In May and June of 2010, the U.S. Congress proposed (but did not ultimately pass) a disqualification rule for some S corporations. Specifically, the U.S. House passed and then the U.S. Senate tried to pass H.R. 4213. HR. 4213, among other things, proposed disqualifying some small professional service corporations from benefiting from the S corporation tax accounting rules.
Fortunately for small S corporations, the H.R. 4213 legislation never became law. (Republicans filibustered the legislation because of spending concerns.) However, if you’re thinking about setting up an S corpoation or you own an S corporation, you probably want to know a bit about what congress almost put into place. The proposed “disqualified S corporation” rules may appear again in the future (Example: Obama raised the idea of S corporation disqualification during the 2012 presidential compaign.)
Answering the “What in the Heck is an S Corporation” question
Let me start this discussion by first explaining what an S corporation even is. (If you already understand this, skip ahead to the discussion about who would have lost the option to use the S corporation classification.)
In a nutshell: An S corporation is a corporation that’s not typically subject to income taxes on its profits. Rather, the S corporation allocates its income to its shareholder and they then pay the income taxes on the profits. For example, if an S corporation makes $100,000 and has two equal shareholders named Smith and Jones, the S corporation doesn’t pay income taxes on its profits. Rather, Smith pays the income taxes on $50,000 of the profits. And Jones pays the income taxes on other $50,000 of profits.
By the way, if a corporation lost its qualification to be treated as an S corporation, it would become by default a C corporation. Note, then, that C corporations and S corporations aren’t “real” corporations. C and S corporations are tax accounting concepts. A C corporation is actually just an entity that’s taxed according to Subchapter C of the Internal Revenue Code. And an S corporation is just an entity that’s taxed according to Subchapter S of the Internal Revenue Code. This is a really important distinction to make because other entities such as limited liability companies can also be treated as C and S corporations. (LLCs do this by filing election paperwork with the IRS.) And some entities that aren’t even incorporated (like an association for homeowners) can be treated as C corporations in certain circumstances.
Note: By default, a corporation you create by filing articles of incorporation with the state gets treated as a C corporation. That means that by default, a corporation pays its own income taxes. And then to convert a C corporation to an S corporation, you file a Subchapter S election with the IRS using a form 2553 (which is available at the IRS web site, irs.gov.)
Any corporation can be a C corporation, but a corporation must meet a handful of eligibility requirements in order to be an S corporation. An S corporation can have only one class of stock, for example. And an S corporation can only have US citizens or permanent residents as shareholders as another example. Finally, an S corporation is limited (sort of) in the number of shareholders it can have.
Let me make now a couple of observations to provide context to people new to the vagaries of C and S corporation taxation. First, small C corporations–and this is a bit awkward to say–small C corporations often don’t actually pay income taxes. Often, seemingly by magic, the small C corporation pays out all of its profit to shareholder-employees in the form of wages. This “no profits but lots of wages” situation means that the small C corporation often doesn’t pay income taxes but does pay heavy payroll taxes.
And another awkward comment: S corporations save taxes for their shareholder-employees when they set modest wages for shareholder-employees. (I talk more about this on C Corp versus S corporation page.) This is the trick. And it works. And the trick lets small businesses in many cases save thousands of dollars a year in payroll taxes per sharholder-employee.
One final point. S corporations can in fact pay income taxes in some circumstances. When this happens is beyond the scope of this short article, but in general, only three types of S corporations have to pay income taxes: S corporations that have previously been C corporations get subjected to federal income tax in special cases, big S corporations in the state of Massachusetts can be subjected to state income taxes, and Tennessee S corporations can be subjected to state income tax because Tennessee state laws just plain don’t recognize S corporation status.
With the preceding information as background, one can make more sense of the S corporation disqualification stuff:
Professionals Potentially Subject to S Corporation Disqualification
The proposed law, Sec. 413(m), said that some S corporations were potentially subject to disqualification if substantially all of what their activities amounted to the provision of professional services. The list of potentially disqualified S corporations included service firms in the areas of health (doctors, dentists, nurses and so on), law, lobbying, engineering (including mapping and surveying), architecture, accounting, actuarial science, performing arts (like musicians, actors, and other entertainers), consulting (a catchall category which meant anyone providing advice or counsel), athletics, investment advice and management, and brokerage services (which presumably included any commissioned sales people).
The preceding categories were pretty broad and easily included people who might not, at first glance, have considered themselves targets. Yet even so, many service businesses escaped disqualification in the first versions of the disqualification rules.
For example, while an architect was vulnerable to disqualification, the general contractors he or she worked with weren’t. While a property manager probably would have been disqualified because he or she fit within the “investment management” bucket, the janitorial and maintenance service the property manager used didn’t. Further, while an attorney or physician practicing law or medicine would have been disqualifiable, another attorney or physician who provided continuing legal or medical education services probably didn’t get disqualified.
Note: I try not to be political in these articles, but here I make an exception: Congressional Democrats appeared to have protected many blue collar and traditionally democratic professions and trades from disqualification, while beating up on all the traditional white collar professionals and any white collar occupational category involved in the recent financial crisis. The proposed disqualifcation, then, wasn’t a general disqualification or repudiation of the S corporation framework. The disqualification targeted specific groups of S corporations.