The following information appeared in the May 28, 2010, issue of "The Kiplinger Tax Letter":

The 15.3% self-employment tax on the profits of S corps will apply to its shareholders starting next year.  This change will eliminate the opportunity for S corp shareholders working in the business to take a portion of their compensation in the form of tax free dividend distributions and puts them on the same "playing field" as members of LLCs and sole proprietorships.

This "revenue raiser" is a late addition to a bill that reinstates a set of expired tax breaks (that primarily benefit individuals e.g., as sales tax deduction, child tax credit, etc.) to help offset a portion of the lost revenue from reinstating the expired tax breaks.  Even though Congress failed to approve the tax bill before Memorial Day, the tax increase on S corps will be part of the measure when it is finally passed according to Kiplinger.

Small personal service S corps will be hit particularly hard since the shareholders will be subject to the 15.3% SE tax on their proportional share of 100% of the profits of the corporation.  Personal service corps are those engaged in the fields of accounting, law, health, actuarial science, engineering, architecture, consulting, et.al.  It will not matter that none of the profits have actually been distributed to the shareholders.  In other words, there will be no credit available for profits left in the firm for working capital purposes.

This will end a popular payroll tax saving strategy for S corps whereas modest salaries were taken by shareholders with the remainder of their "compensation" paid out in the form of tax free dividend distributions, which serve to reduce shareholders' tax basis in their shares of the corporation.  Of course, not all dividends are compensation as enough cash needs to be distributed to the shareholders to cover their federal, state, and local income tax liability on the pass-through of their respective share of the taxable earnings of the corporation.  Presumably, S corp shareholders who work in the business will no longer be W-2 employees of the corporation where their salaries are subject to federal and state/local income tax withholding, FICA withholding, and employer FICA match, FUTA, and SUTA (state unemployment taxes).  Now shareholders will have to cover their SE tax liability through their quarterly federal estimates.   This, again, is the same as it is for sole proprietors (including single member LLCs) and partnerships (including multiple member LLCs which elect to be taxed as partnerships under the "check the box" income tax regulations).

This change has been simmering for several years.  A few years ago, Treasury determined that there was massive tax avoidance in S corps dividing owner compensation into modest salaries and large dividend distributions.  According to the Kiplinger article, more than 35,000 single owner S corps with profits of $100,000 or more paid no payroll taxes on the profits of the corporation because the owners didn't take a salary.  Ditto for owners of about 40,000 S corps with profits in the $50,000 to $100,000 range.

In advising clients who are debating choice of legal entity, they need to be aware that changes are in the works that may significantly impact their decision which makes it all the more important to have closer consultation with their accounting and tax advisors, who presumably will be current on these changes as they work their way through the legislative process.

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From May 2010