Rep. Pete Stark, D-Calif., the ranking Democratic member of the House Ways and Means Health Subcommittee, has introduced a new bill aimed at closing what he considers a “tax loophole” exploited by former House Speaker Newt Gingrich.

The bill would close off a wrinkle in the Tax Code that allows self-employed individuals, including lobbyists, to lower their Medicare payroll tax liability by classifying earnings as profits or dividends, instead of as wages. Stark has named the bill the Narrowing Exceptions for Withholding Taxes, or NEWT, Act, after Gingrich, whose taxes and those of rival Republican Presidential candidate Mitt Romney have recently attracted extra scrutiny in light of the release earlier this month of their tax returns. The bill would also apply to accountants and other professional service providers.

Stark noted that the main provision in his bill passed the House in 2009 as part of the American Jobs and Closing Tax Loopholes Act of 2010. At the time, the Joint Commission on Taxation estimated that closing the tax loophole would save taxpayers $11.2 billion over 10 years.

All earners are subject to a 2.9 percent tax on wages, which helps fund Medicare, Stark’s office noted. Employee-shareholders at S corporations can use an existing loophole to shield earnings from the Medicare tax by classifying them as profits or dividends instead of as wages. Gingrich availed himself of this loophole on his 2010 tax returns, saving an estimated $69,000 in Medicare taxes.

"It seems Gingrich is continuing to do his part —in his own infamous words—to let Medicare "wither on the vine." By taking full advantage of a tax loophole often used by wealthy self-employed lawyers and lobbyists to slash their tax liability, Gingrich is happy to undermine Medicare. This tax dodge throws cold water on his feigned concern for the future of Medicare."

For 2010, Gingrich reported $444,327 of his earnings as wages from Gingrich Holdings, Inc. and Gingrich Productions. By classifying another $2.4 million in profits or dividends he avoided paying an estimated $69,000 in Medicare taxes.

Democrats have also exploited the loophole, Stark noted. Former Senator John Edwards earned $26.9 million from his work as a trial lawyer in 1995. He paid himself a salary of $360,000 each year for four years and took the rest as profits and dividends through an S corporation. This saved Edwards $591,112 in Medicare payroll taxes over those four years. 

The Center on Budget and Policy Priorities and the Citizens for Tax Justice support closing the Medicare tax loophole for S corporations, Stark noted.

The NEWT Act would expand the income categories that are subject to Medicare payroll taxes so employee-shareholders of S corporations could no longer avoid paying the tax by reporting artificially low wage income and correspondingly higher dividends or profits. Certain employee-shareholders of S corporations would have to calculate their Medicare payroll tax obligation based on their share of the S corporation’s profits or dividends, not just income reported as wages. The individuals subject to the provision are the employee-shareholders of a professional service business where the principal assets of that business are the skills and reputations of three or fewer individuals.

The NEWT Act targets the S corporations that have been identified as the most likely to abuse the system. These are professional service businesses engaged in the fields of health, lobbying, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, brokerage services, or investment advice or management. 

Medicare payroll taxes are imposed at a rate of 2.9 percent on all wage income, Stark’s office noted. Under present law, certain self-employed individuals try to avoid paying Medicare payroll taxes on a portion of their wage income by routing it through an S corporation. In general, S corporations do not pay income tax. Instead, the income gains and losses of an S corporation “flow through” to shareholders’ individual tax returns. By law, S corporations can have no more than 100 owners; but they are typically far smaller, with the GAO estimating that 94 percent of S corporations have 3 or fewer owners.

A shareholder of an S corporation who performs services as an employee is subject to Social Security and Medicare payroll taxes on his or her wage income, but generally is not subject to payroll taxes on amounts that are not wages (such as dividends and profits). Nevertheless, an S corporation employee-shareholder is subject to payroll taxes on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wage income. Where an employee-shareholder is entitled to a significant amount of S corporation income, there may be a temptation under present law to understate what portion of the income is compensation for services (and subject to payroll taxes) and correspondingly increase the amount treated as a dividend or profit.

Underreporting of wage income is rampant among employee-shareholders of S corporations, Stark’s office noted. The Government Accountability Office estimates that in the 2003 and 2004 tax years, individuals who used S corporations underreported more than $23 billion in wage income. The median misreported amount was $20,127.

There is no clearly enforceable rule today to help tamp down on this abuse in an efficient manner, Stark noted. If the IRS audits an individual who uses an S corporation, the auditor determines the appropriate reporting based on the facts and circumstances of the individual case. However, the IRS does not have the resources to investigate all four million S corporations.