Owners of an S corporation can receive business profits in the form of wages, which are subject to Social Security and Medicare tax, or dividend distributions, which are not. Naturally they prefer the latter because of the lower tax cost. The IRS can challenge the tax treatment if wage payments are unreasonably low, particularly where business profits are highly dependent on the services or reputation of the owner. Enforcement is difficult, however, and the use of S corporations to avoid paying employment taxes appears to be widespread. Financial disclosures of presidential candidates Newt Gingrich and John Edwards indicate that both of them used this technique.

The idea of closing this loophole has been floating around for some time. For example, California Democrat Pete Stark introduced a bill called the Narrowing Exceptions for Withholding Tax Act (or NEWT Act). The idea hasn’t had much momentum, but may have taken on new life as Democrats have attached a different version of this proposal (without the snarky title) to legislation that would prevent the impending increase in student loan rates. Blocking the increase in student loan rates appears to be a popular idea that has bipartisan support, but it remains to be seen whether the cost will be funded by this particular loophole-closer.