Working for Free?

Richard Winchester, an assistant professor at Thomas Jefferson School of Law, has picked an interesting topic for his first article--Working for Free: It Ought to be Against the (Tax) Law, available on SSRN here in draft form.  He looks at the way the "temporary" treatment of dividends as preferentially taxed net capital gains has created an opportunity for the wealthy to avoid taxes when they work for their own corporations. 

Here'e the gist.  A shareholder-employee can withdraw corporate profits either as compensation for work done or as dividends.  With the temporary change in the tax law, investment income in the form of dividends is preferentially taxed at rates no higher than 15%.  Ordinary compensation income, on the other hand, is taxed at progressive rates up to 35% and is subject, up to a statutory ceiling, to FICA and FUTA employment taxes that fund safety net programs like Social Security and Medicare.  (Investment income is not subject to those taxes.)  Compensation payments are deductible to businesses (and can sometimes be paid in lumpy amounts to ensure lower FICA and FUTA payments than would apply if the compensation were even over multiple years).  Dividend payments are not deductible.  Therefore, the availability of tax savings by reducing compensation and increasing dividends depends on the applicable tax brackets and rates.  But at least in some cases under the temporary dividend rate rules, an owner-employee has an economic incentive to avoid FICA and FUTA taxes (and perhaps lower the overall federal income tax liability) by substituting dividends for compensation.  "Ironically, certain rich individuals can get richer by working for free."

Winchester's solution?  He suggests expanding a proposal for uniform treatment of individuals who own and work for a business conducted through a pass through entity put forward by the Joint Committee on Taxation (JCT).  The JCT proposal would assess employment taxes in respect of owners-employees on the owners' share of the businesses profits (with some adjustment for purely passive investments).  Winchester suggests that the proposal should include closely held corporations, by taxing each owner-employee on the owner's share of the corporation's earnings.  In that way, the legal form of the business would be irrelevant to the employment tax liability of the compensated employee. 

Another solution not mentioned by Winchester is a uniform assessment of FICA and FUTA taxes on all compensation income and investment income such as dividends, interest, and capital gains.  With the broader base, the rate for these taxes might be reduced.  At any rate, the increased base should raise sufficient revenues to deal with the projected shortfalls under the current system.