Harry Reid's Sensible Tax Plan: Close the S-Corp Loophole

Last week, the House attempted a quid pro quo: a proposal to extract funds from the $17 billion ACA fund intended for "immunization campaigns, health screenings and other preventive practices" in exchange for a freeze on student loan interest rates. Certainly, the loans and ballooning interest rates are a huge problem, as I've written recently, but the House solution was, at best, cynical and nasty.

An alternative plan, offered up by Harry Reid, would target S-corporations who do not pay corporate taxes. Here's how The Hill describes it:

Reid's bill would eliminate that flexibility by requiring those with incomes over $250,000 to include, for purposes of employment taxes, income received from an S-corp or limited partnership interest in a professional service business. This change, however, would only apply to S-corps and partnerships in which more than 75 percent of its gross revenues come from the service of three or fewer shareholders, and only those in fields where most of the earnings come from the performance of services, like those involving lobbyists and lawyers.

Reid's bill effectively closes a loophole and would raise $6 billion over the next decade, offsetting the cost of extending the 3.4 percent interest rate for student loans. As it stands now, S-corporations are getting a bit of a free ride:

Under current law, businesses organized as S-corporations don't pay corporate taxes, and income earned is passed through to shareholders, who report that income on their personal tax returns. But if these shareholders are also employees, they can choose to treat some of their income as business profit — not salary, which lets them escape payroll taxes.

Indeed, according to a 2009 Government Accountability Office report [pdf], S-corporations underreported $23.6 billion in shareholder compensation in 2003 and 2004 -- a result of which, suggested the GAO, was "billions in annual employment-tax underpayments."

In a perfect world -- perhaps even in an imperfect, mildly-functional world -- tuition costs would not rise 291 percent in two decades. But absent such a fantasia, Reid's bill might be the best-case scenario. (Which is not to say it isn't deeply lacking. As the Times grumbles, the bill is only good for a year -- now, they noted acidly, "apparently considered a long-term solution.") It's reasonably good governance, it subsidizes a long-term investment in American education and -- admittedly a mild ancillary benefit -- it would do away with a reminder of that perennial embarrassment, John Edwards, whose tarnished name is most associated with the S-corporation loophole.