Taxation Committee Report JCS-02-05: A Closer Look

The Congressional tax change proposal for owners of LLPs, LLCs and S-corporations would fill only a small part ' about 1.5% ' of the projected Social Security funding gap; but the proposal looms much larger when compared with other elements of the Joint Committee's overall tax-revision package (see Table 1, below).

The Forest and the Trees

For a look at the overall package, check out the Joint Committee on Taxation report referenced in T.R. Goldman's accompanying article. Titled “Options to Improve Tax Compliance and Reform Tax Expenditures” (# JCS-02-05, dated January 27, 2005), the report is viewable at www.house.gov/jct/s-2-05.pdf.

The report proposes changes in 11 taxation categories:

• Tax procedure and administration;
• Individual income tax;
• Employment taxes;
• Pensions and employee benefits;
• Corporate and partnership provisions;
• International provisions;
• Other business provisions;
• Exempt organizations;
• Tax-exempt bond provisions;
• Excise taxes; and
• Estate-gift taxation

A quick review of Table 1 shows that multiple interest groups are directly affected by these proposals. Those who are disadvantaged by each proposal will undoubtedly find reasons, more or less compelling, for retaining the status quo ' or perhaps for making some less disruptive type of change.

[IMGCAP(1)]

Within these categories, some proposed tax changes are revenue neutral, while many others will bring in comparatively small increments.

As shown in Table 1, however, the proposed taxation change for LLPs, LLCs and S-corporations is not one of these small changes; on the contrary, it has the second highest yield of all proposed revisions. For this reason, as well as for political-party reasons, this proposal seems likely to attract considerable attention and support. As noted by TaxProf Blog, a blog for law school tax professors by Paul L. Caron of the University of Cincinnati College of Law (http://taxprof.typepad.com/taxprof_blog), however, the report proposals were generated by the Joint Committee staff without item pre-approval by Senator Grassley, Senator Baucus, or their staffs.

Revenue potential aside, one might think the proposal would also gain support because it largely removes confusing tax angles from decision-making on how to organize a professional services firm. Realistically, though, enthusiasm for simplicity pales before enthusiasm for tax savings.

A Closer Look at the Pass-Through Proposal

The report subsection on income taxation of pass-through entity owners starts on page 95 of the report itself (not the PDF page number). After reviewing the current system of rules and commenting on its problems, the subsection describes the committee's proposal. Here, sans quotation marks and footnotes, is a slight abridgement of that description.

Note: To avoid a confusing mismatch if you check the report itself, I've adhered to the oddly fragmented order of the report text:

• Treatment of Partners [all types]
• Treatment of S Corporation Share- holders
• [Discussion:] Treatment of Partners
• [Discussion:] Treatment of S Corporation Shareholders

Report Text: Treatment of Partners [General, Limited or Neither ' Editor]

Under the proposal, the present-law rule for general partners generally applies to any partner for determining net earnings from self-employment. Thus, all partners are subject to self-employment tax on their distributive share (whether or not distributed) of partnership income or loss. As under present law, specified types of income or loss are excluded from net earnings from self-employment of a partner, such as certain rental income, dividends and interest, certain gains, and other items. However, under the proposal, in the case of a service partnership, all of the partner's net income from the partnership is treated as net earnings from self-employment. A service partnership is a partnership, 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 (similar to sec. 448(d)(2)).

If, however, any partner (regardless of whether he or she is a general partner, limited partner, or neither a general nor limited partner, such as a limited liability company member) does not materially participate in the trade or business of the partnership, a special rule provides that only the partner's reasonable compensation from the partnership is treated as net earnings from self-employment. Thus, some general partners who would be subject to self-employment tax on their distributive share of partnership income under present law will be subject to tax only on reasonable compensation from the partnership under the proposal.

Report Text: Treatment of S corporation shareholders

Under the proposal, for purposes of employment tax, an S corporation is treated as a partnership and any shareholders of the S corporation are treated as general partners. Thus, S corporation shareholders are subject to self-employment tax on their shares of S corporation net income (whether or not distributed) or loss. … [Same exclusions as for Partners.]

If a shareholder does not materially participate in the trade or business activity of the S corporation, a special rule provides that only reasonable compensation from the S corporation is treated as net earnings from self-employment.

Report Text: Discussion ' Treatment of partners

The proposal changes the self-employment tax treatment of partners to take account of changes in applicable State law and in business practices. Limited liability companies are generally treated as partnerships ' and their owners as partners ' for Federal income tax purposes. Nevertheless, limited liability company owners are neither general nor limited partners under applicable State law. Applying the present-law self-employment tax rules, which refer specifically to general and limited partners, to limited liability company owners has raised difficult questions of interpretation, creating complexity and compliance problems for both taxpayers and tax administrators. The proposal ends the present-law uncertainty by identifying a minimum base on which all partners must pay employment tax.

The reference in the self-employment tax rules to “limited partners” does not reflect changes in State limited partnership laws permitting individuals designated as limited partners under State law to perform management services as well as other services for the partnership. The present-law rule limiting the amount of self-employment tax of a limited partner to the amount of guaranteed payments does not treat partners performing services comparably, and should be conformed to the rule for general partners.

The conceptual premise of the proposal is that the base for the employment and self-employment tax should be labor income. Historically, the tax has applied to labor income, relating very roughly to the rules for accruing benefits under the Social Security system, which requires the individual to perform quarters of labor. The proposal applies this notion more uniformly than does present law to individuals who perform services for or on behalf of a pass-through entity in which they own an interest (ie, a partnership, limited liability company, or S corporation). The proposal treats such individuals similarly to sole proprietors, as well as similarly to each other. Not only does this more uniform treatment improve the fairness of the tax law and increase the internal theoretical consistency of the tax rules, it also tends to improve tax neutrality by reducing the importance of FICA and self-employment tax differences in taxpayers' choice of business entity.

Previous proposals in this area have sought greater theoretical purity by proposing a carve-out from the self-employment tax for income from the business that is from capital rather than from labor. Under this approach, an attempt is made to determine a reasonable return from partnership capital, which is excluded from the partner's self-employment income. This type of approach raises administrability concerns, as rates of return can vary significantly among different types of businesses, at different times in the life of a business activity, and with different management of the business, among other factors.

By contrast, the proposal (like present law) generally provides that certain readily identifiable types of income such as dividends, interest and rents that generally are not labor income are not subject to self-employment tax. Only in the case of a service business, typically one in which income is primarily from labor rather than capital, is this rule not applicable under the proposal. The proposal does eliminate readily identifiable capital income from the self-employment tax base, but does not require a factual inquiry on a case-by-case basis as to what income of the partnership may be attributable to capital, and therefore is more predictable and more administrable than other approaches.

As a means of further isolating labor income of partners that is subject to self-employment tax, the proposal provides that if a partner does not materially participate in the trade or business of the partnership, only the partner's reasonable compensation from the partnership is treated as net earnings from self-employment. Material participation is a standard that has been frequently applied since its enactment in 1986 as a component of the passive loss rules (sec. 469). Though it does require a factual inquiry, the standard is well developed in the section 469 regulations.

Though also a factual inquiry, the question of whether an individual's compensation is reasonable is one that has been repeatedly addressed in case law. The addition of the independent investor test used in the Seventh Circuit and partially adopted in some other circuits has changed the previously predictable analysis under the multi-factor test applied in many judicial decisions to determine reasonable compensation. It could be questioned whether the determination of reasonable compensation has the predictability that is desirable in a legislative proposal, given the changing analysis among the circuit courts. However, the proposal looks to reasonable compensation to determine net earnings from self-employment only if the individual does not materially participate in the trade or business, limiting the situations in which this standard applies under the proposal.

Report Text: Discussion ' Treatment of S corporation shareholders

In addition to addressing the issues that relate also to partners (discussed above), the proposal relating to S corporation shareholders serves the purpose of minimizing present-law opportunities to avoid the employment tax by re-characterizing wages as some other type of S corporation distribution. Disparate treatment of wages and other distributions under present law creates an undesirable incentive for individuals performing services to avoid FICA tax on labor income, including on the uncapped HI component, by setting up business as an S corporation and characterizing as wages a small amount of service income below the wage cap, while the rest is passed through the S corporation to the shareholder-employee free of FICA tax.

The self-employment tax (and the earlier-instituted FICA tax) were originally designed both to measure Social Security benefit accruals by determining whether individuals earned income from working, and to collect revenues to fund such benefit accruals. However, taxpayers' incentives have changed as the wage base and the resulting tax cost to individual taxpayers of accruing benefits has risen, and the value of Social Security benefits to high-income taxpayers has become relatively lower as a percentage of income. The motivation of higher-income taxpayers to avoid the tax was further increased by the elimination of the cap on the HI component of the tax by the Revenue Reconciliation Act of 1993. Rather than having an incentive to accrue benefits, taxpayers now have the opposite incentive: to avoid or reduce the tax cost, which may exceed the value to them of the social insurance benefit. The tax rules are not currently designed to prevent avoidance, and indeed, may facilitate it because the rules apply unevenly depending on whether the taxpayer chooses to do business through an S corporation, partnership, or sole proprietorship. Eliminating this unevenness not only increases the fairness of the tax as between similarly situated taxpayers, but also is consistent with a purpose to raise revenue among all workers comparably. Under the proposal, the employment tax rules no longer skew taxpayers' choice of business entity because of differing FICA and self-employment tax results. By treating S corporation shareholders who perform services for or on behalf of the S corporation in the same manner as partners who perform services for or on behalf of the partnership, the proposal improves the neutrality of the tax law.

The proposal has the effect of applying the self-employment tax collection system to S corporation shareholder-employees, rather than the withholding regime that applies to them (along with other employees) under the present-law FICA tax rules. Withholding may be a more effective and faster collection mechanism than self-assessment as under the self-employment rules. However, preserving a withholding regime on S corporation shareholder wages, and imposing self-employment tax only on the portion of the shareholder's distributive share that exceeds previously taxed wages, would require a mechanism to prevent double-counting from one taxable year to the next, which could impose additional administrative and recordkeeping burdens on the S corporation. Further, the detriment of eliminating FICA withholding on S corporation shareholder employees is offset by the dual benefits under the proposal of improving tax neutrality and reducing tax avoidance. Therefore, the proposal applies the self-employment tax rules to S corporation shareholder-employees in the same manner that those rules apply to partners.

Conclusion

Law and accounting firms have long been used to evolving tax factors that influence their firm-structure choices. The current tax-revision discussion may simplify that decision going forward, but it may also leave some firms regretting a choice that formerly made sense. This is particularly so because the optimal structure of a professional services firm is influenced not only by federal law but also by state and local municipal laws ' and increasingly by the laws of other nations. For some law firms, therefore, a federal tax-law change might conceivably trigger more far-reaching effects that alter the viability of the firm's structure as a pass-through entity.

Arguably, therefore, any revenue-enhancing legislation that unfairly disadvantages professional services firms should provide some corresponding relief for firms that need to change their form of organization as a result.

The Congressional tax change proposal for owners of LLPs, LLCs and S-corporations would fill only a small part ' about 1.5% ' of the projected Social Security funding gap; but the proposal looms much larger when compared with other elements of the Joint Committee's overall tax-revision package (see Table 1, below).

The Forest and the Trees

For a look at the overall package, check out the Joint Committee on Taxation report referenced in T.R. Goldman's accompanying article. Titled “Options to Improve Tax Compliance and Reform Tax Expenditures” (# JCS-02-05, dated January 27, 2005), the report is viewable at www.house.gov/jct/s-2-05.pdf.

The report proposes changes in 11 taxation categories:

• Tax procedure and administration;
• Individual income tax;
• Employment taxes;
• Pensions and employee benefits;
• Corporate and partnership provisions;
• International provisions;
• Other business provisions;
• Exempt organizations;
• Tax-exempt bond provisions;
• Excise taxes; and
• Estate-gift taxation

A quick review of Table 1 shows that multiple interest groups are directly affected by these proposals. Those who are disadvantaged by each proposal will undoubtedly find reasons, more or less compelling, for retaining the status quo ' or perhaps for making some less disruptive type of change.

[IMGCAP(1)]

Within these categories, some proposed tax changes are revenue neutral, while many others will bring in comparatively small increments.

As shown in Table 1, however, the proposed taxation change for LLPs, LLCs and S-corporations is not one of these small changes; on the contrary, it has the second highest yield of all proposed revisions. For this reason, as well as for political-party reasons, this proposal seems likely to attract considerable attention and support. As noted by TaxProf Blog, a blog for law school tax professors by Paul L. Caron of the University of Cincinnati College of Law (http://taxprof.typepad.com/taxprof_blog), however, the report proposals were generated by the Joint Committee staff without item pre-approval by Senator Grassley, Senator Baucus, or their staffs.

Revenue potential aside, one might think the proposal would also gain support because it largely removes confusing tax angles from decision-making on how to organize a professional services firm. Realistically, though, enthusiasm for simplicity pales before enthusiasm for tax savings.

A Closer Look at the Pass-Through Proposal

The report subsection on income taxation of pass-through entity owners starts on page 95 of the report itself (not the PDF page number). After reviewing the current system of rules and commenting on its problems, the subsection describes the committee's proposal. Here, sans quotation marks and footnotes, is a slight abridgement of that description.

Note: To avoid a confusing mismatch if you check the report itself, I've adhered to the oddly fragmented order of the report text:

• Treatment of Partners [all types]
• Treatment of S Corporation Share- holders
• [Discussion:] Treatment of Partners
• [Discussion:] Treatment of S Corporation Shareholders

Report Text: Treatment of Partners [General, Limited or Neither ' Editor]

Under the proposal, the present-law rule for general partners generally applies to any partner for determining net earnings from self-employment. Thus, all partners are subject to self-employment tax on their distributive share (whether or not distributed) of partnership income or loss. As under present law, specified types of income or loss are excluded from net earnings from self-employment of a partner, such as certain rental income, dividends and interest, certain gains, and other items. However, under the proposal, in the case of a service partnership, all of the partner's net income from the partnership is treated as net earnings from self-employment. A service partnership is a partnership, 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 (similar to sec. 448(d)(2)).

If, however, any partner (regardless of whether he or she is a general partner, limited partner, or neither a general nor limited partner, such as a limited liability company member) does not materially participate in the trade or business of the partnership, a special rule provides that only the partner's reasonable compensation from the partnership is treated as net earnings from self-employment. Thus, some general partners who would be subject to self-employment tax on their distributive share of partnership income under present law will be subject to tax only on reasonable compensation from the partnership under the proposal.

Report Text: Treatment of S corporation shareholders

Under the proposal, for purposes of employment tax, an S corporation is treated as a partnership and any shareholders of the S corporation are treated as general partners. Thus, S corporation shareholders are subject to self-employment tax on their shares of S corporation net income (whether or not distributed) or loss. … [Same exclusions as for Partners.]

If a shareholder does not materially participate in the trade or business activity of the S corporation, a special rule provides that only reasonable compensation from the S corporation is treated as net earnings from self-employment.

Report Text: Discussion ' Treatment of partners

The proposal changes the self-employment tax treatment of partners to take account of changes in applicable State law and in business practices. Limited liability companies are generally treated as partnerships ' and their owners as partners ' for Federal income tax purposes. Nevertheless, limited liability company owners are neither general nor limited partners under applicable State law. Applying the present-law self-employment tax rules, which refer specifically to general and limited partners, to limited liability company owners has raised difficult questions of interpretation, creating complexity and compliance problems for both taxpayers and tax administrators. The proposal ends the present-law uncertainty by identifying a minimum base on which all partners must pay employment tax.

The reference in the self-employment tax rules to “limited partners” does not reflect changes in State limited partnership laws permitting individuals designated as limited partners under State law to perform management services as well as other services for the partnership. The present-law rule limiting the amount of self-employment tax of a limited partner to the amount of guaranteed payments does not treat partners performing services comparably, and should be conformed to the rule for general partners.

The conceptual premise of the proposal is that the base for the employment and self-employment tax should be labor income. Historically, the tax has applied to labor income, relating very roughly to the rules for accruing benefits under the Social Security system, which requires the individual to perform quarters of labor. The proposal applies this notion more uniformly than does present law to individuals who perform services for or on behalf of a pass-through entity in which they own an interest (ie, a partnership, limited liability company, or S corporation). The proposal treats such individuals similarly to sole proprietors, as well as similarly to each other. Not only does this more uniform treatment improve the fairness of the tax law and increase the internal theoretical consistency of the tax rules, it also tends to improve tax neutrality by reducing the importance of FICA and self-employment tax differences in taxpayers' choice of business entity.

Previous proposals in this area have sought greater theoretical purity by proposing a carve-out from the self-employment tax for income from the business that is from capital rather than from labor. Under this approach, an attempt is made to determine a reasonable return from partnership capital, which is excluded from the partner's self-employment income. This type of approach raises administrability concerns, as rates of return can vary significantly among different types of businesses, at different times in the life of a business activity, and with different management of the business, among other factors.

By contrast, the proposal (like present law) generally provides that certain readily identifiable types of income such as dividends, interest and rents that generally are not labor income are not subject to self-employment tax. Only in the case of a service business, typically one in which income is primarily from labor rather than capital, is this rule not applicable under the proposal. The proposal does eliminate readily identifiable capital income from the self-employment tax base, but does not require a factual inquiry on a case-by-case basis as to what income of the partnership may be attributable to capital, and therefore is more predictable and more administrable than other approaches.

As a means of further isolating labor income of partners that is subject to self-employment tax, the proposal provides that if a partner does not materially participate in the trade or business of the partnership, only the partner's reasonable compensation from the partnership is treated as net earnings from self-employment. Material participation is a standard that has been frequently applied since its enactment in 1986 as a component of the passive loss rules (sec. 469). Though it does require a factual inquiry, the standard is well developed in the section 469 regulations.

Though also a factual inquiry, the question of whether an individual's compensation is reasonable is one that has been repeatedly addressed in case law. The addition of the independent investor test used in the Seventh Circuit and partially adopted in some other circuits has changed the previously predictable analysis under the multi-factor test applied in many judicial decisions to determine reasonable compensation. It could be questioned whether the determination of reasonable compensation has the predictability that is desirable in a legislative proposal, given the changing analysis among the circuit courts. However, the proposal looks to reasonable compensation to determine net earnings from self-employment only if the individual does not materially participate in the trade or business, limiting the situations in which this standard applies under the proposal.

Report Text: Discussion ' Treatment of S corporation shareholders

In addition to addressing the issues that relate also to partners (discussed above), the proposal relating to S corporation shareholders serves the purpose of minimizing present-law opportunities to avoid the employment tax by re-characterizing wages as some other type of S corporation distribution. Disparate treatment of wages and other distributions under present law creates an undesirable incentive for individuals performing services to avoid FICA tax on labor income, including on the uncapped HI component, by setting up business as an S corporation and characterizing as wages a small amount of service income below the wage cap, while the rest is passed through the S corporation to the shareholder-employee free of FICA tax.

The self-employment tax (and the earlier-instituted FICA tax) were originally designed both to measure Social Security benefit accruals by determining whether individuals earned income from working, and to collect revenues to fund such benefit accruals. However, taxpayers' incentives have changed as the wage base and the resulting tax cost to individual taxpayers of accruing benefits has risen, and the value of Social Security benefits to high-income taxpayers has become relatively lower as a percentage of income. The motivation of higher-income taxpayers to avoid the tax was further increased by the elimination of the cap on the HI component of the tax by the Revenue Reconciliation Act of 1993. Rather than having an incentive to accrue benefits, taxpayers now have the opposite incentive: to avoid or reduce the tax cost, which may exceed the value to them of the social insurance benefit. The tax rules are not currently designed to prevent avoidance, and indeed, may facilitate it because the rules apply unevenly depending on whether the taxpayer chooses to do business through an S corporation, partnership, or sole proprietorship. Eliminating this unevenness not only increases the fairness of the tax as between similarly situated taxpayers, but also is consistent with a purpose to raise revenue among all workers comparably. Under the proposal, the employment tax rules no longer skew taxpayers' choice of business entity because of differing FICA and self-employment tax results. By treating S corporation shareholders who perform services for or on behalf of the S corporation in the same manner as partners who perform services for or on behalf of the partnership, the proposal improves the neutrality of the tax law.

The proposal has the effect of applying the self-employment tax collection system to S corporation shareholder-employees, rather than the withholding regime that applies to them (along with other employees) under the present-law FICA tax rules. Withholding may be a more effective and faster collection mechanism than self-assessment as under the self-employment rules. However, preserving a withholding regime on S corporation shareholder wages, and imposing self-employment tax only on the portion of the shareholder's distributive share that exceeds previously taxed wages, would require a mechanism to prevent double-counting from one taxable year to the next, which could impose additional administrative and recordkeeping burdens on the S corporation. Further, the detriment of eliminating FICA withholding on S corporation shareholder employees is offset by the dual benefits under the proposal of improving tax neutrality and reducing tax avoidance. Therefore, the proposal applies the self-employment tax rules to S corporation shareholder-employees in the same manner that those rules apply to partners.

Conclusion

Law and accounting firms have long been used to evolving tax factors that influence their firm-structure choices. The current tax-revision discussion may simplify that decision going forward, but it may also leave some firms regretting a choice that formerly made sense. This is particularly so because the optimal structure of a professional services firm is influenced not only by federal law but also by state and local municipal laws ' and increasingly by the laws of other nations. For some law firms, therefore, a federal tax-law change might conceivably trigger more far-reaching effects that alter the viability of the firm's structure as a pass-through entity.

Arguably, therefore, any revenue-enhancing legislation that unfairly disadvantages professional services firms should provide some corresponding relief for firms that need to change their form of organization as a result.