What is a Disqualified S Corporation?

During the summer of 2010, Congress, as part of its "American Jobs and Closing Tax Loopholes Act of 2010" legislation, proposed disqualifying some small professional service S corporations from using an S corporation to save payroll taxes starting in 2011. Fortunately, the S corporation disqualification legislation stalled due to a filibuster in the senate, but because the proposed disqualification was proposed, debated and rejected (ultimately by Senate Republicans and centrist Senate Democrats), S corporation owners and shareholders are sometimes interested in what "almost" happened--and could happen in the future depending on the political environment.

Note: At various times during 2011, 2012 and 2013, this idea of "closing the S corporation loophole" has resurfaced...

Who Would Have Been Disqualified

Perhaps the first thing to understand about the proposed disqualification rules is this: Many small S corporations were not going to be disqualified. For example, S corporations that sell products, including digital products and advertising? Those S corporations would still have been able to save self-employment and payroll taxes under the new "disqualified S corporation rules".

Similarly, S corporations that sell the "non-professional" services of their shareholder-employees (including plumbers, electricians, barbers, handymen, painters, and so on) would have still saved their owners payroll and self-employment taxes.

So who did get hurt under the bill? The proposed "disqualified S corporations" law (which would have become Sec. 413(m) of the Internal Revenue Code) really targeted professional service corporations that fit one of two profiles:

Target #1: The One-Professional S Corporation

In other words, if someone works as an independent contractor providing professional services, this individual can under current law save on self-employment taxes through an S corporation arrangement. For example, a contract programmer making $100,000 a year and taxed as a sole proprietor pays roughly $15,000 in self employment taxes. (Self-employment taxes run 15% on roughly the first $120,000 of self-employment earnings.) However, if the contract programmer incorporates his or her business and then elects S status, he or she only pays the 15% employment taxes on the part of the profit labeled as wages. By calling only the first $40,000 of profit "wages," therefore, the contract programmer pays only $6,000 in employment taxes--which means roughly $9,000 of savings.

Target #2: The S Corporation "Partner"

To explain this situation, if someone is a partner in a firm that provides professional services, the partner's share of the firm profits is subject to self-employment taxes. What aggressive taxpayers sometimes do to avoid these taxes is own their equity in the partnership through an S corporation. In other words, the professional owns an S corporation and the S corporation owns a slice of the partnership equity. With this arrangement, if the partnership paid the partner (the S corporation) $300,000 but the S corporation paid its shareholder-employer only, say, $80,000, the professional saves about $9,000 a year in self-employment taxes. (Note that after a taxpayer reaches $118,500, the self-employment tax drops to either 2.9%  or 3.8% in most cases.)

Now, a quick note: the disqualification laws proposed in the summer of 2010 didn't work perfectly to disqualify only S corporations like I describe above. But you can probably think about the new law most clearly if you keep the two targets of the law in mind.

Details of the Proposed Rules

The proposed law broadly described which professional services were targeted:

IRC Sec. 413(m)(3) PROFESSIONAL SERVICE BUSINESS.--For purposes of this subsection, the term 'professional service business' means any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.

As with past tax laws that call out specific treatment for professional services, the list of professions includes the usual suspects (health, law, accounting, architecture, actuarial science, and engineering); the catchall category, consulting; and performing artists (which probably means actors, musicians, and entertainers but probably not authors, painters, and sculptors).

Taxpayers should note that these categories would have been more expansive that they appear at first glance. The "engineering" category would have included not just engineers but also people providing mapping and surveying services. The "health" category would have included not only doctors and dentists but also nursing services and other similar healthcare professionals. And the consulting category was basically a catchall for anyone providing "advice and counsel". This proposed law's list of professions also added several new professions: lobbyists, athletes, investment advisors and managers, and brokerage services.

Interestingly, the actual "in-the-tax-law" triggers for disqualification were two rules:

  1. If an S corporation is a partner in a professional service business, the S corporation is disqualified if substantially all of the activities of the S corporation are related to being a partner.
  2. If the principal asset of a professional service S corporation is the reputation and skill of 3 or fewer employees, the S corporation is disqualified.

So, actually, just to underscore this point, some professional services that weren't really (in a sense) the target of the law got hit (for example, a three-person accounting firm). And even targeted professional services firms could have avoided disqualification by failing the "substantionally all" test referred to a couple of places in the preceding paragraphs.

A final point: If you want additional information about the disqualified S Corporation rules that were proposed and almost passed in 2010, you can purchase my eBook, "Dodging Disqualification: How to Legally Avoid Disqualification of Your S Corporation--and Minimize Self-employment Taxes If You Can't." By the way, this e-book isn't really a resource for lay readers, but for tax practitioners. Most people shouldn't buy the book...

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