|Self-Employment Tax Policy Considerations
New business practices and concerns about Social Security funding and the tax gap likely warrant a review by lawmakers of the rules and underlying policies of the self-employment tax.
June 10, 2010
In March 2010, healthcare reform included an increased Medicare tax for high-income employees and self-employed individuals (IRC §3101(b)(2) and §1401(b)(2)) and a new unearned income Medicare contribution tax for high-income individuals (IRC §1411). Also in 2010, a "loophole closer" proposal called for self-employment tax on earnings of certain S corporation shareholders (H.R. 4213).
What do these changes and proposals do to longstanding concerns and proposals regarding the application of employment taxes to S corporations and their shareholder/employees? What tax treatment is appropriate for current business structures, choice of entity considerations and neutrality among different business forms? What strategies should be implemented to reduce the self-employment tax gap?
In addition, new technologies and ways of generating income can raise self-employment tax questions. This article notes some of the issues surrounding self-employment tax to highlight that a more in-depth discussion is warranted rather than piecemeal changes that may further increase inequities among different business forms and types of revenue.
Choice of Entity and Self-Employment Tax
Soon after enactment of subchapter S corporation rules in 1958, the Internal Revenue Service (IRS) issued Revenue Ruling 59-221 to answer the question of whether self-employment tax applied to a shareholder's distributive share of S corporation income. The IRS concluded that such income was not subject to self-employment tax. Thus, only wages paid to shareholders are subject to employment taxes. This makes reasonable compensation determinations for S corporation shareholder/employees one that tax advisers and the IRS continually grapple with.
In contrast, sole proprietors owe self-employment tax on their business profits and general partners owe self-employment tax on their distributive share of trade or business income (IRC §1402(a)). In 2005, the Treasury Inspector General for Tax Administration (TIGTA) compared the employment tax rules for S corporations and sole proprietors, stating that the "different tax treatment has caused the S corporation form of ownership to become a multibillion dollar employment tax loophole for single-shareholder businesses” (May 25, 2005 testimony (PDF) before the Senate Finance Committee).
TIGTA's 2005 report suggests that Revenue Ruling 59-221 may have been predicated on the assumption that S corporations would have multiple shareholders that would help ensure that reasonable compensation was paid to shareholder/employees. TIGTA notes, however, that in 2000, almost 80 percent of S corporations had either a single shareholder or one shareholder owned over 50 percent of the stock. In addition, between 1994 and 2001, the number of single owner S corporations increased 64 percent. Also, in 1994, sole shareholders had compensation equal to 47 percent of profits, but that percentage dropped to 42 percent in 2001.
A variety of proposals have been offered to eliminate or reduce the "loophole" described by TIGTA. Most recently, H.R. 4213 (111th Congress), would expand the definition of self-employment income to include the distributive share of S corporation income from certain professional services businesses. New IRC §1402(m) would apply to S corporations where substantially all of the business activities involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management or brokerage services. In addition, the S corporation must be either a partner in a partnership engaged in a professional service business or itself engaged in such a business where its principal asset is the reputation and skill of three or fewer employees.
The H.R. 4213 proposal is awkward in its wording and design, referring to "disqualified S corporations," creating new issues of determining which employees constitute the reputation and skill of the business and enabling shareholders to possibly avoid the rule by having at least four employees provide services. In addition, the proposal does not address the concern of TIGTA and others because shareholder/employees of S corporations not subject to the proposed professional service rule would continue to enjoy employment tax savings relative to sole proprietors and general partners. (See H.R. 4213 (§413) and Joint Committee on Taxation report JCX-29-10 (pages 288 to 294) for further information.)
Other proposals have been broader such as treating S corporation shareholders and limited partners similar to general partners in terms of computing self-employment tax. For example, in 2005, the Joint Committee on Taxation (JCT) proposed that all partners, limited liability company (LLC) owners and S corporation shareholders be subject to self-employment tax on their distributive share of entity income or loss (other than certain rental income, certain gains, dividends and interest). An owner who does not materially participate in the entity's trade or business, would treat only his reasonable compensation from the entity as subject to self-employment tax.
The JCT justified this proposal as one that enables the base for employment and self-employment taxes to be labor income. The JCT's rationale for broadening the application of self-employment tax to limited partners was state law changes which allowed these partners to perform services. (See JCS-02-05 (January 27, 2005), pages 95-105.)
In 2009, the Government Accountability Office (GAO) reported that for 2003 and 2004, inadequate compensation issues for S corporations resulted in about $24 billion of missing wages and about $3 billion of lost payroll taxes.(Tax Gap: Actions Needed to Address Noncompliance With S Corporation Tax Rules (GAO-10-195; December 15, 2009), page 25.)
Sole proprietors also contribute to the self-employment tax gap. The IRS estimates that $39 billion of the annual $345 billion tax gap (11%) represents self-employment tax. (IRS, Tax Year 2001 Federal Tax Gap (PDF).)
New Revenue Generating Techniques
The Internet has led to a variety of money-generating activities, some of which may raise the question of whether the activity is a trade or business and whether self-employment taxes should apply. For example, some individuals have personal websites with ads that generate revenue with little activity required of the website owner. Should such income (assuming it exceeds $400 for the year) be subject to self-employment tax? Should an exclusion for such passive income be added to §1402 or should this be treated as a new way to generate trade or business income? Could such income be viewed as similar to revenue from prizes from entering contests and not subject to self-employment tax per Revenue Ruling 55-258?
Changes — such as those made to Medicare taxes by the recently enacted healthcare reform legislation — that serve primarily to generate revenue, tend to complicate the law, create inequities and miss opportunities to improve the law. A review of employment taxes as applied to each type of business entity would be a better approach for identifying appropriate tax law changes. Such a review should also look at related differences, such as in the treatment of fringe benefits provided to owners, as these differences impact the amount of employment taxes owed. A review should focus on changes that would enable the application of employment taxes to different forms of business to meet the principles of good tax policy including equity and neutrality.
In addition, while Congress has enacted provisions to reduce the tax gap, such as requiring basis reporting and issuance of 1099s to corporations, such measures are not addressing larger parts of the tax gap attributable to sole proprietors. Efforts are needed to find workable techniques to reduce the income and self-employment tax gap for this group.
Finally, new ways of doing business could also be addressed as well so that the self-employment tax rules can be updated to reduce uncertainty and improve compliance.
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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.