What is a Disqualified S Corporation?

In May and June of 2010, the U.S. Congress proposed (but did not ultimately pass) a disqualification rule for some S corporations. Specifically, the U.S. House passed and then the U.S. Senate tried to pass H.R. 4213. HR. 4213, among other things, proposed disqualifying some small professional service corporations from benefiting from the S corporation tax accounting rules.

Fortunately for small S corporations, the H.R. 4213 legislation never became law. (Republicans filibustered the legislation because of spending concerns.) However, if you're thinking about setting up an S corpoation or you own an S corporation, you probably want to know a bit about what congress almost put into place. The proposed "disqualified S corporation" rules may appear again in the future...

Professionals Potentially Subject to S Corporation Disqualification

The proposed law, Sec. 413(m), said that some S corporations were potentially subject to disqualification if substantially all of what their activities amounted to the provision of professional services. The list of potentially disqualified S corporations included service firms in the areas of health (doctors, dentists, nurses and so on), law, lobbying, engineering (including mapping and surveying), architecture, accounting, actuarial science, performing arts (like musicians, actors, and other entertainers), consulting (a catchall category which meant anyone providing advice or counsel), athletics, investment advice and management, and brokerage services (which presumably included any commissioned sales people).

The preceding categories were pretty broad and easily included people who might not, at first glance, have considered themselves targets. Yet even so, many service businesses escaped disqualification in the first versions of the disqualification rules.

For example, while an architect was vulnerable to disqualification, the general contractors he or she worked with weren't. While a property manager probably would have been disqualified because he or she fit within the "investment management" bucket, the janitorial and maintenance service the property manager used didn't. Further, while an attorney or physician practicing law or medicine would have been disqualifiable, another attorney or physician who provided continuing legal or medical education services probably didn't get disqualified.

Note: I try not to be political in these articles, but here I make an exception: Congressional Democrats appeared to have protected many blue collar and traditionally democratic professions and trades from disqualification, while beating up on all the traditional white collar professionals and any white collar occupational category involved in the recent financial crisis.

Triggers for S Corporation Disqualification

Here was the next weird thing about S corporation disqualification proposal. Not all S corporations within the targeted categories ultimately got disqualified. In the house version of the "disqualified S corporation" rule, a vulnerable professional service S Corporations got disqualified only in two situations. First, if an S corporation was a partner in a professional service business, an S corporation was disqualified if substantially all of the activities of the S corporation were related to being a partner. Second, if the principal asset of a professional service S corporation was the "reputation and skill of 3 or fewer employees," an S corporation was also disqualified.

Accordingly, big S corporations, even those that provide professional services exclusively, didn't get disqualified. And even small professional service firms quite possibly escaped disqualification if they also sold other non-professional services or if they sold products.

Note: The senate tried to pass a slightly different set of "S corporation disqualification" rules, but I'm not going to discuss those rules in detail since the Senate proposals were never even voted on.

Result of Disqualification of S Corporation

What happened to a disqualified S corporation? Well, bad stuff in short.

Normally, the profit of an S corporation (the money left over after paying expenses including reasonable wages to S corporation shareholder-employees) is only subject to income taxes. In other words, the income is taxed sort of like other investment income such as interest, dividends, capital gains, rent and so on.

The "disqualified S corporation" rules would have changed this. Under the proposed law, S corporation profit would have been considered self-employment earnings if the shareholder or the shareholder's family worked in the business. In this case, and in addition to the regular federal and state income tax taxes, self-employment taxes also got levied on the income. Self-employment taxes run roughly 15.3% on the first $106,800 of income and then roughly 3% to 4% on amounts above that depending on the year and the taxpayer's income.

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