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||2019||2020||2021||2022||2023||2024||2025||2026||2027||2028||2019-
|Change in Revenues||6.7||12.4||14.0||15.6||17.0||17.9||18.8||19.5||20.2||21.0||65.7||163.1|
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 in 2018 is 12.4 percent of wages and salaries up to $128,400; 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 the amount of wages and salaries taxed. (If wages exceed certain thresholds—$250,000 for married taxpayers who file joint returns and $200,000 for unmarried people—an additional 0.9 percent tax is levied on the amount above the threshold.) The taxes are split equally between the employer and the employee.
By contrast, people with earnings from unincorporated businesses they own themselves contribute to Social Security and Medicare Part A through the Self-Employment Contributions Act (SECA) tax. Their tax base is self-employment income—which, unlike the FICA tax base of wages and salaries, includes some capital income in the form of business profits. The definition of self-employment income depends on whether the business owner 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" (amounts they are paid by the firm regardless of its profits) and on their share of the firm's net income. Limited partners pay SECA taxes solely on any guaranteed payments they receive and 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, many states have expanded eligibility for limited-partner status from strictly passive investors to certain partners who are actively engaged in the operation of businesses. Furthermore, all states 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.
The SECA tax rate is equal to the combined employer and employee rates for FICA taxes. The 0.9 percent Additional Medicare Tax applies to the SECA tax base as well. Both the $128,400 earnings limit on the Social Security component and the applicable threshold for the additional Medicare tax are reduced by the amount of wages subject to FICA when applied to the SECA tax base.
Unlike owners of unincorporated businesses, owners of S corporations—certain privately held corporations whose profits are not subject to the corporate income tax—pay FICA taxes as if they were employees. S corporations must pay their owners reasonable compensation, as defined in Internal Revenue Service (IRS) regulations, for any services they provide, and the owners must pay FICA taxes on that amount. The net income of the firm, after deducting that compensation, is passed through to the owners, whereupon it is subject to the individual income tax but not to the FICA or the SECA tax.
The IRS reported that 20 million individuals paid SECA taxes in 2016. The Congressional Budget Office estimates that in that year, approximately 3 million S corporation owners were actively involved in running their businesses. In CBO's estimation, that number represents a ceiling on the number of S corporation owners who were subject to the FICA tax.
This option would require the owners of all unincorporated businesses and S corporations to pay SECA taxes and would change the tax base in some cases. Owners of S corporations would no longer pay FICA taxes on their reasonable compensation. And for partners (including LLC members), the SECA tax base would no longer depend on whether the taxpayer was classified as a general partner or a limited partner. For both S corporation owners and partners, the SECA tax base would depend on whether the taxpayer was actively involved in running the business. That active involvement would be determined using the Internal Revenue Code's existing definition of a material participant. That definition specifies several criteria, but one commonly used standard is engagement in the operation of the business for more than 500 hours during a given year. S corporation owners and partners categorized as material participants would pay SECA taxes on both their guaranteed payments and their share of the firm's net income. Those who were not deemed to be material participants but were nonetheless actively involved in running their businesses would pay SECA taxes on their reasonable compensation. All sole proprietors would be considered material participants.
Effects on the Budget
According to the staff of the Joint Committee on Taxation, the option would increase federal revenues by an estimated $163 billion from 2019 through 2028. Because that estimate relies on CBO's economic projections of the economy, which drive estimates of the pass-through business income that would be affected by the option over the next decade, it retains the uncertainty associated with those projections.
The increase in revenues would be due to the increased taxes on owners of S corporations and on limited partners classified as material participants, whose entire share of the firm's net income, instead of just their reasonable compensation or guaranteed payments, would be subject to the SECA tax. To put the effects of the material participation standard in context, CBO has estimated that 65 percent of the partnership income of material participants was included in the SECA tax base in 2004. Under the option, that percentage would increase to 100.
By contrast, the option would lower taxes for the minority of general partners who were not material participants by excluding from SECA taxation their share of the firm's net income in excess of their reasonable compensation. CBO has estimated that 15 percent of the partnership income of nonmaterial participants was included in the SECA tax base in 2004. That percentage would decline under the option; however, because of the reasonable-compensation requirement, it would not fall to zero.
By increasing, on net, the earnings base from which Social Security benefits are calculated, the option also would slightly increase federal spending for Social Security over the long term. (The estimate does not include that effect on outlays, which would be very small over the next decade.)
The estimate reflects anticipated responses by some owners of S corporations and limited partnerships, more of whom would face an incentive to reorganize as C corporations—and thus lower the total amount of taxes they pay—under the option than under current law. The uncertainty surrounding how many businesses would undergo such a conversion under the option adds to the uncertainty of the estimate. That uncertainty about conversions magnifies existing uncertainty about how many businesses will convert to C corporations solely in response to individual and corporate income tax rate reductions under the 2017 tax act.
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 determined entirely by federal law and would ensure that owners who were 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 the complexity of preparing tax returns for some firms. Under current law, many S corporations have an incentive to minimize their owners' FICA tax liability by paying them less than reasonable compensation. By subjecting S corporation owners to the SECA tax, the option would make it impossible for material participants to benefit from that practice. Even businesses that reorganized as C corporations would have a smaller incentive to pay less than reasonable compensation to their owners because doing so would reduce their deductions and thus increase their corporate income tax liability. In addition, the option would simplify recordkeeping for S corporations whose owners were all deemed to be material participants because reasonable compensation for those owners would no longer need to be estimated.
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 applies to virtually no income from capital. Having to pay the SECA tax on profits could deter some people from starting a business, 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. Furthermore, by giving more businesses an incentive to switch to C corporation status, the option would ensure that the choice of organizational form was still driven, to some extent, by a desire to minimize tax liability. Finally, the option would place an additional administrative burden on many partnerships and LLCs, because those entities would be required to determine reasonable compensation for any members considered to be nonmaterial participants.