Treasury Department Suggests S Corporation Tax Change
A recent Treasury Department study suggests making sweeping changes to how single-owner S corporations are taxed. Under the proposed recommendation, individuals who operate one-person S corporations would be required to pay employment taxes on their operating income.
The Treasury study argued one-person S corporations have become a major payroll-tax shelter. The study concluded: "The S corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses" saving small business owners $5.7 billion dollars in employment taxes in 2000 alone. In 2000, seventy percent of S corporations were one-person businesses.
One-person businesses which operate as sole proprietorships are required to pay self-employment taxes on their entire operating income. Owners of S corporations, who set their own salary level, have more leeway in determining what salary is "reasonable."
Once a reasonable salary is paid to officer-shareholders running a profitable S corporation, profits in excess of a reasonable salary can be removed as employment-tax-free dividends. This can save a typical entrepreneur $6,000 per year in employment taxes (also known as payroll taxes, Social Security and Medicare).
S corporations have another major advantage. Money retained within the company for growth isn't subject to employment tax. Consider a sole proprietor who is struggling to start a new business. Maybe, in the first year, the entrepreneur works part-time while holding another job. The company earns a modest $30,000. With a sole proprietorship, the individual is forced to pay about $4,500 of those earnings in self-employment taxes. That money isn't available for the entrepreneur to reinvest in growing the business. With the S corporation, the $30,000 can be retained within the company and isn't subject to employment tax.
Operating a small business as an S corporation offers the owner a major advantage in saving money on employment taxes. Unfortunately, some entrepreneurs abuse the privilege. Some entrepreneurs earn hundreds of thousands of dollars a year and pay little or no salary to themselves while withdrawing profits as dividends. No doubt this abuse has contributed to the Treasury Department study's suggestion.
I feel there should be a change to put sole proprietorships on the same tax footing as S corporations. But, not by trying to tap S-corporation owners for more Social Security and Medicare taxes. Instead, sole proprietors should be given the option of choosing a salary level and not paying self-employment tax on money used for business growth. It seems unlikely this change will be made to the taxation of S corporations, because small business groups would object. The Commissioner of the Small Business/Self-Employed (SB/SE) Division at the Treasury disagreed with the new taxation plan.
Treasury Department Study: Actions Are Needed to Eliminate Inequities in the Employment Tax Liabilities of Sole Proprietorships and Single-Shareholder S Corporations.
Peter Hupalo, author of
How to Start And Run Your Own Corporation: S-Corporations For Small Business Owners