This week, Orly Mazur (SMU) reviews a new draft article by Karen Burke (Florida), Exploiting the Medicare Tax Loophole.
Employment taxes comprise an important source of federal tax revenue. Traditionally, only an individual’s earned income was subject to these taxes. However, with the introduction of Section 1411, the tax law now also subjects the unearned income of high-income individuals to a 3.8% Medicare tax (“Unearned Income Medicare Contribution”). Thus, the current law attempts to subject both the earned and unearned income of high earners to the Medicare tax. Unfortunately, not all high income taxpayers pay their fair share of this tax.
Karen Burke’s new work explains the various tax planning techniques that taxpayers currently use to avoid the 3.8% Medicare tax imposed on wages and net self-employment earnings and the 3.8% Medicare tax imposed by Section 1411 on unearned income. In particular, she illustrates how high-income owner-employees can avoid contributing to Medicare financing by providing services as an active limited partner of a state law limited partnership, by conducting business operations as an owner-employee of an S corporation, or by using tiers of entities to circumvent the employment tax rules.
Through this analysis, Burke persuasively argues that by exempting income and gains attributable to an active trade or business activity from taxation, Section 1411 enables the Medicare Tax loophole to continue to be significantly exploited.
There is no doubt that the employment tax system is in need of reform. For any reform to successfully address this type of tax manipulation, it needs to minimize the disparities in the way employment taxes apply across different business forms. Numerous proposals have been recommended in the past to address these employment-tax reduction strategies by seeking parity of tax treatment. More specifically, some proposals (e.g., see the 2005 JCT Proposal) have sought to do this by applying the self-employment tax to all active owners of a tax partnership by eliminating Section 1402(a)(13)’s anachronistic distinction between a limited partner and a general partner. Some proposals have also focused on extending this same tax treatment to owners of S-corporations. Although these proposals are an improvement over our current system, Burke recommends an alternative proposal that may be less disruptive and more effective at minimizing artificial employment tax reduction strategies by taxpayers. Namely, Burke’s proposal is to expand Section 1411 to cover all trade or business income of high-income individuals that is not already subject to employment taxes, regardless of the taxpayer’s level of activity.
In sum, with the employment tax gap steadily increasing, minimizing employment tax loopholes is critical for increasing government revenues, protecting the integrity of the employment tax base and improving the equity and fairness of the employment tax system. By introducing a new way to address the Medicare Tax loophole, Burke’s work provides a fascinating and important contribution to the ongoing discussion of Section 1411 and employment taxes, and is certain to influence the direction of future efforts. Burke’s proposal may also have important implications for efforts to address the carried interest loophole and tax planning surrounding the passive activity loss rules. It would be interesting to further explore the intentional and unintentional implications of expanding the scope of Section 1411 in this manner.
Here’s the rest of this week’s SSRN Tax Roundup:
- Ose Adeoluwa Binitie (Queen Mary University of London), Nigerian Personal Income Tax - Questions and Answers.
- William Byrnes (Texas A&M University School of Law), Background and Current Status of FATCA an CRS (Sept 2017 edition), Guide to FATCA and CRS Compliance, Lexis (Sept. 2017).
- Tsilly Dagan (Bar-Ilan University), The Future of Corporate Residency.
- Maarten Floris de Wilde (Erasmus University Rotterdam), The ATAD's GAAR: A Pandora's Box?
- Russell Stanley Q. Geronimo (University of the Philippines College of Law), How Short Sales Circumvent the Capital Gains Tax System, Philippine Law Journal Vol. 90 Issue No. 01, 2016
- Arnt O. Hopland (Norwegian School of Economics) & Robert Ullmann (University of Augsburg; Norwegian Center for Taxation), For Here or to Go? How VAT Induces Shifting Towards Preferentially Taxed Take-Away Sales
- Thomas Hoppe (University of Paderborn), Deborah Schanz (Ludwig Maximilian University of Munich), Susann Sturm (Ludwig Maximilian University of Munich), and Caren Sureth-Sloane (University of Paderborn), What are the Drivers of Tax Complexity for Multinational Corporations? Evidence from 108 Countries, WU International Taxation Research Paper Series No. 2017-12
- Andrew D. Mitchell (University of Melbourne) & Emma Gan (National University of Singapore), Policy & Legal Issues Raised by the Proposed U.S. Border Adjustable Tax, Asian Journal of WTO & International Health Law and Policy, Vol. 12, No. 2, pp. 289-310, September 2017
- Kienpin Tee (Zayed University) & Abiot Tessema (Zayed University), Dividend Yields and Stock Returns under a Tax-Free Environment