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TREASURY INSPECTOR GENERAL, IRS CLASH OVER S-CORPORATION EMPLOYMENT TAXES

May 26, 2005

The office of the internal IRS watchdog, the Treasury Inspector General for Tax Administration, says that S corporations are abusing the employment tax law:

One of the criteria for judging a tax system is whether similarly situated taxpayers are treated the same. Given equal amounts of income subject to employment taxes, owners of single-shareholder S corporations and sole proprietors are similarly situated for employment tax purposes. However, a fundamental and significant inequity is created between sole proprietors and owners of single-shareholder S corporations by the manner in which taxable income is determined, since sole proprietors pay employment taxes as a percent of all profits, while owners of single-shareholder S corporations pay employment taxes on only the portion of profits they unilaterally select as their salaries.

TIGTA is referring here to the "John Edwards" shelter. This is the practice of taking only part of your S corporation earnings as salary, and leaving the rest as S corporation earnings. S corporation income is subject to income tax as earned (even if left in the company), but not employement taxes. 2004 Vice-presidential candidate John Edwards used this structure for his law practice.

TIGTA proposes a severe remedy:

The IRS Commissioner should consult with Treasury regarding whether the detrimental effects of Revenue Ruling 59-221 should be reversed through the issuance of new regulations or through the drafting of new legislation, either of which should subject all ordinary operating gains of an S corporation that accrue to a shareholder (including the shareholder’s spouse and dependent children) holding more than 50 percent of the stock in the S corporation to employment taxes.

THE IRS DEMURS

The IRS disagrees, according to the TIGTA report. The IRS says that any fix should address all business entities, not just S corporations. The IRS also says that the TIGTA proposal strays from the idea that employment taxes should relate to actual employment income.

WE DEMUR TOO

The employment tax rules are obsolete in this age of S corporations, limited liability companies and other funky pass-through entities. Congress passed a law thwarting the last attempt to address employment tax issues in the context of limited liability companies; in the ten years since, Treasury has shrunk from the issue.

The TIGTA proposal quite easily could leave S corporations worse off than LLCs for employment tax purposes. Under one set of proposed regulations, LLC owners could avoid employment taxes on much income simply by having two classes of ownership - an option unavailable to S corporation shareholders.

The flat "tax it all" rule of the TIGTA proposal also ignores the real life issues of small businesses. A start-up, for example, shouldn't be forced to pay a "reasonable" salary to its owner while it is struggling to get established. A single owner could have a large enterprise with a full administrative staff and for which invested capital is the largest source of income; it makes no more sense to treat that such income as "employment" income than it would to so treat Microsoft dividends.

If Congress does seriously address social security reform, it seems likely they will address employment tax issues of all pass-throughts to help fund it.

LINK: TIGTA Report Reference Number: 2005-30-080

Related Tax Update Post: 'JOHN EDWARDS SHELTER' TARGETED BY IRS

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