In the 110th Congress, Ways and Means Chairman Charles Rangel (D-NY) has introduced legislation, H.R. 3970, to repeal the individual Alternative Minimum Tax and cut the top corporate tax rate.  One of the revenue offsets in the bill is a provision to require shareholders of S Corporations that primarily provide services to include almost any type of distribution from the corporation as income for the purpose of calculating self employment tax liability.


An S corporation is a corporation that does not pay an entity-level tax such as the corporate income tax.  Instead, the profits (or loss) are passed on to the shareholders, who must account for them separately on their individual income tax returns.  This occurs even if the S corporation retains its earnings, rather than distributing them to shareholders.

In order to qualify as an S corporation, a firm must be a domestic corporation with no more than 100 qualified shareholders and no more than one class of stock.  To become an S corporation, a qualifying corporation shareholders all must sign a Form 2553 (Election by a Small Business Corporation). A corporation can lose its S status by failing to continue to meet all the criteria for a small business corporation, or by having excess passive investment income and accumulated earnings and profits at the end of the year for three consecutive tax years.  Once a firm loses its S status, it (or any successor) must wait five years before it can elect that status again.

In dealing with S Corporations, one of the larger concerns, from a tax collection perspective, is whether S corporations sufficiently compensate their owner-employees.  Government officials have increasingly become interested in whether an entity is underpaying the salaries and wages of the shareholders in order to minimize tax liabilities, particular “employment taxes.”

Two government entities have released studies in recent years that have questioned whether the current system of taxation for S corporations is allowing these entities and their owners to avoid paying their fair share of taxes.

Treasury Inspector General for Tax Administration Report

In 2002, the Treasury Inspector General for Tax Administration (TIGTA) reported that the Internal Revenue Service (IRS) needed more effective means of identifying taxpayers who are not properly reporting Subchapter S corporation officer compensation.  The report looked at the incentive to underpay salaries and wages in order to avoid paying FICA and Medicare taxes. 

S corporations were originally established by Congress under the Technical Amendments Act of 1958.  However, as the law did not set the employment tax treatment of corporate profits, a year later, the IRS issued a ruling that created guidelines for taxation of S corporations.  The ruling was issued under the assumption that S corporations would have multiple shareholders and owners.  Over the years, it has become clear that the large majority of S corporations are owned by a single shareholder.  The IRS estimates that in 2003 that there were approximately 3.2 million S corporations in the United States.

According to TIGTA, in Tax Year 2000, 69.4 percent of all S corporations were fully owned by a single shareholder, while another 9.5 percent had a single shareholder who owned more than 50 percent of the shares.  As a result, nearly 80 percent of S corporations had a single shareholder deciding what to pay him or herself. The report discovered that S corporations reported an average of $5,300 in wages on their 1120-S Forms, while reporting an average of $349,323 in distribution on their schedules M-2. 

As a result of these findings, TIGTA made four recommendations.  First, additional technical guidance should be provided to IRS field personnel in determining what qualifies as reasonable officer compensation.  Second, those corporate distributions not presently captured from filed S corporation tax returns should be inputted into the IRS's computer system during returns processing.  Third, that a request for information services to identify officer compensation-related adjustment assessments made to S corporation employment tax accounts should be submitted.  Finally, TIGTA recommended that educational outreach activities should be expanded.

On May 25, 2005, the Senate Finance Committee held a hearing to discuss the solvency of Social Security.  Two of the witnesses who were invited largely talked about the issue in regards to the tax gap; that is, they spoke on how Social Security and Medicare were being short-changed due to loopholes in the tax code. 

George K. Yin, the Chief of Staff of the Joint Committee on Taxation (JCT), spoke about the recommendations the JCT made in its report on the tax gap released earlier that year.  J. Russell George, the Inspector General of TIGTA also testified.  His testimony coincided with a report issued by his office the same day, regarding the taxation of S corporations. 

The report asserts that the current system of taxing S corporations presents a significant loophole that allows single-shareholders to avoid certain taxes.  As an example, TIGTA demonstrates that in 2000, the owners of 36,000 single-shareholder corporations received no salaries from their corporations, even though the operating profits exceeded $100,000, resulting in unpaid employment taxes of $13.2 billion.  As a result, the report concludes that the IRS, by not attending to this issue, leaves a significant amount of tax revenue uncollected.

In addition to their earlier proposals, TIGTA recommended that all net income from S corporations that are more than 50 percent owned by a single shareholder should be subject to payroll taxes.  TIGTA estimates that this action would result in a nearly 80 percent tax increase for S corporations.

Joint Committee on Taxation

In the last Congress, at the request of then Senate Finance Chairman Charles Grassley (R-IA) and Ranking Member Max Baucus (D-MT), the Joint Committee on Taxation (JCT) issued a report on January 27, 2005 entitled “Options to Improve Tax Compliance and Reform Tax Expenditures.”  As stated in its introduction, the report was designed to “present various options to improve tax compliance and reform tax expenditures.” 

The JCT report discovered that, together with partnerships, estate, and trust net income, S corporations contribute between $16 and $24 billion to the tax gap. 

The report suggested that Congress extend the application of payroll taxes to owners of “pass-through” entities such as S corporations, thereby subjecting all of the net earnings of these businesses to the payroll tax, whether or not these earnings are distributed to the owners of the firm.

The report included a recommendation to treat S corporations in a manner similar to partnerships, and shareholders of S corporations like general partners. The result would be that S corporation shareholders, who materially participate in the business, would be subject to self-employment tax on their shares of S corporation net income.  Exceptions would be allowed for certain rental income, dividends and interest, certain gains, and other items.  In the case of a service business, all of the shareholder’s net income from the S corporation is treated as net earnings from self-employment.  In a personal service S corporation substantially all of its activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.

On May 25, 2005, Mr. Yin, the Chief of Staff for the JCT, testified that the Committee has found that “it has become increasingly common for individuals who perform services in businesses that they own to choose the S corporation form to seek to reduce their FICA taxes.”  The shareholders pay themselves a nominal wage while treating the rest of their compensation as a distribution.

Mr. Yin restated JCT’s view that all partners should be subject to self-employment tax on their distributive share of partnership income or loss, even if the distributive share is not distributed.  The proposal would treat S corporations as partnerships and the shareholders as general partners, for purposes of the employment tax.  The JCT estimated that, through their proposals, the federal government could raise an additional $57 billion over the next 10 years. 


S corporations were originally created in order to allow small and family-owned businesses to avoid double taxation.  Prior to the 1958 law, entrepreneurs could either choose to be a regular C corporation or a partnership.  By choosing the former, they would benefit from liability protection but face double taxation at the federal level (both corporate and individual).  By choosing the latter, they would only be taxed once (individual) but sacrifice liability protection.  At the suggestion of the Treasury Department, President Dwight Eisenhower promoted legislation that would create S corporations.

The underlying debate behind both the TIGTA and JCT proposals is how shareholders of an S corporation should determine what portion of their income should be characterized as wages and what portion should be characterized as profit.  Historically, the IRS and the courts have struggled with how to determine “reasonable compensation” for owner-employees.  According to the IRS audit manual, the IRS uses such factors as: “nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, and locally, character and amount of responsibility, time of year compensation is determined, whether alleged compensation is in reality, in whole or in part, payment for a business or assets acquired, the amount paid by similar size businesses in the same area to equally qualified employees for similar services, etc.”

However, over the years, the courts have also weighed in on the subject of reasonable compensation.  In cases involving S corporation payments to a shareholder-employee, courts have re-characterized a portion of the distributions as wages when the individual performing a service does not include any of the income as wages.

Recently, courts have applied a multi-factor test to determine reasonable compensation.  Most notably, they have considered whether an individual's compensation was comparable to compensation paid at similar firms.  Going further, the Seventh Circuit adopted an "independent investor" analysis, which asks whether an inactive, independent investor would be willing to compensate the employee as he was compensated.  The independent investor test has been examined and partially adopted in some other Circuits, changing the analysis under the multi-factor test.

The proposals offered by the JCT and TIGTA essentially take out any guesswork in determining reasonable compensation by assuming that all of the income should be considered wages, reduced by certain excluded items.  By applying payroll taxes to all income, the government would levy a substantial tax increase on many small and family-owned businesses.

H.R. 3980

The proposal would require a shareholder of an S Corporation that primarily provides services to include all distributions, regardless of the nature of the distribution with some narrow exceptions, as income for the purposes of calculating self-employment taxes.  The bill does not define “services.”


As congressional leaders continue to look for ways to address the budget deficit or provide tax relief, particularly under the PAYGO regime, they are going to increasingly look to the “tax gap” and other revenue offsets.

Whether or not it is accurate to consider the issue of reasonable compensation as a tax gap issue, it is likely only a matter of time before Congress look to the taxation of S corporation shareholders income for needed revenue. 



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