The gap in the employment tax gap.

• Author: Winchester, Richard
• Position: Symposium: Closing the Tax Gap

In 2007, the Internal Revenue Service released a lengthy report on the federal tax gap (the "Tax Gap Report") to analyze and quantify the difference between what taxpayers collectively owe in tax and what they actually pay on time. (1) Among other things, the Tax Gap Report showed that underreporting of employment taxes accounted for nearly 16% of the total tax gap in 2001, representing approximately $54 billion of lost revenue. (2) Although this constitutes a substantial share of the total tax gap and a meaningful amount of lost revenue, the figure substantially understates the true shortfall in collections of federal employment taxes.

All but a miniscule portion of the employment tax gap is a result of underreporting by self-employed individuals. The Tax Gap Report gives substantial attention to only one reason why this is the case: the fact that sole proprietors simply do not report amounts they receive from third parties who are not required to either report the transaction to the government or withhold tax on the payment. According to the report, these least visible amounts go unreported a stunning 53.9% of the time. (3)

However, the Tax Gap Report fails to acknowledge another reason why the amount of employment tax collected from self-employed individuals falls short of what they ought to pay. When these persons conduct their business through a corporation, limited liability company or partnership, the law permits them to artificially exclude from the employment tax base amounts that would otherwise be included if they operated as a sole proprietor. (4) A self-employed individual can achieve this objective partly because the employment tax operates in an inconsistent way across business forms. Depending on the business entity that she uses, a self-employed individual can substantially reduce her employment tax liability and often eliminate it entirely. However, the Tax Gap Report does not consider such conduct, or the impact it has on tax collections, in its analysis.

The existence of tax reduction opportunities jeopardizes the integrity of the employment tax base. However, more importantly, it undermines the system's ability to operate in a fair and equitable way. Individuals who are in materially similar situations will pay vastly different amounts in tax solely because the law does not use a uniform rule to define the tax base. That alone offends basic notions of equity. However, it is also difficult, if not impossible, for the interests of equity and fairness to be served when the system permits an individual to determine the rules that will apply to him. When such options are available, tax outcomes will partly reflect how successfully someone has employed strategic measures to artificially reduce her tax liability.

The failure of the Tax Gap Report to adequately measure the employment tax gap is compounded by its failure to identify the full range of measures that should be taken to reduce it. The report emphasizes that any effort to reduce the tax gap cannot rely on any single approach. Instead, the report identifies seven components that any successful strategy must include. Most of them can be implemented by the Internal Revenue Service on its own initiative. (5) However, two of them require action by Congress: Reducing opportunities for evasion and reforming and simplifying the law. In fact, the report does include a number of legislative proposals directed at achieving these two objectives. (6) However, none of those proposals address the inconsistencies in the employment tax laws that permit a self-employed person to reduce her employment tax liability by strategically choosing a business form.

Scholars and policymakers have long known that by strategically selecting and using a business entity, a self-employed individual can reduce or otherwise control her employment tax liability. There have also been a number of proposals for correcting the defects in the law. Each of them operates in a slightly different way and none of them was made with the specific intent of closing the employment tax gap. Instead, the goal was simply to eliminate inconsistencies in the law and to provide a clear set of rules to address situations that were not contemplated when the law was drafted. Nevertheless, these suggestions can form the basis for a comprehensive legislative package to effectively reduce the employment tax gap.

This Article has two objectives. First it will explain how the official employment tax gap understates the amount of revenue lost when self-employed individuals choose to operate through a formal business entity instead of as a sole proprietor. Second, it will offer a legislative proposal designed to substantially reduce these tax reduction opportunities. Part I examines the existing employment tax rules and explains the differences in the way they apply to a self-employed individual depending on the business form used for conducting the business. Part II explains how the inconsistent employment tax rules create substantial tax reduction opportunities for a self-employed person who does not operate as a sole proprietor. Part III shows that the employment tax gap is substantially larger when it takes into account the lost revenue attributable to self-employed individuals who do not operate as sole proprietors. Part IV concludes by exploring possible legislative reforms that can eliminate the tax reduction strategies that now pose the greatest threat to the integrity of the employment tax base.

1. THE FEDERAL EMPLOYMENT TAX SYSTEM AND THE SELF-EMPLOYED INDIVIDUAL

   There are several legal forms through which a self-employed individual can conduct a business. These include the sole proprietorship, various forms of the partnership, the limited liability company, and the corporation. Each business form offers a different mix of features that may affect how suitable it may be for any given situation and how attractive it may be to the owners of the business. One factor that the owners of any business are likely to consider is the extent to which the earnings of the business will be subject to tax, including the employment tax.

   The employment tax obligation of a self-employed individual will vary depending on the way the business is classified for tax purposes. Each state law business form has a default tax classification. However, in many instances, the owners of the business can choose a tax classification other than the default classification. The relevant tax classifications are the C corporation, the S corporation, the partnership, and the sole proprietorship. The following Subpart describes the default tax classification and the optional tax classification that apply to each state law business form.

   1. Business Forms and Tax Classifications

      Any individual who does not use a formal business entity, such as a corporation or limited liability company, to conduct a business activity that she conducts on her own is considered a sole proprietor under state law. A sole proprietor is disregarded as a separate business entity for tax purposes. (7) Instead, any income or loss of the business is merely included in the computation of the owner's individual income tax liability. (8)

      If an individual (or group of individuals) incorporates a business under a state statute, the business is classified as a C corporation for tax purposes by default. (9) When a business is a C corporation, the firm and its owners (shareholders) constitute separate taxpaying units. As a result, the firm pays income tax on its profits. (10) Moreover, the profits will be subject to tax again in the event they are paid out to the shareholders as dividends. (11) However, if the business satisfies certain eligibility requirements, it can elect to be an S corporation for tax purposes. (12) Such a firm pays no tax on its profits. (13) Instead, the shareholders are taxed on their share of the profits of the business, whether they receive any or not. (14)

      An individual (or group of individuals) also has the option to form a limited liability company under state law. The default rules that apply to a limited liability company depend on whether it has one owner (member) or more than one. If it has only one member, the firm will be disregarded for tax purposes and the owner will be treated the same as if it were a sole proprietor, causing the business earnings to be taxed as if they were derived by the owner directly, not through a business entity. (15) However, a single member limited liability company can elect to be classified as a C corporation for tax purposes, causing the business and its owner to be treated as separate and distinct taxpaying units and triggering the two layers of tax. (16) Moreover, such a business can eliminate the firm level tax by making an additional election to be an S corporation, assuming it is eligible to do so. (17)

      If a limited liability company has more than one member, the firm will be classified as a partnership for tax purposes by default. (18) Like an S corporation, such a firm is not a separate taxpaying unit and its profits are taxed directly to the members, whether they receive any or not. (19) However, any multi-member limited liability company can elect to be classified as a C corporation for tax purposes. (20) Moreover, just like any other C corporation, the business can make an additional election to be classified as an S corporation, assuming it is eligible to do so. (21)

      If two or more individuals conduct a business without using a corporation or limited liability company, they will constitute a partnership under state law. (22) A state law partnership is classified as a partnership for tax purposes by default, making the partners, and not the firm, solely liable for the tax on firm profits whether they receive any or not. (23) However, any state law partnership can elect to be classified as a C corporation for federal income tax purposes so that the firm's profits will be...