Congress Again Discussing Closing of Purported S Corporation “Loophole”

Tax Analysts has obtained a copy of a list of tax breaks which Democrats are targeting for savings as part of the Joint Conference Committee on the Budget.[1]  The list highlights the so-called “S corp loophole,” which the Budget Committee states “is a loophole … that allows certain wealthy professionals to avoid paying payroll taxes on their earnings.”  The report also refers to the loophole as the “Newt Gingrich/John Edwards”[2] loophole and states that it is “used by owners of S corporations to avoid the 3.9% [sic] Medicare Tax on earnings, which costs taxpayers hundreds of millions of dollars every year.”  The amount of the tax is actually 3.8% rather than 3.9% as cited in the report.

The genesis of this provision is found in Section 413 of the American Jobs and Closing Tax Loopholes Act of 2010, H.R. 4213, which ultimately was not enacted into legislation, and which would have added new Section 1402(m) to subject certain small professional service S corporation shareholders to the self-employment tax imposed under Section 1402 on their distributive shares of the income from such S corporations.  This provision was resurrected in a bill introduced by Representative Pete Stark on 1/31/2012 entitled the “Narrowing Exceptions for Withholding Taxes” (“Newt”) Act.  Again, this bill failed to be enacted into legislation.  The last attempt to impose self-employment taxes on S corporations was contained in the “Stop Student Loan Interest Rate Hike Act of 2012” (S. 2343), which was introduced by Senate Majority Leader Harry Reid on April 24, 2012.  This bill would have required taxpayers with income of more than $250,000 to pay employment taxes on income received from an S corporation or a limited partnership interest in a professional services business, but again did not pass.  Although this latest iteration of the bill differs from the original bill and from the Newt Act in some respects, it is otherwise very similar to the initial proposal set forth in the American Jobs and Closing Tax Loopholes Act of 2010.  This attempt to impose self-employment tax on S corporation income, as originally introduced in 2002 and as reintroduced on 1/31/2012 and again on 4/24/2012, and which once again is raising its ugly head, is not a sound provision and is critically flawed in a number of ways.  In summary, the provision to impose self-employment tax on S corporation income is unsound for the following reasons:

1. The proposal is too broad and unfairly taxes America’s small businesses currently complying with existing law.
2. The proposal is inconsistent with long-standing policy (to impose the self-employment tax only on services actually rendered by a taxpayer).
3. The IRS already has the tools necessary to combat abusive situations and it has been successful in numerous cases in recharacterizing non-wage distributions as compensation where the S corporation shareholder-employees are receiving unreasonably low compensation.[3]
4. The proposal unfairly discriminates against small businesses versus larger businesses.
5. The proposal would add significant complexity to the tax law in the face of current attempts to simplify the tax code.
6. The need for S corporations for America’s small and family owned businesses.  In particular, it is important to recognize that S corporations are one of the most popular vehicles for small and family-owned businesses, and that there should be at least one structure available whereby small and family-owned businesses can earn entrepreneurial profits subject to only one level of tax and not be subject to unlimited payroll taxes where those earnings are not attributable to the personal services of the shareholder-employees.[4]

The critics of the purported S corporation “loophole” have generally focused on the fact that non-wage distributions from “personal service S corporations” may be one of the few paths to receive income untouched from the FICA tax, the self-employment tax, and on the new Net Investment Income tax imposed under Section 1411.

First of all, it’s important to recognize that non-wage distributions from a non-personal service corporation, such as a manufacturing company, are also not subject to these taxes provided the shareholder materially participates in the business.  It is also important to recognize that with respect to personal service S corporations, the IRS and the courts can and have recharacterized nonwage distributions as ‘‘wages’’ subject to the FICA tax where unreasonably low compensation is being paid to the S corporation shareholders, so that personal service S corporations may not ‘‘avoid’’ the FICA tax on amounts distributed as dividends if they are in substance wages (see Radtke,[5] Spicer Accounting,[6] and the Watson[7]case). 

Additionally, both the IRS and the courts expressly recognize that a so-called personal service corporation may indeed produce earnings that are properly characterized as dividend distributions rather than wages (see the recent Mulcahy[8]case, as well as the Pediatric Surgical Associates[9]and the Richlands Medical Association[10]cases).  Quite simply, the FICA and self-employment taxes were meant to only apply to wages of an individual for personal services he or she actually renders, and not to active operating income (profits) of a business paid out as dividend distributions to shareholders.  On the other hand, the Net Investment Income tax was meant to subject certain higher income taxpayers to the 3.8% tax on passive type investment income, not to the profits of an active trade or business in which they materially participate.  Consequently, any suggestion that the use of S corporations to ‘‘avoid’’ these three taxes is “abusive” or a “loophole” simply misses the mark as entrepreneurial profits of a business not attributable to wages paid for personal services actually rendered by a shareholder were never intended to be subject to any of these three taxes. 

Finally, it is interesting to note that in a recent study,[11] it was found that S corporation shareholders pay the highest effective tax rate of any type of entity.  In particular, the study found that S corporation shareholders pay an effective tax rate of 31.6%, partners of partnerships (which would include limited liability companies taxed as partnerships) pay an effective tax rate of 29.4%, C corporations pay an effective tax rate of 17.8% and that non-farm sole proprietorships pay an effective tax rate of 15.1%.  Consequently, it appears that S corporation shareholders are actually paying more than their fair share of taxes, and it would be inherently unfair to impose additional employment taxes on them under the guise of closing a tax loophole.  Rather, such a provision would very likely have a substantial negative effect on the economic recovery of America’s small businesses following the Great Recession.