Committee Aims To Standardize Pass-Through Taxation

If an influential congressional committee has its way, some professionals and many small business owners could be forced to dig into their own pockets to help bridge the projected $3.75 trillion funding gap for Social Security.

President George W. Bush has chosen the politically contentious route of diverting a portion of Social Security contributions into private securities accounts. But that path faces stiff resistance from Democrats and many Republicans in both houses.

At least some of that funding gap, however, could be closed by taking care of a glaring omission in the tax code, an omission the congressional Joint Committee on Taxation says that, if fixed, would add $6 billion a year to the Social Security coffers.

At issue is the sticky subject of limited liability companies, limited liability partnerships and so-called “S” corporations, and the manner in which participants in those businesses pay their Social Security and medical insurance employment taxes. The entities, which help shield individual partners from the kind of sweeping liability that corporate officers and directors face, have become increasingly popular in the past 15 years.

A study by the joint committee released late last month says new government rules clarifying a limited partner's and an “S” corporation's obligation to pay Social Security taxes would raise $57 billion through 2014. [For additional detail and perspective on the joint committee's report, see the accompanying "Closer Look" article in this issue.]

The confusion has arisen, notes Patton Boggs tax partner George Schutzer, because federal tax law has not kept up with rapid changes in the structure of small businesses and professional service firms.

Not that the Treasury Department hasn't tried. The department issued proposed regulations dealing with the subject in 1997, but was rebuffed by Congress, which felt tax code changes were its provenance, not Treasury's.

Those proposed regulations also mobilized the nation's small business community, which formed a coalition and hired lobbyist Dan Mastromarco of the Argus Group. Conservative radio talk show host Rush Limbaugh took up the issue, which he characterized as a “stealth” tax, The Wall Street Journal weighed in with a critical editorial, and a spooked Congress subsequently slapped a yearlong moratorium on Treasury's regulations involving the definition of a limited partner. Chastened by Congress, Treasury has never revisited the issue.

The problem, explains Steven Frost, a partner at Chapman and Cutler in Chicago who chaired an American Bar Association task force on the issue, stems in part from a tax scam common in the 1970s.

Wealthy people who had never worked, and thus were not eligible for Social Security coverage, would buy a limited partnership interest, pay the very modest employment tax, and later receive Social Security benefits.

“They were scamming the system to get coverage,” says Frost. “So Congress put in a rule that limited partners are not subject to self-employment taxes.”

No Limits

Currently, the federal tax code is quite clear that in a general partnership, partners must all pay a self-employment tax for Social Security of 12.4%, up to $90,000, and a health insurance tax of 2.9% on all income.

It is equally clear that “limited” partners, that is, partners who don't actually work for the partnership but merely provide capital, don't have to pay Social Security or health insurance tax. That's because the money they receive from the partnership is unearned income. And Social Security taxes are only paid on labor income – that is, income derived from actual work.

But state laws have changed, and members of LLCs and LLPs now play active roles in the management of their companies, acting, in effect, the same way as general partners do.

“The notion that a limited partner is still limited has not gone by the wayside, but it has been changed a great deal,” notes William Caudill, a partner in Fulbright & Jaworski's Houston office who chairs the American Bar Association's partnerships committee.

Add to that the situation with increasingly popular “S” corporations. Taxed like sole proprietorships, “S” corps allow unscrupulous owners to pay themselves below-market salaries ' which are subject to employment taxes ' and treat the rest of their profits as corporate income, which has no Social Security obligations.

“Put it all together,” notes Caudill, “and it's a puzzling set of results.”

Adds a senior congressional tax staffer: “The problem today is that there's no valid law to tell practitioners or LLCs or LLPs specifically what to do regarding their employment taxes. We only have these proposed regs.”

The joint committee, in the prosaic language of its report, Options to Improve Tax Compliance and Reform Tax Expenditures, puts it like this: “The uncertainty in treatment creates an opportunity for abuse by taxpayers willing to make the argument that they aren't subject to any employment tax, even though this argument is contrary to the spirit and intent of the employment tax rules.”

Raising Revenue

Lawyers, although one of the biggest users of the LLP business structure, are also notoriously conservative and tend to treat their partners as general partners for employment tax purposes, tax experts say. That is, they treat all their income as labor income, even if a small percentage comes from unearned capital income. That, however, could be less true for some of their clients.

“I'm guessing it's not coming from professionals,” says Patton Boggs' Schutzer. “Any analysis by a tax lawyer or accountant will conclude that in a professional services firm, all or virtually all compensation is subject to SECA,” adds Schutzer, referring to the Self-Employment Contributions Act, which governs employment payments for partnerships.

The 430-page study published last month by the taxation committee, a joint panel of both houses of Congress, contains some 70 different ways to boost tax revenues. Significantly, the extra monies gained from modifying how much employment tax is paid by limited partners and by “S” corporations were one of the biggest revenue raisers in the report.

The study was prompted by a National Taxpayer Advocate report that estimated that in 2001, the amount of tax voluntarily paid was some $311 billion less than the actual tax liability of the nation's taxpayers.

Although $6 billion added by limited partners and “S” corporations might seem like a relatively small sum compared with Social Security's $632 billion in revenue in 2003, the Social Security Administration doesn't see it that way. Number crunchers at the administration say all it would take to raise the additional $3.75 trillion needed to maintain Social Security solvency for the next 75 years would be to hike the current 12.4% Social Security tax rate by 1.89 percentage points.

But clean up the ambiguity involving the employment tax obligations of limited partners, and the Social Security tax increase needed to maintain solvency could drop as much as 0.1 percentage point to 1.79, a figure that “certainly isn't negligible,” says Social Security Administration spokesman Mark Lassiter.

Backing Off

Seth Green was an associate tax legislative counsel in the Treasury Department's Office of Tax Policy who worked on the proposed Treasury regulations rejected by Congress in 1997. The goal of the regs, he says, was to provide an up-to-date interpretation for tax purposes of a limited partner.

“It had become easier and easier to retain limited liability while getting more and more involved in running a business,” recalls Green, now a member at Washington, DC's Caplin & Drysdale, a rare law firm structured as a “C” corporation, or a traditional corporation. “And no one was paying attention to the federal employment tax consequences.”

The regulation, says Green, “was intended to bring an archaic statutory term up to date.”

One key to the Treasury Department proposal was establishing a “500 hour” rule, one that would make limited partners or members of limited liability companies who spent 500 or more hours a year working for a partnership count all of their income as subject to employment tax, even if a large portion of that income was generated by things other than “labor,” such as good will, capital investments, or advertising.

Mastromarco, who led the successful lobbying fight against the regulations, says that's not fair.

“Even if you were to work more than 500 hours, it does not mean that magically, once you cross that threshold, all earnings were from labor,” says Mastromarco, a former assistant chief counsel for tax policy at the Small Business Administration.

And while Treasury believed it was doing nothing more than providing an up-to-date interpretation of a “limited partner,” in fact, says Mastromarco, it was “legislating through rule making, which was one reason we were able to build such a large coalition.”

After Mastromarco's coalition was formed and Rush Limbaugh began sounding his drum about stealth taxes, “Congress was only too happy to beat up on the Clinton Treasury Department, and the issue was not important enough to resurrect,” Green believes.

But it remains politically charged.

The Bush Treasury Department has refused to comment on the issue or to provide a background briefing on the subject.

Rep. Amory Houghton Jr., a moderate New York Republican, had championed a fix in the last Congress as chairman of the Oversight Subcommittee of Ways and Means. But he retired at the end of the 108th Congress, and no one else in the House has taken up the issue. Senate Finance Committee spokeswoman Jill Gerber says the panel is still studying the proposals.

But former Internal Revenue Service Commissioner Donald Alexander, who knows the issue well, believes that budget imperatives may drive Congress to act.

“Revenues frequently drive principles,” says Alexander, a partner at Akin Gump Strauss Hauer & Feld. “And every little percentage point may be deemed to help.”

If an influential congressional committee has its way, some professionals and many small business owners could be forced to dig into their own pockets to help bridge the projected $3.75 trillion funding gap for Social Security.

President George W. Bush has chosen the politically contentious route of diverting a portion of Social Security contributions into private securities accounts. But that path faces stiff resistance from Democrats and many Republicans in both houses.

At least some of that funding gap, however, could be closed by taking care of a glaring omission in the tax code, an omission the congressional Joint Committee on Taxation says that, if fixed, would add $6 billion a year to the Social Security coffers.

At issue is the sticky subject of limited liability companies, limited liability partnerships and so-called “S” corporations, and the manner in which participants in those businesses pay their Social Security and medical insurance employment taxes. The entities, which help shield individual partners from the kind of sweeping liability that corporate officers and directors face, have become increasingly popular in the past 15 years.

A study by the joint committee released late last month says new government rules clarifying a limited partner's and an “S” corporation's obligation to pay Social Security taxes would raise $57 billion through 2014. [For additional detail and perspective on the joint committee's report, see the accompanying "Closer Look" article in this issue.]

The confusion has arisen, notes Patton Boggs tax partner George Schutzer, because federal tax law has not kept up with rapid changes in the structure of small businesses and professional service firms.

Not that the Treasury Department hasn't tried. The department issued proposed regulations dealing with the subject in 1997, but was rebuffed by Congress, which felt tax code changes were its provenance, not Treasury's.

Those proposed regulations also mobilized the nation's small business community, which formed a coalition and hired lobbyist Dan Mastromarco of the Argus Group. Conservative radio talk show host Rush Limbaugh took up the issue, which he characterized as a “stealth” tax, The Wall Street Journal weighed in with a critical editorial, and a spooked Congress subsequently slapped a yearlong moratorium on Treasury's regulations involving the definition of a limited partner. Chastened by Congress, Treasury has never revisited the issue.

The problem, explains Steven Frost, a partner at Chapman and Cutler in Chicago who chaired an American Bar Association task force on the issue, stems in part from a tax scam common in the 1970s.

Wealthy people who had never worked, and thus were not eligible for Social Security coverage, would buy a limited partnership interest, pay the very modest employment tax, and later receive Social Security benefits.

“They were scamming the system to get coverage,” says Frost. “So Congress put in a rule that limited partners are not subject to self-employment taxes.”

No Limits

Currently, the federal tax code is quite clear that in a general partnership, partners must all pay a self-employment tax for Social Security of 12.4%, up to $90,000, and a health insurance tax of 2.9% on all income.

It is equally clear that “limited” partners, that is, partners who don't actually work for the partnership but merely provide capital, don't have to pay Social Security or health insurance tax. That's because the money they receive from the partnership is unearned income. And Social Security taxes are only paid on labor income – that is, income derived from actual work.

But state laws have changed, and members of LLCs and LLPs now play active roles in the management of their companies, acting, in effect, the same way as general partners do.

“The notion that a limited partner is still limited has not gone by the wayside, but it has been changed a great deal,” notes William Caudill, a partner in Fulbright & Jaworski's Houston office who chairs the American Bar Association's partnerships committee.

Add to that the situation with increasingly popular “S” corporations. Taxed like sole proprietorships, “S” corps allow unscrupulous owners to pay themselves below-market salaries ' which are subject to employment taxes ' and treat the rest of their profits as corporate income, which has no Social Security obligations.

“Put it all together,” notes Caudill, “and it's a puzzling set of results.”

Adds a senior congressional tax staffer: “The problem today is that there's no valid law to tell practitioners or LLCs or LLPs specifically what to do regarding their employment taxes. We only have these proposed regs.”

The joint committee, in the prosaic language of its report, Options to Improve Tax Compliance and Reform Tax Expenditures, puts it like this: “The uncertainty in treatment creates an opportunity for abuse by taxpayers willing to make the argument that they aren't subject to any employment tax, even though this argument is contrary to the spirit and intent of the employment tax rules.”

Raising Revenue

Lawyers, although one of the biggest users of the LLP business structure, are also notoriously conservative and tend to treat their partners as general partners for employment tax purposes, tax experts say. That is, they treat all their income as labor income, even if a small percentage comes from unearned capital income. That, however, could be less true for some of their clients.

“I'm guessing it's not coming from professionals,” says Patton Boggs' Schutzer. “Any analysis by a tax lawyer or accountant will conclude that in a professional services firm, all or virtually all compensation is subject to SECA,” adds Schutzer, referring to the Self-Employment Contributions Act, which governs employment payments for partnerships.

The 430-page study published last month by the taxation committee, a joint panel of both houses of Congress, contains some 70 different ways to boost tax revenues. Significantly, the extra monies gained from modifying how much employment tax is paid by limited partners and by “S” corporations were one of the biggest revenue raisers in the report.

The study was prompted by a National Taxpayer Advocate report that estimated that in 2001, the amount of tax voluntarily paid was some $311 billion less than the actual tax liability of the nation's taxpayers.

Although $6 billion added by limited partners and “S” corporations might seem like a relatively small sum compared with Social Security's $632 billion in revenue in 2003, the Social Security Administration doesn't see it that way. Number crunchers at the administration say all it would take to raise the additional $3.75 trillion needed to maintain Social Security solvency for the next 75 years would be to hike the current 12.4% Social Security tax rate by 1.89 percentage points.

But clean up the ambiguity involving the employment tax obligations of limited partners, and the Social Security tax increase needed to maintain solvency could drop as much as 0.1 percentage point to 1.79, a figure that “certainly isn't negligible,” says Social Security Administration spokesman Mark Lassiter.

Backing Off

Seth Green was an associate tax legislative counsel in the Treasury Department's Office of Tax Policy who worked on the proposed Treasury regulations rejected by Congress in 1997. The goal of the regs, he says, was to provide an up-to-date interpretation for tax purposes of a limited partner.

“It had become easier and easier to retain limited liability while getting more and more involved in running a business,” recalls Green, now a member at Washington, DC's Caplin & Drysdale, a rare law firm structured as a “C” corporation, or a traditional corporation. “And no one was paying attention to the federal employment tax consequences.”

The regulation, says Green, “was intended to bring an archaic statutory term up to date.”

One key to the Treasury Department proposal was establishing a “500 hour” rule, one that would make limited partners or members of limited liability companies who spent 500 or more hours a year working for a partnership count all of their income as subject to employment tax, even if a large portion of that income was generated by things other than “labor,” such as good will, capital investments, or advertising.

Mastromarco, who led the successful lobbying fight against the regulations, says that's not fair.

“Even if you were to work more than 500 hours, it does not mean that magically, once you cross that threshold, all earnings were from labor,” says Mastromarco, a former assistant chief counsel for tax policy at the Small Business Administration.

And while Treasury believed it was doing nothing more than providing an up-to-date interpretation of a “limited partner,” in fact, says Mastromarco, it was “legislating through rule making, which was one reason we were able to build such a large coalition.”

After Mastromarco's coalition was formed and Rush Limbaugh began sounding his drum about stealth taxes, “Congress was only too happy to beat up on the Clinton Treasury Department, and the issue was not important enough to resurrect,” Green believes.

But it remains politically charged.

The Bush Treasury Department has refused to comment on the issue or to provide a background briefing on the subject.

Rep. Amory Houghton Jr., a moderate New York Republican, had championed a fix in the last Congress as chairman of the Oversight Subcommittee of Ways and Means. But he retired at the end of the 108th Congress, and no one else in the House has taken up the issue. Senate Finance Committee spokeswoman Jill Gerber says the panel is still studying the proposals.

But former Internal Revenue Service Commissioner Donald Alexander, who knows the issue well, believes that budget imperatives may drive Congress to act.

“Revenues frequently drive principles,” says Alexander, a partner at Akin Gump Strauss Hauer & Feld. “And every little percentage point may be deemed to help.”