There currently is a bill wending its way through the House called the American Jobs and Closing Tax Loopholes Act. Wait a minute – why don’t they ever label one the “We’re going to stick it to you act”? What happened to truth in advertising? Sorry. I digress. Anyway, this bill has a lot of tax stuff in it, something for (or against) almost everyone. One item that sticks out is a change in the way S corporation dividends are taxed.
S corporations do not pay tax. They are treated similar to partnerships in that the net income of the corporation is taxed directly to the shareholder. There are certain circumstances where this is preferable to the standard “C” corporation treatment of paying tax at the corporate level first and then paying taxes on any dividends received at the shareholder level. Whether this is advantageous or not depends on a lot of factors. S corporations are by definition closely held, and are commonly used by small businesses, particularly in the start up years.
Congress is attempting to take away some of the potential benefits for S corporations by adding a layer of tax to the shareholders of S corporations engaged in service type businesses. This legislation provides that the earnings of S corporations that engage in professional services will be subject to Self Employment (FICA and Medicare) taxes. This has historically been a major advantage when considering S status, and its elimination will probably be the death knell for a lot of small S corps that will no longer have an incentive to maintain S status.
The bill hasn’t left the House as of today and will be taken up by the Senate when it does. Given all the revenue raising provisions in it (read: tax increases), its probably guaranteed to pass in some form soon.