The White House
The White House (Photo: Diego M. Radzinschi / NLJ)

The new White House budget calls for closing a long-controversial tax loophole that gives some high-income professionals like lawyers and lobbyists a way to avoid income and payroll taxes.

President Barack Obama sent his proposed 2015 federal budget to Congress today, and highlighted the need to extend the payroll tax to cover distributions from certain pass-through entities for professional service businesses.

The White House budget would expand the Earned Income Tax Credit for low-wage earners, Obama said today during a five-minute speech about the budget. “And it pays for it by closing loopholes like the ones that let wealthy individuals classify themselves as a small business to avoid paying their fair share of taxes,” Obama said.

The loophole that uses Subchapter S corporations—which Senate Democrats previously dubbed as the Newt Gingrich/former Sen. John Edwards (D-N.C.) loophole after its most high-profile users—will keep $5 billion per year out of the Social Security and Medicare Trust Funds by 2020, a White House report released Monday says.

“Together with the EITC expansion, these proposals will help reorient the tax code to reward work for low-wage workers while making sure that highly compensated professionals pay taxes on their incomes like everyone else,” the report says.

Such a change would mostly affect lawyers who do contingency work, said Robert Honigman, a partner at Arent Fox in Washington who specializes in tax and wealth management. Not a lot of partners at big firms are setting up as corporations, he said.

The S corporation provision touches on the question kicked around Washington for more than a decade—whether income from cases should be taxed as salary or as a return on the firm’s investment in the pursuit of the cases.

Senate Democrats, to support a similar proposal in 2012, highlighted that balance with the example of Edwards, who earned $26.9 million from his work as a trial lawyer in 1995. Democrats said Edwards paid himself a salary of $360,000 each year for four years and took the rest as distributions from his S corporation, saving him an estimated $600,000 in payroll taxes, the New York Times reported in 2004.

The White House did not immediately detail the reforms, but cited a change to S corporations in a tax reform plan released last week by House Ways and Means Committee Chairman Dave Camp (R-Mich.).

Camp’s draft bill would apply Self Employed Contributions Act tax to 70 percent of the combined compensation and distributive share of the S corporation for partners and shareholders who participate in the business. The remaining 30 percent would be taxed as earnings on invested capital not subject to SECA.

That is part of a provision that would increase revenues by $15.3 billion over the next 10 years, according to an analysis by the Joint Committee on Taxation.

Still, the loophole has remained for years, and Republicans on Capitol Hill today expressed disapproval of Obama’s budget. House Budget Committee Chairman Paul Ryan (R-Wis.) called it “another disappointment” that reinforces the status quo.

“This budget isn’t a serious document; it’s a campaign brochure,” Ryan said. “In divided government, we need leadership and collaboration. And in this budget, we have neither.”