Corporations, limited liability companies and certain other business entities may make a choice with the Internal Revenue Service to be taxed under Subchapter S of the Internal Revenue Code. If such a choice is made, the entity becomes an “S Corporation” for federal income tax purposes and also under the tax laws of many states. The S company must file an annual tax return with the Internal Revenue Service (Form 1120S) and an annual state income tax return with the states that recognize S companies. The S-Corporation pays no income tax, and its profit / loss and other items “go through” (using a Form K-1) and are reported by the S-Corporation shareholders / owners on their income tax returns.
One of the perceived benefits of owning and operating a business by an S corporation is the potential savings in payroll taxes. While an S corporation may own an S corporation as an employee, the owner / employee must be paid “fair compensation” for his / her services, out of which federal wage taxes are paid. However, while any S-Corporation profit is subject to federal income tax (and others), profit is not subject to employment tax (self-employment tax).
However, S companies have limitations and restrictions, including a limit on the number of shareholders (100), a limit on the types of shares issued (a “single class” of shares), and restrictions on ownership (limited to individuals). , Estates of testators, estates of private individuals and certain trusts can be shareholders – non-resident foreigners cannot be shareholders, at least not directly). Once a business entity is determined to be an S corporation, the shareholders of the S corporation may be taxed on the dissolution of the S corporation, including the conversion of an S corporation into an LLC and other events.
For these reasons, many companies are instead formed and operated as general partnerships, limited partnerships, and especially limited liability companies (LLC). Like an S company, each of these companies is a “pass-through company” that pays no income tax and where the profit / loss is reported by the owners of the company. Unlike an S company, a general partnership, limited partnership, and LLC can dissolve and convert into certain other companies without the owners incurring ongoing income tax. The trade-off, however, is that general partnership owners, general partners of limited partnerships, and LLC owners must pay federal labor tax on profits. This is the position of the Internal Revenue Service, although commentators with certain owners (“members”) of an LLC disagree on this request.
President Biden has now proposed major changes to the US tax system. President Biden’s proposal, which applies to S companies, states that “shareholders of S companies are not subject to the SECA”. [self-employment] VAT. However, tax law prescribes that employee-owners afford “reasonable remuneration” for services rendered, on which they pay FICA tax like any other employee. Additional wage distributions to shareholders of S companies are not subject to FICA or SECA tax ”. President Biden wants to “fill this void in S-Corporation” as follows:
- S Corporations that have a material interest in the trade or company are subject to SECA tax on their distributing shares in company income, provided that this income exceeds certain thresholds.
- The SECA tax exemptions that current law provides for certain types of S-corporate income (e.g., rents, dividends, and capital gains) would continue to apply to that income.
- S-Company profits would be subject to SECA tax provided that the profits consist of normal business income from activities for which the owner has a material interest in the trade or business of the S-Company (“SECA Income”).
- The additional income that would be subject to SECA tax would be the lesser of (i) the potential SECA income and (ii) the excess of over $ 400,000 of the sum of the potential SECA income, wage income, that is under applicable FICA law and 92.35 percent of self-employed income is subject to SECA tax under applicable law. The threshold of $ 400,000 would not be indexed to inflation.
- Material ownership standards would apply to individuals who have an interest in a company in which they are directly or indirectly involved. Taxpayers are typically considered to have a material stake in a business if they are regularly, continuously and significantly involved in it. This often means they work for the company for at least 500 hours a year. The statutory exemption from SECA tax for limited partners would not exempt a limited partner from SECA tax if the limited partner was otherwise materially involved.
- The proposal is intended to apply to tax years beginning after December 31, 2021.
President Biden’s tax bill proposals must first be approved by Congress. However, if passed, one of the primary benefits of owning and running a business by an S corporation will be eliminated (or at least significantly limited) and certain profits of S corporation owners will be subject to federal labor tax. In this case, S companies with appraised assets may find it difficult to dissolve or transform into another legal form without paying income tax upon dissolution / conversion. S companies and their owners are encouraged to speak to their tax advisors to review President Biden’s new tax law proposals and, in particular, to consider possible tax changes for S companies.