The conceptual premise of the proposal is that the base for the employment and selfemployment tax should be labor income. Historically, the tax has applied to labor income, relating very roughly to the rules for accruing benefits under the Social Security system, which requires the individual to perform quarters of labor. 224 The proposal applies this notion more uniformly than does present law to individuals who perform services for or on behalf of a passthrough entity in which they own an interest (i.e., a partnership, limited liability company, or S corporation). The proposal treats such individuals similarly to sole proprietors, as well as similarly to each other. Not only does this more uniform treatment improve the fairness of the tax law and increase the internal theoretical consistency of the tax rules, it also tends to improve tax neutrality by reducing the importance of FICA and self-employment tax differences in taxpayers' choice of business entity. 226 225 Previous proposals in this area have sought greater theoretical purity by proposing a carve-out from the self-employment tax for income from the business that is from capital rather than from labor. Under this approach, an attempt is made to determine a reasonable return from partnership capital, which is excluded from the partner's self-employment income. This type of approach raises administrability concerns, as rates of return can vary significantly among different types of businesses, at different times in the life of a business activity, and with different management of the business, among other factors. By contrast, the proposal (like present law) generally provides that certain readily identifiable types of income such as dividends, interest and rents that generally are not labor income are not subject to selfemployment tax. Only in the case of a service business, typically one in which income is 227 224 See Dilley, Breaking the Glass Slipper - Reflections on the Self-Employment Tax, at note 18. Benefit accruals have historically been tied to performance of labor (quarters of service), but the amount of FICA taxes collected does not necessarily relate to the individual's Social Security benefits. 225 For some individuals, the proposal has the effect of increasing the amount of earnings subject to employment tax. In the case of individuals whose earnings equal or exceed the OASDI wage base, only HI tax applies to the additional earnings that result under the proposal. 226 The AICPA has proposed this type of approach to modernize the self-employment tax reference to limited partners in section 1402(a)(13). See Letter of David A. Lifson, Chair, Tax Executive Committee of AICPA, to the Honorable William V. Roth, Chairman, Senate Committee on Finance, dated June 22, 2000, enclosing such a recommendation originally made by letter dated July 6, 1999. The AICPA proposal would provide that if the partner works less than a minimum number of hours in the partnership's business, none of his income would be treated as subject to the self-employment tax. The AICPA proposal would provide that a limited liability company owner's income would be treated as subject to the self-employment tax, except for a defined rate of return on his capital in the partnership. 227 Alternatively, this approach might specify a definition for a reasonable rate of return on capital. It could be based, for example, on a percentage or multiple of the applicable Federal rate, as defined under present law. While this approach may conceptually take account of a partner's return on capital, it may not represent the simplest and most direct approach, nor would it be accurate in most cases. primarily from labor rather than capital, is this rule not applicable under the proposal. The proposal does eliminate readily identifiable capital income from the self-employment tax base, but does not require a factual inquiry on a case-by-case basis as to what income of the partnership may be attributable to capital, and therefore is more predictable and more administrable than other approaches. 228 As a means of further isolating labor income of partners that is subject to selfemployment tax, the proposal provides that if a partner does not materially participate in the trade or business of the partnership, only the partner's reasonable compensation from the partnership is treated as net earnings from self-employment. Material participation is a standard that has been frequently applied since its enactment in 1986 as a component of the passive loss rules (sec. 469). Though it does require a factual inquiry, the standard is well developed in the section 469 regulations. 229 230 Though also a factual inquiry, the question of whether an individual's compensation is reasonable is one that has been repeatedly addressed in case law." The addition of the independent investor test used in the Seventh Circuit and partially adopted in some other Circuits has changed the previously predictable analysis under the multi-factor test applied in many judicial decisions to determine reasonable compensation. It could be questioned whether the determination of reasonable compensation has the predictability that is desirable in a legislative proposal, given the changing analysis among the Circuit courts. However, the proposal looks to reasonable compensation to determine net earnings from self employment only if the individual does not materially participate in the trade or business, limiting the situations in which this standard applies under the proposal.231 Treatment of S corporation shareholders In addition to addressing the issues that relate also to partners (discussed above), the proposal relating to S corporation shareholders serves the purpose of minimizing present-law 228 Present law does not provide this rule for general partners. Under the proposal, however, in the case of a general partner who does not materially participate in the partnership's trade or business, only his or her reasonable compensation from the partnership is included in net earnings from self-employment. Such a general partner may be subject to a lower selfemployment tax under the proposal than under present law. 229 These regulations provide several bright-line tests for material participation, including, for example, a test based on the number of hours the individual works in the business activity. Rules in the section 469 regulations providing that a limited partner is deemed not to materially participate in the partnership's business would not apply for purposes of the proposal. 230 See the present law description, above. 231 Reasonable compensation has also been suggested as a standard for determining the net earnings from self-employment of all limited partners and LLC members, but the administrative concerns with the standard could make this approach less attractive than the more mechanical approach taken under the proposal. opportunities to avoid the employment tax by recharacterizing wages as some other type of S corporation distribution. Disparate treatment of wages and other distributions under present law creates an undesirable incentive for individuals performing services to avoid FICA tax on labor income, including on the uncapped HI component, by setting up business as an S corporation and characterizing as wages a small amount of service income below the wage cap, while the rest is passed through the S corporation to the shareholder-employee free of FICA tax. 232 The self-employment tax (and the earlier-instituted FICA tax) were originally designed both to measure Social Security benefit accruals by determining whether individuals earned income from working, and to collect revenues to fund such benefit accruals. However, taxpayers' incentives have changed as the wage base and the resulting tax cost to individual taxpayers of accruing benefits has risen, and the value of Social Security benefits to high-income taxpayers has become relatively lower as a percentage of income. The motivation of higherincome taxpayers to avoid the tax was further increased by the elimination of the cap on the HI component of the tax by the Revenue Reconciliation Act of 1993.233 Rather than having an incentive to accrue benefits, taxpayers now have the opposite incentive: to avoid or reduce the tax cost, which may exceed the value to them of the social insurance benefit. The tax rules are not currently designed to prevent avoidance, and indeed, may facilitate it because the rules apply unevenly depending on whether the taxpayer chooses to do business through an S corporation, partnership, or sole proprietorship. Eliminating this unevenness not only increases the fairness of the tax as between similarly situated taxpayers, but also is consistent with a purpose to raise revenue among all workers comparably. Under the proposal, the employment tax rules no longer skew taxpayers' choice of business entity because of differing FICA and self-employment tax results. By treating S corporation shareholders who perform services for or on behalf of the S corporation in the same manner as partners who perform services for or on behalf of the partnership, the proposal improves the neutrality of the tax law. 234 The proposal has the effect of applying the self-employment tax collection system to S corporation shareholder-employees, rather than the withholding regime that applies to them (along with other employees) under the present-law FICA tax rules. Withholding may be a more effective and faster collection mechanism than self-assessment as under the self-employment rules. However, preserving a withholding regime on S corporation shareholder wages, and imposing self-employment tax only on the portion of the shareholder's distributive share that exceeds previously taxed wages, would require a mechanism to prevent double-counting from one taxable year to the next, which could impose additional administrative and recordkeeping 232 note 23-30. 233 See Dilley, Breaking the Glass Slipper - Reflections on the Self-Employment Tax, at Because eligibility for hospital insurance under Medicare is based on an individual's quarters of coverage, not the amount of the individual's wages, paying HI tax on higher wages does not increase the individual's Medicare benefits. 234 For some individuals, the proposal has the effect of increasing the amount of earnings subject to employment tax. In the case of individuals whose earnings equal or exceed the OASDI wage base, only HI tax applies to the additional earnings that result under the proposal. burdens on the S corporation. Further, the detriment of eliminating FICA withholding on S corporation shareholder employees is offset by the dual benefits under the proposal of improving tax neutrality and reducing tax avoidance. Therefore, the proposal applies the self-employment tax rules to S corporation shareholder-employees in the same manner that those rules apply to partners. IV. PENSIONS AND EMPLOYEE BENEFITS A. Conform Definition of Qualified Medical Expenses Present Law Itemized deduction for medical expenses Under present law, expenses for "medical care" are deductible as an itemized deduction to the extent that a taxpayer's aggregate medical expenses exceed 7.5 percent of the taxpayer's adjusted gross income.233 For this purpose, "medical care" is defined as under section 213(d), described below, except that expenses for medicines and drugs can be taken into account only if the medicine or drug is prescribed or is insulin (sec. 213(b)). Exclusion for amounts received under employer-sponsored accident or health plans Present law provides that amounts received under an accident or health plan for employees are excludable from gross income to the extent the amounts are paid directly or indirectly to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as defined in sec. 213(d)) of the taxpayer or the taxpayer's spouse or 236 dependents. Arrangements commonly used by employers to reimburse medical expenses of their employees (and their spouses and dependents) include health flexible spending arrangements ("FSAs") and health reimbursement accounts (“HRAs”). Health FSAs are typically funded on a salary reduction basis, meaning that employees are given the option to reduce current compensation and instead have the compensation used to reimburse the employee for medical expenses. If the health FSA meets certain requirements, then the compensation that is forgone is not includible in gross income or wages and reimbursements for medical care (as defined under sec. 213(d)) from the health FSA are excludable from gross income and wages. Health FSAs are subject to certain requirements, including rules that require that FSAs have certain characteristics similar to insurance, and that they not provide deferred compensation. One of these rules is the so-called "use-it-or-lose-it rule," which provides that any amounts remaining in the health FSA at the end of the year that are not used to reimburse expenses are forfeited by the employee. HRAs operate in a manner similar to health FSAs, in that they are an employermaintained arrangement that reimburses employees for medical expenses (as defined under sec. 213(d)). Some of the rules applicable to HRAS and health FSAs are similar, e.g., the amounts in the arrangements can only be used to reimburse medical expenses and not for other purposes. 235 Only expenses that are not reimbursed by insurance or otherwise may be taken into account for purposes of the deduction. For purposes of the alternative minimum tax, the adjusted gross income threshold is 10 percent, rather than 7.5 percent. 236 This exclusion does not apply to amounts attributable to (and not in excess of) deductions allowed under section 213 for any prior taxable year. |