Thursday, May 26, 2005

More on the Social Security Tax Base: S Corp Problems

George Yin, Chief of Staff on the Joint Committee on Taxation, testified before the Senate Finance Committee yesterday. A story in today’s BNA Daily Tax Report reports his discussion of the problem of S Corporations potentially eroding the social security tax base. Yin is a bright fellow, and his idea is worth mentioning.

S Corporations are often owned by the same people who work for them. As a result, the S corporation owner potentially receives income generated by the business in the form of a salary as well as in the form of investment returns. Unlike the C corporation, where there is an incentive to extract money from the corporate solution in a deductible form, such as a salary payment, to avoid two levels of taxation, the S corporation has only one level of tax on income imposed at the shareholder level. Thus, the S corporation shareholder has a reverse incentive: pay a low salary that will require the payment of little employment taxes, and pay the rest of the returns in the form of distributions. Both face the same income tax rates, but the distributions avoid employment taxes. Yin suggests that taxing all such income would result in net revenues of over $60 billion during the next ten years.

There probably is a need to fix this with some form of rulemaking, as gamesmanship on salaries to S corporation shareholders appears to pay off for their owners, who get to shirk a responsibility. Although heavy audit attention could uncover unreasonably low salary payments, this would be a costly effort. Moreover, since we are talking about reasonable compensation, there is some wiggle room involved. The rule may end up overtaxing them, however, to the extent that the business is capital intensive. I guess in that case you always have the option of moving to C corporation, though that has other detriments.

Yin is on the right track, as partners in partnerships don’t get this kind of opportunity. Neither do sole proprietors. Though I support the interests of small business owners, this is one area that needs reforming.

You can access Yin’s testimony here,


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