Joe Kristan doesn't like the S Corp provision, and thinks my support for the less-than-perfect provision is ill-conceived. See A One-Hitter is "Not Perfect"--This is something else, June 3, 2010.
Now, I think that having an S Corp provision, even though it ended up somewhat complicated because it was drafted as a compromise to focus only on those S Corps where it is clear that the services of a few owner/service providers is the basis of the S Corp business, is a step in the right direction. Without it, we have the specter of continued use of the S Corp entity to avoid payroll taxes, where very well paid doctors, lawyers and other service providers magically convert compensation income to non-compensation income, and avoid paying payroll taxes on most of it.
Joe has some good points, nonetheless, that merit a rebuttal.
1) The language in swection 413 of the bill--such as "principal assets" and "reputation and skill"-- may not be interpreted in the same way by all readers of the text.
True, but most likely only because those readers are trying to find an ambuiguity or indeterminancy to claim substantial authority (based on statutory interpretation) to avoid the application of the provision. Good regulations can and I am sure will provide depth to the words "principal assets" and "reputation and skill" in the provision, but this complaint is picking at straws--admittedly the kinds of straws that practitioners trying to find loopholes for their clients love to pick at. We all know what kinds of businesses this bill is intened to impact.
Reputation and skill as keywords may cause some stumbling, since tax advisers and accountants are used to considering more specific terms for the intangible assets of a business, such as "goodwill", "knowhow", "customer base". Was this intentional or just sloppy drafting? One might argue that these terms are broad enough to include all three of the more traditional intangible assets, and that they are intended to capture a broad-scope set of intangibles that the service provider brings to bear on the services provided.
2) It can be gamed
Most provisions can be gamed. And many tax practitioners spend a good bit of their waking time thinking about how to game a particular requirement, even though they "know" that the requirement is aimed at exactly their client's situation. Regretably, until we have a "more likely than not" base confidence level requirement for positions taken on returns or advised, this will likely continue. That means that regulations will need to provide incentives for complying with the purpose of the statute.
For example, Joe suggests that a business that is a service business might just buy the office that it currently rents and then claim that its principal asset is the physical building and thus it is not subject to the provision. Surely this would not satisfy the purpose or literal language of the statute. Why? Because it's the services that make the business a business. So principal asset should not be interpreted to permit service providers to stuff their corporation with passive assets like real estate or securities and then claim that those passive assets are the "principal asset" of the business so the provision is inapplicable to them.
The IRS should likely include an anti-abuse provision in the regs, noting that the statute will be interpreted in light of its purpose to end the gambit of converting compensation income to distributions that are not subject to the payroll tax. The regs should likely include some examples that demonstrate that passive assets or equipment/office space for service providers do not count.
3) It discriminates against smaller firms
This would be true, to the extent that firms with 10-20 or more service providers operate in S Corp form rather than partnership form. (I need to check this out--I suspect Congress was using a "rough justice" measure of the predominant type of firm that was abusing the S corp formation to avoid payroll taxes, but I haven't looked at this empirically).
But again, as a start it is better than nothing. We in fact have many provisions that treat firms differently even though they are similarly situated. That is not ideal in tax, but it happens because one or another person in Congress fights for a particular constituent and wins an exemption or because the less than complete bill is the only thing that can get passed. HOpefully Congress will revisit the issue once the hullabaloo is over, and remedy such irregularities. Removing exemptions, elections, and similar provisions is generally a good idea. But having a bill that addresses the largest group of payroll tax avoiders is much better than continuing to not deal with this issue. But see item 4.
4) It could have been simpler and more workable.
This is a good point. The rules for S corps could have been changed across the board, treating all income from firms whose business is the provision of services as subject to the payroll tax, regardless of number of service providers.
Of course, I suspect Congress couldn't pass such an across the board change. So while I would prefer a better bill, it is much better to deal with the lion's share of this issue than not to deal with it at all.
The architects' trade association is lobbying against the bill with a similar list of complaints. They argue that requiring these service providers to pay payroll taxes will kill the economy. Funny how these groups never argue that ordinary workers on salary shouldn't have to pay payrool taxes, even though of course those ordinary workers would rather have more income. Sure, S corporation shareholders/service providers would rather have as much profits as possible from their corporations without payroll taxation. But payroll taxation on their compensation isn't going to make the business go out of business. It will not be on gross income, after all, but on the excess after the regular expenses of earning that services income. The service providers/owners will have less take home pay, but they will be for once paying their fair share of the tax burden that ordinary workers have been paying all along. I don't think "the economy will crash (at least for these service providers)" argument holds water--the additional tax won't cause the business to fold, but it might make the service providers work harder so they can still earn the same in spite of paying their due share of the payroll tax burden.
They also argue that the IRS already has sufficient tools at its disposal to prevent the conversion of compensation to profit distribution without payroll taxation. But in fact that provision is extraordinarily difficult to enforce because of the subjective nature of what is "reasonable" compensation, and the time such audits and cases require is a huge drain on the limited resources for enforcement. Having a bright-line rule for S corporations moves the ball forward (even though there will be at least some initial jousting over whether the provision applies to a particular S corporation).
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