Corporations, limited liability companies, and certain other business entities can make an election with the Internal Revenue Service to be taxed under Subchapter S of the Internal Revenue Code.  If such an election is made, the business entity becomes an “S corporation” for federal income tax purposes, and also under the tax laws of many states.  The S corporation does not pay income tax, and its profit/loss and other items “passes-thru” (through a Form K-1) and are reported by the S corporation’s shareholders/owners on their income tax returns.

One of the benefits of owning and operating a business through an S corporation is potential employment tax savings.  While owners of an S corporation may also be an employee of the S corporation, the owner/employee must be paid “reasonable compensation” for his/her services, and from which federal employment taxes are paid.  However, while any profit of the S corporation is subject to federal income (and other) taxes, the profit is not subject to employment (self-employment) taxes.

Many businesses are formed and operate general partnerships, limited partnerships, and limited liability companies (LLC). Like an S corporation, each of these entities is a “pass-thru” entity that does not pay income tax and where the profit/loss is reported by the owners of the entity.  Unlike an S corporation, a general partnership, limited partnership, and LLC must pay federal employment taxes on profits.

President Biden has now proposed major changes to the U.S. tax system. Applicable to S corporations, President Biden’s proposal observes that “S corporation shareholders are not subject to self-employment (SE) tax. However, tax law requires that owner-employees pay themselves “reasonable compensation” for services provided, on which they pay FICA tax like any other employee. Nonwage distributions to shareholders of S corporations are not subject to either FICA or SE taxes”. The proposal if approved would make the following changes:
  • S corporation owners who materially participate in the trade or business would be subject to SE taxes on their distributive shares of the business’s income to the extent that this income exceeds certain threshold amounts.
  • The exemptions from SE tax provided under current law for certain types of S corporation income (e.g., rents, dividends, and capital gains) would continue to apply to these types of income.
  • S corporation profits would be subject to SE tax to the extent the profits are ordinary business income derived from activities for which the owner materially participates in the trade or business of the S corporation (“SE income”).
  • The additional income that would be subject to SE tax would be the lesser of (i) the potential SE income, and (ii) the excess over $400,000 of the sum of the potential SE income, wage income subject to FICA under current law, and 92.35 percent of self-employment income subject to SE tax under current law. The $400,000 threshold amount would not be indexed for inflation.
  • Material participation standards would apply to individuals who participate in a business in which they have a direct or indirect ownership interest. Taxpayers are usually considered to materially participate in a business if they are involved in it in a regular, continuous, and substantial way. Often this means they work for the business for at least 500 hours per year. The statutory exception to SE tax for limited partners would not exempt a limited partner from SE tax if the limited partner otherwise materially participated.
  • The proposal would be effective for taxable years beginning after December 31, 2021.
President Biden’s tax law proposals must first be approved by Congress.  If passed, however, one of the principal benefits of owning and operating a business through an S corporation will be eliminated (or at least significantly restricted), and certain S corporation owner profits will become subject to federal employment taxes.  In this event, it may be difficult for S corporations with appreciated assets to dissolve or convert into another form of a legal entity without paying income taxes on the dissolution/conversion.  S corporations and their owners are encouraged to speak with their tax advisors to consider President Biden’s new tax law proposals, and specifically including potential tax changes to S corporations.