Tax loophole for self-employed has political backstory

Obama's budget proposal wants to close an old loophole: business owners using S corporations to avoid taxes. The loophole famously focused on two presidential hopefuls.

By MSN Money staff Mar 5, 2014 7:07PM

(From left) Newt Gingrich & John Edwards (© Paul Drinkwater/NBCU Photo Bank via Getty Images ; Chuck Liddy/Raleigh News & Observer/MCT via Getty Images)By Mark Koba, CNBC

CNBC on MSN MoneyAs part of his budget for 2015, President Barack Obama has called for ending what's become known as the "Gingrich/Edwards" (pictured) tax loophole. The loophole allows self-employed people who set up so-called S corporations to avoid paying taxes into Social Security and Medicare.

In a 2009 report, the Government Accountability Office said that people who used the loophole underreported about $23.6 billion in compensation in 2003 and 2004.

We'll get into why the loophole has the label from two well-known politicos, but before we do, let's look at how it works.

$900,000 untaxed

It's important to note that the loophole is legal and used quite often, said Edward Rigby, a business tax expert at the accounting firm ParenteBeard. It's just a matter of degree on how it's used.

So, let's say someone has set up their own S corporation, in this case a consulting firm, and makes $1 million for the year advising their clients. An S corporation is one that elects to pass corporate income, losses, deductions and credits through to its investors and shareholders for federal tax purposes. Many owners of S corporations classify themselves as investors and shareholders.

To use the loophole, that person will treat only $100,000 of that $1 million as personal wages. The other $900,000 is treated as company profits — not salary — even though the person, as owner, will get the money. (The $900,000 is not tax-free. It is subject to distribution taxes.)

That allows the business owner to avoid paying payroll taxes into Social Security and Medicare by some $26,000. By using the loophole, the person is declaring that he or she is more of an investor than an active employee of their own company.

"The red flag for the IRS would be if they think someone's work salary is too low in regards to compensation for services offered," said ParenteBeard's Rigby. "Then there would be some back taxes owed."

Controversy around S corporations has in recent years ensnared two prominent politicians, both of whom have seen their names attached to the loophole — usually by their political opponents. (Neither man's office responded to multiple inquiries that were made by CNBC.)

The Edwards connection

Before former senator and vice presidential candidate John Edwards, D-N.C., joined the senate in 1999, he earned millions as a trial lawyer. In 1997 alone, he made more than $26 million.

Despite the high income, Edwards paid himself a salary of $360,000 each year from 1995 to 1999 and took the rest as distributions from his S corporation. That saved Edwards an estimated nearly $600,000 in payroll taxes for those years.

The information about Edwards came out during the 2004 presidential campaign, with the release of his tax returns when he ran as the Democratic vice presidential nominee to presidential candidate, former senator and now Secretary of State John Kerry.

It was during the campaign that Edwards attacked President George W. Bush as favoring the wealthy with his tax policies and blamed tax shelters for undermining the Medicare program.

The Kerry-Edwards team said at the time that Edwards created the tax shelter on the advice of his accountant, who cited its legal liability protections as well as its tax advantages, about two years after he left a larger firm to start his own practice with a partner.

The loophole had been called the "John Edwards" loophole until 2010, when it scooped up another presidential candidate and took on a more bipartisan tone.

Newt Gingrich

In 2010, former speaker of the House and GOP presidential contender, Newt Gingrich, R-Ga., got paid $444,327 from his two firms, Gingrich Holdings and Gingrich Productions.

But the firms declared $2.4 million as profits of the S corporation in 2010. By declaring only the $444,327 as income and the rest as profits, it allowed Gingrich to avoid $69,000 in Medicare payroll taxes.

Like Edwards, this information came out during Gingrich's run in the GOP presidential primary campaign of 2012, when the former speaker released his tax returns. But he never publicly commented on the loophole.

It was during the campaign that Gingrich called for a national 15 percent flat rate, with limited deductions and for privatizing some parts of Social Security and Medicare.

Neither Gingrich nor Edwards were made to pay any back taxes, but the publicity surrounding the use of it didn't help their political images.

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Mar 5, 2014 8:44PM
Why characterize this as a "self-employed" tax loophole when large corporations pay millions of dividends that also are NOT subject to self-employment tax.   Sounds like they are picking strictly on small business who already carries too much of the tax load.   Why not be fair and apply the same law to all corporations - regardless of size or type - and tax the dividends using the same exact law instead of carving out a special self-employment tax rule just for small business corporations.
Mar 6, 2014 12:21PM
Sounds like a nothing burger. Remember, these S corporations also pay there employees social security, medicare, medicade, unemployment insurance, workers comp, and now obamacare. There social security benefit is based on there reported income subject to social security. The remainder of the S corporation is subject to ordinary income tax. The only fair solution, would be a simple flat tax with a generous standard deduction. Then when the courageous amongst us clamor for increased taxes, all are affected. There is no nobility in expecting someone else to pay what you would not. Even a fool like John Edwards knows that.  
Mar 6, 2014 12:43PM

in all of the examples given in the article, the person was paying themselves a salary that was over the $110K SS wage cap.  So the only part of payroll taxes that they were avoiding was on medicare.


They were declaring wages of 360K and 445K.  It would have been a bigger deal if they only declared like 20K as wages to avoid the payroll taxes.

Mar 6, 2014 9:26AM
This is just one of many that favor the rich. 35% is a bunch of crap. there are so many loopholes it is nothing more than a talking point.
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