As Congress considers possible "extender" bills that would extend for another year a number of the Bush tax cuts that will otherwise sunset, it is also considering ways to pay for providing those tax breaks. One item up for consideration is reform of the way payroll taxation works in connection with S corporations, which though corporate in form are treated as pass-throughs, with their income subject to tax only at the shareholder level. Remember that John Edwards' income for his services was funneled through an S corp, so that he received a portion as his "compensation" (subject to payroll taxes) but then claimed the rest as a passthrough of corporate profits. In reality, almost all of those profits were attributable to his services and in an ideal system would have been subject to payroll tax.
Naturally, those S corp shareholders who are currently receiving profit passthrough without payroll taxation are objecting. A coalition of various business groups (Air conditioning contractors of america, American council of engineering companies, Associated builders and contractors, Food marketing institute, Independent community bankers of America, International franchise association, National association for the self-employed, National federation of independent business, National funeral directors association, National restaurant association, S corporation association, Small business legislative council, U.S. chamber of commerce & Wine & spirits wholesalers of America) has written Sandy Levin urging him to chuck the proposal as a revenue raiser to offset extended tax cuts. (The letter is available on BNA at this link for those with a subscription.)
Although there is no text for the proposed statutory change yet, the letter refers to a similar proposal in the past that would have applied payroll taxes to active shareholders of S corporations that are primarily engaged in the performance of services. The coalition suggests that if a company's business is partly from services and partly from sales, the mechanism would require payroll taxes to be paid on the company's profits in proportion to the split of the revenues between services and sales--so if 80% of the company's profits are from the performance of services, 80% of the distributive share to the active shareholder would be subject to payroll taxes.
Now, this strikes me as a workable, "rough justice" provision that would make it simple to make the determinations in a fair way and would ensure that service providers are really paying the appropriate payroll tax on their compensation.
But the coalition has a number of objections.
First, the coalition wants to treat returns as partly attributable to greater investment in physical or human capital. So if the firm invests in a new computer, the coalition wants to take the "return" from the improved capital out of the profits from the provision of services. Similarly, if the company trains a worker so that the worker can perform better, the coalition wants to treat part of the profits as derived from the return to human capital.
This would be quite complicated and is not really supportable. Certainly, part of my compensation income as a law professor is a return to human capital (my education and experience), but I cannot therefore reduce my compensation income and payroll taxes. It seems reasonable to treat the profits as earned by the end-point revenue creators--the services or sales conducted by the business and exact payroll taxes accordingly.
The letter also raises scope issues, asking whether landscapers and similar businesses are primarily performing services or conducting sales. Anyone who has hired a landscaper knows that the bill is divided into "labor" and "materials": shouldn't it be relatively easy to determine whether a particular business is one that depends primarily on sales or services?
The letter suggests that Congress's exclusion of S corporations from the new health care tax on investment income would be "effectively reverse[d]" if this provision were enacted. But can't the exemption be read to mean that Congress considers most S corp income to be either inventory sales or services income and not "investment" income. That is harmonious with applying the payroll taxes to such income from S corps that are primarily engaged in the provision of services.
The objections include a worry about "increasing taxes on small business owners" and "adding to the tax code's complexity" and being "an unfair tax increase on small and family-owned businesses." Yes, it would increase taxes on small business owners and on owners of "family owned" businesses (which may in fact be quite large businesses). That is the point of the proposal. Unlike their employees whose wages are reported and subject to immediate withholding to cover the payroll taxes, S corp owners have had the advantage of claiming only a small amount of the profits of their firm as their compensation, while treating the rest as non compensatory passthroughs not subject to payroll taxes. This proposal would treat active shareholders of service firms more like their employees, and that seems a reasonable result.
The letter also objects to "blurring the line between labor income and income from capital." One of the reasons the tax code is so complex is that the "line" is an arbitrary one with many places where the distinction is at best hard to make. Accordingly, those with sufficient resources have frequently attempted to arbitrage the boundary. The best way to simplify the tax code, by far, would be to eliminate the "capital" and "labor" income distinction altogether. And that would also result in a Code that would raise more in taxes from those who have the greater ability to pay. At the least, we should err on the side of including items of income on the labor side when the profits of a firm are predominantly due to the performance of services by the owners of the firm. Sounds to me like this provision is on the right track.