What is it about Presidential candidates and S corporations?  First John Edwards made the practice of abusing the S corporation structure infamous back in 2004.  Then we learned Newt Gingrich did the same thing when he ran in 2012.  And now Joe Biden.  At some point, these candidates are going to realize that saving 3.8 percent on your taxes isn’t worth the political pain it will cost you.  (Hat tip to Bernie Sanders and former President Obama.)

For those not up to speed, the former Vice President and his wife released their tax returns this week.  Focusing on his 2017 return, they show that the Biden’s had adjusted gross income of just over $11 million and paid $3.7 million.  That’s a 34 percent effective rate and well above what most Americans think is fair.

They also show most of their income came from Biden’s writing and speeches, but instead of simply having his clients make the check out to “Joe Biden”, they set up two S corporations and ran the income through those.  He then paid himself a small salary and claimed the rest as business profits.  As a result, he was able to avoid about $380,000 of payroll taxes.

The Wall Street Journal wrote about the issue yesterday, and had very nice summary of the law and the challenge the IRS has in enforcing it:

Under current law, S-corporation owners can legally avoid paying the 3.8% tax on their profits as long as they pay themselves “reasonable compensation” that is subject to regular payroll taxes. S corporations are a commonly used form for closely held businesses in which the profits flow through to the owners’ individual tax returns and are taxed there instead of at the business level.

The difficulty is in defining reasonable compensation, and the IRS has had mixed success in challenging business owners on the issue…

For businesses that generate money from capital investments or from a large workforce, less of the profits stem from the owner’s work, and thus reasonable compensation can be lower. For businesses whose profits are largely attributable to the owner’s work, the case for reasonable compensation that is far below profits is harder to make.

As S-Corp reader know from previous posts, we don’t support the misuse of the S corporation structure to avoid payroll taxes, and believe the IRS needs to be more active going after those that engage in this practice.  If the reasonable compensation standard means anything, it should preclude a one-man shop whose occupation is writing and giving speeches from claiming a salary that’s less than 2 percent of revenues.  As the Journal quoted accountant Tony Nitti, “This is pretty cut and dried. If you’re speaking or writing a book, it’s all attributable to your efforts.”

Going back to their overall tax burden, one question we have is what difference, if any, tax reform would make.  Would the Biden’s tax burden go up or down?

The first thing is that the Biden’s don’t take the 199A deduction on their 2018 returns.  As Peter J. Reilly with Forbes notes:

It is interesting to note that Biden did not take a 199A deduction in 2018.  Presumably, they determined that the businesses were of the sort that don’t qualify.  I could see that on the speaking fees but earnings on the book should qualify.   Of course, some of the salary would have to be allocable to the writing business in order for that to work.

We believe the last point is that the guardrail limiting the deduction to 50 percent of W-2s would effectively reduce any available 199A deduction, since they set their salaries so low.  It’s one of the more interesting side-effects of tax reform – the less salary an S corporation shareholder pays themselves to avoid payroll taxes, the more they limit their 199A deduction.

And while tax reform lowered the Biden’s top tax rate from 39.6 to 37 percent in 2018, they also lost the ability to deduct the state and local taxes they paid, so it’s kind of a wash.  Their effective tax rate stayed remarkably flat – its 33.9 percent in 2017 and, despite making less than half the income, 33.4 percent in 2018.  It’s even possible that tax reform raised their taxes above what they otherwise would have been.

Finally, notice how the Biden’s didn’t get caught up in the AMT in 2017?  They simply made too much money.  The AMT was designed to make sure millionaires paid a minimum level of tax, but it mostly hit upper-middle class families making between $100,000 and $500,000.  Only a small percentage of taxpayers in the Biden’s income range got caught up in it, one of the reasons the AMT had to go.

So the Edwards-Gingrich-Biden loophole lives on (at least until the IRS begins to use the newly codified “reasonable compensation” standard) and that will be the focus of discussion in the coming weeks, but the headline here should be that wealthy taxpayers continue to pay a lot of taxes.  The Biden’s paid more than one-third of their income to the IRS, and over 40 percent when you include the state and local taxes they paid.  That’s a lot.  But don’t expect to see many stories about that.