Tax Law Change for S-Corporation Shareholders

The party may just about be over for S-Corp shareholders, as all good things must eventually come to an end.  Feel free to thank those congressmen who voted for section 413 of HR 4213-American Jobs & Closing Tax Loopholes Act of 2010.  Although this bill has not been passed by the Senate yet (as of this writing,) the bill imposes self-employment tax on S-Corp distributive income that meets the following two tests:

• The corporation is engaged in a "professional service business," i.e. law, engineering, accounting, consulting, investment advice/management/brokerage services, performing arts, etc.
• The principal asset of the business is the "reputation or skill" of three (3) or fewer employees.

Historically, S-Corp shareholders took no salary (or a modest salary) and received the rest of their profits as a dividend, thereby avoiding employment taxes on the non-salary distribution.  But if the bill is signed into law, effective as of 2011, shareholders will have to pay self-employment tax on his or her pro-rata share of taxable income, regardless of how much was paid via a traditional paycheck.  

Forget about quickly transferring the shares to a relative, as the proposed bill includes the family attribution rules, which extends the tax to shares owned by spouses, parents, children, etc., as well as to limited partner distributive shares. 

As with any new legislation, the minute details and definitions could change, but hold on to your wallet, because the S-Corp "free lunch" is just about over.