In Obama’s budget, a case study on finding and closing tax loopholes

Sometimes it’s hard to tell the difference between a justified tax break and a tax loophole. (One rule of thumb: If it benefits you, it’s a well-justified tax break.)

Sometimes, though, it’s not hard to tell the difference. Take the loophole that the Obama administration is targeting in its new budget. You’ll find it deep in the small print, far from the talking points about universal preschool and the cancer “moon shot.”

To help pay for the Affordable Care Act, President Barack Obama and Congress imposed a 3.8% “net-investment-income tax” (NIIT) on couples with incomes above $250,000 and singles with income above $200,000. It applies to interest, dividends, royalties, and–here’s the rub–“income derived from a trade or business in which the taxpayer does not materially participate.”

If you get a big paycheck or if you’re an ordinary law-firm partner, you pay the tax. But if you can morph yourself into a partnership, limited liability corporation (LLC) or S-corporation in which you can reasonably claim to be active (not hard), you can escape the NIIT as well as the old Self-Employment Contributions Act (SECA) tax, an analog to the payroll tax that wage earners pay toward Social Security and Medicare. OK, it’s a little more complicated: Owner-employees do have to pay themselves “resasonable compensation” and pay SECA tax on that.

As is so often the case, once rich people and their advisers find what began as a tightly drawn exemption, more of them exploit it. Dentists who used to be self-employed or general partners in their practices (and thus paid the SECA tax on all of their income) have turned themselves into S-corp or LLC owners and avoid both the SECA and NIIT on at least part of their income. Similarly, many hedge fund managers who were receiving fees taxed at ordinary-income rates now say they are actively managing LLCs and avoid the tax.

The Obama proposal would close this loophole by taxing nearly all trade or business income no matter how the businesses are legally organized. The Treasury says this would raise $272 billion over 10 years (which, for perspective, is roughly double the Interior Department’s budget over that period).

A few lessons here:

One, if government taxes businesses that are legally organized one way at a lower rate than businesses organized another way and it’s easy to switch, people will switch. Kansas discovered that when it cut the state income tax on S-corps to zero; it estimated that 191,000 taxpayers were eligible. In 2013, more than 330,000 self-employed layers, accountants, architects, and farmers took advantage of the lower S-corp rate.

Two, you can impose a tax or repeal a tax (and Jeb Bush, for one, would repeal the NIIT). But if you craft a tax to shield a narrow constituency, you not only add complexity to the tax code, you also add to unproductive gaming of the system and, often, increase unfairness.

Three, as the Journal’s Richard Rubin noted recently, business tax reform is going to be tough because the pass-throughs (partnerships and S-corps that are taxed at the individual rate, not at the corporate tax rate) are winning big right now. U.S. Treasury economists estimated that, in 2011, the effective tax rate on conventional shareholder-owned C-corporations (including big publicly traded ones such as Procter & Gamble) was 31.6%, compared with 25% on S-corps, 15.9% on partnerships, and 13.6% on sole proprietors.

Lobbyists for those who benefit from the NIIT loophole will be quick to accuse the administration of attacking small business. There are a lot of truly small businesses organized as pass-throughs, but the NIIT doesn’t affect them because they don’t earn $200,000 a year. The Treasury estimates that 67% of all S-corp income and 69% of all the partnership income goes to the top 1% of taxpayers, those with income greater than $375,000 a year.

Editor’s note: This piece originally appeared on The Wall Street Journal’s Washington Wire.