A Tax Lesson on S-Corps

A Tax Lesson on S-Corps

July 5, 2010 Posted by J. Scott Moody - No Comments

A recent editorial in the Portland Press Herald discusses the negative impact of a small provision in the recent so-called “jobs bill” that would have applied FICA taxes to dividends paid by S-corps.  Unfortunately the author was unable to go into the history of the S-corp to better understand why this is a horrible, horrible idea.

First, let’s start with some definitions:  “S-corps” is shorthand for “Sub-Chapter S Corporations” which are a special class of corporations as defined under sub-chapter S of the Internal Revenue Code. “FICA” stands for the Federal Insurance Contributions Act which mandates that 15.3 percent (divided equally between the employee and employer) of wages and salaries are taxable to fund Social Security and Medicare.  “Dividends” are payments made to shareholders by a corporation.

Now, let’s turn to the history of the S-corp which first starts with the original C-corp which folks are most familiar with since C-corps are what constitute stock markets such as the New York Stock Exchange.  From a tax perspective, one of the major drawbacks of the C-corp is the double-taxation of dividends.  For example, a dollar of C-corps profits is first taxed by Uncle Sam via the corporate income tax.  Whatever is left over goes to the shareholder but is then taxed again as taxable dividends.  As a result, the original dollar in profits was taxed twice–once at the corporate level and again at the personal level.

In order to remedy this problem, Congress created the S-corp which is a “flow-through” entity that allows the taxation of corporate profits at the individual level thereby eliminating the double-taxation problem.  As such, dividends paid by an S-corp represent the profits of the S-corp which are taxed by the individual income tax and not subject to its own corporate income tax.  However, unlike a C-corp dividend, an S-corp dividend may not actually be dispersed to the individual.  For instance, the S-corp may keep the money to start an emergency cash fund.  Though the money stays with the S-corp, the owners must still pay income taxes on the money.

So what does all this have to do with extended FICA to S-corp dividends?  A lot.  First, when dividends are distributed to shareholders, this represents payment on capital not labor.  As a result, applying FICA to capital income would be a huge shift in tax policy and deserves to be thoroughly vetted and not as a little-noticed rider on a so-called “jobs bill.”

Second, S-corp dividends are taxes being paid by the business whether or not the funds actually end up with the shareholder or not.  As such, S-corp dividends are not equivalent to salary and wages where cash always changes hands from the business to the employee.

Third, applying FICA to S-corp dividends would dramatically erode the tax benefits of ending double-taxation on capital income on S-Corps relative to C-corps.  Also, given that the 15.3 percent FICA tax is split 50-50 between the business and the individual then double-taxation is also literally creeping its way back in.  This move would be the opposite of tax reform and would start to undo the incremental steps that Congress has taken to end the double-taxation of income.

Finally, this proposal would sever the link between an individual’s FICA contributions and Social Security/Medicare.  Keep in mind, that your Social Security benefits are tied to your wages and salaries (within limits).  This link, while already extremely tenuous, is suppose to remind you that you are in essence buying “insurance” from Uncle Sam.  After all, it is officially called “Old-Age, Survivors and Disability Insurance.”  Would FICA paid on S-corp dividends increase your Social Security benefits?  Would an S-corp qualify for Social Security based on taxes paid on its retained dividends?  Seems absurd, but these are the types of questions raised by this proposal.

It was good tax policy to see this proposal defeated . . . but since its been floated once, it is sure to raise its ugly head again.  You have been forewarned.