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.