Small corporations line up to protest closing ‘Edwards loophole'

Small-corporation representatives are lining up to protest a tax increase known as the “John Edwards loophole.”

Tax legislation the Senate is slated to pick up this week would raise approximately $11.2 billion by requiring principals in professional service S corporations to pay employment taxes on a firm’s profit.

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Proponents of the proposal say it will stop owners from dodging employment taxes by paying themselves a nominal salary, which is subject to employment taxes, but then taking a huge distribution that is not subject to employment taxes.

This strategy has been dubbed the “John Edwards loophole” because the scandal-ridden former presidential contender used it to pay himself millions from his S corporation.

Edwards paid himself a $360,000 salary from his S corporation, but then took an additional $26 million from the firm that was subject to income taxes, but not employment taxes. The loophole likely saved Edwards at least $500,000 in taxes.

Revenue from the tax change would be used to pay for other provisions in the bill extending other business and individual tax breaks. Money is also raised from a provision changing the tax on carried interest, the income commonly paid to hedge fund managers and venture capitalists. That fight to date has largely overshadowed the debate over S corporation taxes.

The Treasury Inspector General for Tax Administration and the Joint Committee on Taxation have both urged lawmakers to close the loophole, and supporters argue it would add fairness to the tax code.

But opponents contend language in the Senate’s tax bill is ill-defined and goes too far in trying to stop the abuse.

“The way it’s structured, in our view, it’s going to be extremely difficult, if not impossible, to make workable,” Brian Reardon, executive director at the S Corporation Association of America, told The Hill. “I think the longer this is out there, the more you’re starting to hear from folks who work in this area that this provision is not ready for primetime.”

Reardon’s concerns with the proposal are illustrated in a May 27 letter from S-corp guru Thomas Nichols to House Ways and Means Committee Chairman Sandy Levin (D-Mich.), Senate Finance Committee Chairman Max Baucus (D-Mont.) and their respective ranking members.

The Nichols letter criticizes lawmakers for expanding the definition of a “professional service business” because it makes more companies liable for the tax but does not give them fair warning about the impending tax increase. It also chides them for taxing family shareholders “who [do] not provide substantial services,” warning the change will make children of S-corp owners liable for employment taxes.

“[The] child in this situation likely has no idea that he or she has done anything wrong to deserve these draconian tax consequences,” the letter states. “The [Treasury] Secretary is authorized to promulgate regulations to correct this (hopefully) unintended consequence, but that could be years from now.”

The proposal also does not distinguish between taxing retained earnings and profits that are taken out of the company. Nichols, who chairs the Committee on S Corporations for the American Bar Association Tax Section and has over 20 years of experience working in the S-corp world, argues this oversight will mean that profits reinvested in the company will be taxed, which will reduce the amount of capital available to improve the business.

His last criticism is also a point of contention for Debra Dockery, who heads up Debra J. Dockery Architects in San Antonio.

Her firm is structured as an S corp, and every year a chunk of the company’s profits is reinvested back into the business. But based upon how the tax proposal currently reads, Dockery will either have to forgo or restrict annual upgrades to the firm’s computer system to pay for the levy.

“It will affect our ability to provide a level of upgrades that we need to keep competitive,” she told The Hill. “That’s a big thing. When you submit your qualifications [for a potential job], there used to be 10 companies competing with you. Now there are 30 or 40. So you’ve got to stand out. You’ve got to keep current.”

Dockery pays herself a salary that is more than the highest-paid employee at her firm. Employment taxes are taken out of her wage.

“I’m not skirting any kind of employment tax,” she said. “But the proposed increase in taxes with this bill would affect our ability to purchase the hardware and the software that would keep my firm competitive.”

Reardon isn’t optimistic that the tax increase will be stripped from the bill, but he thinks it's possible it could be slimmed down to affect fewer S corporation principals.

He and Nichols are urging lawmakers to at least hold hearings on the tax increase before advancing it to the White House.

“Normally, far-reaching legislation such as this is subject to hearings and there is an opportunity for written input,” Nichols wrote. “Such input is especially critical now in dealing with [S corps] when the American economy is only very slowly emerging from the worst economic downturn since the Great Depression.”

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