Many pundits have lamented the fact that the Republican plans for tax reform largely seem to favor the rich over the everyman, with the biggest breaks going to the wealthiest individuals. But there is at least one change that should benefit the little guy if enacted, by giving a multi-billion dollar boost to Social Security and Medicare.
The increase would come with the closure of a payroll tax loophole that’s somehow been allowed to linger for decades, despite several attempts to seal it. To understand how it works, we first need a quick lesson in non-corporate taxation — a popular, and often misunderstood, topic in the press these days.
The first thing you should know is that 95 percent of businesses aren’t taxed as corporations in the traditional sense; their income “passes through” the business entity and is taxed to the owners. Thus, for most U.S. businesses, what is important is not the change to the corporate tax, but the change to the individual income tax.
And one set of provisions in the recently proposed House tax bill would ensure that individuals cannot use such pass-throughs to avoid paying Social Security and Medicare taxes.
This leads to the second thing you should know: The difference between partnerships and so-called “S corporations,” both of which are pass-throughs.
In its simplest sense, a partnership is a business operation run by two or more people. It offers flexibility and can require less paperwork. What it doesn’t do is offer a way around payroll taxes. Here’s why: In a partnership, the IRS considers virtually all of the partners’ income from a partnership to be “self-employment income” that is subject to payroll taxes.
In an S Corporation, on the other hand, the shareholders can distribute funds to themselves in ways that aren’t subject to payroll taxes.
Here’s how it works: Say an S corporation owned by a surgeon has a net income of $300,000; that’s the money she made for her services. If she earned that as a partner in a partnership, she would owe payroll taxes on that full amount. But as an S corporation, she can pay herself a salary of, say, half that, with the other half paid as a kind of dividend. Payroll taxes are owed on salary, but not on dividends, saving roughly $4,000 in taxes.
In 2010, former Speaker of the House Newt Gingrich avoided $69,000 in payroll taxes by paying himself $444,327 in salary despite the fact that his two firms earned $2.4 million in profits. And John Edwards, the former senator and V.P. candidate, used the loophole to save more than half a million dollars on taxes in the late 1990s, paying himself a salary of of just $360,000 each year even though he made more than $26 million as a trial lawyer.
A 2009 report by the Government Accountability Office estimates that billions are underreported each year this way, roughly $24 billion in just tax years 2003 and 2004 alone.
Medicare may run out of funds in the near-term, and Social Security is also not on the best financial footing. The last thing the country needs is taxpayers gaming the payroll tax system. A legislative solution requiring all of the income of service pass-throughs, whether partnerships or S corporations, to be subject to payroll taxes is long overdue.
Walter D. Schwidetzky is a professor of law at the University of Baltimore School of Law; he can be reached at email@example.com.