

Thanks for posting this Vince.   Our accountants sent an email and called to discuss this exact issue a while ago.  

[Mileage Psycho]

20 minutes ago, Zambroski said:

Why on earth would any reasonably sane and intelligent person with that kind of coin put themselves on a payroll status within this company rather than a contractor/advisor position under a multitude of other corporations or LLC's.  They wouldn't or they aren't listening to their accounting firms.  Or, they won the lottery and decided to do this...in which case, this whole enterprise is on borrowed time.  

There are a multitude of reasons why an investor may want to become the president or an officer of the corporation that he or she has invested in, any event I posted this for the folks that have an S-Corp to be aware of the 70/30 rule, if so now is the time to contact your rep in DC.

And for the record, my company is a C-Corp.

[Mileage Psycho]

2 minutes ago, Highmark said:

Completely depends on the work being done at the company.   There are other reasons to consider such as HI and 401K contributions which both carry tax deductions.  Yes they can applied to the other entity you work for but you are just adding more accounting work for multiple companies.  Its also different between starting the company and just buying it to be managed from arms length.  

We work with one of the largest and most respected accounting firms in the country and I can tell you they always want to be very careful at under compensating management if those in charge are owners.   S-corps of any size having extremely low SG&A can be prime audit red flags.   Especially large changes in one year.   For example paying yourself $500K one year then dropping it to $30K the next.   The firm has informed us that they have customers who insisted on pushing the envelope and had gotten audited and fined because of this.      

 

Thanks for posting this Vince.   Our accountants sent an email and called to discuss this exact issue a while ago.  

You are welcome  

[Turf]

Interesting read. I just sent this to my accountant as this could very well effect me. Thanks for the heads up.

[racer254]

2 hours ago, Zambroski said:

Why on earth would any reasonably sane and intelligent person with that kind of coin put themselves on a payroll status within this company rather than a contractor/advisor position under a multitude of other corporations or LLC's.  They wouldn't or they aren't listening to their accounting firms.  Or, they won the lottery and decided to do this...in which case, this whole enterprise is on borrowed time.  

Isn't this guy considered part of the "wealthy"?   If so, I thought democrats want to raise taxes on the wealthy?

[Mileage Psycho]

20 hours ago, Turf said:

Interesting read. I just sent this to my accountant as this could very well effect me. Thanks for the heads up.

You're welcome, this could have implications for a lot of small business owners.

[T1R9sledder]

2 minutes ago, Mileage Psycho said:

You're welcome, this could have implications for a lot of small business owners.

I sent it off to my accountant. 

[ArcticCrusher]

Troody called small business owners tax cheats.  

Speak out speak loud.

[T1R9sledder]

3 minutes ago, ArcticCrusher said:

Troody called small business owners tax cheats.  

Speak out speak loud.

What a stooge.....