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
Nebraska Law Review 92.3 (2014)
42 Pages Posted: 21 Sep 2015
Date Written: June 1, 2014
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 tax payers based solely on the type of entity the owner elects to be taxed as 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. 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 is it 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 and 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 and there are currently pending proposals for legislation that seek to merge the income tax provisions for the various flow-through entities under one standardized set of rules. 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 should issue significant regulations to improve the administration of the reasonable compensation standard including providing safe harbor amounts for the value of services 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 deficiencies should be carried forward for up to three future tax years and applied to increase the payroll tax base of the employee-owner to the extent that the owner-employee’s share of income exceeds the value of services provided in such later year. Finally, the definition for net investment income should be modified to simply include all items of income that are not otherwise subject to the payroll tax base.
Since the proper implementation of these recommendations would require congressional action, these changes should be made on a revenue neutral basis. After taking the projected revenue adjustments along with the projected adjustments to future outlays, the tax rates should be adjusted downward to the extent the changes increase net revenues or upward should these changes result in a decreased 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.
Keywords: net investment income tax, payroll tax, affordable care act, tax base, capital income, tax entities, self-employment tax base
JEL Classification: K34
Suggested Citation: Suggested Citation