Today, and in forthcoming posts, I will address some of the proposals. The first that I will discuss are the proposal to modify the determination of amounts subject to employment or self-employment tax for partners and S corporation shareholders and a related proposal to treat guaranteed payments to partners as payments to nonpartners.
It will come as no surprise to regular readers of this blog that, as the Committee Report notes:
[T]here are significant differences in the employment tax treatment of individuals who are owners of interests in passthrough entities and who perform services in the business. S corporation shareholder-employees are treated like other employees (i.e., subject to FICA), whereas a broader category of income of some partners (other than limited partners) is subject to self-employment tax. These discontinuities cause taxpayers choice-of-business form decisions to be motivated by a desire to avoid or reduce employment tax, rather than by nontax considerations.The Committee Staff is more than aware of the growing number of taxpayers playing audit roulette in this area. Thus the report notes that:
S corporation shareholders may pay themselves wages below the wage cap, while treating the rest of their compensation as a distribution by the S corporation in their capacity as shareholders. They may take the position that no part of the S corporation distribution to them as shareholders is subject to FICA tax. While present law provides that the entire amount of an S corporation shareholders reasonable compensation is subject to FICA tax in this situation, enforcement of this rule by the government may be difficult because it involves factual determinations on a case-by-case basis.The reform suggested by the Committee has three parts.
First, all partners of any type of partnership, general, limited, or LLC, would be subject to self-employment tax on their share of self-employment income. This general rule would be subject to a carve-out for certain specified types of income or loss, such as certain rental income, dividends and interest, certain gains, and other items. However, income from service partnerships, described by the report as being partnerships substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, would be entirely subject to SECA.
Second, the general rule would be further blunted in the case of a partner who did not materially participate in the business of the partnership. In such a case, only that portion of that partner's income that represented reasonable compensation for the services the partner actually rendered to the partnership would be subject to SECA.
Finally, in the most radical departure from current law, S corporation shareholders would be treated for all employment tax purposes as partners. That is, instead of being subject to FICA, they would be subject to SECA. More importantly, unless they did not materially participate in the business of the corporation, all of their income from the corporation (subject to the source limitations noted above) would be subject to SECA. Thus, S corporation shareholders could no longer engage in audit roulette by taking an aggressive position and hoping that the Service would either not challenge the position or that they could compromise with the Service if it did raise a challenge. The change to the manner in which employment taxes are imposed on S corporation shareholders would be coupled with an end to all income tax withholding for these individuals. In other words, they would not be treated in any way as employees for federal tax purposes.
The staff estimates that over a ten-year period beginning in 2006, this proposal would generate $57.4 Billion. It would be effective for tax years beginning after the date of enactment.
The proposal has several shortcomings, either perceived or real.
First, it rejects any carve-out of income from employment tax based upon some imputed return on invested capital. A proposal of this sort had been suggested by the AICPA. Thus income from a radiology practice, for instance, would be completely subject to SECA, even though a significant portion of the income represents a return on capital invested in the practice's expensive equipment. I haven't read the actual text of the proposal, but it would seem that there will have to be fairly complicated anti-abuse provisions to prevent businesses from forming separate equipment or real estate partnerships and entering into leases with their service partnerships to generate SECA-exempt income.
Second, the proposal does not address the "lowly employee" issue. That is, an employee who has only a small percentage of the equity of the business, but who works there full time. As I understand the proposal, all income paid to these employees would be treated as partnership income and none of the affected employees would be subject to withholding. This works a hardship on lower level employees who actually desire to have their taxes withheld from their wages. Also, the Report seems to have overlooked the possibility that it is likely that suddenly "partners" will be popping out the woodwork in order to allow unscrupulous employers to avoid their withholding tax obligations on compensation paid to their employees. Taken to its logical extreme, § 6672 could be, for all practical purposes, written out of the Code entirely.
In a closely related area, there is a seemingly contradictory proposal to repeal § 707(c). Specifically, it is proposed that all compensation for services or use of capital that is not based on the net income (or an item of net income) of the partnership is treated as arising from a transaction between a partnership and a nonpartner. The proposal with respect to employment tax is not discussed here, however it is noted that the under the § 707(c) proposal the income and deduction timing rule for guaranteed payments is repealed and such payments are subject to the income and deduction timing rules for nonpartner payments. What this means, I suspect, is that whether these payments are subject to SECA will continue to be governed by the rules proposed in the employment tax reform area.
If the employment tax law is changed along the guidelines suggested by these proposals, it can be fairly stated that justice in this area will be swift if not particularly fine.