Interest rates on newly issued subsidized Stafford loans are set to double on July 1 if Congress does not act. In general the leaders of both the House and Senate say that they want to block this rate increase for at least one more year, but they have put forward differing proposals on how to offset its budget cost.
The House bill (H.R. 4628) would cut a fund for public and preventive health care. The Senate bill (S. 2343) takes a far better approach: closing a tax loophole used by certain well-off professionals to avoid Medicare taxes—most famously used by former Sen. John Edwards (D-NC) and former House Speaker Newt Gingrich during their private-sector careers. The U.S. Treasury’s inspector general for tax enforcement has called the loophole a “multibillion dollar employment tax shelter.”
This column is intended to explain the so-called Gingrich-Edwards loophole and why closing it is a commonsense way to pay for the student loan fix.
The problem: The Gingrich-Edwards loophole
Imagine if avoiding payroll taxes were this simple—step 1: Form your own corporation called Your Name, Inc.; step 2: Tell your employer to stop sending you a paycheck and start sending a check to Your Name, Inc., for the gross amount of your salary before taxes; step 3: Pay yourself a “dividend” from Your Name, Inc., every other Friday.
Obviously, it’s not that simple. For regular workers this kind of scheme wouldn’t work. Employers withhold Medicare taxes directly from paychecks and also pay their share of Medicare taxes directly to the government. The Medicare tax is 1.45 percent on both employee and employer, and it applies to all wages. Most self-employed people who operate their own businesses generally are required to pay self-employment taxes (at the combined rate of 2.9 percent) on all of the income from their businesses. The upshot is that nearly all people who work for a living are required to pay Medicare taxes on all of their earnings. It’s not optional.
That’s not the case, however, for some well-compensated professionals, including many lawyers, doctors, consultants, and entertainers. They sometimes use a scheme that is similar to the one described above, though a little more complicated, to avoid paying their fair share of Medicare taxes.
The scheme exploits a loophole in the payroll tax rules that apply to so-called S-corporations. An S- corporation (named after subchapter S of the tax code) is one of several ways to organize a business. In general it’s a common and perfectly legitimate business form. But because of the loophole, some S-corporation owners have an opportunity to avoid payroll taxes—an option that other workers and other small business owners (such as sole proprietors or general partners in a partnership) do not have.
The key to the scheme is that while payroll taxes apply to virtually all income derived from working, they do not apply to profits from an S-corporation. So certain professionals such as lawyers and doctors can avoid payroll taxes by first organizing their business as an S-corporation and then characterizing their income as business profits rather than as wages or salaries.
Because these professionals both own and work for the business, they can decide how much to pay themselves in salary, which means they have an incentive to shortchange their own salaries so that the rest of the money their businesses take in after expenses is treated as profits—and therefore free of Medicare taxes. The same rules apply to the Social Security tax, but because that tax applies to a capped amount of wages or self-employment income, high-income professionals are probably more likely to use the loophole to reduce their Medicare taxes.
This scheme is supposed to be limited by an Internal Revenue Service rule requiring business owners to pay themselves “reasonable compensation” in the form of wages or salaries. If a business paying an unreasonably low salary to its owner is audited, the IRS can potentially recharacterize profits as wages and impose payroll taxes. But whether a salary paid to oneself is “reasonable” is a fuzzy standard, allowing for a great deal of leeway. A report by Congress’s investigative arm, the Government Accountability Office, found that, “The vagueness of federal tax law on determining adequate wage compensation shareholders mean that the facts and circumstances have to be analyzed in each case.” The “difficulty and subjectivity in determining what constitutes an adequate wage enables some S-corporations to pay inadequate wage compensation,” which results in more of the income treated as profits that are free from payroll taxes.
The Government Accountability Office also found extensive abuse of this loophole. From 2003 to 2004, 13 percent of S-corporations underpaid wages to owners, resulting in about $24 billion in underpaid wages. That translates into approximately $3 billion in lost federal revenue that had to be made up for by other taxpayers, according to a rough estimate by the Government Accountability Office. In one year, according to the Treasury Department’s tax inspector general, 36,000 single-shareholder S-corporations reported profits of $100,000 or more (totaling $13 billion)—without paying a penny in employment taxes.
The solution: Making people pay the taxes they owe
Senate bill S. 2343—Stop the Student Loan Interest Rate Hike Act of 2012—closes the Gingrich-Edwards loophole. It does so by requiring the owners of professional services businesses—those who themselves perform substantial services for the business such as a lawyer who owns her own firm—to pay employment taxes on any income from that business. The bill is crafted to root out common areas of abuse. It would require individuals with incomes of more than $250,000 ($200,000 for singles) to pay payroll taxes on all of the income they receive from an S-corporation or a limited partnership interest in a professional service business—those 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. The bill’s provisions apply to S-corporations deriving 75 percent of their income from the service or with three or fewer shareholders (or where the S-corporation itself is a partner in a professional service business). S-corporations with three or fewer shareholders account for “almost all” of the underpayment of wages by S-corporations, according to the Government Accountability Office.
In other words, the bill takes away the opportunity to recharacterize income from a professional service business to avoid payroll taxes. That solution puts such businesses on par with other kinds of small business owners, who are required to pay self-employment taxes on all of their business income.
Closing this tax loophole is a commonsense measure to make people pay what they should be paying already. But closing any tax loophole always provokes opposition. It’s worth addressing some of the claims of critics, and then examining further why we indeed need to shut down the Edwards-Gingrich loophole.
Closing the loophole will help honest small businesses by requiring other businesses that shirk their responsibilities to pay what they owe.
Those opposed to closing the tax loophole say that doing so would impose a new tax on small businesses. In fact, closing the loophole would not impose a new tax. It would instead simply require businesses that have found aggressive ways to avoid the Medicare tax to pay what they legitimately owe. That would help the vast majority of small businesses that simply pay what they owe.
Congress needs to act because existing enforcement mechanisms have proven inadequate.
Critics of the loophole-closing provision have claimed that the IRS already has the ability to pursue people who are not paying what they owe. The facts, however, show otherwise. In its 2009 report the Government Accountability Office found that IRS enforcement was thin despite the prevalence of abuse. The IRS examined the employment tax issue only “in the most egregious cases,” representing just a tiny fraction of S-corporation returns.
Similarly, the U.S. Treasury inspector general for Tax Enforcement found that IRS audits did not always examine the employment tax issue even in cases where little or no compensation was paid (and therefore little or no employment tax was paid). With a lack of enforcement, the inspector general found that, “there are evidently many owners of S-corporations who have determined the employment tax savings available from minimizing salaries is worth the risk of an IRS examination.”
The fundamental problem is the law, not the IRS. The determination of whether compensation that business owners pay themselves is “reasonable” inevitably depends on the specific circumstances of each individual case. As the inspector general emphasized, “The cost of the IRS resources needed to effectively combat such a large problem on a case-by-case basis would be prohibitive.”
The accusation that closing this loophole represents a raid on Medicare is illogical.
Some critics have made the provocative claim that closing the loophole and at the same time extending the current student loan rates would represent a “raid” on Medicare. This makes no sense. To state the obvious, Medicare taxes go into the Medicare trust fund only if people actually pay them. When business owners find ways to avoid paying their fair share of Medicare taxes, the taxes they owe are not going into the Medicare trust fund. If anyone is raiding the Medicare trust fund, it is the people who are exploiting the loophole.
The implication that S. 2343 would divert funds from the Medicare trust fund to other programs is also false on a mechanical level. The additional Medicare self-employment taxes collected because of S. 2343 would, in fact, go into Medicare’s trust fund, while the extended student loan subsidies would be paid for by the federal government’s general revenues.
But what’s most important is the bottom line: The bill would have a net-positive impact on the overall federal budget, according to Congressional Budget Office.
Conclusion
A basic question underlying the Gingrich-Edwards loophole issue is why any income should be exempt from Medicare tax. The answer is that there is no good reason. Income from work has long been subject to Medicare taxes—working people pay Medicare taxes on all of their wages, salaries, or self-employment income. In 2010 Congress removed the exemption from Medicare taxes for income from investments, including dividends, capital gains, interest, and the profits of “passive” investors in a business. (This applies to the high-income people who receive the bulk of such income and will be effective in 2013.) Yet there is a special category of income exempt from Medicare taxes: the business profits earned by some people “actively” engaged in a business. There is no logical or economic reason why this type of income should have a special Medicare tax exemption. After all, everyone benefits from Medicare no matter the source of their income. Exempting such income from Medicare taxes makes loopholes like the Gingrich-Edwards loophole possible.
The more fundamental issue is not what’s at stake with S. 2343. The bill simply zeroes in on a very specific loophole that allows certain people, whose income is clearly derived from their skill and labor, to avoid the taxes paid by all other working people. This loophole is without purpose, unfair, inefficient, and costly for other taxpayers. Closing it is simply common sense. Closing the loophole while also preventing a student loan rate increase is common sense times two.
Seth Hanlon is Director of Fiscal Reform at the Center for American Progress.