ataxingmatter

Updated--S Corp payroll tax changes may pay for lower-cost student loans

UPDATE:  the filibuster rule again permitted a minority in the Senate to prevent good legislation from getting off the ground.  On May 8 the Senate fell 8 votes short of the 60 vote supermajority needed to bring the loan provision with the S corp payroll provision to a vote.  The right wing has by this vote explicitly condoned the gamesmanship that most closely held S corp owners engage in whereby they pretend that their service compensation is a return on investment. 

The White House has endorsed a move by Senate Democrats to tighten up partnership and S Corps payroll tax payments--something long needed anyway--in order to fund the protection for students from paying too high interest rates on their loans. See  Statement of Administration Policy (May 7, 2012); Stop the Student Loan Interest Rate Hike Act of 2012 (S. 2343).  The payroll tax provision would require owners of certain closely held partnerships and S corporations to pay payroll taxes on their income from the entities if they have income in excess of $200,000 (singles)/ $250,000 (joint filers).  The provision would raise almost $6 billion over the next 10 years to pay for a one-year extension of the current 3.4% rate on government-guaranteed loans. 

A procedural vote will take place on Tuesday, but the routine use of the filibuster by Republican opponents will likely make it hard to enact.  Both parties claim a desire to hold the student loan rate steady, but Republicans can't stand the idea of rich people not being able to use their S corporations to avoid paying payroll taxes on all of their compensation, so the GOP passed a bill in the House that would pay for student loan relief by eliminating funding for a preventive care program! 

Campaigns highlight the Sub S payroll tax avoidance problem

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. 

HR4213's S Corp provision

Joe Kristan doesn't like the S Corp provision, and thinks my support for the less-than-perfect provision is ill-conceived.  See  A One-Hitter is "Not Perfect"--This is something else, June 3, 2010.

Now, I think that having an S Corp provision, even though it  ended up somewhat complicated because it was drafted as a compromise to focus only on those S Corps where it is clear that the services of a few owner/service providers is the basis of the S Corp business, is a step in the right direction.  Without it, we have the specter of continued use of the S Corp entity to avoid payroll taxes, where very well paid doctors, lawyers and other service providers magically convert compensation income to non-compensation income, and avoid paying payroll taxes on most of it. 

Joe has some good points, nonetheless, that merit a rebuttal. 

1)  The language in swection 413 of the bill--such as "principal assets" and "reputation and skill"-- may not be interpreted in the same way by all readers of the text. 

True, but most likely only because those readers are trying to find an ambuiguity or indeterminancy to claim substantial authority (based on statutory interpretation) to avoid the application of the provision.  Good regulations can and I am sure will provide depth to the words "principal assets" and "reputation and skill" in the provision, but this complaint is picking at straws--admittedly the kinds of straws that practitioners trying to find loopholes for their clients love to pick at.  We all know what kinds of businesses this bill is intened to impact. 

Reputation and skill as keywords may cause some stumbling, since tax advisers and accountants are used to considering more specific terms for the intangible assets of a business, such as "goodwill", "knowhow", "customer base".  Was this intentional or just sloppy drafting?  One might argue that these terms are broad enough to include all three of the more traditional intangible assets, and that they are intended to capture a broad-scope set of intangibles that the service provider brings to bear on the services provided. 

2) It can be gamed

Most provisions can be gamed.  And many tax practitioners spend a good bit of their waking time thinking about how to game a particular requirement, even though they "know" that the requirement is aimed at exactly their client's situation.  Regretably, until we have a "more likely than not" base confidence level requirement for positions taken on returns or advised, this will likely continue.  That means that regulations will need to provide incentives for complying with the purpose of the statute.

For example, Joe suggests that a business that is a service business might  just buy the office that it currently rents and then claim that its principal asset is the physical building and thus it is not subject to the provision.  Surely this would not satisfy the purpose or literal language of the statute.  Why?  Because it's the services that make the business a business.  So principal asset should not  be interpreted to permit service providers to stuff their corporation with passive assets like real estate or securities and then claim that those passive assets are the "principal asset" of the business so the provision is inapplicable to them.

The IRS should likely include an anti-abuse provision in the regs, noting that the statute will be interpreted in light of its purpose to end the gambit of converting compensation income to distributions that are not subject to the payroll tax.  The regs should likely include some examples that demonstrate that passive assets  or equipment/office space for service providers do not count.

3)  It discriminates against smaller firms

This would be true, to the extent that firms with 10-20 or more service providers operate in S Corp form rather than partnership form. (I need to check this out--I suspect Congress was using a "rough justice" measure of the predominant type of firm that was abusing the S corp formation to avoid payroll taxes, but I haven't looked at this empirically). 

But again, as a start it is better than nothing.  We in fact have many provisions that treat firms differently even though they are similarly situated.  That is not ideal in tax, but it happens because one or another person in Congress fights for a particular constituent and wins an exemption or because the less than complete bill is the only thing that can get passed.  HOpefully Congress will revisit the issue once the hullabaloo is over, and remedy such irregularities.  Removing exemptions, elections, and similar provisions is generally a good idea.  But having a bill that addresses the largest group of payroll tax avoiders is much better than continuing to not deal with this issue.   But see item 4.

4) It could have been simpler and more workable.

This is a good point.  The rules for S corps could have been changed across the board, treating all income from firms whose business is the provision of services as subject to the payroll tax, regardless of number of service providers.  

Of course, I suspect Congress couldn't pass such an across the board change.  So while I would prefer a better bill, it is much better to deal with the lion's share of this issue than not to deal with it at all.

The architects' trade association is lobbying against the bill with a similar list of complaints.  They argue that requiring these service providers to pay payroll taxes will kill the economy.  Funny how these groups never argue that ordinary workers on salary shouldn't have to pay payrool taxes, even though of course those ordinary workers would rather have more income.  Sure, S corporation shareholders/service providers would rather have as much profits as possible from their corporations without payroll taxation.  But payroll taxation on their compensation isn't going to make the business go out of business.  It will not be on gross income, after all, but on the excess after the regular expenses of earning that services income.  The service providers/owners will have less take home pay, but they will be for once paying their fair share of the tax burden that ordinary workers have been paying all along.  I don't think "the economy will crash (at least for these service providers)" argument holds water--the additional tax won't cause the business to fold, but it might make the service providers work harder so they can still earn the same in spite of paying their due share of the payroll tax burden.

They also argue that the IRS already has sufficient tools at its disposal to prevent the conversion of compensation to profit distribution without payroll taxation.  But in fact that provision is extraordinarily difficult to enforce because of the subjective nature of what is "reasonable" compensation, and the time such audits and cases require is a huge drain on the limited resources for enforcement.  Having a bright-line rule for S corporations moves the ball forward (even though there will be at least some initial jousting over whether the provision applies to a particular S corporation).

S Corps as a way to avoid payroll tax--will the Republicans succeed in "saving" the tax evasion technique?

As most know by now, the "extenders" bill, which extends several of the Bush tax breaks for a few more years, will cost money.  So it requires revenue raisers.

Two of those revenue raisers are things Congress should have done anyway--taxing "carried interest" for all those managers of partnerships as everybody else's compensation for services is taxed, and taxing the profits of S corporations (at least the small ones with a few people whose services are the income of the corporation) as the compensation income it is. For carried interest--especially in the case of private equity funds, real estate partnerships and other service partnerships-- that means taxing it now at ordinary rates instead of preferential capital gains rates.  For S corps, the bill would recognize that distributions are really compensation on which payroll taxes are due for these corporations with 3 or fewer service shareholders.

But the wealthy lobbyiests are busy convincing Congress to let their clients continue to have their big tax giveaways.  When Congress has something reasonable for the impoverished, the right wing keeps on about "entitlements" and how awful they are, even though a safety net for the vulnerable is as fundamental to a sustainable democracy as voting.  But when there are preferences for the wealthy, there isn't a heavily financed contingency to protest them, and there are heavily financed contingencies fighting to preserve them for the wealthy. 

So the HOuse passed a compromised provision on carried interest--phasing it in gradually, and only taxing 75% of the amount as compensation at ordinary rates.  That nuts, of course.  All of it is compensation for services.  The idea of a compromise to preserve some of the preference for the wealthy is crazy.  But the Senate is being pushed to compromise even further--leave some working partners exempted from the provision and cut the amount that is taxed at ordinary rates to 65% or less.  Will they have the gumption to do the right thing?  One has doubts.

And on the S corp provision, which the House passed as applicable only to S corps with three or fewer key service providers, the Senate is also waffling.  The right, of course, doesn't like any tax increase for the wealthy (though it is generally just fine with pension cuts, or layoffs, or the impossibility of modifying mortgage loans in bankruptcy, or other much more serious financial hurdles for ordinary folks). See, e.g., Dean Zerbe, The Big Tax Increase for Small Businesses, Forbes, Jun. 9, 2010.   Doctors, dentists and others who have established S corps to "launder" their services income so that they can avoid payroll taxation on the full amount will view this as a 15% tax increase--the 12.4% Social Security tax on approximately the first $108,000 and the 2.9% medicare tax on the full amount.

Well, it is a loophole closer and therefore a tax that these doctors and dentists and other service providers should have been paying all along, just like all of us ordinary folk who get regular salary checks from our employers pay the tax.  The issue is straightforward.  Some people have been sole proprietorships and had to pay ordinary rates on all of their income and payroll tax on all of their income, because all of their income (not offset by business deductions) is compensation for their services.  Then they incorporate and make the S corp election.  Suddenly, they claim that their compensation for services (paid in the same way by the same clients) is no longer really all compensation for services:  THEY CLAIM A SALARY PAYMENT THAT IS LESS THAN THE ACTUAL COMPENSATION THEY ARE PAID, AND THEN THEY CLAIM THE REST OF IT AS "DISTRIBUTIONS" FROM THE "PROFITS" OF THE S CORPS.    The government has estimated that in 2003 and 2004 S Corps underpaid their owners/service providers by $24 billion, cheating the government on payroll taxes that should have been paid on that amount.  SeeForbes article (with link to GAO study and reminder that John Edwards paid himself a salary of about $360,000 when his services as an attorney actually earned him about $5 million). Not surprisingly, the Forbes article argues that the impact will be that service providers will decide to go out of business if they have to pay the regular taxes that all us ordinary folk have been paying all along.  I don't buy it.  Maybe there will be one or two who were ready to retire anyway.  But I don't expect that people who are in the midst of their careers will quit just because they have to work a little harder to make the same amount of money because they have to pay the same payroll taxes that their employees already have had to pay forever (on much lower salaries than the jefe makes).  This argument is made for every tax increase, but the work world hasn't come to a screeching halt from any of them. 

This gambit should have been ended long ago--all of the profits ought to be subject to payroll taxes, as the House bill provides (in many cases).  Olivia Snowe and Bill Enzi--both Republicans--want to save doctors and dentists and lawyers and others from paying the same tax that ordinary workers pay.  They've offered an amendment on Friday that would remove the S corps provision.

Do we need any more evidence of the capture of Congress by the wealthy?  Will ordinary people who pay ordinary income tax rates on their full salaries, and pay payroll taxes on all that salary, stand by while wealthy partners continue to get preferential treatment?

S corporation tax reform proposal to fund extenders: more payroll taxes

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.

S Corporations: GAO report, recommendations regarding noncompliance

The Government Accountability Office (GAO)  issued a December 2009 report to the Senate Finance Committee on the "Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules."

Many Americans doubtless don't know an S Corporation from a German silent partnership, except for the attention the S Corp got when John Edwards was running for President and word got out that he managed some considerable tax savings through his  S Corp.  So, herewith a small primer.

S corporations are ordinary "C corporations" that have made an election that permits qualifying corporations to avoid the corporate level tax and pass through the tax items (income, deductions, etc.) to the S corporation shareholders.  S corporations cannot have multiple classes of stock and can only have certain types of shareholders, so that they are somewhat less flexible than taxable C corporations.  Most S corporations have just 1-3 shareholders.  (Of course, some of the tax changes made during the Bush years made the S corporation more widely available, and in particular facilitated certain banks' use of the form.)  S corporations have been increasing in popularity, because of the combination of limited liability protection and pass-through of tax items that avoids an entity level tax. 

According to the report, a large majority of S corp returns (68% for 2003-2004, the last years for which the reporters had data) misreport at least one item and tend to misreport to the favor of the S corporation/shareholder 80% of the time.   The returns misreport net income, basis, distributions, and gross sales.  Many treat shareholders' personal expenses as deductible in calcuating the net income reportable.  Many don't substantiate the expenses that are taken as a deduction.  A common error is for a shareholder to use losses that should be disallowed because the shareholder doesn't have enough basis to take the loss. Another common problem is underreporting of shareholder compensation, which, unlike distributions, is subject to payroll taxes.  (/this was the issue raised about John Edwards' S corporation.).  The fewer shareholders the S corporation has, the more likely it is to have errors on the return.  And of course, paid preparers tend to add to problems (71% use paid preparers).

The recommendations include improving return preparer compliance, which the IRS already has started working on, and changing the statute to require basis calculation at the entity level.  The report also note that the vagueness about what constitutes reasonable wage compensation is a problem that could be addressed in the Code or regulations, and lack of IRS nenforcement in this area is a problem.  The report discusses some legislative options (such as making net business income subject to emplyment taxes) and some administrative options (such as improving guidance for examiners and better educating taxpayers).

By the way, these S Corporation shareholders are mostly comprised of the "small businessmen" that the right-wing anti-tax crowd constantly claims is overtaxed.   Hmmmm. Looks like the bigger issue with this group is noncompliance, not overtaxation.  We need to increase enforcement efforts, especially focused on the particular items that have tended to be misreported in S corporation returns.