UPDATE: Small-Business Payroll Tax Increase Dropped From Senate Bill

(Updates with response from Finance Committee spokeswoman and Senate vote)
By Martin Vaughan

WASHINGTON -(Dow Jones)- U.S. Senate Finance Committee Chairman Max Baucus ( D., Mont.) has removed a controversial proposal that would force lawyers, accountants and other professionals to pay more in payroll taxes from a broader proposal to extend expired tax cuts.

The payroll tax provision, which would have raised $9 billion to help pay for tax cut extensions, had drawn strong criticism from business advocacy groups and Republicans including Sen. Olympia Snowe (R., Maine).

An email from Senate Finance Committee staff, obtained by Dow Jones Newswires, outlined several changes to an amendment Baucus planned to offer to small- business legislation pending on the Senate floor.

Among those changes was the elimination of the small business payroll tax provision. A Senate Finance Committee spokeswoman said plans for the amendment were still under discussion. She said she couldn’t comment at this time on whether the proposal has been shelved indefinitely.

An attempt by Senate Democrats to limit debate on the small-business bill failed in a Thursday morning Senate vote, making it unlikely that the Baucus amendment would come up for a vote anytime soon.

The proposal had aimed to crack down on a tax-sheltering technique known as the “John Edwards loophole,” named after the former North Carolina senator and Democratic presidential candidate.

Proposal supporters say some S-corporation owners pay themselves a nominal salary, while collecting the rest of the firm’s profits through a dividend that isn’t subject to payroll taxes.

But small business groups said the Senate proposal would have applied Medicare and Social Security taxes to income that represented a return on business owners’ investment, which they said is distinct from salary.

Besides dropping the S-corporation payroll tax provision, Baucus also modified provisions that would restrict the use of foreign tax credits by U.S. multinational firms.

He moved until later the effective dates of those provisions, so that the new rules will apply only after Dec. 31, 2010. That shaved $2.9 billion off the revenue those provisions are expected to raise.

Those effective date changes are also reflected in legislation the House is expected to vote on Thursday to encourage investment in the U.S., which also includes the foreign tax credit changes.

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