Last week’s circuit court decision on the meaning of “limited partner” has broad implications for S corporations in the coming tax battles. As noted in the court’s ruling:

This case turns on the meaning of “limited partner” in 26 U.S.C. § 1402(a)(13). The Tax Court interpreted “limited partner” to refer only to passive investors in a limited partnership. It therefore upheld the IRS’s upward adjustment of Sirius Solutions’s net earnings from self-employment. We disagree. A “limited partner” is a partner in a limited partnership that has limited liability. So we vacate and remand.

The court further noted:

So, to review, the pass-through share of partnership income (or loss) of a limited partner is not subject to Social Security and Medicare taxation; but neither does it count toward the Social Security benefits the person may receive later in life.

The ruling comes in the face of efforts by the IRS to expand payroll tax collections to include the pass-through earnings of limited partners, arguing that “that for purposes of the § 1402(a)(13) exception, the term “limited partners” only “refer[s] to passive investors.””

One little problem — that’s not the rule:

The sole issue on appeal is the meaning of “limited partner” in § 1402(a)(13). We hold that a “limited partner” is a partner in a limited partnership that has limited liability. This is confirmed by (A) the text, and (B) the Social Security Administration (“SSA”) and IRS’s contemporaneous and longstanding interpretation of the term.

As you can imagine, this is a critical distinction, and we’re glad the court sided with workers and employers. The effort to expand the payroll tax base to include business profits goes way back and, if successful, it would deepen the wedge between tax rates paid by pass-throughs and corporations. (See here, here, and here)

It also begs the question – why tax wages at all?

The simple reality is that wage taxes hurt workers.  They lower real wages, reduce employment levels, and impose expensive complexities on employers. Not convinced? Here’s a sample of recent economic literature highlighting the damage wage taxes inflict on the economy:

  • Gruber (1997), The Incidence of Payroll Taxation: Evidence from Chile: Finds the full cost of wage taxes falls on workers through lower pay
  • Kugler & Kugler (2008/2009), Labor Market Effects of Payroll Taxes in Developing Countries: Evidence from Colombia: Finds a 10 percent rise in payroll taxes reduced wages between 1.4 and 2.3 percent and employment by between 4 and 5 percent.
  • Anderson & Meyer (1997), The Incidence of a Firm-Varying Payroll Tax: Uses firm-specific unemployment insurance tax variation to show that workers bear most of the tax but there is employment reallocation.
  • Antón (2014), The Effect of Payroll Taxes on Employment and Wages under High Labor Informality: Finds that reforms reducing payroll taxes increased formal employment and wages.

What would be better than wage taxes?  How about a VAT or border adjusted tax? Replacing a wage tax with a VAT could help address Social Security’s pending insolvency, increase wages, increase employment, and actually benefit the economy as a whole. Here’s a sample of the literature exploring the value of such a swap:

  • Laszlo Goerke (1999), Value-Added Tax Versus Social Security Contributions: A budget-neutral shift from payroll taxes to a VAT can increase employment.
  • OECD Taxation Working Paper (2012): Shifting from Social Security Contributions to Consumption Taxes: Shifting social security contributions toward VAT in European countries could increase work incentives for low-income workers at both participation and hours-worked margins.
  • Toder & Rosenberg (2010) Tax Policy Center / Urban Institute (2016), Swapping the Employer Share of the Payroll Tax for a Consumption Tax: A detailed analysis of the efficiency gains of replacing the employer payroll tax with a VAT/GST. All but the highest earners benefit.
  • Nunns & Rosenberg (2016) Urban Institute / Tax Policy Center, A Federal Consumption Tax as Replacement for the Employer Payroll Tax: Explores why a consumption tax base is well-suited to replace employer payroll taxes and how it interacts with the labor market and existing tax system.

So definitely something to think about.

But don’t expect a whole lot of thoughtful analysis in response to last week’s court decision. The pro-tax crowd will ignore the law and complain that their efforts to “tax the wealthy” are being thwarted, while the anti-tax crowd will reflexively reject VATs, ignoring their relative superiority to existing payroll taxes.  In the meantime, Social Security will continue its inevitable march towards insolvency.