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.