Working For Free: It Ought To Be Against the (Tax) Law

Abstract

Employment taxes account for an enormous share of federal tax receipts. It is widely acknowledged that taxes on the self-employed are collected under a dysfunctional set of laws that is long overdue for repair. Yet, there is surprisingly little legal scholarship in the field. This article fills a portion of that gap. It examines some fundamental flaws that plague our nation's employment tax laws, focusing on how President Bush's dividend tax cut created an incentive for wealthy individuals to exploit those flaws at the government's expense when they work for a corporation that they also own and control. Specifically, prior to the Bush tax cut the corporation would have (correctly) paid these employee-shareholders a salary for their labor. However, the corporation is now more likely to substitute a dividend for that compensation, preventing any employment tax from coming into play and shortchanging the social security trust fund at a time when its long term solvency is in jeopardy. This article proposes a new and practical framework for addressing the defects in the law in order to produce more sensible and equitable results while eliminating opportunities for abuse.

Keywords: employment tax, self-employment tax, dividend tax cut, closely-held business, tax fairness

JEL Classification: G35, H24, H25, K34