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DUMB: Small Firms, S Corps, Face Higher Payroll Tax Under House Plan

(Why do the stupidest ideas seem to come from the House?)

The proposal aims to crack down on "the John Edwards loophole" -- a bit of tax planning that allows S corporations to escape Medicare taxes.

By MARTIN VAUGHAN

WASHINGTON—Small law, architectural and engineering firms could forfeit more of their income to payroll taxes under a proposal the House plans to vote on as early as next week.

House aides say the provision could raise as much as $10 billion to help offset the cost of a $180 billion bill to extend expired tax cuts, jobless benefits and other programs.

The proposal aims to crack down on what some have dubbed "the John Edwards loophole," after the former Democratic presidential candidate -- a bit of tax planning by the owners of closely-held businesses that allows much of their income to escape the 2.9% Medicare tax.

But some business owners and their Washington lobbyists argue that the tax would put a damper on entrepreneurial activity at a time the economy can ill afford it.

Details of the small business tax compliance proposal, along with details of the larger tax bill, have not yet been released and could change by the time the House actually votes on the plan, expected late next week.

In addition to the payroll tax change, House and Senate Democrats are expected to propose raising taxes on the earnings of private equity and hedge fund managers, raising another $20 billion for the package.

Senate Democrats at week's end were still polling their members to find out if they will have 60 votes in the chamber for the package; the impact of the tax changes on small businesses and on fund managers are complicating those prospects.

The House small business tax proposal aims to attack a practice by the owners of S corporations who under-report their wages in order to pay less in FICA taxes. S corporation owners often pay themselves a salary, to which Social Security and Medicare taxes apply. But profits that are paid to the owner as a shareholder are not subject to payroll taxes.

According to a recent estimate from the Government Accountability Office, about 13% of small business S corporations owners mis-reported compensation in 2003-2004, depriving the government of about $3 billion.

Edwards was criticized during the 2004 presidential campaign for using the loophole when he was the sole shareholder of an S corporation law firm. For example, in 1997 Edwards earned $540,000 in salary but took shareholder profits of $5 million, saving tens of thousands in Medicare taxes.

"This really makes no sense. People can structure their businesses in different ways, but we shouldn't have a special loophole for certain types of businesses but not others," said Steve Wamhoff, legislative director at Citizens for Tax Justice, a liberal group.

The House plan would make active shareholder income subject to FICA taxes, not just amounts set aside as salary.

House Democratic aides say the provision will be narrowly targeted, focusing on areas where there is greatest evidence of fudging the rules. It will only apply to S corporations who are service providers -- exempting manufacturers -- and will focus on firms in which there is only one or a handful of shareholders.

Lawyers, consultants, architects and engineers stand to see more of their income taxed. Still unclear is the extent to which the proposal will affect hair stylists, restaurant owners and landscapers.

Critics of the House plan say that it over-reaches by applying payroll taxes to income that is less like wages and more like a return on investment. The proposal is a "direct attack on entrepreneurial activity in the middle of a recession," said Thomas Nichols, an attorney at the firm of Meissner, Tierney, Fisher & Nichols.

"There are still some benefits of being self-employed or owning a business, and this might be one of the few that remains," said Jason Mudd, owner of an S corporation public-relations firm in Jacksonville, Fla.

Write to Martin Vaughan at [e-mail]

http://online.wsj.com/article/SB10001424052748703302604575294463267921150.html?mod=WSJ_hps_sections_smallbusiness