How Will Proposed New Taxes On S Corporation Shareholders Affect Startup Technology Companies? : Startup Company Blog - By Joe Wallin and Brian Todd, 2010 June 6

How Will Proposed New Taxes On S Corporation
Shareholders Affect Startup Technology Companies? : Startup Company Blog

http://bit.ly/bChKiz

As we've
blogged about before, there is a tax planning opportunity available
with S corporations that is not available with limited liability
companies taxed as partnerships (LLCs).  With an S corporation you may
be able to save employment taxes that you would otherwise have to pay if
you were operating your business through an LLC.

How? By
paying yourself a reasonable salary and taking distributions beyond your
reasonable salary in the form of dividends. This works if your salary
is reasonable. Your tax savings depend on the amount of your salary and
the amount of your dividends. If your salary exceeds the FICA wage base,
the total tax savings is 2.9%--the total of the employer and employee
side Hospital Insurance (HI) (aka Medicare) taxes beyond the FICA wage
base.

These
tax savings can be significant. To use an example:

In 2010, a taxpayer
reported a salary of $360,000 from his consulting business and profits
paid in the form of dividends in excess of the salary amount of $5
million. Tax savings: 2.9% of $5,000,000 is $145,000.

Of course, if you are running for public
office and employ this tax saving tactic, your political opponents might
describe it as a "deceitful
ploy."

In
choosing the right type of entity through which to do business, this
opportunity to potentially save on employment taxes is one of a number
of factors entrepreneurs might consider in choosing an S corporation
over an LLC. As we've
blogged before, for entrepreneurs starting early stage technology
companies who desire pass-through tax treatment, we believe the S
corporation is preferable in form over the LLC for a number of reasons,
including, in addition to potential employment tax savings, the
following:

·        the ease with which employee equity plans
can be deployed in an S corporation (stock options and traditional forms
of equity compensation are easier to put to use in S corporations than
comparable equity awards are in LLCs);

·        the tax-free reorganization provisions are
available to S corporations; meaning, you can do a tax-free stock swap
with an S corporation (say, if you are acquired by a publicly traded
company in exchange for stock), but you can't use the tax-free
reorganization provisions with an LLC (and a LLC units for stock
exchange would be taxable, even if you don't get any cash to pay the tax
in the transaction);

·        it is easier for an S corporation to do an
equity fund raise than an LLC (the documents for raising capital through
a corporation are more widely understood and accepted than complex LLC
documents); and

·        it is generally easier to convert an S
corporation to a C corporation to accept angel or VC funding (if that is
required as a condition to obtaining the funding).

In
Congress's latest tax bill, there is a provision which would take
away the potential for employment tax savings for certain types of S
corporations. The provision eliminates the employment tax savings
structure for each shareholder of any “disqualified S corporation” who
provides substantial services with respect to a “professional service
business.”

A
“disqualified S corporation” is (i) an S corporation which is a partner
in a partnership which is engaged in a “professional service business”
if substantially all of the activities of such S corporation are
performed in connection with such partnership, and (ii) any other S
corporation which is engaged in a “professional service business” if the
principal business of such business is the reputation and skill so 3 or
fewer employees.

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

• consulting,
  


• engineering,


• investment
  advice or management,


• brokerage
  services,


• health,
  


• law,
  


• lobbying, 


• architecture,
  


• accounting,
  


• actuarial
  science,


• performing
  arts, or


• athletics.

The provision is summarized in the House
Ways and Means Summary of the bill as follows:

Ensuring collection of employment taxes
earned by certain service professionals. Social Security taxes are imposed on
compensation and self-employment income up to the Social Security Wage
Base (currently $106,800) and the Medicare tax is imposed on all
self-employment and compensation income. Some service professionals have
been avoiding Medicare and Social Security taxes by routing their
self-employment income through an S corporation. These taxpayers then
pay themselves a nominal salary and take the position that the remaining
earnings are exempt from employment taxes. The bill would address this
abuse in situations where (1) an S corporation is engaged in a
professional service business that is principally based on the
reputation and skill of 3 or fewer individuals or (2) an S corporation
that is a partner in a professional service business. The bill would
also clarify that individuals that are engaged in professional service
businesses are unable to avoid employment taxes by routing their
earnings through a limited liability corporation or a limited
partnership. This proposal is estimated to raise $9.618 billion over 10
years.

The good news for
early stage technology startups in this?  They probably do not need to
worry too much because of the narrow scope of the bill. However, for
startups in the designated fields (especially the broad catch all of
“consulting” businesses), the bill could be problematic, if passed by
the Senate. 

Joe Wallin -
June 6, 2010 2:31 PM