S-Corporation Taxation Alert

9/15/2011

By Charles J. Garrison, CPA

In August, the U.S Department of Treasury Office of Tax Analysis released a Technical Paper that includes a proposal to redefine a “small business.” Under the current tax code, there is no income or asset limits under which a business may file as a pass-through entity (S-Corporation, Partnership, Limited Liability Companies, etc.), only limitations on the number of shareholders in the case of S-Corporations. Under two much narrower definitions proposed by Treasury, many current S-Corporations would no longer be eligible to file as pass-through entities and would face the double taxation of C-Corporations.

Under current regulations, approximately 35 million taxpayers file as “small businesses” under some type of pass-through entity. Treasury proposes two narrower definitions: income or deductions of $10 million or less and business owners whose income from such pass-through entities represent less than 25 percent of taxable income. The obvious problem with the second definition is that, depending on the income of the business in question or the owner’s other income, the business may be a “small business” in some years but not others. The effect of the proposed definitions, however, would reduce small business files to approximately 20 million filers under the first definition and 9.4 million under the second.

The intention of this proposal appears to be two-fold. First, approximately $662 billion in income was reported by the 35 million filers under the current definition in 2007 as reported by the Treasury Technical Paper. This would be reduced to $376 billion under the first proposed definition and to $335 billion under the second, narrower definition. The remaining income of approximately $300 billion under either scenario would be taxed as corporate income and then taxed again at the personal level. Secondly, there is political cover for those who support a tax increase in that they will be able to claim that taxes were not raised on “small businesses” which are generally credited as the largest creators of new jobs.

Shareholders of S-Corporations, particularly those that would no longer be considered a small business under one or both of the proposed definitions, still have time to take action. This topic can be addressed with shareholders’ Representatives and Senators as well as industry trade groups before the proposal is enacted.