Wednesday, June 09, 2010

The Big Tax Increase Facing Small Business

The Senate is set to consider a hefty tax increase owners of S-corporations in certain service industries. The House of Representatives has already approved the increase, which taxes carried interest on hedge funds. posted a story explaining the new tax increase, you can check out a section of their article below.

While a possible increase in taxes on the "carried interest" of hedge fund and private equity money managers is getting all the attention, in the same bill Congress is also creating a tax mess for small-business owners in the form of an $11 billion tax hike over the next 10 years.

The tax increase was included in H.R. 4213, a peddler's wagon of legislation (new spending, physicians' reimbursement, extensions of expired tax breaks, etc.) that was passed by the House in a narrow vote just before Memorial Day and is now being considered by the Senate. The Democratic-backed Senate version of the bill includes the same tax on small business.

The tax hit affects the owners of small S corporations (a common way many small businesses are organized) in "professional service businesses"--doctors, lawyers, accountants, engineers, architects and so on. An S corp pays no taxes but passes through all its profits to its owners' tax returns, even when those profits or "distributions" are reinvested in the business.

Professionals have long been able to reduce their tax bills by incorporating as S corps and then receiving part of their earnings in the form of distributions or profits, rather than taking it all as ordinary compensation or wages. Unlike wages, profits aren't subject to payroll taxes--that is, Social Security and Medicare taxes. It is this longstanding tax benefit that the House has eliminated for certain small S corporations.

Here's why this is a big deal: The Social Security tax is now 12.4% of the first $106,800 of wages, with half paid by the employer and half by the employee. A self-employed person pays the whole 12.4%. The Medicare tax is 2.9%, with no cap on the amount of pay taxed. This too is split between employer and employee, with the self-employed paying the whole 2.9%.

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