AICPA Opposes Subchapter S Tax Provision in Extenders Bill

The American Institute of Certified Public Accountants (AICPA) opposes language in the tax extenders bill now being considered by the U.S. Senate that would subject small business professionals, who have organized their businesses as S corporations, to self employment taxes on their non-salary income.  The AICPA said the provision, which would help pay for the cost of the bill, is a major change in longstanding tax policy that should be discussed in public hearings and that it would lead to increased taxes and complexity for S corporations and their shareholders.  The AICPA said the Internal Revenue Service has the enforcement tools it needs to force any taxpayers avoiding payroll taxes to re-characterize S corporation distributions as salary, which would then be subject to employment taxes under FICA, the Federal Insurance Contributions Act.

 In a June 14 letter to Senate Finance Committee Chairman Max Baucus and Senate Finance Committee Ranking Minority Member Charles Grassley, the AICPA endorsed an amendment by Senator Olympia Snowe and Senator Michael Enzi that would remove Section 413 from H.R. 4213, the American Jobs and Closing Tax Loopholes Act of 2010.  The AICPA’s letter supporting the amendment and the AICPA’s June 9 letter to the Senate Finance Committee and House Ways and Means Committee outlining its opposition to the payroll tax provision is highlighted below.

June 9, 2010

The Honorable Max Baucus, Chairman
Senate Committee on Finance
511 Hart Senate Office Building
Washington, DC 20510

The Honorable Charles Grassley
Ranking Member
Senate Committee on Finance
135 Hart Senate Office Building
Washington, DC 20510

The Honorable Sander Levin, Chairman
House Committee on Ways & Means
1236 Longworth House Office Building
Washington, DC 20515

The Honorable Dave Camp
Ranking Member
House Committee on Ways & Means
341 Cannon House Office Building
Washington, DC 20515

RE: H.R. 4213, SECTION 413 – EMPLOYMENT TAX TREATMENT OF PROFESSIONAL SERVICE BUSINESSES

Dear Chairmen Baucus and Levin, and Ranking Members Grassley and Camp:

The AICPA is concerned about certain aspects of Section 413 of the American Jobs and Closing Tax Loopholes Act of 2010 (the 2010 Act) and has the following comments that we hope you will consider as the Senate works towards constructing and finalizing its version of this important legislation. 

The AICPA, first and foremost, believes that the Internal Revenue Service currently has the appropriate enforcement tools it needs to re-characterize the distributions of S corporations as salary subject to employment taxes under FICA.  We also believe that the IRS can and should expand such enforcement tools by providing taxpayers with stronger guidance on determining a reasonable fair market value of compensation.  Doing so would reduce litigation, increase compliance and allow employment taxes to continue to be levied only on the performance of personal services as intended. 

The AICPA believes that the change in the law proposed by the House represents a major change in policy that should have been the subject of public hearings.  This proposal not only threatens to result in a significant increase in taxes and complexity for S corporations and their shareholders, and for certain limited partners, but it continues the definitional blurring between capital and labor begun in the general partnership arena by further expanding laws that were clearly established to tax only labor. We are also concerned that the proposal may reduce Social Security benefits for certain retirees.  This proposal taxes the returns on the invested capital of owners as described more below.  The policy to continue using the Self-Employment Contributions Act (SECA) to blur this capital-labor line should demand scrutiny from within Congress to examine whether this is really the right policy to maintain, or even expand.

Notwithstanding the foregoing serious concerns, including an unintended reduction of Social Security benefits for certain retirees, we appreciate that the proposal, as written, was limited to a subset of personal service businesses where perceived abuse may have been present.  If the current law must go forward, we respectfully suggest the following amendments and clarifications:

  • Consider the impact of expanding Section 211 of the Social Security Act on the amount of Social Security benefits to be received by an individual and also on the amount of the reduction of the Social Security benefit for an early retiree.  Other sections of the Social Security Act may need to be modified to exclude this provision from the definition of earned income for purposes of collecting Social Security benefits and also for the amount of Social Security benefit for an eligible Social Security recipient.  As written, the proposal may have the effect of a loss of Social Security benefits for an early retiree solely because they are deemed to have additional self-employment income through the proposal’s family attribution rules by virtue of sharing ownership of stock in an S corporation. 
  • Substantial services as used throughout Section 413 should be defined as 75% or more of a full time employee shareholder’s total services (at least 1560 hours out of 2,080 hours a year) are contributed to the professional service business.  See Treas. Reg. § 1.414(r)-11(b)(2) for the precedent where Treasury has defined a substantial service employ as one who provides at least 75% of his or her time to a particular line of business.
  • Substantially all as used within the definition of “Disqualified S Corporation” should be defined as at least 90% of the S corporation’s activities being performed in connection with the partnership.
  • Allow a SECA/FICA-free return on human and non-human capital which is an essential component of every business and which does not represent earnings from the labor of the owner, but of the invested capital of the owner.  As a starting point, we believe the carried interest proposal of Section 412 of the 2010 Act (proposed Internal Revenue Code section 710(g)(1) and (7)) takes a similar approach and could be easily mirrored by simply excluding a percentage of the distributable net income.

Human capital is often the largest expenditure of any business and therefore significant earnings are often generated by non-owner employees that should not subject owners to FICA or SECA.  A flat percentage return on capital (ROC) should be built-in to Section 413 of the 2010 Act such that FICA will apply to salaries and SECA (or FICA) will apply to the balance of the pro rata share of distributable net income to shareholders to which this section applies (rather than 100%).  Such ROC percentage provides a fair, bright line for S corporation shareholders and limited partners (and even for general partners and limited liability members) of professional service businesses.  Every professional service business with more than one non-shareholder employee invests in human capital that generates income for the owners and should not be subjected to employment taxes of any kind since the income was generated by the efforts of non-owner employees.  While some taxpayers would pay more and others less under such an approach, calculating a return on capital based on a percentage of net income is good policy because it provides for a simple to administer, bright-line test that stays true to the spirit of employment and self-employment taxation and to the entrepreneurial spirit of funding and operating a successful business with the expectation of a return.

Sincerely,

Alan R. Einhorn
Chair, Tax Executive Committee

 

cc:        Members of the Senate Finance Committee
              Members of the House Ways & Means Committee

June 14, 2010

The Honorable Max Baucus, Chairman                                             
Senate Committee on Finance                                   
511 Hart Senate Office Building                               
Washington, DC 20510                                             

The Honorable Charles Grassley
Ranking Member
Senate Committee on Finance
135 Hart Senate Office Building
Washington, DC 20510

AMENDMENT TO H.R. 4213, SECTION 413 – EMPLOYMENT TAX TREATMENT OF PROFESSIONAL SERVICE BUSINESSES – S. AMDT. 4342

Dear Chairman Baucus and Ranking Member Grassley:

The American Institute of Certified Public Accountants (AICPA) opposes Section 413 of the American Jobs and Closing Tax Loopholes Act of 2010 which we believe threatens to result in a significant increase in taxes and complexity for S corporations and their shareholders, and for certain limited partners. Section 413 represents a major change in longstanding tax policy that has never been the subject of public hearings, thus, we are concerned that there may be unintended consequences that have not been fully aired and discussed. Accordingly, we strongly support the amendment being offered by Senators Snowe and Enzi, S. Amdt. 4342, which would strike Section 413. The proposed Section 413:

  • Fails to take into account a fair and reasonable return on the human and investment capital of the owners;
  • may reduce Social Security benefits for early retirees;
  • may create unintended consequences to qualified and non-qualified retirement plans of owners that would now have both wages and self-employment income; and
  • ignores the fact that the IRS currently has the appropriate enforcement tools it needs to re-characterize the distributions of S corporations as salary subject to employment taxes under FICA.

The AICPA would like to work with Congress and the IRS to address the best way to collect S corporation shareholders’ and partners’ fair share of employment/self-employment taxes.  Such a provision should not be rushed through the legislative process without due process and deliberation.

Sincerely,

Alan R. Einhorn
Chair, Tax Executive Committee