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Why Closing the S Corporation Loophole Is a Good Move

The House-passed tax extenders legislation, which the Senate is now considering, would partially close a loophole that allows shareholder-employees of S corporations to avoid paying payroll tax.  These people receive both wages from the firm and a share of the firm’s profits, but they pay payroll tax only on their wages, which gives them a huge incentive to underreport the share of their income that consists of wages in order to reduce their payroll tax liability. As policymakers sift through the letters of protest coming in from affected groups, they should also read what various government watchdogs have said on this issue:

  • The Government Accountability Office calculates that in 2003 and 2004, S corporations underreported approximately $23.6 billion in wage compensation to shareholders, “which could result in billions in annual employment [i.e., payroll] tax underpayments.”
  • The Treasury Department’s Inspector General for Tax Administration has concluded that “The S corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses.”
  • Analyzing 84 suspect S corporation tax returns, the Inspector General found that shareholders reported average wages of $5,300, while profit distributions — which are exempt from payroll taxes — averaged $349,323.

A typical target of the provision, according to a popular website that advises small businesses on tax issues, is a partner in a professional services firm (like a law firm) who creates an S corporation to hold his or her slice of the partnership.  The S corp receives the partner’s share of the firm’s profits and passes it on to the partner as both wages and S corporation profits; the partner pays payroll taxes only on the former.  “With this arrangement, if the partnership paid the partner (the S corporation) $300,000 but the S corporation paid its shareholder-employer only, say, $80,000, the professional saved about $9,000 a year in self-employment taxes.” That’s certainly a lucrative arrangement, but is it fair?  Shouldn’t these people pay payroll taxes on all of their earnings just like everybody else?  I think they should.

Chuck Marr
Vice President for Federal Tax Policy