Less Is More: Applying a Modified Reasonable Compensation Standard to Eliminate the Inconsistencies Among the Payroll Tax Bases and the Net Investment Income Tax Base Under the Affordable Care Act

• Publication year: 2021

92 Nebraska L. Rev. 586. Less Is More: Applying a Modified Reasonable Compensation Standard to Eliminate the Inconsistencies Among the Payroll Tax Bases and the Net Investment Income Tax Base Under the Affordable Care Act

Less Is More: Applying a Modified Reasonable Compensation Standard to Eliminate the Inconsistencies Among the Payroll Tax Bases and the Net Investment Income Tax Base Under the Affordable Care Act

John Spencer Treu, LL.M., J.D., C.P.A.(fn*)

TABLE OF CONTENTS

I. Introduction .......................................... 588

II. FICA and SECA Taxes in a Nutshell .................. 589

III. The Policy for the Last Great "Regressive" and "Flat" Taxes ................................................. 592
A. Legislative History Illustrates the Critical Differences Between the Policy for Payroll Taxes and Income Taxes ................................. 593
B. The Subsequent Decoupling of the Payroll Tax Benefits and Burdens Through the Passage of Medicare Changed the Character and Perception of Payroll Taxes to More Closely Approximate the Income Tax Regime Than Was Originally Intended .......................................... 597

IV. The SECA and FICA Tax Bases Vary for Self-Employed Individuals Owning Different Entity Types and Employees and Fails to Comply with the Original Policy for the Payroll Tax Regime ............................ 598
A. The SECA Tax Base Includes Capital Income ...... 598

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B. SECA Tax on Capital Is Inconsistently Applied to Owners of LLPs, LLCs, and S Corporations ........ 600
C. Illustrating the Inconsistencies .................... 603
1. SECA Tax Base for S Corporation, LLC, and LLP Modeled .................................. 603
2. Comparing Treatment of Owners and Employees Under SECA and FICA ........................ 605
3. The Benefits of Ownership Under SECA Tax Where the Value of Services Provided Exceeds the Income from the Entity .................... 606
D. The Tax on Net Investment Income Enters the Fray, Adding Another Layer of Complexity on Top of an Already Incoherent Payroll Tax Regime ...... 607

V. Standardizing the Payroll Tax Treatment for All Taxpayers ............................................ 609
A. Why a Standardized Payroll Tax System May Be Politically Feasible ................................ 610
B. The Three Standardizing Approaches Previously Proposed by the Congressional Budget Office ....... 611
C. Another Approach for Standardization Is to Apply the SECA Tax Base for Tax Partnerships to Limited Partners in LLPs and Shareholders of S Corporations, but This Approach Is Also Inconsistent with the Policy for Payroll Taxes ...... 617
D. The IRS's Noble but Futile Attempt to Standardize the SECA Tax Base Between LLCs and LLPs ...... 619

VI. Utilizing a Modified Version of the Reasonable Compensation Standard to Remedy the Inconsistencies Between the Bases for SECA Tax, FICA Tax, and the Net Investment Income Tax ........................... 620
A. The SECA Tax Base Should Include Only the Value of Services the Owner-Employee Provides to the Entity ............................................. 621
B. To the Extent the Value of Services Provided by an Owner-Employee Exceeds the Income from the Entity, the Difference Should Be Carried Forward for Up to Three Years and Applied to Other Income of the Owner-Employee to the Extent Such Income Exceeds the Value of Services Provided ............ 622
C. Modifying the Definition of Net Investment Income to Correct the Loophole for S Corporations ......... 623
D. The Practical and Political Feasibility of This Proposal-How to Pay for and Pass It ............. 624

VII. Conclusion ............................................ 626

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I. INTRODUCTION

The original policy for the implementation of payroll taxes was to impose a tax on wages as both a funding mechanism for, and a limitation to, qualifying for social security. However, the self-employment tax base developed severe inconsistencies with this original policy and among different tax entities by including certain returns on capital investments in the tax base. At present, different payroll tax obligations arise for similarly situated taxpayers based solely on how business owners elect to be taxed under the check-the-box regulations. These inconsistencies resulted from misguided efforts by Congress and the Treasury to view the payroll tax base with the same lens as the income tax. This misconception is evident in regulations and proposals that seek to distinguish wages from capital for purposes of payroll taxes based on the active/passive distinction that arose under the passive loss limitation rules of the income tax.

Following the lead of the self-employment tax base, the newly minted net investment income tax base that arose under the Affordable Care Act now suffers from similar inconsistencies.(fn1) Consequently, certain capital income for active members of tax partnerships is included in the self-employment tax base, and this same income for shareholders of S corporations is neither taxed as self-employment income nor taxed under the net investment income tax regime. Also, owner-employees are entitled to significant reductions in their payroll tax obligations when the value of their services provided to the company exceeds their share of the income from the company. This reduction is never recaptured even if the company becomes very profitable in subsequent years. The net investment income tax takes effect for the first time in 2013,(fn2) and there are currently pending legislative proposals that seek to merge the income tax provisions for the various flow-through entities under one standardized set of rules.(fn3) So the time is ripe to eliminate the various inconsistencies in the payroll tax and net investment income tax by using a uniform standard consistently applied across all entities and taxpayers.

This Article makes four recommendations to restore the payroll tax regime to its original purpose and cure these inconsistencies in the payroll tax and net investment income tax bases. First, payroll taxes should be standardized for all taxpayers across all tax entities by using the reasonable compensation standard so that capital income is entirely eliminated from the payroll tax base. Second, the Treasury

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should issue additional significant regulations to improve the administration of the reasonable compensation standard, including providing safe harbor amounts that can be claimed as reasonable compensation for the value of services provided by owner-employees based on the average remuneration paid to similarly situated non-owner taxpayers. Third, to the extent that the owner-employee's share of income for the year is less than the value of services provided to the company, such deficiency should be carried forward for up to three future tax years and applied to increase the payroll tax base of the owner-employee to the extent that the owner-employee's share of income exceeds the value of services provided in such later years. Finally, the definition for net investment income for purposes of the net investment income tax, a tax which is specifically meant to apply to returns on capital, should be modified to simply include all items of income that are not otherwise subject to the payroll tax base as wages.

Since the proper implementation of these recommendations would require congressional action and the motivation for such changes is to restore the payroll tax base to its original foundation rather than to cut taxes or raise revenues, these changes should be made on as close to a revenue-neutral basis as possible. After taking the projected revenue adjustments in the payroll and net investment income taxes along with the projected adjustments to future outlays within the relevant budget window, the tax rates could be adjusted downward to the extent the changes increase net revenues or upward should these changes result in a decrease in net revenues. These changes would reacquaint payroll taxes with the original policy for the social security tax and benefit system-namely, that it be based on the wages of wage earners rather than capital income-and would eliminate the arbitrary variance in the self-employment and net investment income tax bases between identical business activities of owners of different flow-through entities.

II. FICA AND SECA TAXES IN A NUTSHELL

The Federal Insurance Contributions Act (FICA) imposes a tax on both employees and employers on most wages paid to an employee with respect to employment.(fn4) Subject to a few limited exceptions,(fn5) the

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vast majority of wages paid to employees are subject to FICA tax, and employers are required to deduct and withhold the employee's FICA tax obligation.(fn6) Income paid to owner-employees in exchange for services provided to the company are subject to self-employment tax pursuant to the Self Employment Contributions Act (SECA), although the SECA tax base also includes certain types of capital income.(fn7)

The rate of tax on includible wages that applies both to the employer and the employee is 7.65%. This is made up of a tax to support old age, survivors, and disability insurance-the social security portion-in the amount of 6.2%(fn8) and hospital insurance-the Medicare portion-in the amount of 1.45%.(fn9) The social security portion applies only to income below the wage base limit,(fn10) which was $113,700 in 2013,(fn11) while the Medicare...