Should Closing The ‘John Edwards Loophole’ Be A ‘Poison Pill’ For The Senate’s Tax Extenders Bill?

Yesterday, the Senate failed to move its tax extenders bill (which extends unemployment benefits and a handful of popular tax credits) past a procedural hurdle, sustaining a budget point of order raised by Sen. Judd Gregg (R-NH). The final vote was 45-52, with 60 votes needed to proceed past the point of order.

One of the criticisms that opponents of the bill are raising is that it includes a tax increase that unfairly target small businesses. The legislation partially closes what’s known as the “John Edwards loophole,” which enables some businesses to avoid paying Medicare taxes by classifying wages as something they are not. Sens. Olympia Snowe (R-ME) and Mike Enzi (R-WY) called this provision the bill’s “poison pill”:

At a time when Congress continues to dither on enacting a small business jobs bill, Section 413 is a poison pill in this tax bill, robbing American small businesses of the capital they need to create new, good-paying jobs,” Senator Snowe said. “Indeed, this is a job-killing tax hike that will force entrepreneurs across the nation to retrench and reconsider any plans for hiring employees or expanding their business.”

But what’s really going on here? Should these Senators be so concerned about closing the loophole and therefore clobbering small businesses?

S corporations, which are the most commonly employed business structure in the United States, don’t pay corporate income taxes, but instead pass all their earnings through to the firm’s shareholders, who report them on their personal income tax. This pass-through income is exempt from the payroll tax (which funds Medicare). So employees of S corporations have an incentive to accept their money not as wages (which are subject to the tax) but as pass-through income that is tax-exempt.

The epitome of this was former Sen. John Edwards paying himself millions in pass-through income from his law practice, even though it was clearly money that he earned by simply doing his law work. There’s no reason for employees of a firm to be able to escape payroll taxes by classifying their wages as something else.

The extenders bill before the Senate doesn’t fully close the loophole, but merely stipulates that any shareholder who performs substantial services for the S corporation pay payroll taxes on all the income they receive. According to Citizens for Tax Justice, this should help the majority of small businesses:

Passing legislation to close this loophole will benefit the majority of small businesses. Most small businesses pay all of their taxes, including Medicare taxes on all of their personal service income. (The loophole is not allowed for partnerships or sole proprietorships.) When some small business owners avoid taxes, honest taxpayers make up the gap by paying higher taxes. Lawmakers who are concerned about the tax burden of small businesses need to do everything possible to close loopholes in the tax code so that all Americans pay their fair share.

And, in fact, most S corporations aren’t all that small. According to the Center on Budget and Policy Priorities, “businesses with gross receipts of more than $10 million accounted for about two thirds of the gross receipts of all partnerships and S corporations.” Cleaning up the tax code to make sure that these companies pay their fair share will be to the benefit of businesses small and large.