Not every S corporation is a “John Edwards” shelter. The TaxProf highlights a New York Times piece by Colorado Tax Professor Victor Fleischer, who says that Mitt Romney may be using the “John Edwards Tax Shelter” to avoid Medicare taxes.
The “John Edwards shelter” got its name from the model husband and former Democratic vice-presidential nominee. He ran his law practice in an S corporation, so much of his multi-million dollar income came to him on the K-1. Unlike wage income or law partnership K-1 income, S corporation K-1 income is not subject to self-employment, Social Security or Medicare taxes.
Mr. Fleischer says:
Mr. Romney continues to receive cash payments from the companies that manage Bain Capital’s funds. A couple of weeks ago in this column, I described how private equity firms like Bain Capital convert management fees, which would normally generate ordinary income, into investments that yield capital gain.
R. Bradford Malt, the trustee who manages Mr. Romney’s Bain holdings, has stated that Mr. Romney did not participate in the fee conversion program. One might have logically inferred, then, that Mr. Romney’s share of the management fee income would be reported as wage income on Mr. Romney’s tax return.
Not so. Instead, the payments are reported on Schedule E of the return as distributions from S corporations — the largest being $1,961,325 from Bain Capital Inc. The distinction between wage income and an S corporation distribution is meaningless from a business standpoint, but it’s important for tax purposes.
Current law imposes a 2.9% Medicare tax on all wages and self-employment income. To avoid this tax, taxpayers have an incentive to characterize as much labor income as they can as investment income (like carried interest) or as a distribution from an S corporation.
Mr. Fleischer gets this badly wrong. Wage income and S corporation income can be hugely different from a business standpoint. For an obvious example, consider a second-generation family business S corporation — say, a farm. One member of the second generation may continue the business, while the others may go do other things but remain owners. As S corporation earnings must be allocated straight-up based on share ownership, the only way to compensate the sibling who runs the business is through additional salary. The working sibling gets the only salary in the family, while all siblings get K-1 income.
While much is uncertain about how much S corporation income should go between K-1 income and W-2 income, it is certain that it usually isn’t all compensation when capital investments are involved. To the extent that that Bain Capital Inc. owns passive interests in Bain Group investments, it certainly isn’t disguised wages. As his termination deal largely involved receiving passive investment interests, it’s a stretch to say that this translates into an Edwards Shelter.
Update: Victor Fleischer replies in the comments:
Hi Joe. Thanks for the thoughtful post. I’ve replied here: http://victorfleischer.com/archives/365
Bain Capital Inc. is the management company, and as far as I can tell receives nothing but fee income. No passive investments, which are instead held by the GP. You are right that I overstated the general point about S Corps, but in this particular case it’s hard to see how the S Corp income is related to passive investments or investment income of any kind.
Is Romney really paying the “lowest rate”? From Joseph Thorndike at Tax Analysts (Subscriber link):
So applying the Romney method to his actual returns, we get an average rate of 14.02 percent in 2010 and 2011. As many commentators have noted, that’s a lot lower than President Obama’s average effective tax rate of 26.45 percent during his presidency. (It’s also lower than the average rate Obama paid in the same two years covered by the Romney release: 23.4 percent.)
But Romney’s rate isn’t low just by comparison with our current president. It’s also low compared with every president of the last 40 years.
That 14.02% rate is because of several factors.
- Lots of dividend income, taxed at 15%.
- Lots of capital gain deductions, taxed at 15%.
- Huge itemized deductions for charitable gifts and state taxes.
Of course, this also ignores how dividends come from corporations, which pay their own 35% federal tax. Capital gains are from the sale of corporate stock, which means accumulated and anticipated corporate earnings taxed at 35%. Romney is only paying the second tax on that income.
Mr. Thorndike acts like Romney has done something shady:
If he wins his race for the White House — and continues to file tax returns that look like the ones released during the campaign — President Romney will have only Richard Nixon to keep him company at the bottom of the rate roster. Generally speaking, Nixon is not a happy point of comparison for presidents, and this is true for taxes as well as break-ins and cover-ups.
Joseph Thorndike, what is Romney supposed to do? Dump his dividend paying investments and buy bonds so he only earns interest, taxable at the top rate? Stop earning long-term capital gains? Stop deducting his charitable contributions? Oh, wait, he’s already done that.
Trish McIntire, Shorting Deductions
Dear Client – I know what you’re thinking. Since Gov. Romney didn’t claim all his charitable deductions so that he could hit his target tax rate, you’re thinking about not taking all your business (farm) deductions so that you can manipulate your income tax. I’m sorry to break the news to you but you can’t do that. Business deductions are not the same as charitable deductions.
Daniel Shaviro, Should Romney pay a lower tax rate than the rest of us?
Howard Gleckman, Will Romney Scale Back Rate Cuts If Congress Won’t Curb Tax Breaks? (TaxVox)
Paul Neiffer, IRS Extends Drought Replacement Period for Ranchers
Joseph Henchman, D.C. Judge Rules Online Travel Companies Must Pay Hotel Tax on Their Services (Tax Policy Blog)
Jim Maule, Biting the Hand that Feeds the Tax Critic.
Peter Reilly weighs in on the Iowan who claimed to be a South Dakotan while sporting Iowa vanity plates: State Residence For Income Tax – Pay Attention To The Basics
Martin Sullivan, Capital Gains: The Missing Link toTax Reform?
Robert D. Flach has posted his Wednesday Buzz.
The Critical Question: Who — Aside From the Rap Community — Doesn’t Pay Any Income Tax? (Anthony Nitti)
Tags: S corporations, TaxProf, Joseph Thorndike, Trish McIntire, Howard Gleckman, Daniel Shaviro, John Edwards Shelter, Peter Reilly, Mitt Romney, Anthony Nitti, Victor Fleischer, Joseph Hencman, The Critical Question