National Journal's CongressDaily
January 29, 2010 Friday
S Corp. Proposal Draws Interest, Ire
by Peter Cohn
Charges of "tax-dodging" that dogged former Sen.John Edwards, D-N.C., during the 2004 presidential campaign have emerged as a behind-the-scenes issue as Democratic leaders attempt to revive a fully paid-for healthcare bill.
The Edwards comparison is a result of a proposal to raise money by applying the Medicare payroll tax, which currently only applies to wages, to investment income as well. The tax would hit individuals making more than $200,000 or households above $250,000.
House-Senate negotiators are debating whether the tax should apply to income that is passed through to shareholders in a business structure formed under subchapter S of the tax code. Seemingly an arcane accounting issue, the answer could mean the loss or gain of as much as $40 billion in revenues to pay for subsidies to help low-income individuals and families buy health insurance.
S corporations are generally privately owned businesses with a small number of shareholders, whose income is taxed at the individual level in the form of dividends, not wages.
Senate negotiators want to keep active S corporation income -- other than income from passive investments -- exempt from the payroll tax, fearing their chamber's fragile voting math can ill afford what could be seen as a new small business tax, aides said. House lawmakers disagree, citing the revenue loss, relatively few actual small-business employers that would be affected, and potential to game the system -- such as opting for S corporation status simply to avoid the tax.
That's where Edwards comes in: When he earned $26.9 million as a trial attorney in 1995, his firm's S corporation status enabled him to avoid paying $591,000 in payroll taxes for Social Security and Medicare over the next four years. As a partner in his firm, Edwards paid himself a salary of $360,000 a year, which was subject to payroll taxes -- but the remaining $25.5 million he earned was not. TheWall Street Journaleditorial page called it the "Liberal Loophole," and progressives have argued for years that S corporations enable the rich to dodge their fair share of social insurance taxes.
The Joint Committee on Taxation recommended tightening S corporation rules in 2005. Earlier this month, GAO found that underreporting of S corporation income has led to billions of dollars a year in lost revenues. Given that report, "a special carve-out for them here would seem to move in the wrong direction," said Chuck Marr, director of federal tax policy at the Center on Budget and Policy Priorities.
"This is one of the biggest loopholes we have," added Citizens for Tax Justice Director Robert McIntyre, whose group put the investment tax idea on the radar. "If you set up a subchapter S corporation, you can argue that you are really not worth that much, and only pay yourself a small salary. Look atJohn Edwards... this is a notorious problem in the tax code and it ought to be fixed."
Small business advocates argue the tax will not just hit the Edwards types. Dena Battle, director of tax policy at the National Association of Manufacturers, said S corporations are employers and provide much of the job-creation, if any, that is taking place.
"When you run a business, it's never quite that simple; you're not just paying yourself, you're raising capital, making investments and hiring," she said. "They're literally putting their homes on the line. The level of risk is really amazing. ... That's exactly what we need in this economy, people who are willing to take those kinds of risks."
Typically, investment income is defined as capital gains, taxable interest, dividends, estate and trust income, and income from rents, royalties, partnerships and S corporations.
According to preliminary estimates, dropping active S corporation income from the tax would sacrifice about $40 billion in revenues, although it would still raise $84 billion over a decade. Including pass-through income earned by lawyers, physicians and others who have opted for S corporation status -- but not small-business owners in the traditional sense -- could raise $104 billion. Including all S corporation income would bring the total to about $125 billion, revenues that House progressives are eyeing.
Small-business advocates don't like the idea of a new tax on S corporations and would like to knock out the investment tax altogether. Several trade groups, including NAM, the S Corporation Association and National Federation of Independent Business, penned a letter to congressional leaders Thursday arguing their case.
"As organizations representing Main Street businesses with millions of middle-class workers, we are writing to express our intense opposition to any effort by Congress to apply payroll taxes to non-wage income," they wrote. "[T]his new tax increase would strike at the heart of the employers who are struggling to increase savings and productivity, hire new workers and reduce double-digit unemployment, and help lead us out of this recession."
The letter argues that the proposal undermines the concept of social insurance taxes, which are based on the premise that workers' wages earned over a lifetime will go toward an entitlement when they retire. If nonwage income is taxed, Medicare would become just another "welfare" program, the letter states. They also said it would undermine the Medicare trust fund by diverting money to other purposes.
Advocates for closely held businesses on both sides of the Capitol are wary of the proposal, including S corporation boosters like Rep.Ron Kind, D-Wis., a New Democrat and member of the Ways and Means Committee.
"I just think there are better pay-fors than going after investment income, things that we need to be able to grow the economy right now," Kind said. "But at the end of the day, it's got to be paid-for. And that's the hard part ... I wish my Republican colleagues had lived under that philosophy for the previous eight years when they were passing huge spending bills, unpaid-for and driving us further and further into debt."