Tax All Pass-Through Business Owners Under SECA and Impose a Material Participation Standard

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 5.8 10.4 11.6 13.1 14.2 14.9 15.6 16.5 17.3 18.1 55.1 137.4

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

Most of the revenues would be off-budget. In addition, the option would increase outlays for Social Security by a small amount. The estimates do not include those effects on outlays.

Under current law, workers with earnings from businesses owned by other people contribute to Social Security and Medicare Part A through the Federal Insurance Contributions Act (FICA) tax. The tax rate for Social Security is 12.4 percent of the tax base up to $118,500, and that threshold increases each year with average wages. For Medicare Part A, the tax rate is 2.9 percent, and there is no ceiling on that base. The tax bases for both programs are limited to labor income (specifically, wages and salaries), and the taxes are split equally between the employer and the employee.

In contrast, people with earnings from businesses they own themselves are taxed either through FICA or through the Self-Employment Contributions Act (SECA), depending on whether the business is incorporated. Owners of unincorporated businesses are subject to the SECA tax, and their tax base is self-employment income (which, unlike the FICA base, generally includes some capital income.) The definition of self-employment income depends on whether one is classified as a sole proprietor, a general partner (that is, a partner who is fully liable for the debts of the firm), or a limited partner (a partner whose liability for the firm’s debts is limited to the amount he or she invests). Sole proprietors pay SECA taxes on their net business income (that is, receipts minus expenses). General partners pay SECA taxes on their “guaranteed payments” (payments they are due regardless of the firm’s profits) and on their share of the firm’s net income. Limited partners pay SECA tax solely on any guaranteed payments they receive, and then only if those payments represent compensation for labor services.

The definition of limited partners is determined at the state level and, as a result, varies among states. Since the enactment of federal laws distinguishing between the treatment of general and limited partners under SECA, state laws have expanded eligibility for limited-partner status from strictly passive investors to certain partners who are actively engaged in the operation of businesses. Furthermore, state laws have recognized new types of entities, such as the limited liability company (LLC), whose owners do not fit neatly into either of the two partnership categories.

Unlike owners of unincorporated businesses, owners of privately held corporations pay FICA taxes as if they were employees. That treatment includes owners of S corporations—which are certain privately held corporations whose profits, like those of partnerships, are “passed through” to their owners—making them subject to the individual income tax rather than the corporate income tax. Owners of privately held corporations are required to report their “reasonable compensation” for any services they provide and pay FICA tax on that amount. The net income of the firm, after deducting that compensation, is subject to neither the FICA nor the SECA tax.

This option would require owners of all pass-through businesses to pay the SECA tax on their share of net income. In the case of S corporations, owners would no longer pay the FICA tax on their reasonable compensation. In addition, the option would change the definition of self-employment income so that it would no longer depend on whether a taxpayer was classified as a general partner or a limited partner. That distinction would be replaced with a “material participation” standard in which the primary test would be whether the individual engaged in the operation of the business for more than 500 hours during a given year. Partners, LLC members, and S corporation owners categorized as material participants would pay SECA tax on both their guaranteed payments and their share of the firm’s net income. Those not deemed to be material participants would pay SECA tax on their reasonable compensation. All sole proprietors would be considered material participants.

The option would increase taxes on owners of S corporations and on limited partners who are material participants by subjecting their entire share of the firm’s net income to the SECA tax instead of just their reasonable compensation or guaranteed payments. However, the option would lower taxes for general partners who are not material participants by excluding from SECA taxation their share of the firm’s net income that is in excess of their reasonable compensation. On balance, federal revenues would increase by an estimated $137 billion over the period from 2017 through 2026, according to the staff of the Joint Committee on Taxation. By increasing, on net, the earnings base from which Social Security benefits are calculated, the option also would increase federal spending for Social Security over the long term. (The estimates do not include that effect on outlays.)

An advantage of this option is that it would eliminate the ambiguity created by the emergence of new types of business entities that were not anticipated when the laws governing Social Security were last amended. The treatment of partners and LLC members under the SECA tax would be defined entirely by federal law and would ensure that owners who are actively engaged in the operation of a business could not legally exclude a portion of their labor compensation from the tax base. Moreover, because all firms not subject to the corporate income tax would be treated the same, businesses would be more likely to choose their form of organization on the basis of what allowed them to operate most efficiently rather than what minimized their tax liability.

Other arguments in favor of the option are that it would improve compliance with the tax code and reduce complexity for some firms. Under current law, the owners of S corporations have a strong incentive to underreport reasonable compensation so as to minimize their FICA tax liability. By subjecting S corporation owners to the SECA tax, the option would eliminate the ability of material participants to reduce their tax liability by underreporting their reasonable compensation. In addition, the option would simplify recordkeeping for S corporations whose owners are all material participants because they would no longer have to estimate the reasonable compensation of those owners.

A disadvantage of the option is that additional income from capital would be subject to the SECA tax, making the tax less like FICA, which taxes virtually no income from capital. That could deter some people from starting a business and paying the SECA tax on the profits (leading them instead to work for somebody else and pay the FICA tax on their wages). The option could also result in new efforts to recharacterize business income as either rental income or interest income, neither of which is subject to the FICA or the SECA tax. In addition, it could lead to the use of C corporations (businesses that are subject to the corporate income tax) as a tax shelter. For example, faced with a 15.3 percent SECA tax rate on top of the individual income tax, the owners of an S corporation might choose to pay the corporate income tax instead (even though profit distributions would be taxed again under the individual income tax). If the corporate income tax rate was lowered in the future, that incentive would be magnified. Finally, the option would place an additional administrative burden on many partnerships and LLCs: Those entities would be required to determine reasonable compensation for any members considered to be nonmaterial participants.