Managing taxes is an important part of saving for college. S corporations can help manage a business owner’s tax burden because corporate income “passes through” to shareholders.
This means that S corporations don’t pay income taxes. Rather, shareholders pay the taxes on corporate earnings but not on any cash that is distributed. In addition, shareholders pay Social Security and Medicare taxes (the combined rate could be as much as 15.3%) on their salaries but not their share of these corporate earnings. So, S corporation owners have a built-in incentive to take their compensation as profits instead of wages.
According to the IRS, the average S corporation delivers approximately 41.5% of its economic benefit to shareholders as salary and the remaining 58.5% as profit distributions.
Even former Senator John Edwards organized his law practice as an S corporation. In just four years, Mr. Edwards avoided over $560,000 in Medicare tax. The magnitude of potential savings makes S corporations prime candidates for the abuse described in the General Accounting Office’s recently released report Action Needed to Address Noncompliance with S Corporation Tax Rules.
• 68% of S corporations filed in returns for 2003 and 2004 misreported at least one item. In 80% of those cases, the errors favored the taxpayer.
• 13% of S corporations paid inadequate wages to shareholders. The smallest corporations, those with one to three shareholders, were the worst offenders.
This favorable tax treatment is now in jeopardy. H.R. 4213, or the American Jobs and Closing Tax Loopholes Act of 2010, would subject the earnings of “an S corporation which is engaged in a professional services business if the principal asset of such business is the reputation and skill of three or fewer employees” to Social Security and Medicare taxes.
The bill goes on to include the following fields as professional service businesses: health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, and brokerage services.
H.R. 4213 has passed the House but not the Senate. Unfortunately for S corporation shareholders, the Senate’s filibuster doesn’t seem that concerned with stripping this provision from the bill. As such, small business owners may soon need to consider ways to blunt its impact on their tax liabilities and college funding plans.
