Actions Are Needed to Eliminate Inequities in the Employment
Tax Liabilities of Sole Proprietorships and Single-Shareholder S Corporations
May 2005
Reference
Number: 2005-30-080
This report has cleared the Treasury
Inspector General for Tax Administration disclosure review process and
information determined to be restricted from public release has been redacted
from this document.
May
20, 2005
MEMORANDUM FOR
DEPUTY COMMISSIONER FOR SERVICES AND ENFORCEMENT
FROM: Pamela J. Gardiner /s/ Pamela J. Gardiner
Deputy Inspector General for
Audit
SUBJECT: Final Audit Report - Actions
Are Needed to Eliminate Inequities in the Employment Tax Liabilities of Sole
Proprietorships and Single-Shareholder S Corporations (Audit # 200430022)
This
report presents the results of our review of the Internal Revenue Service’s
(IRS) administration of self-employment tax laws. The overall objective of this review was to determine whether the existing tax laws, tax
regulations, and IRS policies and practices ensure fairness in the administration
of self-employment tax laws for similarly situated taxpayers.
In
summary, inequities exist between the employment tax liabilities of sole
proprietors and the employment tax liabilities of the owners of single-owner S
corporations. The employment tax methodology applied to S
corporations does not properly address the facts and circumstances related to
the predominant ownership structure of today’s S corporations. This condition is largely the result of Revenue Ruling
59-221 issued by the IRS in 1959 because the 1958 statute that established S
corporations in tax law was silent on
the employment tax treatment of the corporate profits.
When the Revenue Ruling was
issued, no S corporation tax returns had yet been filed, so the IRS based its
ruling on assumptions regarding the ownership structure of S corporations. Apparently assuming that a majority of S
corporations would involve multiple shareholders, the IRS concluded only
shareholders actively operating the business should be subject to employment
taxes and only on amounts received for their services. In a multishareholder environment, it would
have been reasonable to assume that the salary of the business operator would
be set by a consensus of shareholders at a level reflecting the market value of
the operator’s services.
What apparently was not
anticipated was that most S corporations would eventually consist of sole
proprietors who chose to incorporate without expanding ownership to include additional
shareholders. In Tax Year (TY) 2000, 78.9
percent of all S corporations were either fully owned by a single shareholder
(69.4 percent) or more than 50 percent owned by a single shareholder (9.5
percent). Also apparently unanticipated
was the fact that, when there is only one shareholder controlling and operating
an S corporation, the determination of a salary is unilateral, highly
subjective, and influenced by the knowledge that a higher salary will result in
higher employment taxes and therefore lower profits.
One of the criteria for
judging a tax system is whether similarly situated taxpayers are treated the
same. Given equal amounts of income
subject to employment taxes, owners of single-shareholder S corporations and
sole proprietors are similarly situated for employment tax purposes. However, a fundamental and significant
inequity is created between sole proprietors and owners of single-shareholder S
corporations by the manner in which taxable income is determined, since sole
proprietors pay employment taxes as a percent of all profits, while owners of
single-shareholder S corporations pay employment taxes on only the portion of
profits they unilaterally select as their salaries.
The 1959 Revenue Ruling that
created this inequity has had three major detrimental effects on the tax
system. First, the S corporation form of
ownership has become a multibillion dollar employment tax shelter for
single-owner businesses. In 1959, the
maximum potential loss of employment tax revenue from allowing owners of single-shareholder
S corporations to select their own salaries would have been only $8.3 million
($49.1 million in Calendar Year 2000 dollars).
In TY 2000, the cost was $5.7 billion due to historical increases in
employment tax rates and the ability of nearly 80 percent of S corporation
owners to minimize their employment taxes by minimizing their salaries.
Second, Revenue Ruling
59-221, in effect, places the burden on the IRS to prove that the salary chosen
by the owner of a single-shareholder S corporation is not “reasonable” (i.e.,
commensurate with the services the shareholder provided to the S
corporation). Dealing with this issue on
a case-by-case basis puts a severe strain on the limited resources of the IRS. In TY 2000 alone, 36,000 single-shareholder S
corporations with profits of $100,000 or more passed through total profits of $13.2
billion to their sole owners without paying any employment taxes. The cost of the IRS resources needed to
effectively combat such a large problem on a case-by-case basis would be
prohibitive.
Third, trends point to
continued erosion of the employment tax base and related reductions in Social
Security and Medicare revenues that employment taxes produce. The number of single-shareholder S
corporations (as reported on U.S. Income Tax Return for an S Corporation (Form
1120S)) grew from 1,030,716 in TY 1994 to 1,684,861 in TY 2001, a 63.5 percent growth
rate. Single-shareholder S corporations
accounted for 26.4 percent of the combined profits of sole proprietorships and single-shareholder
S corporations in TY 1994 and 36.1 percent in TY 2001. As single-owner business profits shift to the
S corporation structure, the amount of salaries selected are steadily declining
as a percent of corporate profits. Owners
of single-shareholder S corporations paid themselves salaries subject to
employment taxes that equaled only 47.1 percent of their profits in TY 1994,
which fell to just 41.5 percent by TY 2001.
In contrast, unincorporated sole proprietors pay self-employment taxes
on all of their profits.
To eliminate the employment
tax shelter for most S corporations, increase Social Security and Medicare
employment tax revenues by $30.8 billion and $30.2 billion respectively between
Calendar Years 2006 and 2010, provide for equitable employment tax treatment of
taxpayers, and reduce the burden on IRS examination resources, we recommended the
IRS Commissioner inform the Assistant Secretary of the Treasury for Tax Policy
of the detrimental effects discussed in this report of Revenue Ruling 59-221
that was apparently issued under the historically inaccurate assumption that
most S corporations would involve multiple shareholders. The IRS Commissioner should consult with
Treasury regarding whether the detrimental effects of Revenue Ruling 59-221
should be reversed through the issuance of new regulations or through the
drafting of new legislation, either of which should subject all ordinary
operating gains of an S corporation that accrue to a shareholder (including the
shareholder’s spouse and dependent children) holding more than 50 percent of
the stock in the S corporation to employment taxes.
Management’s
Response: The Commissioner, Small
Business/Self-Employed (SB/SE) Division, disagreed with the report
recommendations but agreed there were problems related to compensation paid to
S corporation officers and that differences exist between the employment tax
liabilities of sole proprietorships and single-shareholder S corporations. The Commissioner, SB/SE Division, did not
agree that IRS Revenue Ruling 59-221 was the cause of these problems. In discussions and in management’s response,
the IRS has expressed its belief that, since it was based upon corporate
employment taxation statutes and regulations in effect prior to the creation of
S corporations, Revenue Ruling 59-221 confirms that Self-Employment
Contributions Act (SECA) taxes do not apply to S corporation shareholders. The IRS believes legislative rather than
regulatory changes could help reduce the problems they experience in relation
to the employment taxes of single-shareholder S corporations and believes any
such legislation should also address possible similar inequities in other types
of business structures. However, the IRS
also stated that simplifying the assessment of employment taxes, as we recommended,
would not be consistent with the underlying principles of employment tax
statutes in connection with the performance of services.
Because
the Commissioner, SB/SE Division, does not agree the source of the problem was
Revenue Ruling 59-221 and believes it is important to consider the problem in
the context of other business entities, the Commissioner, SB/SE Division, did
not agree with the specific recommendations in this report or with the related
outcome measures. Regarding the outcome
measures, the Commissioner, SB/SE Division, expressed concerns that the outcome
measures did not take into account that some taxpayers may react to the implementation
of our recommendations by converting S corporations to other business
structures. Concern was also expressed that
our outcome measures did not reflect the impact of additional employment taxes
that may be paid by owners of single-shareholder S corporations having multiple
sources of income subject to employment taxes.
Management’s complete response to the draft report is included as
Appendix V.
Office
of Audit Comment: We disagree with the
IRS position that Revenue Ruling 59-221 confirmed
rather than established that SECA
taxes should not apply to single-shareholder S corporations, and we continue to
believe the current employment tax inequities are the result of the Revenue
Ruling. The historical file for this
Revenue Ruling shows the Revenue Ruling was prompted by a 1958 question from a
taxpayer regarding whether or not self-employment taxes (applicable to sole
proprietors) would apply to the profits of the newly-created S
corporations. Rather than addressing the
case of a sole proprietor choosing to become a single-shareholder S
corporation, the IRS response discussed a multi-shareholder S corporation and
concluded that self-employment taxes should not apply to the profits of such S
corporations. The IRS applied the concepts
supporting this decision to all S corporations, regardless of the number of
shareholders, when it issued Revenue Ruling 59-221 in 1959.
We
are encouraged the IRS recognizes that changes in tax law may be advisable as
it relates to the compensation of owners of single-shareholder S
corporations. While we support the IRS
desire to eliminate through such legislation similar employment tax inequities
in other business structures, identifying and quantifying such possible
additional inequities were beyond the scope of this review. In addition, we do not believe correction of
the current inequities discussed in the report should be delayed while a search
for possible additional inequities is conducted. Nor do we believe current inequities should
continue out of apprehension that an unquantifiable number of taxpayers may change
their business structures to pursue new strategies to avoid employment taxes.
In
response to IRS concerns related to the possible impact of taxpayers having
multiple sources of employment-taxable income, we have reduced our original
5-year estimate of total additional employment tax revenues to $61 billion. See Appendix IV for additional information. In addition, we have added notes (a) through (c)
to Recommendation 2 on page 18 to clarify our position on various uncertainties
expressed in IRS management’s response.
While
we still believe our recommendations are worthwhile, we do not intend to
elevate our disagreement concerning them to the Department of the Treasury for
resolution.
Copies of this
report are also being sent to IRS managers affected by the report. Please contact me at (202) 622-6510 if you
have questions or Philip Shropshire, Acting Assistant Inspector General for
Audit (Small Business and Corporate Programs), at (215) 516-2341.
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix IV
– Outcome Measures
Appendix V –
Management’s Response to the Draft Report
The Federal Insurance Contributions Act (FICA) and the Self-Employment Contributions Act (SECA) require the payment of employment taxes to the Federal Government that fund both the Social Security (i.e., old age, survivor, and disability insurance or OASDI) and Medicare (i.e., hospital insurance or HI) trust funds. The OASDI portion of both FICA and SECA taxes is 12.4 percent of taxable wages or self-employment income, up to a maximum earnings limit that is sometimes adjusted by statute. For Tax Year (TY) 2000, this limit was $76,200; it has increased to $90,000 for TY 2005. The HI portion of both FICA and SECA taxes is 2.9 percent of total taxable income.
Employers withhold FICA taxes from the wages of employees, with matching amounts paid by the employers. Employees do not pay FICA taxes on the amount paid by their employers on their behalf. Sole proprietors (i.e., individuals who own unincorporated businesses) must pay SECA taxes on profits from the operation of their businesses. The SECA tax law treats all profits (except for an amount equal to the employer portion of FICA) as if they were wages, and the proprietor pays the equivalent of both the employer and employee portions of FICA on the profits.
In 1958, the Congress established Subchapter S of the Internal Revenue Code (I.R.C.) that enabled small businesses, including sole proprietorships, to form corporations owned by 10 or fewer shareholders. Electing this form of business organization, commonly referred to as an S corporation, exempts the profits from corporate taxation and allows the profits to “pass through” to the shareholders who are then responsible for individual income taxes on the profits received. Shareholders who actively operate the business are subject to employment taxes on compensation received for their services.
Sole proprietorships and S corporations were, respectively, the first and second most prevalent types of business organizations in TY 2000. For TY 2000, there were approximately 17.9 million sole proprietorships that reported approximately $245 billion in profits from business operations. Also for TY 2000, approximately 2.9 million S corporations reported approximately $200 billion in profits from business operations.
To perform the audit, we analyzed
TY 2000 data collected by the Internal Revenue Service (IRS) Statistics of
Income (SOI) function regarding S corporations and compared ownership
information reported by S corporations to information on the IRS Individual
Returns Transaction File for TY 2000. TY
2000 was the most current year for which specific data was available from
multiple sources at the time audit planning commenced. We did not attempt to identify partnerships and
corporations other than S corporations that may be solely-owned or
majority-owned by a single individual. Data
analysis was conducted in our
The employment tax methodology applied to S corporations does not properly address the facts and circumstances related to the predominant ownership structure of today’s S corporations. This condition is largely the result of Revenue Ruling 59-221 issued by the IRS in 1959 because the 1958 statute establishing S corporations in tax law was silent on the employment tax treatment of S corporation profits.
When the Revenue Ruling was issued, no S corporation tax returns had yet been filed, so the IRS based its ruling on assumptions regarding the ownership structure of S corporations. Since the law allowed up to 10 shareholders in an S corporation, the IRS apparently assumed that a majority of S corporations would involve multiple shareholders when it concluded only shareholders actively operating the business should be subject to employment taxes and only on amounts received for their services. In a multishareholder environment, it would have been reasonable to assume the salary of the business operator would be set by a consensus of shareholders at a level reflecting the market value of the operator’s services.
What apparently was not anticipated was that most S corporations would eventually consist of sole proprietors who chose to incorporate without expanding ownership to include other shareholders. In TY 2000, 78.9 percent of all S corporations were either fully owned by a single shareholder (69.4 percent) or more than 50 percent owned by a single shareholder (9.5 percent). Also apparently unanticipated was the fact that, when there is only one shareholder controlling and operating an S corporation, the determination of a salary is unilateral, highly subjective, and influenced by the knowledge that a higher salary will result in higher employment taxes and therefore lower profits.
One of the criteria for judging a tax system is whether similarly situated taxpayers are treated the same. Given equal amounts of income subject to employment taxes, owners of single-shareholder S corporations and sole proprietors are similarly situated for employment tax purposes. However, a fundamental and significant inequity is created between sole proprietors and owners of single-shareholder S corporations by the manner in which taxable income is determined. Sole proprietors pay employment taxes as a percent of all profits, while owners of single-shareholder S corporations pay employment taxes on only the portion of profits they unilaterally select as their salaries.
The 1959 Revenue Ruling that, due to unanticipated predominance of single-shareholder S corporation ownership structures, created the inequity between sole proprietors and single-shareholder S corporations has had three major detrimental effects on the tax system:
1) The S corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses ($5.7 billion in TY 2000 alone).
2) Officer compensation issues have become a drain on limited IRS examination resources.
3) Trends point to continued erosion of the employment tax base and resulting reductions in Social Security and Medicare revenues.
The IRS Revenue Ruling inadvertently created a multibillion dollar employment
tax shelter
The 1959 Revenue Ruling appears to influence the salary-setting decisions by the owners of single-shareholder S corporations. As shown in Figure 1, the salaries declared by the owners of S corporations have been steadily declining over the years. Owners of single-shareholder S corporations paid themselves salaries subject to employment taxes that equaled only 47.1 percent of their profits in TY 1994, which fell to just 41.5 percent by TY 2001. In contrast, unincorporated sole proprietors pay employment taxes on all of their profits.
Figure 1: Officer
Salaries Declared by Single-Shareholder S Corporations As a Percentage of
Operating Profits (TYs 1994 – 2001)
Figure 1 was removed due to its size. To see Figure 1, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
The ability to independently set salary levels also extends to S corporation shareholders who own more than one-half of the corporation’s stock, which in effect allows them the ability to make unilateral decisions, such as setting officer salaries. The ability of a single shareholder of an S corporation to set officer salaries has a significant effect on employment tax receipts. As shown in Figure 2, the amount of employment taxes paid in TY 2000 by single-shareholder S corporations was $5.7 billion less than the SECA taxes that would have been paid if the taxpayers were unincorporated sole proprietors.
Figure 2:
Actual FICA Taxation vs. Theoretical SECA Taxation of S Corporations (TY
2000)
Figure 2 was removed due
to its size. To see Figure 2, please go
to the Adobe PDF version of the report on the TIGTA Public Web Page.
In 1959, the IRS ruling appeared to have limited impact. Just 71,140 S corporations existed in TY 1959 and, of these, only 46,037 reported profits. Since the maximum amount of self-employment tax per individual was just $180 in 1959, the maximum potential loss of self-employment tax revenue in 1959 would have been only $8.3 million ($49.1 million in Calendar Year (CY) 2000 dollars).
However, the 1959 ruling does not reflect conditions in today’s business and tax environments. A number of factors have combined to significantly increase the employment tax consequences of the IRS decision.
Thus, historical increases in employment tax rates and the ability of nearly 80 percent of S corporation owners to minimize their employment taxes by minimizing their salaries combined to transform the original $8.3 million maximum potential self-employment tax revenue cost into an estimated $5.7 billion revenue cost in TY 2000.
The IRS has limited resources for combating abuses
On a mass scale, it is extremely difficult for the IRS to alleviate the serious problem of self-employment tax avoidance by S corporations. Revenue Ruling 59-221, in effect, places the burden on the IRS to prove that officer compensation was not “reasonable” (i.e., commensurate with the services the shareholder provided to the S corporation). Therefore, the IRS must examine the S corporation returns and supporting business records to make reasonable compensation determinations.
As shown in Figure 3, however, the IRS is able to examine only a small fraction of the S corporation returns that are filed each year. Between Fiscal Years (FY) 1996 and 2003, the examination coverage rates for S corporation returns ranged from a high of 1.04 percent to a low of 0.30 percent in the most recent year.
Figure 3:
Examination Rates for S Corporation Returns
(FYs 1996 – 2003)
|
Fiscal Year |
Returns Examined |
Coverage Rate |
|
1996 |
19,490 |
0.92% |
|
1997 |
23,898 |
1.04% |
|
1998 |
25,522 |
1.04% |
|
1999 |
21,169 |
0.81% |
|
2000 |
15,200 |
0.55% |
|
2001 |
12,437 |
0.43% |
|
2002 |
11,646 |
0.39% |
|
2003 |
9,695 |
0.30% |
Source: TIGTA analysis
of IRS data.
In addition, Figure 4 shows the IRS examination coverage of S corporation returns in the past 5 years has been insufficient to keep pace with the steady growth in the number of returns filed.
Figure 4:
Examination Coverage of S Corporation Returns
(FYs 1988 – 2003)
Figure 4 was removed due to its size. To see Figure 4, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Making reasonable compensation determinations is a complex and somewhat subjective endeavor that can result in litigation for the IRS. Since the IRS is forced to address the issue of reasonable officer compensation on a case-by-case basis, there are evidently many owners of S corporations who have determined the employment tax savings available from minimizing salaries is worth the risk of an IRS examination.
As shown in Figure 5, owners of single-shareholder S corporations vary widely in the amount of risk they wish to assume. As shown in the far left column, many are willing to set their salaries at $0 to maximize their employment tax savings.
Figure 5:
Variations in Salaries Selected by Owners
of Single-Shareholder S Corporations (TY 2000)
Figure 5 was removed due to its size. To see Figure 5, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Significant amounts of business profits frequently accrue to the owners of single-shareholder S corporations who choose to pay themselves no salaries and, therefore, pay no employment taxes. As shown in Figure 6, approximately 36,000 single-shareholder S corporations with profits of $100,000 or more in TY 2000 passed through total profits of $13.2 billion to their owners without paying any employment taxes.
Figure 6:
Operating Profits of S Corporations That Paid No Salaries to the Sole
Owners (TY 2000)
Figure 6 was removed due to its size. To see Figure 6, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Court records show the IRS can enforce reasonable compensation determinations through costly litigation. For example, in a recent tax court case, a veterinarian who was the sole shareholder in his S corporation had received 3 years of profits from the business totaling nearly $419,000 while declaring no salary for himself, despite the fact the S corporation’s sole source of income was from the services he provided. The court agreed with the IRS that the taxpayer’s profits should be subject to employment taxes.
While such successes are helpful, there were 36,000 similar situations (see Figure 6) in TY 2000 alone in which the owners of single-shareholder S corporations took no salaries from the businesses while having over $100,000 in income. The cost of the IRS resources needed to effectively combat such a large problem on a case-by-case basis would be prohibitive.
If the S corporation owners who now have the ability to set their own salaries were instead subject to employment taxes on their profits, as are unincorporated sole proprietors, we estimate that Social Security and Medicare tax revenues would increase by $30.8 billion and $30.2 billion, respectively, during the 5-year period from CYs 2006 to 2010. This change would also allow the IRS to devote scarce compliance resources to examination priorities other than reasonable compensation determinations. See Appendix IV for additional information.
Trends indicate continued erosion of the employment tax base
The number of single-shareholder S corporations (as reported on U.S. Income Tax Returns for an S Corporation (Form 1120S)) grew from 1,030,716 in TY 1994 to 1,684,861 in TY 2001, a growth rate of 63.5 percent. While there may be other reasons for small businesses to choose the S corporation form of organization, the opportunity to choose how much to pay for employment taxes must certainly be a consideration.
In fact, advising small businesses to shelter earnings from self-employment taxes through the formation of S corporations has become a cottage industry. A search of the Internet yields multiple sites that offer advice, assistance, and encouragement to sole proprietors to convince them to become S corporations. The sole proprietors are advised they can save thousands of dollars a year in employment taxes simply by incorporating. It is also possible on the Internet to gauge the size of the savings using computer-generated savings amounts based on the user’s entries for anticipated profits and chosen salary levels. Not surprisingly, the lower the salary chosen, the higher the savings become, reaching maximum savings at a salary level of $0.
Figure 7 shows the growth in the numbers of single-shareholder
and multiple-shareholder S corporations as reported to the IRS on S corporation
returns. Although Figure 7 shows that
there are far more single-shareholder S corporations than multiple-shareholder
S corporations, our analysis of taxpayer data revealed that the imbalance is
significantly more pronounced than is shown in Figure 7.
Figure 7:
Growth in Single-Owner and Multiple-Owner
S Corporations (TYs 1994 - 2001)
Figure 7 was removed due to its size. To see Figure 7, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Approximately 54.6 percent of all S corporations reported that they were owned by a single shareholder in TY 2000. However, this does not reflect the fact that tax law treats a husband and wife as 1 shareholder or the fact that ownership of more than 50 percent of a corporation’s stock by a single shareholder gives that shareholder control of business decisions, including the amount of business profits that will be paid to that individual as a salary.
By accounting for these factors, we determined that, in TY 2000,
78.9 percent of all S corporations are either owned by a single shareholder
(69.4 percent) or majority owned by a single shareholder (9.5 percent). Figure 8 demonstrates the true predominance
of single-shareholder S corporations in TY 2000, as well as the sizable portion
of business income related to single-shareholder S corporations. The left-most column in Figure 8 shows the
operating profits and the volume of S corporations that were either solely owned
or solely controlled by a single shareholder.
The remaining columns show the S corporations with more diverse
ownership.
Figure 8:
Number of S Corporations and Operating Profits Stratified by Number of
Shareholders
(TY 2000)
Figure 8 was removed due to its size. To see Figure 8, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
The trend toward single-shareholder S corporations may
account for the relatively slow growth of business profits that are subject to
SECA taxes seen in Figure 9. The average
annual growth in net income from the operation of single-shareholder S
corporations between TYs 1994 and 2001 was 18.8 percent. The average annual growth in net income from
the operation of sole proprietorships was only 4.2 percent during the same
period.
Figure 9: Average
Annual Growth in Net Operating Income of S Corporations and Sole Proprietorships
(TYs 1994 – 2001)
Figure 9 was removed due to its size. To see Figure 9, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
The continuing migration of sole proprietors to the S
corporation structure diverts business profits away from the SECA tax base into
S corporations where the amount of FICA taxes that will be generated is
significantly less, due to the subjectivity of establishing reasonable officer
compensation. Figure 10 shows that single-shareholder
S corporations accounted for 26.4 percent of the combined profits of sole
proprietorships and single-shareholder S corporations in TY 1994 and 36.1
percent in TY 2001, an increase of nearly 10 percentage points in just 8 years.
Figure 10:
Operating Profits of Incorporated and Unincorporated Single-Owner
Businesses
(TYs 1994 – 2001)
Figure 10 was removed due to its size. To see Figure 10, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
To eliminate the employment tax shelter for most S corporations, increase self-employment tax revenues, provide for equitable employment tax treatment of taxpayers, and reduce the burden on IRS examination resources:
1. The IRS Commissioner should inform the Assistant Secretary of the Treasury for Tax Policy of the detrimental effects discussed in this report of Revenue Ruling 59-221 that was apparently issued under the historically inaccurate assumption that most S corporations would involve multiple shareholders.
Management’s Response: The Commissioner, Small Business/Self-Employed (SB/SE) Division, did not agree with this recommendation. The Commissioner, SB/SE Division, disagrees that Revenue Ruling 59-221 is the cause of the inequities reflected in the report. The issue is not with Revenue Ruling 59-221. In fact, the statutory and judicial laws that form the basis for Revenue Ruling 59-221 are still the law today. The Commissioner, SB/SE Division, stated, under current law for S corporations, the issue is how best to determine “reasonable compensation” for application of the FICA tax.
Office of Audit Comment: We continue to believe the current employment tax inequities are the result of the Revenue Ruling. The historical file for this Revenue Ruling shows the Revenue Ruling was prompted by a 1958 question from a taxpayer regarding whether or not self-employment taxes (applicable to sole proprietors) would apply to the profits of the newly-created S corporations. Rather than addressing the case of a sole proprietor choosing to become a single-shareholder S corporation, the IRS response discussed a multi-shareholder S corporation and concluded that self-employment taxes should not apply to the profits of such S corporations. The IRS applied the concepts supporting this decision to all S corporations, regardless of the number of shareholders, when it issued Revenue Ruling 59-221 in 1959.
Management’s Response: The Commissioner, SB/SE Division, does not agree with this recommendation. The Commissioner, SB/SE Division, stated new regulations would not affect the fundamental application of employment taxes to S corporations. A recommendation to discuss legislative changes to simply subject to employment tax “all ordinary operating gains of an S corporation that accrue to a shareholder” is not consistent with the principles underlying the employment tax statutes in connection with the performance of services. Nor does it properly recognize the administrative and taxpayer burdens that this legislation may cause or consider the application of employment taxes to other flow-through entities. However, the IRS will continue its outreach efforts to communicate all employment tax provisions as they pertain to each tax entity. As appropriate, the IRS will work with the Department of the Treasury in furtherance of legislation that would resolve the issues in the best interest of tax administration.
Because the Commissioner, SB/SE Division, does not agree with our premise that the source of the problem is the revenue ruling and believes it is important to consider the problem in the context of other business entities, the Commissioner, SE/SE Division, does not agree with the specific recommendations of this report and, therefore, cannot agree with the outcome measures. The Commissioner, SB/SE Division, also has concerns with our calculation of the outcome measures. The Commissioner, SB/SE Division, stated the calculation does not take into account that some taxpayers may react to implementation of the proposal by converting S corporations to another entity (such as a C corporation or a limited liability company). The Commissioner, SB/SE Division, also stated our report assumes the S corporation shareholder has no other self-employment income (or FICA tax wages) and does not account for an offset to self-employment taxes for any S corporation that will reflect an ordinary loss.
Office of Audit Comment: We disagree with the IRS assertion that Revenue Ruling 59-221 confirmed rather than established that SECA taxes should not apply to single-shareholder S corporations, and we continue to believe that the current employment tax inequities are the result of the Revenue Ruling. However, we are encouraged that the IRS plans to work with the Department of the Treasury in furtherance of legislation that would resolve the issues in the best interest of tax administration.
While we support the IRS desire to eliminate through such legislation similar employment tax inequities in other business structures, identifying and quantifying such possible additional inequities were beyond the scope of this review. In addition, we do not believe correction of the current inequities discussed in the report should be delayed while a search for possible additional inequities is conducted. Nor do we believe current inequities should continue out of apprehension that an unquantifiable number of taxpayers may change their business structures to pursue new strategies to avoid employment taxes.
In response to IRS concerns related to the possible impact of taxpayers having multiple sources of employment-taxable income, we have reduced our original 5-year estimate of additional employment tax revenues to $61 billion. See Appendix IV for additional information. In addition, we have added notes (a) through (c) to this recommendation to clarify our position on the uncertainties expressed in IRS management’s response.
Appendix I
Detailed Objective,
Scope, and Methodology
The overall objective of this review was to determine whether the existing tax laws, tax regulations, and Internal Revenue Service (IRS) policies and practices ensure fairness in administering self-employment taxes to all similarly situated taxpayers.
To accomplish this objective, we:
I.
Researched historical tax law changes regarding sole
proprietors and S corporations and, where possible, identified the reasons for
those changes.
II.
Reviewed available IRS studies, reports, and general
information regarding self-employment taxes and related compliance information,
including tax court cases.
III.
Identified and evaluated the characteristics of S
corporations by analyzing databases that were developed by the IRS Statistics
of Income (SOI) function for Tax Year (TY) 2000 U.S. Income Tax Return for an S Corporation (Form 1120S) and related Shareholder’s Share of
Income, Credits, Deductions, etc. (Schedule K-1).
TY 2000 was the most current year for which specific data was available
from multiple sources at the time audit planning commenced.
A.
To determine the presence of spousal ownership among the
shareholders in S corporations, matched the Schedule K-1 data to the IRS
Individual Returns Transaction File for TY 2000 to identify the shareholders in
the same S corporation that filed jointly or as married filing separately for
TY 2000.
B.
Once the spousal ownership test was completed,
identified all shareholders owning more than 50 percent of the stock in an S
corporation (regardless of whether the stock was owned by 1 spouse or both).
IV.
Evaluated historical trends regarding both nonfarm sole
proprietorships and S corporations by analyzing statistics published by the SOI
function from 1959 to 2001.
V.
Researched Social Security Administration (SSA) records
regarding the historical rates for Federal
Insurance Contributions Act and Self-Employment
Contributions Act tax rates as well as the annual contribution bases for the
SSA’s Old-Age, Survivors, and Disability Insurance .
VI.
Researched Internet sites for applicable information and
advice offered to the public regarding employment taxes.
Appendix II
Major Contributors to This
Report
Philip Shropshire, Acting Assistant Inspector General for Audit (Small
Business and Corporate Programs)
William E. Stewart,
Audit Manager
Theodore J. Lierl, Lead
Auditor
James M.
Allen, Information Technology Specialist
Joseph C.
Butler, Information Technology Specialist
Kevin
O’Gallagher, Information Technology Specialist
Appendix III
Commissioner C
Office of the Commissioner – Attn: Chief of Staff C
Assistant Deputy Commissioner for Services and
Enforcement SE
Commissioner, Large and Mid-Size Business Division SE:LM
Commissioner, Small Business/Self-Employed Business
Division SE:S
Chief Counsel CC
Deputy Commissioner, Large and Mid-Size Business Division SE:LM
Deputy Commissioner, Small Business/Self-Employed Business Division SE:S
Director, Campus Compliance Services, Small Business/Self-Employed Division SE:S:CCS
Director, Communications, Government Liaison, and Disclosure, Small Business/Self-Employed Division SE:S:CGL&D
Director, Examination, Small Business/Self-Employed Division SE:S:E
Director, Strategy, Research, and Program Planning, Large and Mid-Size Business Division SE:LM:SR
National Taxpayer Advocate TA
Director, Office of Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk
Analysis RAS:O
Office of Management Controls OS:CFO:AR:M
Audit
Liaisons:
Deputy
Commissioner for Services and Enforcement
SE
Commissioner,
Large and Mid-Size Business Division
SE:LM
Commissioner,
Small Business/Self-Employed Division
SE:S
Appendix IV
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration for Calendar Years 2006 through 2010. These benefits will be incorporated into our Semiannual Report to the Congress.
Type and Value of Outcome Measure:
Methodology Used to Measure the Reported Benefit:
To determine the number of solely owned and solely controlled (i.e., a single shareholder with more than 50 percent ownership) S corporations, we relied on the percentage of ownership information reflected on Shareholder’s Share of Income, Credits, Deductions, etc. (Schedule K-1) that was developed by the Internal Revenue Service (IRS) Statistics of Income (SOI) function for Tax Year (TY) 2000 U.S. Income Tax Return for an S Corporation (Form 1120S). We enhanced this information by matching the Social Security Numbers (SSN) from the Schedules K-1 to an extract from the Individual Master File that contained the primary and secondary SSNs and the filing status from each individual income tax return filed for TY 2000. If both the primary and secondary SSNs matched one return and both SSNs matched the Schedules K-1 issued by the same S corporation, we totaled the percentage ownership from the Schedules K-1 and reduced the number of shareholders shown on the S corporation return by one.
After this analysis was complete, we identified all S corporations with more than 50 percent ownership as modified for spousal ownership. To determine the income received by these taxpayers from their S corporations, we multiplied the total operating profits of the S corporations by the percentage of ownership of the taxpayers. To determine the operating profits of the S corporations on a basis equivalent to Self-Employment Contributions Act (SECA) tax treatment of sole proprietors, we added officer compensation to the net income (or deficit) from the operation of the trade or business. Although both Federal Insurance Contributions Act (FICA) taxes and SECA taxes are virtually identical on this amount (as explained on page 3 of this report) and officer compensation is not a deductible amount for determining operating income for sole proprietors, the change was necessary for clarity of discussion and SECA tax computations and for comparability of S corporation profits and sole proprietorship profits. Both the unadjusted operating net income and the amount of officer compensation were obtained from the TY 2000 Form 1120S database developed by the IRS SOI function.
To determine the amount of FICA Social Security taxes currently paid by taxpayers owning more than 50 percent of an S corporation, we multiplied the taxpayer’s percentage of ownership by the amount of officer compensation for the S corporation and then multiplied the result, limited to the TY 2000 Social Security income ceiling of $76,200, by 12.4 percent. Our computations assumed the taxpayer had no other income subject to Social Security taxes. To determine the amount of FICA Medicare taxes currently paid, we multiplied all of the taxpayer’s officer compensation by 2.9 percent.
To determine the amount of SECA taxes that would be paid on the taxpayer’s share of the operating profit from the S corporation, we applied the SECA tax rules to the total of operating net income plus officer compensation that exceeded zero. In the case of officer compensation that was partially or wholly in excess of available gains, we computed no SECA taxes on the portion of the officer compensation that exceeded the available gains. The operating profits were multiplied by 92.35 percent to determine the taxable SECA base. To determine the amount of SECA taxes that would be assessed on the taxable SECA base, we multiplied the taxpayer’s operating profits, limited to the TY 2000 Social Security income ceiling of $76,200, by 12.4 percent. Our computations assumed the taxpayer had no other Social Security-taxable income for the year, but the presence of such income would reduce both taxable FICA income and taxable SECA income and, thus, would not materially affect the difference between the FICA and SECA taxation computed by the Treasury Inspector General for Tax Administration (TIGTA). To determine the amount of SECA Medicare taxes that would be paid, we multiplied the taxable SECA base by 2.9 percent. To produce national statistics, the record weights provided by the SOI function on all TY 2000 Form 1120S database items were applied to all taxpayer counts and amounts.
To determine the increase or decrease that would result from subjecting S corporations to SECA taxes, we compared the amount of FICA taxes currently paid on officer compensation to the amount of SECA taxes that would be assessed if they were applied, instead, to all operating profits. To determine these future amounts, our computer programs totaled all applicable FICA and SECA amounts and we then expressed these amounts as a percentage of officer compensation (for FICA taxes) or operating profits (for SECA taxes). The future annual growth in officer compensation (7.70 percent) and operating profits (9.60 percent) were based upon average annual increases in those items from TYs 1999 through 2001 according to SOI function data published by the IRS. While the average annual growth in single-owner S corporation profits from TYs 1995 through 2001 was 12.77 percent, we used a more conservative average annual profit growth rate of 9.60 percent for TYs 1999 through 2001 for our analysis to more closely reflect recent economic conditions.
Table 1:
Employment Tax Revenue Losses Before SECA Taxes Can Be Applied to Single-Owner
S Corporations
Table 1 was removed due to its size. To see Table 1, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Table 2:
Employment Tax Revenue Increases From Applying SECA Taxes to Single-Owner
S Corporation Profits
Table 2 was removed due to its size. To see Table 2, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
To address concerns expressed by the IRS in response to this report regarding the impact of single-shareholder S corporation owners who may have employment-taxable income from multiple sources, we conducted further analysis. Such multiple sources of employment-taxable income would include multiple single-shareholder S corporations owned by one individual and wages received by the owner of a single-shareholder S corporation for services not related to the single-shareholder S corporation. Multiple-source employment-taxable income would not impact HI revenue which applies to all employment-taxable earnings. However, it could impact OASDI taxes that in TY 2000 were assessed on only the first $76,200 of such income. SOI records for TY 2000 indicate that 2 percent of single-shareholder S corporations are owned by taxpayers that own more than 1 single-shareholder S corporation. Information was not available regarding non-S corporation wage income for the owners of single-shareholder S corporations, so we relied on data regarding sole proprietors to gauge the impact of wage-related employment taxes on such income. The IRS Individual Return Master File records for TY 2000 indicates that 5.9 percent of sole proprietors at least partially reduced their self-employment taxes due to employment taxes paid on wages. To maximize the reduction in our 5-year revenue increases, we added these percentages and assumed that the OASDI increases would be completely eliminated for 7.9 percent of the owners of single-shareholder S corporations whose OASDI increases involved employment-taxable income from multiple sources. This reduced our original OASDI estimated increase to 92.1 percent (100 - 7.9) of the original $33,456,979,038, resulting in a revised estimate of $30,813,877,694 in OASDI increases.
Implications of
Officer Compensation Allocation
The recipient of officer compensation from an S corporation is not identified on Forms 1120S or the Schedules K-1 attached to those returns. As a result, it was necessary to make assumptions regarding the amount of compensation (salary) paid to the sole owners or majority owners of the corporations. For our calculations, we distributed officer compensation according to the percentage of ownership shown on Schedules K-1 of Forms 1120S, as adjusted for spousal ownership. The FICA taxes were then computed on the amount of officer compensation and the SECA taxes were computed on the total profits available for distribution by the S corporation (consisting of officer compensation plus nonofficer-compensation profits). The difference between the FICA and SECA taxes was then calculated.
Implications for fully-owned S corporations: For S corporations owned by a single shareholder, we allocated all officer compensation to the shareholder. If, as an extreme example, all of the officer compensation was actually paid to someone other than the single shareholder, the amount of FICA taxes paid by the single shareholder would be reduced to $0, leaving the total amount of SECA taxes on the nonofficer compensation (business operating profits) as the total difference between the FICA tax of $0 and SECA taxes that would be applied to the business operating profits. In this case, the business profits of up to $76,200 (the Social Security taxable limit) that were not subject to Social Security taxes for SECA purposes (because they were above the Social Security Administration limit when officer compensation was added to operating profits) would now be subjected to SECA taxes of 12.4 percent, which would increase the difference between FICA taxes ($0 in this example) and SECA taxes.
Thus, our estimate of the amount of the increase in SECA taxes over FICA taxes may be understated if all officer compensation was not paid to the single shareholder of an S corporation, to the extent that decreasing the amount of officer compensation decreases the amounts we considered subject to FICA taxation and concurrently increases the amounts we should have considered subject to SECA taxation. Approximately 85 percent of the SECA tax increases we computed were related to single-shareholder S corporations. Allocating no officer compensation to the shareholders would add 44.9 percent to the tax increases we computed.
Implications for majority-owned S corporations: For multiple-shareholder S corporations in which 1 shareholder owns more than 50 percent of the stock (and thus controls the S corporation’s decision making), we allocated officer compensation to the majority shareholder by applying the shareholder’s percentage of ownership to the total amount of officer compensation paid by the S corporation. The results from allocating too much officer compensation to the majority shareholder would mirror those described for single-shareholder S corporations. That is, if we assigned too much officer compensation to the majority shareholder, it would cause the SECA tax increases we computed to be understated.
However, if more officer compensation was paid to the majority shareholder than we allocated, the difference between the FICA taxes and SECA taxes we computed may be overstated to the extent that increasing the amount of officer compensation increases the amounts we should have considered subject to FICA taxation and decreases the amounts we considered subject to SECA taxation. Approximately 15 percent of the SECA tax increases we computed were related to majority shareholders in multiple-shareholder S corporations. Allocating all officer compensation to the majority shareholders would reduce the SECA increases we computed for these taxpayers by 10.1 percent. Allocating no officer compensation to the majority shareholders would add 60.1 percent to the tax increases we computed.
In summary, if we underestimated the officer compensation attributable to sole owners or majority owners of S corporations, our estimates of the SECA tax increases could be overstated by as much as 1.5 percent. Conversely, if we overestimated the officer compensation attributable to the sole owners or majority owners, our estimates of the SECA tax increases could be understated by as much as 47.2 percent.
Appendix V
Management’s Response
to the Draft Report
The response was removed due to its
size. To see the response, please go to
the Adobe PDF version of the report on the TIGTA Public Web Page.