E. Apply Employment Taxes to Sales Incentive Payments Made by Manufacturers (secs. 3121, 3306, and 3401) Present Law Employment taxes generally consist of the taxes under the Federal Insurance Contributions Act ("FICA"), the tax under the Federal Unemployment Tax Act ("FUTA”), and the requirement that employers withhold income taxes from wages paid to employees ("income tax withholding")." 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. Under FUTA, employers must pay a tax of 6.2 percent of wages up to the FUTA wage base of $7,000. An employer may take a credit against its FUTA tax liability for contributions to a State unemployment fund and certain other amounts. Employers are required to withhold income taxes from wages paid to employees. Withholding rates vary depending on the amount of wages paid, the length of the payroll period, and the number of withholding allowances claimed by the employee. 198 Employment taxes apply to all compensation for employment (including commissions and other sales incentives) unless an exception applies. Generally all amounts received in connection with the performance of services are considered compensation, even if paid by a person other than the person for whom services are performed. In addition, if compensation is paid to an employee by a person other than the employer, the payor is generally responsible for complying with the applicable employment tax requirements, regardless of whether an employment relationship exists between the employee and the payor. In such circumstances, 197 199 Secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404 (income tax withholding). 198 See, e.g., Treas. Reg. sec. 1.61-2T(a)(5) (fringe benefits treated as provided by the person for whom services performed, regardless of whether actually provided by that person) and Treas. reg. sec. 1.83-6(d) (rules for transfers of property by a shareholder to an employee of a corporation in consideration of services performed for the corporation). 199 Sec. 3401(d)(1) (for purposes of income tax withholding, if the employer does not have control of the payment of wages, the person having control of the payment of such wages is treated as the employer); Otte v. United States, 419 U.S. 43 (1974) (the person who has the control of the payment of wages is treated as the employer for purposes of withholding the all compensation paid to the employee, whether paid by the employer or by another person, is taken into account in applying the OASDI and FUTA wage bases. 200 Thus, a single OASDI or FUTA wage base applies to all such compensation. FICA tax does not apply to individuals engaged in a trade or business. Instead, such individuals are subject to tax under the Self-Employment Compensation Act ("SECA") on their net earnings from self-employment (generally defined as income derived from a trade or business, less the deductions attributable to the trade or business)." 201 For SECA purposes, the term "trade or business" generally does not include the performance of services as an employee.202 Thus, SECA tax does not apply to compensation paid to an employee. In various situations, the Internal Revenue Service ("IRS") has ruled that amounts received by employees from a person other than the employer as compensation for services for the employer are wages for employment tax purposes. This position applies, for example, to: (1) salaries paid by a racing association to race track stewards employed by the state racing board; (2) a baseball league's receipts from post-season play distributed among players employed by the teams in the league; and (3) compensation paid by colleges and universities to athletic contest officials employed by an athletic association.203 However, IRS guidance has held that commissions or other sales incentives paid by a manufacturer or distributor (referred to herein as "sales incentive payments") to sales people employed by a dealer are compensation for services for the manufacturer or distributor, rather than for services for the dealer.204 IRS guidance holds that the sales incentive payments are not wages because the sales people are not employees of the manufacturer or dealer.205 Thus, the sales incentive payments are includible in employee's share of FICA from wages); and In re Armadillo Corporation, 561 F.2d 1382 (10th Cir. 1977), and In re The Laub Baking Company v. United States, 642 F.2d 196 (6th Cir. 1981) (the person who has control of the payment of wages is the employer for purposes of the employer's share of FICA and FUTA). 200 201 See, e.g., Cencast Services, L.P., v. United States, 62 Fed. Cl. 159 (2004). Secs. 1401-1403. 203 See, respectively, Rev. Rul. 73-253, 1973-1 C.B. 414; Rev. Rul. 57-456, 1957-2 C.B. 629; and Rev. Rul. 57-119, 1957-1 C.B. 331. 204 Rev. Rul. 70-337, 1970-1 C.B. 191, and Rev. Rul. 70-331, 1970-1 C.B. 15. In the facts of these rulings, the manufacturer or distributor makes the sales incentive payments under an agreement with, or with the consent of, the dealer. In addition, Rev. Rul. 70-337 states that the sales people are hired by the dealers. 205 Compare Rev. Rul. 66-162, 1966-1 C.B. 234, holding that commissions paid by a concessionaire of a leased department in a department store to sales people employed by the store are wages because the sales people are employees of both the store and the concessionaire. income by the sales people, but are not subject to FICA, FUTA or income tax withholding. The IRS has also indicated that sales incentive payments are not subject to SECA tax. Reasons for Change 206 Under current IRS guidance and practices, sales incentive payments made by manufacturers or distributors to employees of a dealer are not subject to either FICA or SECA taxes, even though such payments are compensation for services. Such payments, like other compensation paid to employees, should be subject to employment taxes. Description of Proposal Under the proposal, sales incentives payments made by manufacturers or distributors to sales people employed by dealers are wages for employment tax purposes, regardless of whether an employment relationship exists between the sales people and the manufacturers or distributors. Thus, sales incentive payments are subject to FICA, FUTA, and income tax withholding, unless an exception applies. Consistent with present law, the manufacturer or distributor is responsible for complying with applicable employment tax requirements with respect to sales incentive payments. Also, as under present law, all wages paid to sales people, including sales incentive payments, are taken into account in applying the OASDI and FUTA wage bases. Effective Date The proposal is effective with respect to sales incentive payments for services performed in calendar years beginning after the date of enactment. Discussion Under present law, amounts received for services performed by an employee from a person other than the employer are generally treated as wages to the same extent as amounts received from the employer. Although services performed by sales people who are the employees of a dealer benefit the manufacturers and distributors of the products sold, treating sales incentive payments as compensation for services for the manufacturer or distributor creates an artificial standard that causes inconsistent employment tax results. In effect, by structuring compensation as payments from a manufacturer or dealer, the parties can determine among themselves to what extent compensation will be subject to employment taxes. This undermines the employment tax base. Sales incentive payments are compensation for services and, therefore, should be subject either to FICA or SECA taxes. The proposal imposes FICA taxes rather than SECA taxes because this is consistent with IRS position in other, similar cases, as well as with judicial 2002). 206 See IRS Publication 3204, Automotive Manufacturers' Incentive Program (Rev. 3 207 precedents. In addition, compliance is greater with respect to payments subject to FICA and wage withholding than with respect to other payments. 208 The proposal has the effect of increasing FICA taxes for employees who receive commissions and other sales incentives from manufacturers or distributors and increasing FICA and FUTA taxes for the manufacturers or distributors. The proposal also increases revenues for the Social Security, Medicare, and unemployment programs. The proposal also results in additional wages for these purposes, which is likely to increase benefits for some individuals, as well as long-term costs under such programs. Manufacturers and distributors who pay commissions or other sales incentives are subject to additional administrative requirements under the proposal, such as withholding FICA and income taxes from the payments, depositing employment taxes, and filing employment tax returns. However, manufacturers and distributors who are employers are already subject to these requirements with respect to other wages. Under present law, commissions and other sales incentives paid by a manufacturer or dealer are includible in income, but are not subject to income tax withholding. As a result, an individual who receives such amounts generally must either adjust the amount of income tax withheld from his or her wages or pay quarterly estimated taxes. Otherwise, the individual may have to pay additional taxes when filing his or her return and could be subject to a penalty. Applying withholding to these amounts is likely to result in better coordination between the amount of tax withheld and the individual's tax liability, leading to improved compliance. 207 Authorities for this approach are cited in footnotes 199 and 203. 208 The increase in compliance as a result of tax withholding is discussed in detail in Part I.A. of this Report. F. Modify Determination of Amounts Subject to Employment or Self-Employment Tax for Partners and S Corporation Shareholders (sec. 1402) Present Law In general 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 (the FICA tax). 209 A similar tax is imposed on the net earnings from self-employment of an individual under the Self-Employment Contributions Act (the SECA or self-employment tax). FICA tax In general 210 211 The FICA tax has two components. Under the old-age, survivors, and disability insurance component (OADSI), the rate of tax is 12.40 percent, half of which is imposed on the employer, and the other half of which is imposed on the employee." The amount of wages subject to this component is capped at $90,000 for 2005. Under the hospital insurance component (HI), the rate is 2.90 percent, also split equally between the employer and the employee. The amount of wages subject to the HI component of the tax is not capped. The wages of individuals employed by a business in any form (for example, a C corporation) generally are subject to the FICA tax. S corporation shareholders An S corporation is treated as a pass-through entity for Federal income tax purposes, and its income generally is taxed to the shareholders. A shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages, but generally is not subject to FICA tax on amounts that are not wages (such as distributions to shareholders). Nevertheless, an S corporation employee is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wages. A significant body of case law has addressed the issue of whether amounts paid to shareholder-employees of S corporations constitute reasonable 212 212 Though unrelated to the FICA tax, present law provides that an S corporation is treated as a partnership and a two-percent shareholder is treated as a partner, for applying rules relating to employee fringe benefits. Sec. 1372. purposes of |