S-Corp Payroll Tax Hike Re-Emerges

Both the Camp discussion draft and the President’s budget include provisions to expand the application of payroll taxes to S corporation income.

The White House proposal is an expanded version of efforts that failed in the Senate in 2010 and 2012, where 100 percent of income from a professional services businesses – law, accounting, consulting, etc. – organized as an S corporation, general or limited partnership, or an LLC taxed as a partnership, would be subject to SECA taxes.

The Camp provision, on the other hand, is a whole new approach that is dramatically broader than anything considered to date.  It would reach beyond professional services businesses and would impact all S corporations, including manufacturers and other producers.  The draft would:

  • Bring S corporation business income under self-employment taxes (SECA);
  • Create a new 70-30 rule, whereby 70 percent of an active shareholder’s wage and business income derived from the S corporation would be subject to payroll taxes;
  • Credit the active shareholder with any FICA taxes paid on the S corporation wages;
  • Apply to all S corporations, not just professional services businesses; and
  • Apply the same 70-30 rule to partnerships.

Another area of difference between the two plans is their revenue estimates.  The Obama provision is narrower – it applies to professional services businesses only – yet Treasury estimates it will raise $38 billion over ten years!  The Camp provision is significantly broader – it applies to all S corporations – but the JCT says it will only raise $15 billion.  What gives?

We’re not sure, but since the new 70/30 rule applies to both S corporations and partnership income, it appears the Camp proposal would both raise and lose revenue, with the net effect resulting in a $15 billion tax hike. Under current rules, a significant portion of partnership income is fully subject to payroll taxes – particularly among large law and accounting firms – which means the new 30 percent exclusion would have the effect of lowering collections on those businesses.  That’s good for partnerships, but bad for S corporations, because it means the tax hike on them is significantly larger than $15 billion.

The Committee claims their approach is simpler than current rules, but we don’t see it.  Consider the case of an owner of a large manufacturing plant with dozens of employees and millions in capital investments.  This is not a rare example – drive around any sizable town and you’ll see dozens of them.   He pays himself a market-based salary of $250,000 and the business makes $750,000 in profit.  Under the current rules, his salary is subject to FICA while the business income is not.  Since he’s paying himself a market wage, the business income is, by definition, a return on the capital invested in the business and should not be subject to payroll taxes.

The Camp proposal, however, would do just that.  Under the provision, the owner would need to aggregate his salary and business income ($250,000 + $750,000 = $1 million) and then multiply the result by 70 percent.  That’s the amount of his total income that would be subject to payroll taxes ($700,000).  The owner would then subtract out the salary income that has already been subject to FICA ($700,000 – $250,000 = $450,000).  That’s the amount of the owner’s business income that would be subject to SECA taxes.  It’s not simple, and it’s certainly not fair.

Moreover, the Camp approach appears to severely limit the benefit of excluding domestic manufacturing income from the new 10-percent surtax.  As advertised, the Camp plan would tax S corporation “producers” at a top rate of 25 percent.  But the draft also appears to apply the same 70/30 rule to production income as it does to payroll taxes.  That means, in the example above, the owner would pay a 25 percent rate on $300,000 of his business income, but 35 percent on the rest.  Suffice it to say that the C corporation down the street doesn’t face this byzantine approach to marginal tax rates.  The combination of the 10 percent surtax and the 70/30 applied to active shareholders presents a strong incentive for the owner of this business to retire, convert to C corporation status, or sell the business entirely.

Finally, it’s important to address the origins of the 70/30 rule.  According to the Committee’s section-by-section:

The provision’s distinction between net earnings from self-employment and other income not subject to SECA reflects the fact that over the last several decades, the portion of Gross Domestic Product (GDP) attributable to labor has remained remarkably constant at approximately 70 percent, while the portion of GDP attributable to capital has held steady at roughly 30 percent. The 30-percent deduction recognizes that a portion of the distributive share of a partnership, LLC or S corporation represents earnings on invested capital. 

In other words, since the nation’s income is divided 70/30 between labor and capital, that ratio should also apply to the business income from an S corporation or partnership.  We’re not so sure.  Take the example above.  The GDP definition of “income” is not limited to the combined $1 million in business and salary income attributed to the owner.  It also includes all those wages paid to the other workers.  Those wages are included in the GDP calculations, but the Committee ignores them in applying the 70/30 rule to S corporations.

As we pointed out, since the owner in our example pays himself a market wage, any business earnings beyond that amount are a return on capital.  So taxing that income as a return on labor is simply not correct.  Not every S corporation has lots of capital – some have little, while others have tons.  Applying a one-size-fits-all 70/30 rule to all S corporations does not accurately capture this diversity, and it certainly doesn’t justify a massive increase in the application of payroll taxes to business income.

As readers know, we’ve been fighting this issue for a decade now, ever since Vice President Dick Cheney chastised Senator John Edwards for using the S corporation structure to avoid payroll taxes on the income from his law practice.  Over the decade that followed, S-Corp has developed the following position on the issue:

  1. We don’t support using the S corporation structure to avoid payroll taxes.  We represent businesses that comply with the law, not sneak around it.
  2. It’s not a loophole, its cheating.  This issue is often described as a loophole, but that’s not accurate.  Underpaying yourself in order to avoid payroll taxes is already against the rules.
  3. The IRS has a long history of successfully going after taxpayers who abuse the S corporation structure.  The current S corporation rules on this have been in place since 1958.
  4. Any “fix” needs to improve on the current rules.  That means they need to be easier to enforce and they need to target wage and salary income only.  Employment taxes should apply to employment.

Measured against those rules, the two proposals put forward here fall short.  They ignore the distinction between employment and investment, and they unfairly raise taxes on business owners who are fully complying with the law.  They might successfully raise revenues, but they don’t appear to contribute to fairness or simplicity.

Payroll Tax Hikes Back On The Agenda

Last week, the S corporation community was put on high alert when we received word that an S corporation payroll tax increase similar to the provision from the old Rangel Mother bill (H.R. 3970) was being discussed as an offset to the extender package. The “Mother” provision (see Sec. 1211) would apply payroll taxes to all the service-related income of active shareholders of S corporations primarily engaged in service businesses. While we anticipate that the language of any new provision will differ somewhat from its 2007 predecessor, the general concept remains the same. As CongressDaily noted:

Sources familiar with the House Ways and Means and Senate Finance discussions said applying payroll taxes to certain S corporation profits could raise anywhere from $10 billion to $15 billion, depending on how it is structured. Revenues in that ballpark would go a long way toward closing a $30 billion gap tax-writers need to fill to pay for extensions of numerous expired provisions.

An earlier proposal floated in 2007 was estimated to raise $9.4 billion over a decade by subjecting S corporation and partnership income earned from providing services to payroll taxes, although the new healthcare law would raise the Medicare portion of the tax beginning in 2013 for wealthier earners. The 2007 proposal was scaled back from an earlier option outlined by the Joint Committee on Taxation that would have applied the payroll tax to all S corporation income, estimated to raise $57.4 billion over a decade.

Team S-CORP has had to fight this battle in the past, and we have been in to discuss this provision with Ways and Means on several occasions to get a better idea what they have in mind. Letters sent back in 2007 on behalf of S-CORP as well as our allied trade associations should give you a better sense of the history of this issue.

The future of this particular effort is still very much up in the air. Our communications with the Hill suggest there continues to be strong interest in legislating on this issue — you could characterize this as just one more legacy item left to us by former Senator John Edwards and his law practice — albeit it may take place on a bill other than extenders.

We have pledged to work constructively with taxwriters on a resolution to this issue, but unless they are willing to dramatically pare back the Mother provision to target only bad actors, it is going to be very difficult for business groups to support yet another tax increase on their members.

Stay tuned. More to come.

Latest on Dividends

Whither Tax Rates? The Hill’s On the Money Finance & Economy Blog had an excellent discussion this month on the topic, focusing on the future of dividend rates.
As On the Money notes, “President Barack Obama has proposed that the current rate of 15 percent on dividends be extended for most taxpayers. He’d raise the tax on dividends for individuals making $200,000 or more and families making $250,000 or more to 20 percent. There are several reasons to think wealthier taxpayers will get hit with a much higher tax.”

Meanwhile, The Hill mentions that one possible outcome would be for the dividend tax to fall somewhere between the current 15 percent rate and the top rate on ordinary income. Any divergence from the baseline, however, would require positive action by Congress. As The Hill observes, that’s not something to be taken for granted:

Finally, the lesson of the expired estate tax also has dividend-tax watchers nervous. Congress was expected to extend the estate tax last year, but instead let it expire when Republican and Democratic senators could not reach a compromise. The estate tax is set to kick in again in 2011 at a much higher rate if no action is taken this year.

Also at play is a possible House-Senate dynamic. Our impression is Senate leadership would like to keep capital gains and dividends taxed at the same rates, while their House counterparts are more comfortable seeing the rate on dividends go back to 39.6 percent.

In the end, we believe process will dictate outcome here. The recently enacted ”pay-go” rules require Congress to offset any reduction in the dividend tax rate below 39.6 percent for 2011. Exactly what tax increases would Congress use to offset dividend tax cuts for folks making more than $200,000? We don’t know either, and expect the tax hikes already imbedded in current law will take place as scheduled.

Long To-Do List

Tax policy is in danger of becoming that honey-do list that never gets done. The traditional tax extenders — R&E tax credit, state sales tax deduction, etc. — all expired at the end of last year and, almost five months later, are still expired. Legislation to extend them is stuck between the House and Senate without a pay-for, yet (see above).

Meanwhile, the estate tax fix that was supposed to be done last year — before the tax took its one-year sabbatical — remains stalled in the Senate. Efforts to negotiate some sort of permanent fix are actively taking place in the Senate, so there’s hope. As with the extender package, however, the hold-up is primarily over offsets.

There’s also the most recent in the growing line of “jobs” bills being considered by Congress this year. The latest one passed the House under the banner of a “small business jobs” bill, despite the fact that most of its benefits went to Build America Bonds. We expect the Senate to take up a bill that’s more small-business oriented soon.

Finally, there’s the burning issue of all those tax cuts expiring at the end of the year.

With that as background, reasonable folks might ask themselves: “What’s the plan?” Ways and Means Committee Chairman Sander Levin (D-MI) addressed this question earlier this month, stating he hopes to complete work with the Senate on both tax extenders legislation and the House-passed small business bill by the end of May, telling reporters, “These bills are a critical priority for the leadership of this Congress and the president. These are jobs bills and we need to get these done.”

According to BNA, Levin met with Senate Finance Committee Chairman Max Baucus (D-MT) to discuss the two bills, but the two “did not discuss efforts to address the estate tax, which expired at the start of 2010, and no detailed plans have been set for how lawmakers will deal with the middle-class tax cuts of 2001 and 2003 that are set to expire at the end of the year.”

Your S-CORP team has numerous member companies who are intently interested in Congress moving forward on both the estate tax and the expiring tax provisions. We are five months into 2010 already. It’s time for Congress to act.

Built-In Gains in Play

Team S-CORP spent the last couple weeks on the Hill, educating members and staff on the virtues of reducing the built-in gains (BIG) holding period.

When a company converts to an S corporation, it must hold onto any appreciated assets for 10 years or face a punitive level of tax. This tax effectively locks up these assets, preventing the company from selling them and putting the resources to better use. We’ve raised this issue before, but allowing private companies access to their own capital makes lots of sense in an economy where capital is scarce. It also reflects the reality of today’s shorter lifespan for key business investments.

Last year, Congress agreed and included a shorter, seven-year holding period in the stimulus package. That seven-year period expires at the end of 2010 and needs to be made permanent. A five-year period would work, too. Last summer, Senator Grassley (R-IA) introduced legislation to reduce the BIG tax holding period to five years which we view as tremendously valuable to S corporations struggling to raise capital.

With the Senate actively considering provisions to help small businesses grow and create jobs, a shorter BIG holding period is going to give you more job-creating umph than any other tax provision we know. It would benefit Main Street firms located in every state and every sector of the economy and should be included in the final package.

Business Community Rallies Around S Corporation Modernization

Last week, your S-CORP team sent a letter signed by 22 of our association allies to members of theB House andB Senate, urging them to cosponsor legislation to replace the dated rules that have governed S corporations for over fifty years.B B As the letter notes:

These outdated rules hurt the ability of S corporations to grow and create jobs. Many family-owned businesses would like to become S corporations, but the rules prevent them from doing so. Other S corporations are starved for capital, but find the rules limit their ability to attract investors or even utilize the value of their own appreciated property.

Well into the 21st century, Americabs most popular form of small-business corporation deserves rules adapted to today, not fifty years ago. The S Corporation Modernization Act would ensure the continued success of these businesses.

Earlier this Congress, House Ways and Means Member Ron Kind (D-WI) and Senate Finance Committee Members Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) introduced the bS Corporation Modernization Act of 2009b (H.R. 2910 andB S. 996) in their respective chambers.

The legislation, designed to update and simplify the rules governing S corporations, enhances the ability of S corporations to attract and raise capital, makes it easier for family-owned S corporations to stay in the family, and encourages additional charitable giving by S corporations and the trusts that hold them.

In the coming weeks, S-CORP will be ramping up its efforts to gather additional support for these bills.B At a time when Americabs job creators struggle through the difficult economy and the Federal government struggles with massive deficits, smaller, targeted reforms like these are an attractive means of helping Main Street without breaking the bank.

Health Care Reform Outlook & S Corporations

Just about everybody agrees the political landscape has shifted to the point where, while there were once 218 House votes in favor of a reform package, now there are nowhere near that many.

This lack of support is evidenced by the Rube Goldberg-nature of the current efforts to resurrect reform and move it through the Congress.B B One popular idea is for the House to pass the Senate bill, and then take up a reconciliation package of items to bfixb whatbs wrong with the Senate bill.

We are skeptical anything like that happens.B Health care reform is unpopular and members are nervous and tired.B Moreover, this approach would require House members to bvote on faithb that the Senate would follow-through and adopt the fix.B There is rarely a lot of trust between House members and the Senate under normal circumstances, and these are not normal circumstances.

Our expectation is for the hand-wringing to continue for a month or so and then for other pressing items like the jobs bill and the budget to push heath reform aside.

For S corporations, it is hard to regret the demise of this particular reform effort.B B We have refrained from weighing in on the merits of health care reform — it is a little outside our focus, after all — but the impact ofB paying for health care reform was clearly going to be a negative.

The House bill would have raised marginal rates on upper-income S corporation shareholders by 5.4 percentage points, while the Senate bill would have increased the Medicare HI tax from 1.45 percent to 2.35 percent — not a direct shot at S corporations, but it would have increased pressure on the IRS and others to change the payroll tax treatment of S corporation income.

And before talks broke down, House and Senate negotiators were seriously considering tossing out those items and expanding the tax base for payroll taxes to include capital gains, dividends, interest income, and S corporation income instead.B B As the Los Angeles Times wrote:

Democratic congressional leaders are considering a new strategy to help finance their ambitious healthcare plan — applying the Medicare payroll tax not just to wages but to capital gains, dividends and other forms of unearned income.B B The idea, discussed Wednesday in a marathon meeting at the White House, could placate labor leaders who bitterly oppose President Obama’s plan to tax high-end insurance policies that cover many union members. It could also help shore up Medicare’s shaky finances, and the burden of the new tax would fall primarily on affluent Americans, not the beleaguered middle class.

It would have fallen on the beleaguered S corporation community, too.B B Moreover, these increases were going to take place when taxes on S corporations (and other flow-through businesses) already were going up.B B Current law has the top income tax rate returning to 39.6 percent at the beginning of next year, and we anticipate the President will propose to keep these rate hikes in place, at the very least.

Finally, with health care reform out of the way, taxwriters on the Hill will have time to address some of the many tax items that were pushed aside last year, including tax extenders and a broader tax reform effort.B B As BNAB noted this morning:

Last December, Rangel told a group of executives that he planned to press his case for tax reform at the conclusion of the health care debate.

It appears health care reform is over, so we expect Congress to refocus on tax policy this year.