If You Want To Save On Your Student Loans, S Corporation Shareholders May Have To Suffer The Consequences
If you went to college and weren’t fortunate enough to either earn a scholarship or pay your way by moonlighting as a pool hustler or exotic dancer, you’re probably still dedicating a portion of your paycheck to whittling away your student loans.
Unfortunately, you’re fighting an uphill battle, because on July 1, 2012, interest rates on subsidized Stafford loans are set to double from 3.4% to 6.8%.
Congress has your back, however, as proposals have been formulated that would grant a stay of execution to the rate hike.
One such proposal — creatively named the “Stop the Student Loan Interest Rate Hike Act of 2012” — would postpone the rate increase for one year, and pay for the lost revenue by doing away with the “S corporation loophole” that allows S corporation shareholder-employees to forego compensation in favor of distributions that are not subject to payroll taxes.
For somebackground, we’ve previously discussed this loophole here and here, but in short, it works like this: Because S corporation flow-through earnings are not subject to payroll taxes — unlike their partnership counterparts — there is tremendous motivation for S corporation shareholder-employees to limit the compensation they pay themselves. While compensation is subject to payroll taxes, by forgoing salary S corporation owners increase their flow-through income, which can be withdrawn from the corporation as distributions that are also not subject to payroll taxes.
As a result, many S corporation shareholder-employees, including John Edwardsand Newt Gingrich — have used this loophole to limit their compensation and take large sums of cash out of closely-held S corporations free from payroll tax.
The IRS routinely attacks such transactions and requires the shareholder-employees to pay themselves a minimum “reasonable” salary. In the fifty year case history of reasonable compensation cases, however, the IRS has never required a salary of more than $95,000, so the opportunity still exists for shareholder-employees to trade compensation above this amount for distributions. (For a detailed history of S corporation reasonable compensation issues and the relevant case history, please see this brilliantly written piece — Tax Adviser – S Corporation Shareholder-Employee Reasonable Compensation) — which, like most great works of art, won’t be fully appreciated until the author is dead and gone.)
Lawmakers have long sought to close the S corporation compensation loophole and put S corporations and partnerships on equal footing. Many different types of proposals have been floated, including:
1. subjecting the flow-through income of shareholders owning more than 50% of S corporation stock to self-employment income;
2. subjecting the flow-through income of shareholders in “professional services S corporations” to self-employment tax; and
3. Simply subjecting all S corporation flow-through income to self-employment tax.
The “Stop the Student Loan” Act takes a hybrid approach to closing the loophole. The proposal would subject the income allocated to shareholders of “professional service” S corporations to self-employment tax only if:
1. the shareholder provides substantial services to the S corporation;
2. 75% or more of the gross income of the business is attributable to 3 or fewer shareholders; and
3. the shareholder has AGI > $250,000 if MFJ and $200,000 if single.
The proposal would also apply to a S corporation that is a partner in a professional service partnership.
Lastly, “professional service” businesses are defined as any trade or business providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.
Despite being attached to the attractive student loan bill, I wouldn’t expect this to get passed. The bill is too narrow and the law changes too difficult to enforce, and would simply give rise to a new era of loopholes intended to circumvent the 75% rule.
Joe Kristan has more.
