Tax Development: Proposed Rules to Unify Income Taxation of Pass-through Entities

March 18, 2015

President Obama's proposed budget for 2016 includes a plan to standardize the income taxation of all pass-through entities. If this were enacted, shareholders of S corporations would be subject to tax (including self-employment tax) on the same basis as partners in a partnership.

Historically, the IRS has struggled to fairly and consistently tax pass-through income under the Federal Insurance Contribution Act (FICA) and its self-employment tax counterpart (SECA). This is because only "wages" are subject to FICA taxes and only self-employment "earnings" are subject to SECA taxes.

Under the current regime, general partners and sole proprietors pay SECA taxes on their entire share of "earnings." S Corporation (S Corp.) shareholders are not subject to SECA taxes; instead, they pay FICA taxes only on wages paid for services rendered. Nonwage distributions to employee-shareholders of an S Corp. are not subject to either FICA or SECA taxes, although the IRS may reclassify such distributions as wages to the extent that the S Corp. does not pay reasonable compensation. Many S Corps. intentionally pay very little compensation to their owner-shareholders in order to avoid liability for payroll taxes. Thus, S Corp. shareholders are able to receive a substantial portion of their income as nonwage distributions that are not subject to either FICA or SECA taxes. As a result, S Corp. shareholders generally pay much less employment tax on their S Corp. income than partners in a partnership are required to pay on similar partnership income.

The President's proposal would eliminate this disparity by allowing the IRS to tax the income of owners that materially participate in a professional service business (an S Corp., a limited partnership, a general partnership, or an LLC) as partnerships under SECA. (See Laura Davidson, Treasury: Simplifying S Corporation Taxes Would End "Reasonable Compensation" Game, BNA Daily Tax Report No. 45, G-7 (Mar. 9, 2015).) The exemptions provided under current law for certain types of partnership income would be extended to apply to a professional service S Corp. and LLCs. Owners who do not materially participate would be subject to SECA taxes only on an amount of income equal to reasonable compensation, if any, for services rendered. The administration hopes that standardizing the income tax scheme for all professions services pass-throughs will simplify IRS "reasonable compensation" determinations and create income tax equality among the various pass-through entity forms.

The Firm's tax practice involves a wide variety of federal, state, and local matters dealing with tax planning and tax controversies. We are involved in all aspects of tax planning, including rendering tax advice relating to business startup operations, financing, ownership changes, taxable and tax-free acquisitions, reorganizations, liquidations, divisions, dispositions, and terminations of businesses.

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