Democrats Consider Payroll Tax Increase on “S Corporation” Income

House and Senate Democrats are considering whether to subject income earned by shareholders of S corporations engaged in service businesses to payroll taxes in an effort to raise revenue to pay for the annual tax extenders bill or other tax legislation this year.  S corporation income is not directly taxed.  Instead, S corporation earnings "flow through" to shareholders who are taxed at the individual level as ordinary income.  S corporation shareholders who are active in their business, however, pay themselves a salary, on which they pay self-employment taxes that go towards Social Security and Medicare like traditional employee payroll taxes. Applying payroll taxes to certain S corporation profits could raise anywhere from $10 to $15 billion.  Roughly $30 billion is needed to offset the cost of the annual tax extenders bill, which would extend for one year certain expired tax provisions, such as the research and development tax credit and the 15-year shorted cost recovery period for retail, restaurant, and leasehold improvements.  Critics of the proposal argue that it would violate the long-standing principle that payroll taxes be applied solely to wages received for labor, not capital income.  However, the recently-enacted health care bill applied a 3.8 percent Medicare payroll tax to unearned income, including that earned by passive shareholders in S corporations.  Moreover, the proposal is inconsistent with the health law which exempted S corporation income earned by active shareholders. AGC is a member of The S Corporation Association of America and will oppose this proposal.