S Corp Payroll Tax Hike Resurfaces

Last week, Senate Democrats released a paper highlighting a dozen tax increases they would like to use to offset spending cuts in the current budget negotiations. As Politico reported:

Tax expenditures topping the list include the deduction corporations take when they move operations overseas and the carried interest loophole, which allows private equity and some other investment advisers to pay the lower capital gains tax rate on some of their income.

Also on the list is our old nemesis, the S corporation payroll tax hike. Labeled the Edwards Loophole by Republicans and the Gingrich Loophole by Democrats, the issue is that some professionals are using the S corporation structure to avoid paying payroll taxes. According to the Democrats’ release:

Some wealthy business owners knowingly mischaracterize their income as business profits instead of salary to avoid Medicare and Social Security payroll taxes. Ending this loophole would save about $12 billion over the next ten years.

We have a number of objections to this characterization. First, using your S corporation to avoid payroll taxes is not a loophole, it’s tax avoidance. The current reasonable compensation rules are clear and the IRS has a history of going after offenders and winning.

Second, the proposals offered to date are worse than the existing rules. The JCT might score them as raising $12 billion over ten years, but it’s hard to see how the IRS would be able to come up with that level of enforcement.

For example, the provision defeated by the Senate back in 2012 would have replaced reasonable compensation with a “principle rainmaker” test where the IRS would have to determine whether 75 percent or more of the gross income of the S corporation is attributable to the service of three or fewer shareholders. Oh, that’s easy. As a letter signed by 38 business organizations observed:

This new approach, particularly the ”principal rainmaker” test, is neither clear nor more enforceable than existing rules. These rules have been in effect for over half a century, and the IRS has repeatedly and successfully used them to ensure that active S corporation shareholders pay themselves a reasonable wage, most recently in Watson v. US (2011).

The business community responded strongly in 2012 and that opposition remains today. We do not support the misuse of the S corporation structure to avoid payroll taxes, but any replacement to the current ”reasonable compensation” test must be easier for the IRS to enforce and for businesses to comply with.

For those who want more, here are links to the business community letter as well as a longer history of the issue:

SBA Weighs in on Corporate Tax Reform

A new study sponsored by the Small Business Administration adds to the case that corporate-only tax reform, as advocated for by the Obama Administration, would shift the tax burden on to smaller, private companies. As reported by Politico:

Cutting corporate tax rates by trimming costly breaks is a popular selling point for a tax code overhaul, but some small businesses could wind up unintended victims, an independent government agency on Wednesday said, lending support to Republican concerns.

New data from the Small Business Administration warn that the trade-off would be a double whammy to smaller businesses that file taxes as individuals.

These businesses get nothing from a corporate rate cut but they could still lose their tax breaks. The SBA study found that these businesses account for about $40 billion in tax benefits, or about one-third of the $161 billion spent each year on all business tax expenditures.

The top U.S. corporate rate is 35 percent, among the highest in the industrialized world. Although the code is riddled with breaks and loopholes that allow some companies to pay far less, others pay much more.

By contrast, the top rate for individuals, including these so-called pass-through entities, is more than 40 percent.

The study compared the value of tax expenditures for all businesses with those used by pass through and corporate businesses with annual receipts under $10 million. As the study notes:

Of the largest tax expenditure provisions utilized by all businesses in 2013, small businesses will utilize approximately $40 billion out of a total of $161 billion. The estimates indicate that small businesses will utilize approximately 25 percent of the largest business tax expenditure provisions in 2013.

So any effort to eliminate tax expenditures to pay for a lower corporate tax rate would also hit pass through businesses that pay at the individual rates. Not good. As our 2011 E&Y study made clear, such a policy would increase taxes on pass through businesses by $27 billion a year.

S Corporations and Payroll Taxes, Again

The release of Newt Gingrich’s tax return has returned the issue of payroll taxes and S corporations to the public’s attention. This issue first came to prominence during the 2004 election cycle, when Vice Presidential nominee John Edwards was accused of using an S corporation to avoid paying Medicare taxes on some of his income as a lawyer.

Now it appears Newt Gingrich may be using a similar structure. USA Today has an excellent report on the issue. Here are a couple excerpts:

Gingrich’s tax return shows his S Corporation, Gingrich Holdings, accounted for the bulk of his $3,142,066 adjusted gross income in 2010. The corporation paid him nearly $2.5 million in distributions beyond his salary and wages total of $252,500, his tax return and 2011 federal financial disclosure filing show.

Non-salary distributions from S Corporations are not subject to the 2.9% Medicare tax rate, half paid by the corporation and half by the employee.

But the IRS requires S corporations to pay “reasonable” salary compensation to employees for their services before paying non-wage distributions. That’s designed to prevent the corporations from avoiding Medicare taxes by issuing disproportionate payments in distributions, rather than wages.

An IRS publication about S Corporations states that if most of the gross receipts and profits are associated with an employee’s personal services, “then most of the profit distribution should be allocated as compensation.”

DeSantis said the candidate’s speaking engagements and television appearances produced the bulk of the payments received by Gingrich Holdings.

McKenzie said the IRS would typically ask how much investment an S corporation filer put into her or his business. Gingrich Holdings was renamed Gingrich Productions last year, corporate records in Georgia show and his spokesman confirmed. Gingrich’s federal financial disclosure report, filed in July, lists Gingrich Productions as an asset valued at between $500,001 and $1 million.

“The general rule of thumb they’ll usually apply is they don’t view anything greater than a 20% return on investment as reasonable. The rest should be paid as salary,” said McKenzie.

As USA Today points out, the IRS has two tools it can use to test whether a taxpayer is paying the appropriate level of tax — areasonable compensation test and a reasonable return test on the businesses capital investments.

Several years ago, the House tried to replace these enforcement tools and re-write the rules surrounding how and when S corporation income is subject to payroll taxes. The effort was badly flawed and with the help of Main Street allies, it died in the Senate.

Well, now it’s back. House Ways and Means Member Peter Stark (D-CA) introduced legislation this week called the Narrowing Exceptions for Withholding Taxes (NEWT) Act. The bill appears to be identical to the changes that passed the House back in 2010. According to a summary, Congressman Stark’s concern is that the current reasonable compensation test is too dependent on the facts and circumstances of each individual case. In our view, however, the fix he is proposing is worse. Here’s how it’s described:

Certain employee-shareholders of S corporations would have to calculate their Medicare payroll tax obligation based on their share of the S corporation’s profits or dividends, not just income reported as wages. The individuals subject to the provision are the employee-shareholders of a professional service business where the principal assets of that business are the skills and reputations of three or fewer individuals.

How is a principal asset test easier to enforce than the existing reasonable compensation test?

  1. It would require affected businesses to get a valuation of each of its significant assets in order to determine which asset was its principal asset.
  2. This analysis would require the valuation of assets that are very difficult to value (i.e., skill and reputation).
  3. The bill taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except that it has four key employees.
  4. The bill requires difficult legal conclusions about uncertain areas. For example, whose asset is an employee’s “skill and reputation” - the employees or the company for which the employee works?
  5. The bill provides no definition of asset- it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single asset for purposes of determining the principal asset of a company.

The bottom line is that the IRS already has sufficient tools to combat the payroll tax problem and it has successfully litigated cases in which taxpayers have taken compensation that was less than reasonable.

They can apply a reasonable compensation test to the shareholder’s salary income, or they can apply a reasonable return standard to the company’s capital investment. And while it’s true that these tools are dependent on the facts and circumstances of each particular business, so is the new standard outlined above. Only more so.

Presidential Candidates and Their Tax Returns

So, we now have the tax returns for President Obama, Governor Romney, and Speaker Gingrich. Did anybody notice that the S corporation owner is the one with the highest effective tax rate?

Seriously, of the three, Newt Gingrich paid the highest effective tax (32 percent), followed by President Obama at 26 percent and then by Governor Romney at 14 percent. Given that the Wall Street Journal is reporting that S corporations pay no tax at all, that result might come as a surprise to their readers.

On the other hand, readers of the more authoritative S-Corp Washington Wire understand that of the four business structures — S corporations, partnerships, C corporations, and sole proprietorships — the Small Business Administration found that S corporations paid the highest effective tax rate for firms with less than $10 million in revenues.  S corporations paid 27 percent, while C corporations paid just 18 percent.

To be fair, this estimate doesn’t include the second layer of tax paid by C corporation shareholders. Add in the shareholder tax on capital gains and dividends, and the effective rates for C and S corporations are probably about the same. We’ve been pointing that out for two years now.

But wait. Doesn’t this same “second layer of tax” apply to some of Mitt Romney’s income? A cursory look at his return suggests that a good portion of it is investment income that has already been subject to the corporate layer of tax. In that case, his real effective tax rate — including any taxes paid by corporations he owns — should be significantly higher. The same can be said for Warren Buffett.

Which brings us to the President’s State of the Union speech. In it, he called for a new “minimum tax” to ensure millionaires pay a minimum tax to the federal government. Here’s what he said:

Tax reform should follow the Buffett Rule. If you make more than $1 million a year, you should not pay less than 30 percent in taxes. And my Republican friend Tom Coburn is right: Washington should stop subsidizing millionaires. In fact, if you’re earning a million dollars a year, you shouldn’t get special tax subsidies or deductions. On the other hand, if you make under $250,000 a year, like 98 percent of American families, your taxes shouldn’t go up. You’re the ones struggling with rising costs and stagnant wages. You’re the ones who need relief.

Now, you can call this class warfare all you want. But asking a billionaire to pay at least as much as his secretary in taxes? Most Americans would call that common sense.

The 30 percent threshold is new. Before, the rhetoric around the Buffett Rule was simply that the millionaire should pay more than the secretary. This new approach is described in the “Blueprint” document that accompanied the speech. It says:

Make the tax code fairer and simpler for the middle class and make sure millionaires and billionaires follow the Buffett Rule by paying at least 30% in taxes.

Later, the Blueprint calls for corporate reform that, among other things, lowers corporate rates:

The President believes that we need comprehensive corporate tax reform that will close loopholes, lower rates, and eliminate incentives that make it more attractive to ship jobs overseas.

So, the President is advocating for raising rates on capital gains and dividends, but he’s also advocating for cutting corporate rates. The former is part of his “fairness” agenda and the latter is part of a “jobs” agenda.

How does it balance out? The total tax on corporate profits equals the corporate tax combined with the dividend and capital gains tax paid by shareholders like Mitt Romney. Today, that tax is equal to 45 percent (35 percent corporate first and 15 percent dividends/cap gains second). Assuming the President calls for a 25 percent corporate rate as part of his corporate tax reform, then the total tax on corporate profits in the future would be 25 percent first and 30 percent second, or 47.5 percent. The tax on corporate profits would go up.

In other words, the President’s “fairness” agenda totally trumps the President’s “jobs” agenda. Kind of shows you where his priorities are.

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