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Reputation and skill

May 26, 2010

It's hard to do something exceptionally stupid to a tax code already brim-full of dumb, but Sander Levin, Charlie Rangel's replacement as head of the House Ways and Means Committee, is up to the job. Exhibit A: his new proposal to apply self-employment tax to some -- but only some -- professional S corporations.

Mr. Levin's proposal, part of the annual-or-more-frequent "extenders" bill, would hit K-1 earnings of S corporation shareholders with self-employment tax under two sets of circumstances:

- When the S corporations are members of a professional services partnership, and
- When the S corporation provides personal services and "the principal asset of such business is the reputation and skill of 3 or fewer employees."

Complex attribution rules would keep people from shifting income to other family members by gifting them stock.

If enacted, as seems likely, this rule would create odd problems.

It would penalize the smallest personal service providers to the benefit of their larger competitors.. A sole proprietorship would pay taxes at a rate at least 2.9% higher than a competitor whose "principal asset" is the reputation of more than three employees.

The bill also will require businesses and the IRS to determine what the "principal asset" of a personal service corporation is. The bill obviously requires the valuation of intangible assets -- reputation and skill -- but in a way not elsewhere attempted in the tax law. How do you do this?

Let's take an entirely hypothetical S corporation CPA firm with nine shareholders. All have been practicing in tax or audit work since they had hair. They like to think they are all highly skilled, but the skill sets differ. Some are known more as rainmakers, some view themselves more as technicians. One has an enormous Google footprint, while others are more old-school in their business development methods. Which counts more?

How often would you have to measure "skill and reputation"? In 1986, the last major rewrite of the Code drastically and suddenly reduced the "skill" of many old accountants by making their knowledge obsolete. The spread of computers greatly devalued the lovely handwriting of manual spreadsheet jockeys, enabling the graphically-challenged among us to do pretty spreadsheets with the best of them. How do you design an 1120-S schedule to measure that? Or would you just look at the name -- is Ernst and Young based on the reputation of Ernst, Ernst and Young?

Why can't you game the "principal asset" thing? Many accounting and law firms own their own building. If you own a building in your little S corporation, especially one big enough to generate rent from other tenants, it seems like that, rather than your "skill and reputation," could become your "principal" asset. The bill might just turn a bunch of small professional businesses into real-estate speculators.

And what skills do you measure? In my younger days in another firm, one of the (now deceased) partners was known around the office for his amazing ability to bill clients seemingly impossible amounts and make them think they were getting a bargain -- a valuable skill, certainly, if one not fully appreciated by his clients. How does the IRS measure this? Sadly, this is the sort of dark skill common among congresscritters like Mr. Levin, offsetting their apparent absence of skills in sound tax policy.

UPDATE, 5/31/2010: The S corporation medicare tax grab: what is to be done?

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Great post. I found your blog from taxgirl, a blog I regularly read. I'll have to add you to my list. This act is going to cause headaches, I'm sure of it.

Great Post. I had to mention it on one my blog, this was a must read. Thanks

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