III. EMPLOYMENT TAXES A. Provide Consistent FICA Treatment of Salary Reduction Amounts 152 (sec. 3121(a)) Present Law Compensation received for services performed as an employee, including benefits provided to employees, is generally subject to tax as wages under the Federal Insurance Contributions Act (“FICA”). FICA tax consists of two parts: (1) old age, survivor and disability insurance ("OASDI"), which correlates to the Social Security program that provides monthly benefits after retirement, disability, or death; and (2) Medicare hospital insurance ("HI"). The OASDI tax rate is 6.2 percent on both the employee and employer (for a total rate of 12.4 percent). The OASDI tax rate applies to wages up to the OASDI wage base ($90,000 for 2005). The HI tax rate is 1.45 percent on both the employee and the employer (for a total rate of 2.9 percent). Unlike the OASDI tax, the HI tax is not limited to a specific amount of wages, but applies to all wages. 153 For FICA tax purposes, "wages" generally includes all remuneration for employment unless a specific exception applies under the FICA rules. The same definition of wages generally applies for purposes of determining an individual's quarters of coverage for purposes of eligibility for Social Security benefits and Medicare and for purposes of determining the amount of an individual's Social Security benefits.154 155 Employer contributions to certain tax-favored retirement plans are excepted from wages for FICA purposes. However, this exception does not apply to contributions made by salary reduction.156 Thus, for FICA purposes, contributions made by salary reduction are treated as 152 Secs. 3101-3128. FICA tax applies separately from income tax. Therefore, certain types of compensation may be: (1) excluded from income for income tax purposes, but subject to FICA tax; or (2) includible in income for income tax purposes, but exempt from FICA tax. 153 Definitions similar to the FICA definition of wages apply also for purposes of taxes applicable to compensation under the Railroad Retirement Tax Act ("RRTA") (secs. 3201-3241) and to wages under the Federal Unemployment Tax Act ("FUTA") (secs. 3301-3311). However, a lower wage base applies for purposes of Tier 2 tax under RRTA ($66,900 for 2005) and for purposes of FUTA ($7,000). 154 For 2005, the amount of wages required for a quarter of coverage is $920, or $3,680 for four quarters of coverage for the year. 155 Sec. 3121(a)(5)(A) (qualified retirement plans), (C) (simplified employee pensions), (D) (tax-sheltered annuities), and (H) (SIMPLE IRAs). Employer contributions to these plans are also excluded from income for income tax purposes. 156 Sec. 3121(a)(5)(C), (D), and (H) and (v)(1). For income tax purposes, contributions made to these retirement plans by salary reduction are treated as employer contributions and are excluded from income. wages. Legislative history indicates that this treatment is intended to assure that salary reduction amounts are included in the FICA base. Otherwise, individuals could, in effect, control which portion of their compensation is included in wages for Social Security purposes, which would make the Social Security system partially elective and undermine the FICA tax base.157 Various types of employer-provided benefits are excepted from FICA wages, such as employer-provided health coverage (including reimbursements for medical expenses), dependent care assistance, and certain fringe benefits. 158 These types of benefits paid for by salary reduction under a cafeteria plan (including a flexible spending arrangements or "FSA") are also excepted from FICA wages if the benefits would be excepted from wages without regard to the cafeteria plan. In addition, qualified transportation fringe benefits are excepted from FICA even if provided on a salary-reduction basis. 159 Reasons for Change Present law provides inconsistent treatment of salary reduction amounts for FICA purposes. Contributions made to tax-favored retirement plans by salary reduction are wages for FICA purposes. However, salary reduction amounts used to provide other benefits are excluded from wages. Description of Proposal The proposal provides consistent treatment of salary reduction amounts for FICA purposes. Specifically, salary reduction amounts used to provide benefits under a cafeteria plan or to provide qualified transportation fringe benefits are included in FICA wages in a manner similar to salary reduction contributions to employer-sponsored retirement plans. Such amounts are also taken into account in determining wages for purposes of determining Social Security benefits (both eligibility and amount) and Medicare eligibility. 160 157 S. Rep. No. 98-23, at 40 (1983). Legislative history also provides that treating salary reduction contributions to employer-sponsored plans as FICA wages is consistent with the treatment of individual contributions to an individual retirement account ("IRA"). Individuals may make IRA contributions based on their compensation income. Although such contributions may be deductible for income tax purposes (subject to limitations), the FICA rules do not provide an exemption for IRA contributions. 158 Sec. 3121(a)(2), (18), and (20). These benefits are also excluded from income for income tax purposes. 159 Sec. 3121(a)(5)(G). These benefits are also excluded from income for income tax purposes when provided under a cafeteria plan. 160 The proposal applies also for purposes of the RRTA definition of compensation and the FUTA definition of wages. Effective Date The proposal is effective with respect to wages for services performed in calendar years beginning after the date of enactment. Discussion Under present law, retirement plan contributions made by salary reduction are wages for FICA purposes. Legislative history reflects the intent to assure that such salary reduction amounts are included in the FICA tax base and in wages for Social Security purposes in order to avoid undermining the FICA tax base and making the Social Security system partially elective. This rationale for the FICA treatment of retirement plan contributions made by salary reduction applies equally to salary reduction amounts used to provide benefits under a cafeteria plan or qualified transportation fringe benefits. However, present law provides disparate treatment of salary reduction amounts by excepting from FICA salary reduction amounts under a cafeteria plans or to provide qualified transportation fringe benefits. The proposal eliminates this disparity by treating all salary reduction amounts as FICA wages. 161 The proposal also provides consistent FICA treatment of amounts paid by employees to purchase benefits, regardless of whether the benefits are provided through an employersponsored plan. For example, under present law, an employee who cannot purchase health insurance through his or her employment must pay FICA tax on his or her salary, including any amounts used to purchase individual health insurance coverage. Under the proposal, similar FICA treatment applies to salary reduction amounts used to purchase health insurance coverage through a cafeteria plan. 162 The proposal has the effect of increasing FICA taxes for some employers and employees, as well as increasing revenues for the Social Security and Medicare programs. The proposal also results in additional wages for Social Security and Medicare purposes, which is likely to increase benefits for some individuals, as well as long-term costs under such programs. Applying FICA tax consistently to salary reduction amounts may make payroll processing and employment tax compliance less complicated for some employers. 161 Legislative history regarding the application of FICA to salary reduction contributions to an employer-sponsored retirement plan indicates the intent of treating such contributions in a manner consistent with IRA contributions. 162 In the case of employees whose other wages equal or exceed the OASDI wage base, only HI tax applies to the additional wages that result under the proposal. B. Conform Calculation of FICA Taxes and SECA Taxes (sec. 1402(a)(12)) Present Law As part of the financing for Social Security and Medicare benefits, a tax is imposed on the wages of an individual received with respect to his or her employment under the Federal Insurance Contributions Act ("FICA”). A similar tax is imposed on self-employment income under the Self-Employment Contributions Act ("SECA”). 163 The FICA tax has two components. Under the old-age, survivors, and disability insurance component ("OASDI"), the rate of tax is 6.2 percent for the employee, and 6.2 percent for the employer. The amount of wages subject to this component is capped at $90,000 for 2005. Under the hospital insurance ("HI") component, the rate is 1.45 percent for the employee and 1.45 percent for the employer. The amount of wages subject to HI taxes is not capped. Similarly, the SECA tax has two components. Under the OASDI component, the rate of tax is the combined employer and employee rates under the OASDI portion of FICA, i.e., 12.40 percent. Under the HI component, the rate is the combined employer and employee rate under the HI portion of FICA, i.e., 2.90 percent. The amount of self-employment tax under the OASDI is subject to the same limit as under FICA, i.e., this component is capped at $90,000 of selfemployment income (for 2005). The amount of self-employment income subject to HI taxes is not capped. For purposes of determining net earnings from self-employment for SECA liability, taxpayers are permitted a deduction from net earnings from self-employment equal to the product of the taxpayer's net earnings (determined without regard to this deduction) and one-half of the sum of the rates for OASDI (12.4 percent) and HI (2.9 percent), i.e., 7.65 percent of net earnings. 164 This deduction reflects the fact that the FICA rates apply to an employee's wages, which do not include FICA taxes paid by the employer, whereas a self-employed individual's net earnings are economically the equivalent of an employee's wages plus the employer share of FICA taxes. The deduction is intended to provide parity between FICA and SECA taxes. Self-employed individuals may deduct one-half of self-employment taxes for income tax purposes. 165 Reasons for Change Although the intent of the present-law rules is to provide parity between FICA and SECA taxes, the deduction allowed under present law in calculating SECA taxes is larger than the amount needed to make SECA taxes the economic equivalent of FICA taxes. This is because the calculation of the deduction does not properly reflect the fact that net earnings are inclusive of SECA taxes. In addition, it does not take into account the fact that wages above the OASDI wage base are subject to tax only at the hospital insurance rate of 2.9 percent. Description of Proposal The proposal modifies the deduction from net earnings from self-employment to make SECA taxes economically equivalent to FICA taxes. Under the proposal, the deduction is determined as shown in Table 2. Table 2.-Calculation of Deduction Allowed in Determining SECA Taxes 1 Threshold amount is 1.0765 multiplied by the FICA taxable wage base. Threshold amount for 2005 is $96,885 ($90,000 x 1.0765). Effective Date The proposal is effective for taxable years beginning after the date of enactment. Discussion The Social Security Act amendments of 1983 attempted to put SECA taxes on the same economic footing as FICA taxes. This involved applying the same rates of tax for the first 166 166 The conference report to the Social Security Amendments of 1983 (H. Rep. No. 9847, p. 146) states: "b. Effective in 1990 and thereafter, the credit would terminate and be replaced 1. The base of the self-employment tax would be adjusted downward to reflect |