Back when John Edwards was trying to get the presidential nod instead of Obama, some attention got focused on the way Edwards was able to avoid certain payroll taxes by having his compensation as a lawyer funneled through his professional service corporation, a Subchapter S corporation for US federal income tax purposes. Doesn't make sense, when you really think about it, that a lawyer's income for services would magically be transformed when a corporation, the only meaningful services of which are performed by that lawyer, is paid the compensation on his behalf and then pays the lawyer a (smaller) salary plus a purported "dividend". But that was the gimmick.
Now, another campaign has again brought attention to the issue. Newt Gingrich similarly avoided taxes on his compensation income by using an S Corp format.
And finally maybe Congress will act?
Pete Stark, D-CA, has introduced a bill to undo the gimmick. Similar to bills introduced in prior Congresses, the bill would treat dividend payments as payments subject to the Medicare tax for principal shareholders of a small S Corp whose principal assets consist of the skills and reputations of three or fewer shareholders. See the January 31, 2012 Stark e-Alert, announcing the introduction of H.R. 3840, the Narrowing exceptions for Withholding Taxes (NEWT) Act:
I introduced the Narrowing Exceptions for Withholding Taxes (NEWT) Act (H.R. 3840) yesterday, which would close a tax loophole that allows self-employed individuals -- typically lobbyists, lawyers and investment managers -- to avoid paying Medicare payroll taxes by routing earnings through an S corporation and classifying them as profits or dividends, instead of as wages.
Teachers, firefighters, and nurses can't structure their income to avoid payroll taxes. ...
Former Speaker Newt Gingrich availed himself of this loophole on his 2010 tax returns. He reported [only] $444,327 of his earnings as wages .... and avoided paying an estimated $69,000 in Medicare taxes.
See also Stark Introduction Statement, which points out in simple language the rationale for the bill.
Medicare payroll taxes are imposed at a rate of 2.9 percent on all wage income. Under present law, certain self-employed individuals try to avoid paying Medicare payroll taxes on a portion of their wage income by routing it through an S corporation. In general, S corporations do not pay income tax. Instead, the income gains and losses of an S corporation “flow through” to shareholders’ individual tax returns. By law, S corporations can have no more than 100 owners; but they are typically far smaller, with the GAO estimating that 94 percent of S corporations have 3 or fewer owners.
A shareholder of an S corporation who performs services as an employee is subject to Social Security and Medicare payroll taxes on his or her wage income, but generally is not subject to payroll taxes on amounts that are not wages (such as dividends and profits). Nevertheless, an S corporation employee-shareholder is subject to payroll taxes on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wage income. Where an employee-shareholder is entitled to a significant amount of S corporation income, there may be a temptation under present law to understate what portion of the income is compensation for services (and subject to payroll taxes) and correspondingly increase the amount treated as a dividend or profit.
The provision would produce about $11.2 billion more in taxes annually, according to the JCT estimate.