What is a Disqualified S Corporation?

UPDATE (6/30/2010): The legislation described below has stalled due to a Senate filibuster. We'll update this article as information becomes available.

Congress, as part of the "American Jobs and Closing Tax Loopholes Act of 2010," is currently attempting to disqualify some small professional service S corporations from using an S corporation to save payroll taxes starting in 2011.

Who Gets Disqualified from Using the S Corporation Loophole?

Perhaps the first thing to understand about the new disqualification rules is this: Many small S corporations are not going to be disqualified. For example, S corporations that sell products, including digital products and advertising? Those S corporations should still be able to save self-employment and payroll taxes by using an S corporation.

Similarly, S corporations that sell the "non-professional" services of their shareholder-employees (including plumbers and painters, electricians, barbers, handymen, painters and so on) still save their owners payroll and self-employment taxes.

The new law (which becomes Sec. 413(m) of the Internal Revenue Code) really targets professional service corporations that fit one of two profiles:

Target #1: The one-person S corporation that really just incorporates a professional's job. In other words, if someone works as an independent contractor providing professional services, in the past this individual has been able to save on self-employment taxes through an S corporation arrangement. For example, a contract programmer making $100,000 a year and taxed as a sole proprietor pays roughly $15,000 in self employment taxes. (Self-employment taxes run 15.3% on the first $106,800 of self-employment earnings.) However, if the contract programmer incorporates his or her business and then elects S status, he or she only pays the 15.3% employment taxes on the part of the profit labeled as wages. By calling only the first $40,000 of profit "wages," therefore, the contract programmer pays only $6,000 in employment taxes--which means roughly $9,000 of savings.

Target #2: The S corporation "partner" in a professional services firm (like a law firm, accounting firm, medical practice, engineering firm and so on). To explain this situation, if someone is a partner in a firm that provides professional services, the partner's share of the firm profits is subject to self-employment taxes. What aggressive taxpayers sometimes did to avoid these taxes is own their equity in the partnership through an S corporation. In other words, the professional owned an S corporation and the S corporation owned a slice of the partnership equity. With this arrangement, if the partnership paid the partner (the S corporation) $300,000 but the S corporation paid its shareholder-employer only, say, $80,000, the professional saved about $9,000 a year in self-employment taxes. (Note that after a taxpayer reaches $106,800, the self-employment tax drops to 2.9% in most cases.)

Now, a quick note: The law doesn't work perfectly to disqualify only S corporations like I describe above. But you can probably think about the new law most clearly if you keep the two targets of the law in mind.

Details of the New Self-employment Tax Rules for Professional Service S Corps

And now let me share just a couple more comments to add some precision to my answer:

The actual law broadly describes which professional services are targeted:

IRC Sec. 413(m)(3) PROFESSIONAL SERVICE BUSINESS.—For purposes of this subsection, the term ‘professional service business’ means any trade or business if substantially all of the activities of such trade or business involve 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.

As with past tax laws that call out specific treatment for professional services, the list of professions includes the usual suspects (health, law, accounting, architecture, actuarial science and engineering); the catchall category, consulting; and performing artists (which probably means actors, musicians and entertainers but probably not authors, painters and sculptors).

Taxpayers should note that these categories are often more expansive that they appear at first glance. The "engineering" category includes not just engineers but also people providing mapping and surveying services. The "health" category includes not only doctors and dentists but also nursing services and other similar healthcare professionals. And the consulting category is basically a catchall for anyone providing "advice and counsel." This new law's list of professions also adds several new professions: lobbyists, athletes, investment advisors and managers, and brokerage services.

Finally, the actual "in-the-tax-law" triggers for disqualification are two rules

Rule #1: If an S corporation is a partner in a professional service business, the S corporation is disqualified if substantially all of the activities of the S corporation are related to being a partner.

Rule #2: If the principal asset of a professional service S corporation is the reputation and skill of 3 or fewer employees, the S corporation is disqualified.

So, actually, just to underscore this point, some professional services that aren't really (in a sense) the target of the law get hit (for example, a three-person accounting firm). And even professional services firm that should be targeted may avoid disqualification if they fail the "substantionally all" test referred to a couple of places in the preceding paragraphs.

A final point: If you need additional information about the new disqualified S Corporation rules, consider purchasing our new eBook, Dodging Disqualification: How to Legally Avoid Disqualification of Your S Corporation--and Minimize Self-employment Taxes If You Can't.

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