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.