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If you went to college and weren’t fortunate enough to either earn a scholarship or pay your way by moonlighting as a pool hustler or exotic dancer, you’re probably still dedicating a portion of your paycheck to whittling away your student loans.  

Unfortunately, you’re fighting an uphill battle, because on July 1, 2012, interest rates on subsidized Stafford loans are set to double from 3.4% to 6.8%.

Congress has your back, however, as proposals have been formulated that would grant a stay of execution to the rate hike.

One such proposal — creatively named the “Stop the Student Loan Interest Rate Hike Act of 2012″ —  would postpone the rate increase for one year, and pay for the lost revenue by doing away with the “S corporation loophole” that allows S corporation shareholder-employees to forego compensation in favor of distributions that are not subject to payroll taxes.

For some background, we’ve previously discussed this loophole here and here, but in short, it works like this:  Because S corporation flow-through earnings are not subject to payroll taxes — unlike their partnership counterparts — there is tremendous motivation for S corporation shareholder-employees to limit the compensation they pay themselves. While compensation is subject to payroll taxes, by forgoing salary S corporation owners increase their flow-through income, which can be withdrawn from the corporation as distributions that are also not subject to payroll taxes.

As a result, many S corporation shareholder-employees, including John Edwards and Newt Gingrich — have used this loophole to limit their compensation and take large sums of cash out of closely-held S corporations free from payroll tax.

The IRS routinely attacks such transactions and requires the shareholder-employees to pay themselves a minimum “reasonable” salary. In the fifty year case history of reasonable compensation cases, however, the IRS has never required a salary of more than $95,000, so the opportunity still exists for shareholder-employees to trade compensation above this amount for distributions. (For a detailed history of S corporation reasonable compensation issues and the relevant case history, please see this brilliantly written piece — Tax Adviser – S Corporation Shareholder-Employee Reasonable Compensation) — which, like most great works of art, won’t be fully appreciated until the author is dead and gone.)

Lawmakers have long sought to close the S corporation compensation loophole and put S corporations and partnerships on equal footing. Many different types of proposals have been floated, including:

 1.  subjecting the flow-through income of shareholders owning more than 50% of S corporation stock to self-employment income;

2. subjecting the flow-through income of shareholders in “professional services S corporations” to self-employment tax; and

3. Simply subjecting all S corporation flow-through income to self-employment tax.

The “Stop the Student Loan” Act takes a hybrid approach to closing the loophole. The proposal would subject the income allocated to shareholders of “professional service” S corporations to self-employment tax only if:

 1. the shareholder provides substantial services to the S corporation;

2. 75% or more of the gross income of the business is attributable to 3 or fewer shareholders; and

3. the shareholder has AGI > $250,000 if MFJ and $200,000 if single.

 The proposal would also apply to a S corporation that is a partner in a professional service partnership.

Lastly, “professional service” businesses are defined as any trade or business providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.

Despite being attached to the attractive student loan bill, I wouldn’t expect this to get passed. The bill is too narrow and the law changes too difficult to enforce, and would simply give rise to a new era of loopholes intended to circumvent the 75% rule.  

Joe Kristan has more.

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If you’ve got teenaged kids who aren’t cut out for life in the carnival, you’re probably starting to stress about funding their college education,  particularly in light of the fact that the average four-year education at a private university will run you upwards of $120,000.

Hopefully, you started socking away money long ago, so your primary concern at this point is maximizing your eligibility for financial aid. If that’s the case, then it’s high time you start paying attention to your tax returns, as the information included on your Form 1040 will, in large part, determine just how much you’re entitled to in educational handouts.

William (don’t call me Billy) Baldwin over at Forbes has published a wonderful column detailing the numerous tricks a taxpayer can employ to “manage” their adjusted gross income for several different reasons, one of which is to maximize educational assistance. Your first order of business? Start thinking outside the typical “defer income/accelerate deductions” box:

Accelerate income.Most taxpayers would like to defer income and the tax bill that goes with it. But it makes sense to go the other way if your tax bracket is headed upward or if you will be filling out college aid forms two years from now or if you are planning a joint replacement next year. If your child is going to college in fall 2015 and you’re going to sell some appreciated stock to cover the costs, you should probably sell that stock now so that it doesn’t inflate the 2013 income shown on your financial aid application, says Barry Picker, a Brooklyn, N.Y. CPA.

As Baldwin points out, additional dollars of taxable income during your application years will cost you dearly:

Who’s the tax collector with the stiffest rate? For many middle-class families the ogre is a college bursar. Take home an extra $100 and the financial aid ­formula will snatch $37 away. That makes income planning a powerful idea for taxpayers with kids likely to qualify for tuition breaks. The idea is to shrink your income in the years that will show up on any aid application.

Carefully choosing your deductions can also mean more cash come college time. Baldwin explains:

Some things that lower your adjusted gross income also lower the income measured by aid formulas. One is the deduction (up to $7,250) for contributions to a health savings account. But some things that work fine with federal taxes don’t cut any ice with aid officers, warns Troy Onink, a FORBES contributor whose Strategee.com gives advice on financing education.

A deductible contribution to a 401(k), for example, reduces your AGI and thus your federal tax bill. But it gets added back in the income measure used by colleges. Perversely, colleges do count retirement assets going the other way. If you withdraw from a tax-deferred account or convert it into a Roth, the aid formula will treat the money as if it were lottery winnings.

What to do?

First, fund your retirement accounts to the max when your kids are young. Assets parked in retirement accounts are beyond the reach of aid officers.

Next, be careful about converting to a Roth if you have kids aged 16 to 21. It may cost you in reduced aid more than it saves over the years in federal taxes.

Finally, if you have a child in college and are contributing pretax money to a 401(k), think about switching to an aftertax (i.e., Roth) contribution. That will raise your 2012 taxes, lower your taxes in retirement and—surprise—increase the aid you get in 2013. That’s because aid formulas do deduct current tax bills in computing disposable income.

It is somewhat paradoxical that converting is bad, but electing a Roth for new money is good. Here’s the arithmetic. If you are in a combined 40% state and federal bracket, then converting $10,000 raises your tax bill by $4,000 and lowers your aid by $2,220. Switching from a $10,000 pretax to a $10,000 aftertax contribution raises your tax bill by $4,000 and raises your aid by $1,480.

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