CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

CBO

The Taxation of 

Capital and Labor 

Through the 

Self-Employment Tax

SEPTEMBER 2012
CBO

Note

Numbers in the text and tables may not add up to totals because of rounding.

Pub. No. 4168
Contents

CBO

Summary iv

Background on Social Security and Medicare Taxes 1

How the FICA and SECA Tax Bases Differ 1

The Definition of Self-Employment Income 2

Defining the Roles of Partners 3

Incentives Created by SECA Tax Treatment 5

Mischaracterizing Involvement with a Business 5

Influencing Employment Decisions 5

A Snapshot of the SECA Tax Base 6

Disaggregating the Tax Base 6

What Portion of Noncorporate Business Income Is Included in the SECA Tax Base? 8

Comparing Labor and Capital Income in the FICA and SECA Tax Bases 10

Measuring Total Labor Income 11

Box 1. How the Number of Owners Affects Incentives to Mischaracterize 

Labor Income Under a Reasonable Compensation Standard 14

Calculating Labor’s Share of the SECA Tax Base When Labor Income Exceeds 

Net Business Income 16

Shares of Income from Labor and Capital 16

Comparing the FICA and SECA Tax Bases 17

Alternative Options for Defining the SECA Tax Base 18

The Material Participation Standard 19

The Reasonable Compensation Standard 21

The Safe-Harbor Calculation of Capital Income 23

Appendix A: Imputing Labor Income to the Self-Employed 25

Appendix B: Allocating Negative Nonlabor Income Between Labor and Capital 31

Appendix C: Description of Tax Organizations’ Options for Modifying the SECA Tax Base 33

List of Tables and Figures 35

About This Document 36
CBO

Summary

Since 1950, self-employed individuals have been 

covered by the Social Security system. In many regards, 

their obligation to pay Self-Employment Contributions 

Act (SECA) taxes into the Old-Age, Survivors, and Disability Insurance (OASDI) and Hospital Insurance (HI) 

trust funds and their entitlement to Social Security and 

Medicare benefits parallel those of workers who are not 

self-employed and who thus are covered under the Federal Insurance Contributions Act (FICA). In both cases, 

the OASDI tax base is limited to income below a certain 

threshold, and the HI tax base is not constrained by any 

income ceiling. The two systems, however, diverge in an 

important way: The FICA tax is based solely on income 

from labor, but the SECA tax is based on net business 

income, which can also include income from capital. 

Such a difference in the tax code (say, among businesses 

providing the same goods and services) can prompt people to make choices that they would not otherwise make 

about self-employment or the organizational form of a 

business, thereby reducing the efficient allocation of 

resources.

For this analysis, the Congressional Budget Office 

(CBO) decomposed the SECA tax bases for HI and 

OASDI into their labor and capital components, but the 

discussion focuses on the HI tax base because it is unconstrained by the income ceiling of the OASDI tax. CBO 

estimates that approximately 40 percent of the SECA-HI 

tax base (the amount of self-employment income subject 

to the HI tax) derives from capital, and the remainder 

derives from labor. Furthermore, more than half of the 

labor income of self-employed people—that is, the portion of their business income that would be subject to the 

FICA-HI tax if the business was incorporated instead of 

being a sole proprietorship or a partnership—is not 

included in the SECA-HI tax base. That occurs because 

when net income from all of a taxpayer’s businesses is less 

than the labor income from those businesses, the excess 

labor income is excluded from the SECA tax base. There 

is no similar exclusion from the FICA tax base. With 

both the taxed capital income and the excluded labor 

income accounted for, the total SECA-HI tax base is 

roughly three-quarters of the amount of income that 

would be taxable under the FICA-HI rules.

Lawmakers could change the SECA tax base to try to 

align it more closely with the rules governing the FICA 

tax base. CBO analyzed three options for alignment that 

would modify the SECA tax base by either reducing the 

share of capital income or increasing the share of labor 

income included in that base. No option by itself would 

accomplish both of those objectives when applied to both 

sole proprietorships and partnerships, but one option 

would do so if applied only to partnerships. Two of the 

options would reduce the size of the SECA tax base—in 

one case by more than half—whereas the third option 

would increase the SECA tax base by a little.

Entities Subject to the SECA Tax

The SECA tax base has not been changed by statute 

since the Social Security Amendments of 1977. Those 

amendments, governing Social Security and Medicare, 

envisioned three types of entities whose owners would be 

subject to the SECA tax:

 Sole proprietorships, whose owners are required to 

include all of their business earnings in the SECA tax 

base.

 General partnerships, in which each partner is fully liable for the debts of the business. Partners must include 

their share of the partnership’s earnings in the SECA 

tax base along with any guaranteed payments they 

receive in exchange for the services they provide. 
V THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

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 Limited partnerships, in which one or more general 

partners are fully liable for the debts of the business 

and the limited partners are liable only up to the 

amount of their investment. Limited partners face 

SECA tax only on their guaranteed payments.

Since 1977, new types of business entities—most notably, 

limited liability companies (LLCs) and limited liability 

partnerships (LLPs)—have emerged. Such entities have 

no equivalent to general partners: Except in a few cases, 

all members are liable for the company’s debts only up to 

the amount they invested. The SECA tax obligations of 

LLC members and limited liability partners are less 

straightforward than those of general and limited 

partners. 

Labor and Capital Income Under 

Current Law

For owners of corporations, the amount of labor income 

subject to the FICA tax must represent “reasonable 

compensation”; in other words, it should bear some 

resemblance to the market wage for their services. In 

this analysis, CBO estimated the labor income for selfemployed workers using an assessment of their reasonable 

compensation. All other positive net income was attributed to capital. In 2001 and 2004, labor income 

accounted for 58 percent of the SECA-HI tax base and 

almost 75 percent of the SECA-OASDI tax base, CBO 

estimates. (For this report, CBO examined the SECA tax 

base in 2001 and 2004.1

 The discussion focuses on the 

more recent data, referring to the earlier year only when 

the results differ substantially.)

Overall, more than half (65 percent) of the capital 

income of unincorporated businesses was included in the 

SECA-HI tax base in 2004, but less than half (44 percent) of the labor income was included (see Summary 

Figure 1). In contrast, if all self-employed people had 

worked for others and paid FICA taxes, none of their 

capital income—and all of their labor income—would 

have been included in the HI tax base. Because of the 

income ceiling for OASDI, only 26 percent of the capital 

income of unincorporated businesses was included in the 

SECA-OASDI tax base in 2004. 

The Taxation of Labor and Capital 

Income Under Alternative Options

CBO examined three policy options that would alter the 

structure of the SECA tax: 

 A material participation standard would change the criteria for determining which partners must pay SECA 

taxes on their share of business income and extend 

those criteria to LLC members. Such a standard would 

clarify much of the ambiguity surrounding the SECA 

tax but, on balance, would subject more income from 

capital to the self-employment tax.

 A reasonable compensation standard for identifying 

labor income and including it in the SECA tax base 

would exclude capital income from the SECA tax base 

by definition and require all labor income to be 

included. If the option was limited to partnerships 

(including multimember LLCs), it would, on average, 

increase the included share of labor income. If sole 

proprietorships were included, however, the opportunity to mischaracterize labor income as capital income 

(a choice not available under current law) would probably reduce the included share of labor income.

 A safe harbor for a return on capital would provide taxpayers with a formula that used their tangible assets to 

calculate how much capital income should be 

excluded from the SECA tax base. The policy that 

CBO examined would shelter a relatively small share 

of capital income, probably reflecting the importance 

of intangible capital (such as patents, trademarks, and 

intellectual property) in generating income for unincorporated businesses. Furthermore, such a policy 

would reduce the included share of labor income in 

cases where the return on capital was less than the 

safe-harbor amount.

1. The data necessary to conduct the analysis in this report are generally not available until three years after the tax year ends. The data 

from 2004 were the most recent available when CBO began its 

analysis of the SECA tax base.
SUMMARY THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX VI

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Summary Figure 1.

Labor and Capital Shares of the Business Income of Profitable Sole 

Proprietorships and Partnerships Included or Not Included in the SECA-HI 

Tax Base, 2004

Source: Congressional Budget Office.

Notes: The SECA tax base excludes $24 billion for which an entity type could not be identified. 

SECA = Self-Employment Contributions Act; HI = Hospital Insurance (Medicare Part A).

Not in SECA-HI Tax Base: 56 Percent

Not in SECA-HI 

Tax Base: 35 Percent

In SECA-HI Tax Base: 44 Percent

SECA-HI

Tax Base:

In SECA-HI Tax Base: 65 Percent

Total Business Income

Labor Income

58 Percent

Capital Income

42 Percent

$289 Billion

$90 Billion

$229 Billion

$165 Billion

LABOR INCOME

CAPITAL INCOME
CBO

The Taxation of Capital and Labor Through the 

Self-Employment Tax

Background on Social Security and 

Medicare Taxes

Social Security and Medicare Part A (which covers 

inpatient services provided by hospitals and certain other 

care) are largely financed by taxes on the earnings of 

employees and self-employed workers. Currently, 

employers and employees covered under the Federal 

Insurance Contributions Act (FICA) each contribute 

6.2 percent of an employee’s annual earnings—up to a 

ceiling—to the Old-Age, Survivors, and Disability Insurance (OASDI) trust fund, which supports the Social 

Security program.1

 That ceiling, which is set at $110,100 

in 2012, is adjusted for average wage growth. Social Security benefits for retired workers, their survivors, and 

disabled workers are based on workers’ earnings histories. 

Wage earners and their employers also each contribute 

1.45 percent of earnings to the Hospital Insurance (HI) 

trust fund, which supports Medicare Part A. There is no 

ceiling on earnings subject to the HI tax.2

When it was established in 1937, the Social Security system made no provision for self-employed workers: They 

did not contribute to the system, nor were they eligible to 

collect benefits based on their self-employment income. 

Beginning in 1950, however, Social Security coverage 

was extended to some self-employed workers, who began 

to make contributions under the Self-Employment 

Contributions Act (SECA). Subsequent amendments 

to the Social Security Act gradually expanded coverage 

for self-employed individuals. After the creation of 

Medicare in 1965, the SECA tax increased to include 

contributions to the HI program. By 1983, the SECA tax 

rate (both the OASDI and HI portions) was equal to the 

combined FICA rates that applied to wage earners and 

their employers. To maintain the parallelism with wage 

earners, whose employers can deduct their share of FICA 

taxes, self-employed workers were allowed to deduct half 

of their contributions (after making certain adjustments) 

from their income taxes.

When the SECA tax was enacted in 1950, FICA taxes 

were just over 5 percent of federal revenues. By 2011, 

more than 30 percent of federal revenues came from 

FICA taxes. SECA taxes are a much smaller share, making up just 2 percent of federal revenues in 2011. The 

ratio of SECA tax revenues to FICA tax revenues closely 

reflects the ratio of self-employed people to wage earners.

How the FICA and SECA Tax Bases Differ

A tax’s “base” is the measure—for example, income or 

property—that is subject to the tax. The FICA tax base 

includes the wages of employees, and the SECA tax base 

is the net business income (that is, receipts minus 

expenses) of self-employed workers. The FICA tax base is 

limited to labor income, but the SECA base can include 

some capital income. Although the intent of the Congress 

was to tax the self-employed “on remuneration received 

for one’s own labor,” the tax base that was enacted did not 

conform to that intent.3

1. The rate of OASDI tax paid by employees was reduced by 2 percentage points for calendar years 2011 and 2012.

2. Beginning in 2013, the Affordable Care Act (comprising Public 

Law 111-148 and the health care provisions of Public Law 111-

152) increases the total HI tax to 3.8 percent on earnings in excess 

of $200,000 for unmarried people, on combined earnings in 

excess of $250,000 for married couples filing joint returns, and on 

earnings in excess of $125,000 for married individuals filing separate returns.

3. See Patricia E. Dilley, “Breaking the Glass Slipper—Reflections on 

the Self-Employment Tax,” The Tax Lawyer, vol. 54, no. 1 (Fall 

2000), p. 74. That article cites the quotation from Senate Report 

No. 81-1669 (1950), which accompanied the Social Security 

Amendments of 1950.
2 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

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Specifically, the SECA tax base can include the return on 

investments in tangible and intangible (but not financial) 

assets made by an unincorporated business. In contrast, if 

an incorporated business makes the same investment, the 

return is reflected in the company’s profits, not in its 

employees’ wages, and therefore is not included in the 

FICA tax base. Another difference is that when a person’s 

labor income exceeds net business income across all businesses (or portions thereof) owned by that person, the 

excess labor income is excluded from the SECA tax base. 

In contrast, for an incorporated business, profitability has 

no effect on the FICA tax liability of its owners. 

Those differences can affect an individual’s decision 

about whether to be self-employed or to work for somebody else. It can also influence the choice of how to 

organize a firm: A business owner’s capital income (and 

losses) will be taxed differently under the Social Security 

Act depending on whether the business incorporates. In 

both cases, the tax code can prompt people to make 

choices that they would not otherwise make, thereby 

reducing the efficient allocation of resources.

Both tax bases exclude a portion of labor income, but the 

FICA and SECA tax bases differ in the types of labor 

income that they exclude. Although the FICA tax base 

excludes employer-provided health insurance (a form of 

labor income), self-employed individuals generally cannot deduct from the SECA tax base the cost of the health 

insurance they purchase for themselves.4

 Also, partners 

whose liability for a partnership’s debts is limited to the 

amount they invested are not required to pay SECA 

taxes, regardless of how much labor they contribute, 

unless they receive “guaranteed payments” (that is, 

compensation for labor that is to be paid even if the 

partnership has no net income). In contrast, owners of 

incorporated businesses—those subject to the corporate 

income tax (C corporations) and those that pass their 

profits through to their owners (S corporations)—are 

required to include “reasonable compensation” for their 

labor in their FICA tax base (although many owners have 

an incentive to characterize as much compensation as 

they can as capital income to avoid that tax).5

The Definition of Self-Employment Income

Whether an owner of a small business is considered 

self-employed, and therefore is subject to the SECA tax, 

depends on the legal form in which his or her business is 

organized. The key distinction is between firms that are 

incorporated and those that are not. Owners of incorporated businesses are never considered self-employed for 

tax purposes. In contrast, owners of unincorporated businesses are generally considered self-employed.6

 (Members 

of the clergy are also subject to SECA taxes, even if they 

are considered church employees for income tax purposes.)

Among unincorporated businesses, a common distinction is between sole proprietorships and partnerships. 

Most owners are sole proprietors—that is, they own the 

entire business themselves. All net income from those 

businesses is considered self-employment income and 

thus is subject to SECA taxes. 

Unincorporated businesses with more than one owner are 

partnerships. A partnership reports its profits to the Internal Revenue Service (IRS) using Form 1065, but no 

income or SECA taxes are assessed at the partnership 

level. Instead, the partnership’s business and investment 

income are allocated, or “passed through,” to the partners. If a partner is an individual, pass-through income is 

taxed under the individual income tax in the same way as 

4. The Small Business Jobs Act of 2010 (P.L. 111-240) allowed selfemployed individuals to deduct from the SECA tax base—for 2010 

only—the cost of health insurance for themselves as well as their 

spouse, dependents, and children under age 27. For income tax 

purposes, they have generally been able to deduct a portion of their 

health insurance premiums since 1986, and all of them since 2003.

5. The Treasury’s regulations defining reasonable compensation 

include the following: “It is, in general, just to assume that 

reasonable and true compensation is only such amount as would 

ordinarily be paid for like services by like enterprises under like 

circumstances” (see www.taxalmanac.org/index.php/

Treasury_Regulations,_Subchapter_A,_Sec._1.162-7). That 

amount is not necessarily the market wage one would have to pay 

an employee, whose circumstances differ from an owner’s. Some 

people argue that business owners realize nonmonetary labor 

income from “being their own boss,” even after considering the 

extra stress that self-employment can entail, and that an employee 

would demand comparable compensation in monetary form. See, 

for example, Barton H. Hamilton, “Does Entrepreneurship Pay? 

An Empirical Analysis of the Returns to Self-Employment,” Journal of Political Economy, vol. 108, no. 3 (June 2000), pp. 604–631. 

6. Since 1997, most unincorporated businesses have had the rarely 

exercised option of being taxed as corporations. If that option is 

exercised, the business is subject to an entity-level corporate tax, 

and its owners are not considered self-employed. Also, because 

most publicly traded partnerships are required to be taxed as 

corporations, their partners are not considered self-employed.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 3

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Table 1.

Income Subject to SECA Tax

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act.

a. Includes partners in limited liability partnerships and members 

of limited liability companies whose interest in the firm is not 

basically of an investment nature.

b. A share of rental income is also included if the partner is 

engaged in the sale of real estate. A share of portfolio income is 

included if the partner is engaged in the sale of securities.

c. Includes partners in limited liability partnerships and members 

of limited liability companies whose interest in the firm is 

basically of an investment nature.

income from other sources. In some cases, the partner 

may be a corporation, in which case pass-through income 

is subject to the corporate income tax. Pass-through 

income (as well as certain deductions and credits) is 

divided into various items that are handled differently on 

the receiving partner’s tax return. Three of those items are 

potentially included in the SECA tax base:

 Guaranteed payments received as compensation for 

services provided by the partner;

 The partner’s proportional share of the partnership’s 

net business income (from which all guaranteed 

payments have been deducted); and

 The partner’s proportional share of rental and portfolio income (but only if it is received in the course of 

business as a dealer in real estate or securities).7

The tax code recognizes two different kinds of partners 

for purposes of calculating SECA taxes. General partners, 

who are fully liable for the debts of the partnership, must 

include all three of the above items in their tax base. In 

contrast, limited partners, who assume liability up to the 

amount of their investment, must include only guaranteed payments for services (see Table 1). 

Some self-employed people own all or part of more than 

one business. If so, they can use the losses of one or more 

of their unincorporated businesses to offset the gains 

from their other unincorporated businesses. Business 

losses cannot, however, reduce the SECA tax base 

below zero, nor can they be carried over to other tax years 

(as they can be for income tax purposes). If net selfemployment income is less than $400 in a given year, 

no SECA tax is due.

Defining the Roles of Partners

SECA tax liabilities depend not only on whether a taxpayer is a sole proprietor or a partner, but also, if a 

partner, on whether the taxpayer is a general or limited 

partner. The distinction between general and limited 

partners was introduced by the Social Security Amendments of 1977. Before then, all partners were treated as 

general partners are today. However, it is state laws—not 

the Social Security statutes or other federal laws—that 

define the difference between general and limited partners. State laws also recognize other types of business 

entities that may be treated as partnerships for federal 

income tax purposes, but those laws do not address 

whether the owners of such entities should be classified as 

general or limited partners for SECA purposes. Thus, 

changes in state laws regarding businesses’ organization 

have resulted in some confusion over the appropriate 

classification of partners’ income under SECA. 

Although the role of general partners has not changed, 

the legal concept of the limited partner has evolved over 

time. Since 1916, states have generally tried to maintain 

uniformity by adopting the Uniform Limited Partnership 

Act (ULPA), a model statute proposed by the National 

Conference of Commissioners on Uniform State Laws. 

The purpose of limited partnerships was to facilitate passive investing in a noncorporate environment. Hence, 

until 1985, ULPA did not permit limited partners to participate in control of a business—that role was reserved 

for general partners. The 1985 version of ULPA allowed 

limited partners to participate in certain management 

activities, and the 2001 version removed virtually all 

7. A partner’s “proportional” share generally refers to allocations 

based on his or her ownership share in the business. However, 

partnerships are free to allocate income among partners in any 

way they find mutually agreeable. In this report, the term “proportional share” covers all such allocations, whether or not they 

are actually proportional to anything. The term is synonymous 

with “distributive share”—the phrase used in the Internal Revenue 

Code even though it covers allocations that are retained by a firm 

rather than distributed.

Type of Ownership Interest Income Subject to Tax

Sole Proprietor Net business income

General Partnera Guaranteed payments and

share of net business incomeb

Limited Partnerc Guaranteed payments
4 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

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restrictions on the management activities of limited partners.8

 In the states that adopted that version, the primary 

distinction between general and limited partners (other 

than the liability aspect) is that only general partners 

can enter into binding contracts on behalf of the entire 

partnership.9

The creation of new types of entities, such as limited liability partnerships (LLPs), was not anticipated in the 

Social Security Amendments of 1977, upon which current law regarding the SECA tax base rests. In an LLP, 

no partner can be held liable for another partner’s fraud 

or negligence. Even though the liability shield is broad—

partners are shielded from the partnership’s liabilities as if 

it were a corporation—some states’ LLP statutes provide 

that a partner is not shielded from liability for his or her 

own actions. Most LLPs are found in the professional services industry (which includes, for example, medical, law, 

and accounting firms). The tax treatment of such partners is not explicitly addressed in Social Security laws. 

However, if a general partnership converted to an LLP, 

the partners previously classified as general partners 

would retain the corresponding SECA tax treatment even 

after the conversion. In 2011, the U.S. Tax Court ruled 

that limited liability partners who provide services on 

behalf of their firm could not be classified as limited 

partners for SECA tax purposes.10

More important than the changing role of limited partners under ULPA or the development of LLPs, however, 

is the rise of limited liability companies (LLCs)—an 

organizational form that provides liability protection similar to that of a limited partnership without restricting 

participation in management or the right to enter into 

contracts.11 Although LLCs had been established as early 

as the late 1970s, not until 1988 did the IRS definitively 

rule that LLCs could be taxed as unincorporated businesses rather than as corporations. Under current IRS 

rulings and regulations, LLCs are taxed as unincorporated 

businesses unless they specifically request to be treated as 

corporations, an option that few select. However, because 

members of multiowner LLCs are not classified under 

state laws as either general or limited partners—the types 

recognized in Social Security laws—their SECA tax treatment remains ambiguous. 

In 1997, the Department of the Treasury proposed regulations to clarify the definition of limited partners under 

SECA. The proposed 1997 regulations would have 

deemed any partner or LLC member to not be a limited 

partner (making his or her share of the partnership’s business income subject to the SECA tax) if the partner met 

one of the following conditions:

 Personal liability for the debts of the partnership;

 Authorization to enter into binding contracts on 

behalf of the partnership; 

 Contribution of more than a minor amount of labor 

by a service partner to a service partnership; or

 Contribution of more than 500 hours of labor per 

year to any other type of partnership.

Although those proposed regulations would have 

removed some of the ambiguity in the tax treatment of 

partners, they also would have subjected to SECA taxes 

more of the income of limited partners (as defined by 

state law) contributing more than 500 hours of labor. 

The proposed regulations were never finalized, and the 

Congress forbade the Treasury from engaging in rulemaking on the subject for a short period.12 Although that 

prohibition ended in 1998, the Treasury has indicated 

that it plans to wait for further legislative guidance before 

issuing new regulations. For many years, most tax practitioners believed they would not be challenged by the IRS 

if they followed the proposed 1997 regulations with 

8. Both the 1916 and 1976 versions of the Uniform Limited Partnership Act were eventually adopted by 49 states. As of July 

2012, 18 states and the District of Columbia had adopted the 

2001 version. For further updates, see National Conference of 

Commissioners on Uniform State Laws, “Legislative Fact Sheet—

Limited Partnership Act” (no date), http://uniformlaws.org/

LegislativeFactSheet.aspx?title=Limited%20Partnership%20Act.

9. American Bar Association, Section of Taxation, “Tax Rules Governing Self-Employment Income of Limited Liability Companies 

and Partnerships” (May 29, 2002), p. 2, www.americanbar.org/

content/dam/aba/migrated/tax/pubpolicy/2002/020529c

.authcheckdam.pdf. 

10. Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 7 

(2011).

11. Limited liability companies are now more common than general 

or limited partnerships. In 1994, only 3 percent of partnerships 

filing Form 1065 (representing 2 percent of partners) were LLCs. 

Ten years later, 50 percent of partnerships (representing 32 percent of partners) were LLCs. See David Wheeler and Nina 

Shumofsky, “Partnership Returns, 2004,” SOI Bulletin, vol. 26, 

no. 2 (Fall 2006), p. 111.

12. Section 935 of the Taxpayer Relief Act of 1997 (P.L. 105-34).
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 5

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respect to LLC members.13 The 2011 Tax Court decision 

involving an LLP’s SECA tax status did not follow those 

regulations, but it nevertheless gave greater weight to the 

contribution of labor than to liability exposure. Some tax 

professionals have warned LLCs that the opinion might 

apply to them as well.14

Incentives Created by SECA Tax 

Treatment

The current treatment of partnership income with 

respect to SECA taxes creates incentives to organize partnerships in ways that minimize tax liabilities—and, more 

rarely, maximize Social Security benefits. In addition, 

partners have an incentive to characterize their involvement in a business in ways that would reduce their tax 

liability. The extent to which labor income and capital 

income are included in the FICA and SECA tax bases can 

affect the choice between working for someone else or 

being self-employed.

Mischaracterizing Involvement with a Business

Most significantly, people have an incentive to be 

classified as limited partners, even if they are active in a 

partnership.15 The incentive is strongest for those whose 

combined wages and self-employment income exceed the 

OASDI ceiling, because income over the ceiling that 

they earn as general partners would be subject to the HI 

portion of the SECA tax but would not earn them any 

additional retirement benefits. The same incentive would 

apply to guaranteed payments they might earn as a limited partner, which would encourage them, in certain 

circumstances, to forgo such payments for their labor in 

favor of a larger proportional share of profits. Because 

there is no requirement that guaranteed payments represent reasonable compensation, such “SECA-averse” 

behavior is legal.

At the other extreme (and probably much less common), 

people with a partnership interest but little or no wages 

or self-employment income over the course of their career 

might become “Social Security seekers.”16 They would 

have an incentive to be classified as a general partner, 

even if they could qualify as a limited partner, because 

they would receive greater Social Security benefits. 

Whether a person became a Social Security seeker would 

depend on whether the accrual of retirement benefits 

through the Social Security system outweighed the risk of 

losses and liability inherent in being a general partner. As 

wages and self-employment income from other sources 

increased, the incentive to characterize passive partnership income as income subject to the SECA tax would 

diminish.

Influencing Employment Decisions

If employment decisions are affected by the tax treatment 

of labor income and capital income, resources in the 

economy will probably be allocated inefficiently. For 

example, a creative person might, solely for tax reasons, 

choose not to be self-employed and thus would have his 

or her creativity channeled toward the employer’s priorities rather than the person’s talents. Alternatively, tax 

considerations might lead a skilled worker with limited 

aptitude for independent work to be self-employed. That 

would divert the worker’s attention toward management 

tasks and away from the best use of his or her abilities.

The current FICA and SECA tax system creates incentives to become self-employed as well as incentives to 

work for another person. Including capital income in 

the SECA-HI tax base, for example, discourages selfemployment because it increases a person’s tax bill without generating any corresponding increase in Medicare 

benefits.17 The effect of including capital income in the 

13. Kiplinger Tax Letter, vol. 78, no. 13 (June 20, 2003).

14. Claire Y. Nash, “Partners’ Limited Liability and Self-Employment 

Tax,” The Tax Adviser (July 1, 2011), www.aicpa.org/Publications/

TaxAdviser/2011/July/Pages/nash_jul2011.aspx?action=print.

15. The fact that an individual can have a split interest in a partnership (part as a general partner and part as a limited partner) 

does not change the incentive. It merely provides a more subtle 

mechanism for manipulating tax liability.

16. Such behavior has been cited as a reason the Social Security 

Amendments of 1977 changed the treatment of limited partnership income; see Patricia E. Dilley, “Breaking the Glass Slipper—

Reflections on the Self-Employment Tax,” The Tax Lawyer, 

vol. 54, no. 1 (Fall 2000), p. 85.

17. Beginning in 2013, the Affordable Care Act requires taxpayers 

with adjusted gross income in excess of $200,000 ($250,000 for 

married taxpayers filing joint returns) to pay an “Unearned 

Income Medicare Contribution”—a tax that explicitly targets capital income such as interest, dividends, and capital gains. Despite 

its name, the tax is not allocated to the HI trust fund. Nevertheless, it increases the cost of investing in financial securities relative 

to the cost of investing in tangible business property and thus will 

probably make self-employment a more attractive option than it is 

now. Analysis of the effects of that legislation is outside the scope 

of this report. 
6 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

Table 2.

Distribution of the SECA Tax Base, by 

Type of Entity, 2004

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act; * = between 

zero and 0.5 percent.

a. Includes income from both general partners and limited 

partners in the limited partnership.

SECA-OASDI tax base is less clear: Although taxing such 

income results in higher expected Social Security benefits, 

the increase is not necessarily enough to encourage people 

to choose to be self-employed.18 Excluding labor income 

creates the opposite incentives. In particular, the ability to 

exclude labor income in excess of the net income of all of 

a taxpayer’s businesses from the SECA-HI tax base makes 

self-employment more attractive.

A Snapshot of the SECA Tax Base

In this report, the Congressional Budget Office (CBO) 

examines the SECA tax base in 2001 and 2004—two 

very different points in the business cycle. In early 2001, 

the economy was in a recession, and the unemployment 

rate rose throughout the year. As a share of national 

income, capital income—defined here as net interest, 

rental income, and corporate profits—was slightly 

smaller than average: 17.0 percent, compared with a post1928 average of 17.7 percent.19 In 2004, the economy 

was expanding, and the unemployment rate fell throughout the year. Capital income as a share of national income 

was slightly higher than average (18.1 percent). Despite 

those differences, many of the report’s findings are similar 

in both years. For that reason, the discussion focuses on 

the more recent data, referring to the earlier year only 

when the results differ substantially. The statistical snapshot in this section is presented for the tax base for the 

Hospital Insurance program—that is, the SECA-HI tax 

base, which is unconstrained by the ceiling for the 

OASDI tax.

Disaggregating the Tax Base

Between 2001 and 2004, the SECA-HI tax base grew 

from $328 billion to $385 billion.20 In 2004, most 

self-employment income was received by sole proprietors—that income (from both farm and nonfarm 

sources) constituted 69 percent of the SECA-HI tax base 

(see Table 2). About one-quarter of the tax base consisted 

of income from partnerships. The remaining 6 percent 

came from other sources (such as payments to clergy) 

or could not be linked to a type of entity.

CBO examined the tax bases of partnerships in three 

ways:

 By entity type—general partnership, limited 

partnership, LLC, LLP, and other;

 By degree of participation—material and nonmaterial; 

and

 By type of pass-through item—guaranteed payments 

and proportional shares of business and rental income.

18. This report adopts the convention of appending either “HI” or 

“OASDI” to “SECA” or “FICA” whenever the situation or 

conclusion being discussed applies only to that tax. Whenever 

references to the FICA or SECA tax bases are not specific to either 

the OASDI or HI taxes, the usual conventions (that is, simply 

“FICA” and “SECA”) are used. 

Nonfarm 68

Farm 1

General partnerships 5

Limited partnershipsa 2

Limited liability companies 9

Limited liability partnerships 7

Other partnerships *

Unknown type of partnership 1

6 ___

All Types of Entities 100

Other or Unknown (Including clergy’s wages)

Partners in or Members of:

Sole Proprietors

Tax Base

Percentage of

19. Shares were calculated from Table 1.12, “National Income by 

Type of Income,” of the national income and product accounts 

tables produced by the Bureau of Economic Analysis, available at 

www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1.

20. Because of the 7.65 percent exclusion to approximate the deduction for FICA taxes taken by employers, the SECA tax base is less 

than self-employment income. The latter was $355 billion in 

2001 and $418 billion in 2004.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 7

CBO

Figure 1.

Distribution of Partnership Income in the SECA Tax Base, by Type of Entity, 

2001 and 2004

(Percent)

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act.

Type of Entity. Although the share of the SECA tax base 

attributable to partnerships did not change between 2001 

and 2004, CBO found that the portion coming from 

LLCs and LLPs increased noticeably over that period. Of 

partnership income in the SECA tax base that could be 

attributed to an entity type in 2001, general partnerships 

provided the largest share (35 percent); LLCs had 29 percent, followed by LLPs (22 percent) and limited partnerships (12 percent). By 2004, however, LLCs provided the 

largest share (38 percent), followed by LLPs (31 percent); 

general partnerships fell to 21 percent and limited partnerships to 9 percent (see Figure 1). Those shifts are 

consistent with a well-documented trend, at the entity 

level, of growth in the importance of LLCs.21 (For net 

business income, that trend seems to have leveled off after 

2004, but it continued at least through 2007 with respect 

to the number of firms and businesses’ receipts.)

Degree of Participation. Partnership income can also be 

disaggregated by partners’ degree of participation in their 

business. Income received by “material participants” 

(defined primarily in terms of hours worked) is reported 

as “nonpassive,” whereas income received by “nonmaterial participants” is categorized as “passive.” Under 

current law, the material participation test is used for 

individual income tax purposes to distinguish between 

nonpassive losses, which can offset regular income, and 

passive losses, which can offset only passive income. That 

test, however, does not apply to the SECA tax base. In 

2004, about 90 percent of partnership income in the 

SECA tax base was classified as nonpassive and the rest 

was considered passive (see Table 3). 

2001 2004

0

20

40

60

80

100

General Partnerships

Limited Partnerships

Limited Liability Companies

Limited Liability Partnerships

Foreign Partnerships and

Other Types of Entities

21. Although the changes in shares of the SECA tax base attributable 

to general partnerships, limited partnerships, and LLCs mirror 

the changes in income shares at the entity level, the change in 

the SECA tax base attributable to LLPs is much greater than the 

corresponding change at the entity level; see Figure I in David 

Wheeler and Nina Shumofsky, “Partnership Returns, 2004,” SOI 

Bulletin, vol. 26, no. 2 (Fall 2006), p. 111. Also, the share of the 

SECA tax base attributable to other or unknown types of entities 

declined substantially between 2001 and 2004 for unknown reasons. Much of the unexplained increase in the share attributable to 

LLPs probably reflects the more complete assignment of entity 

types to individuals in 2004.
8 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

Table 3.

Distribution of Partnership Income 

in the SECA Tax Base, by Degree of 

Participation and Pass-Through 

Item, 2004 

Source: Congressional Budget Office.

Note: As specified in section 469 of the Internal Revenue Code, 

material participation is defined, for income tax purposes, 

primarily in terms of hours worked. It does not apply for 

Self-Employment Contributions Act (SECA) purposes.

Pass-Through Item. Partnership income can also be disaggregated among the three key pass-through items 

shown in Table 3. In 2004, more than three-quarters of 

the partnership income in the SECA tax base was passed 

through as the partner’s share of business income. 

Approximately 20 percent was passed through as guaranteed payments, CBO estimates, and the rest was passed 

through as rental income.

What Portion of Noncorporate Business Income 

Is Included in the SECA Tax Base?

Net noncorporate business income is part of the individual income tax base. Depending on the circumstances, 

however, only a portion of that income may be included 

in the SECA tax base. Treatment under those two tax 

bases may be similar for owners of some types of 

entities (for example, sole proprietorships and general 

partnerships) but dissimilar for others (such as limited 

partnerships). Differences can reflect statutory exclusions 

from the SECA tax or aggressive interpretations of 

ambiguous statutes and their application to different 

types of entities.22

Business Income of Profitable Sole Proprietorships.

Nearly all sole proprietorship income was subject to 

SECA and individual income taxes in 2004 . CBO found 

that almost 99 percent of net income attributable to profitable nonfarm sole proprietorships was included in the 

SECA tax base (see Table 4).23 Among farmers with positive net income, 92 percent of their income was included 

in the SECA tax base.

Income of Profitable Partnerships. Only about half of 

individuals’ income from profitable partnerships was 

included in the SECA tax base in 2004, in CBO’s estimation. The income omitted from the SECA tax base 

reflects, at least in part, an exemption under the statute 

that explicitly excludes certain limited partnership 

income from the SECA tax base. It also could reflect an 

aggressive minority of LLCs trying to take advantage of 

the uncertainty regarding their status by claiming that 

same exemption. To gain additional insight, CBO examined three key pass-through items individually as well as 

in total.

Guaranteed Payments. Under current law, guaranteed payments to partners who are individuals should be included 

in the SECA tax base, except payments received by limited partners for reasons unrelated to the personal services 

they provide to the partnership. CBO estimates that partners of profitable firms included 81 percent of guaranteed 

payments in their SECA tax base (see Table 5). The share 

was fairly uniform among entity types, varying (with one 

Degree of Participation

Material (Or nonpassive) 91

Nonmaterial (Or passive) 9 ____

All Degrees of Participation 100

Pass-Through Item

Guaranteed payments 21

Proportional share of business income 77

Proportional share of rental income 2 ____

All Identifiable Pass-Through Items 100

Partnership Income

Percentage of

22. The IRS has identified unincorporated businesses as a major 

source of noncompliance with the individual income tax, accounting for 80 percent of the $245 billion gross individual income tax 

gap in 2001. This report does not directly examine that phenomenon (although the results here are affected by negative business 

income, which is a common consequence of noncompliance). 

Instead, it focuses on the possibility that noncorporate business 

income as reported for income tax purposes might be improperly 

excluded from the SECA tax base. For more details on noncompliance, see Internal Revenue Service, Reducing the Federal Tax 

Gap: A Report on Improving Voluntary Compliance (August 2, 

2007), www.irs.gov/uac/Treasury,-IRS-Release-Report-onImproving-Voluntary-Compliance.

23. For sole proprietorships, firms reporting positive net income on 

Schedule C or F were deemed profitable. For partnerships, firms 

for which the sum of net business income, net rental income, and 

guaranteed payments, minus section 179 deductions, was positive 

were deemed profitable.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 9

CBO

Table 4.

Share of Net Income or Loss Included in the SECA Tax Base, by Type of 

Entity, 2004

(Percent)

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act; n.a. = not available (because partnership type and specific pass-through items are 

identified together).

a. Includes income from both general partners and limited partners in the limited partnership.

minor exception) between 74 percent and 92 percent for 

all types in both years.24

Proportional Shares of Business Income. Unlike guaranteed 

payments, the treatment of proportional shares of business income varies significantly by entity type. By statute, 

such income is excluded from the SECA tax base of limited partners. Furthermore, neither the statute nor IRS 

rulings have definitively addressed whether shares passed 

through to LLC members must be included in the SECA 

tax base. Overall, 64 percent of shares passed through 

from partnerships to individuals were included in the 

SECA tax base in 2004 (see Table 5). That percentage 

represents a slight decline from 2001. 

Among entity types, those proportions varied widely. 

Limited liability partners included the highest percentage 

of their proportional shares in their SECA tax base 

(89 percent—see Table 4); the shares distributed by limited partnerships were the least likely to be included in 

the SECA tax base (36 percent). Those figures are not 

zero primarily because limited partnership entities 

include people who are general partners (who must 

include their proportional shares in the SECA tax base) as 

well as individuals who are limited partners (who are not 

required to include that income in the SECA base). 

The data suggest that most members of LLCs, despite the 

possible opportunity to take a more aggressive position 

and behave like partners in limited partnerships, instead 

behave like partners in general partnerships. In 2001, the 

percentage of shares distributed by LLCs that were 

included in the SECA tax base was 64 percent, CBO 

estimates—5 percentage points lower than for general 

partnerships but 19 percentage points higher than for 

limited partnerships.25 In 2004, the corresponding figure 

for LLCs was 58 percent—8 percentage points 

Sole Proprietors

Nonfarm 99 11 99 11

Farm 92 16 92 16

Partners in or Members of:

General partnerships 66 16 45 17

Limited partnershipsa 36 6 32 6

Limited liability companies 58 16 52 15

Limited liability partnerships 89 18 86 19

Other partnerships 59 6 56 5

Unknown type of partnership n.a. n.a. 20 1

Positive Net Income

Entities with Entities with Entities with Entities with

Positive Net Income Net Loss Net Loss

Proportional Share of Business Income Only All Pass-Through Items 

24. The exception, occurring in 2001, was the relatively small “other 

partnerships” category (which consists primarily of foreign partnerships), in which only 59 percent of guaranteed payments were 

included in the SECA tax base. For the breakdown by entity type, 

see Congressional Budget Office, “Share of Partnership Income or 

Loss Included in the SECA Tax Base, by Type of Entity and PassThrough Item, 2001 and 2004,” supplemental material for The 

Taxation of Capital and Labor Through the Self-Employment Tax

(September 2012), Supplemental Table 12.

25. For the 2001 figures, see Congressional Budget Office, “Share of 

Net Income or Loss Included in the SECA Tax Base, 2001,” supplemental material for The Taxation of Capital and Labor Through 

the Self-Employment Tax (September 2012), Supplemental Table 4, 

column 1.
10 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

Table 5.

Share of Partnership Income or Loss 

Included in the SECA Tax Base, by 

Degree of Participation and 

Pass-Through Item, 2004

(Percent)

Source: Congressional Budget Office.

Note: As specified in section 469 of the Internal Revenue Code, 

material participation is defined, for income tax purposes, 

primarily in terms of hours worked. It does not apply for 

Self-Employment Contributions Act (SECA) purposes.

lower than for general partnerships but 22 percentage 

points higher than for limited partnerships (see Table 4).

Rental Income. Rental income is subject to SECA taxes 

only if it is received by a real estate dealer as a result of a 

business transaction. Because most rental income is 

received by passive investors, only about 10 percent of it 

shows up in the SECA tax base, CBO estimates (see 

Table 5). 

All Pass-Through Income. Overall, limited liability partners included the highest percentage of their income in 

the SECA tax base—more than 80 percent in both years, 

according to CBO (see Table 4). That outcome largely 

reflects the fact that LLPs do not typically invest in real 

estate. In contrast, partners in limited partnerships 

included relatively little of their income (about 32 percent in 2004) in the SECA tax base. (Partners in entities 

that could not be identified actually included an even 

lower percentage, which suggests that they probably are 

limited partners.)

Among other types of partnerships, the share of total 

income included in the SECA tax base depended largely 

on the sources of that income. Partners in general 

partnerships included a higher percentage of their income 

in the SECA tax base in 2001 than did LLC members, 

but the reverse was true in 2004 (compare column 3 in 

the body of Table 4 with that of Supplemental Table 4). 

That change reflects a shift in what types of income were 

passed through to partners between the two years. 

Among members of general partnerships, only rental 

income increased between 2001 and 2004, while the 

business income of LLC members almost doubled. 

Sole Proprietorship and Partnership Losses. The losses 

of unprofitable sole proprietorships and partnerships 

affect the SECA tax base when they are used to partially 

offset income from other (profitable) businesses. If there 

is no other business income to offset, losses are simply 

excluded from the SECA tax base. CBO estimates that 

in 2004 only 11 percent of the losses of nonfarm sole 

proprietorships and 16 percent of the losses of farm sole 

proprietorships were used to partially offset other selfemployment income (see Table 4). The figures for general 

partnerships, LLCs, and LLPs were slightly higher, ranging between 15 percent and 19 percent. For limited 

partnerships and other (mostly foreign) partnerships, a 

lower percentage of losses, ranging between 5 percent 

and 6 percent, were used to offset other income. 

Comparing Labor and Capital Income 

in the FICA and SECA Tax Bases

CBO estimates that labor’s share of the SECA-HI tax 

base was 58 percent in 2004 (see Table 6). To derive that 

estimate, CBO defined labor income as the portion of an 

owner’s business income that would properly be subject 

to the FICA-HI tax if the business was incorporated. By 

law, that amount must represent “reasonable compensation.” The remaining amounts of the SECA tax base are 

attributed to capital.26

CBO also compared the way in which labor and capital 

income of the self-employed is treated with how that 

income would have been treated if the same people 

worked for others and were covered by FICA. CBO 

estimates that 65 percent of capital income of the selfemployed was included in the SECA-HI tax base in 2004 

(see Table 7); none of that income would have been 

included in the FICA tax base. In contrast, only 44 percent of labor income of the self-employed was included 

in the SECA-HI tax base in 2004—the remaining

Degree of Participation

Material (Or nonpassive) 65 8

Nonmaterial (Or passive) 15 5

Pass-Through Item

Guaranteed payments 81 15

Proportional share of business income 64 14

Proportional share of rental income 10 13

All Pass-Through Items (Including unknown) 49 7

with Net With Net

Income Loss

Entities Entities

26. If labor income exceeds business income, however, the negative 

difference is not necessarily attributed to capital. That situation is 

discussed in more detail below.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 11

CBO

Table 6.

Taxable Labor Income as a Share of 

the SECA Tax Base, by Type of Entity, 

2004

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act.

a. Includes income from both general partners and limited 

partners in the limited partnership.

 56 percent would have been included in the FICA tax 

base if the self-employed had worked for someone else. 

On balance, the exclusion of more than half of labor 

income from the SECA-HI tax base and the inclusion of 

more than half of capital income in that tax base probably 

encouraged people to choose self-employment over working for another person. The aggregate SECA-HI tax base 

was 76 percent of the hypothetical FICA-HI tax base that 

self-employed workers would otherwise face—that is, 

total labor income. (That percentage is computed by 

dividing the last row of Table 7, column 1, by the last row 

of Table 6; that is, 44/58 = 76 percent.)27 The difference 

between the FICA-HI and SECA-HI tax bases, however, 

is explained by the opportunity to exclude the portion of 

labor income that exceeds the net income of all of a taxpayer’s businesses. Without that offset, the SECA-HI tax 

base of taxpayers reporting positive self-employment 

income would have been roughly 5 percent greater than 

the hypothetical FICA-HI tax base.

In this analysis, CBO assumed that the alternative to 

being self-employed was working for someone else and 

that people who worked for someone else would not 

receive employer-provided health insurance. Data limitations prevented CBO from examining the labor income 

of the self-employed that is included in the SECA tax 

base but that would have been excluded from the FICA 

tax base if they had worked for someone else. Employers’ 

contributions for health insurance are the most common 

form of labor income that is excluded from the FICA tax 

base. However, health insurance payments made by owners of unincorporated businesses on their own behalf are 

not excluded from the SECA tax base. Measuring the 

health insurance premiums included in the SECA tax 

base would reveal how much labor income would have 

been excluded had the self-employed worked for someone 

else and received health insurance—but that estimation 

requires information that is not available from tax data.28

Measuring Total Labor Income

For people who are not self-employed, the distinction 

between labor income and capital income appears 

straightforward—wages and benefits are labor income, 

and interest, dividends, rents, and capital gains are capital 

income.29 In this analysis, CBO assumes that the FICA 

tax base consists entirely of labor income and that all 

labor income from working for someone else (except 

27. The 44 percent from Table 7 represents SECA labor income 

divided by total labor income. The 58 percent from Table 6 

represents SECA labor income divided by SECA total income. 

Dividing 44 by 58 is the equivalent of SECA total income divided 

by total labor income (which is equal to 76) and also to SECA 

total income divided by FICA total income because FICA total 

income equals total labor income.

Sole Proprietors

Nonfarm 65

Farm 64

Partners in or Members of:

General partnerships 43

Limited partnershipsa 34

Limited liability companies 53

Limited liability partnerships 20

Other partnerships 18

All Types of Entities (Excluding unknown) 58

Entity's Tax Base

Percentage of

28. Although self-employed people can deduct health insurance 

expenses on their income tax return, that line item includes 

expenses of certain S corporation shareholders and excludes 

amounts paid during months in which the beneficiary was also 

covered by an employer’s plan (or by the plan of a spouse’s 

employer). The deduction amounted to less than 5 percent of the 

SECA tax base in 2004. On the FICA side, figures from the 

national income and product accounts published by the Bureau of 

Economic Analysis indicate that approximately 7 percent of labor 

income (in the form of employer-provided health insurance 

benefits) was excluded from that tax base in 2004.

29. Economists generally agree that wages reflect more than just the 

return on pure labor. For example, a portion of wages may represent the return on knowledge and skills obtained through education and experience—what is often referred to as “human capital.” 

See Jacob Mincer, “Investment in Human Capital and Personal 

Income Distribution,” Journal of Political Economy, vol. 66, no. 4 

(August 1958), pp. 281–302. For some people, such as celebrities, 

a portion of their wages can be a return on their fame—a form of 

intangible capital analogous to a company’s brand name. In this 

report, CBO uses the FICA-HI tax base as the definition of labor 

income, which includes the wages that are attributable to a return 

on human capital as well as to a return on other intangible assets. 
12 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

Table 7.

Shares of Capital and Labor Income Included or Not Included in the SECA-HI 

Tax Base, by Type of Entity, 2004

(Percent)

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act; HI = Hospital Insurance (Medicare Part A).

a. Includes income from both general partners and limited partners in the limited partnership.

employers’ contributions for health insurance) is subject 

to FICA taxes.30

For people who are self-employed, the distinction 

between labor income and capital income is less clear. If 

asked, most such taxpayers probably would not be able 

to identify which portion of their self-employment 

income represents wages and which is a return on capital 

investments. And although various groups have proposed 

ways to modify the SECA tax base, research on the 

Sole Proprietors

Nonfarm 94 6 5 1

Farm 82 18 10 9

Partners in or Members of:

General partnerships 34 66 4 62

Limited partnershipsa 30 70 2 68

Limited liability companies 48 52 2 50

Limited liability partnerships 88 12 1 12

Other partnerships 17 83 1 82

All Types of Entities (Excluding unknown) 65 35 3 32

Sole Proprietors

Nonfarm 57 43 27 16

Farm 29 71 19 51

Partners in or Members of:

General partnerships 24 76 28 48

Limited partnershipsa 16 84 10 74

Limited liability companies 21 79 23 56

Limited liability partnerships 54 46 14 32

Other partnerships 9 91 83 7

All Types of Entities (Excluding unknown) 44 56 27 29

SECA-HI Tax Base Total Negative Nonlabor Income Income on Schedule SE

Capital Income

Labor Income

Included in the

Reported as

Self-Employment Income on

Schedule SE, but Offset by Self-Employment

Not Reported as

Not Included in the SECA-HI Tax Base

30. One study found a small amount of capital income in the FICA 

tax base in the case of certain owners of privately held C corporations seeking to avoid corporate income taxes. That income 

was not considered in this analysis. See Nicholas Bull and Paul 

Burnham, “Taxation of Capital and Labor: The Diverse Landscape by Entity Type,” National Tax Journal, vol. 61, no. 3 

(September 2008), p. 416.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 13

CBO

relative contributions of labor and capital to selfemployment income is sparse.31

In this report, CBO estimates labor income for the 

owners of sole proprietorships and partnerships in the 

following way: 

 Identifying businesses that are required to report the 

reasonable compensation (a proxy for labor income) of 

their owners, 

 Using those businesses to statistically estimate the relationship between reasonable compensation and other 

factors (such as industry and gross receipts) that are 

reported by unincorporated businesses, and 

 Imputing reasonable compensation to unincorporated 

businesses as if those same relationships applied to 

them. (A more detailed discussion of the methodology 

can be found in Appendix A.) 

The experiences of S corporations provide some information on reasonable compensation.32 Although they are 

taxed as pass-through entities, like sole proprietorships 

and partnerships, S corporations are required to report 

the reasonable compensation of their owners. Shareholders in such entities are not considered self-employed, so 

their shares of the company’s profits are not subject to the 

SECA tax (although they are subject to the individual 

income tax). Instead, amounts reported as “compensation 

of officers” are subject to FICA taxes, just as if the owner 

were an employee.

Although amounts reported by corporations as compensation of officers are supposed to represent reasonable 

compensation, the reported amounts cannot be equated 

to labor income because most S corporations have an 

incentive to misreport that amount. Reporting compensation of officers that is below labor income results in 

lower FICA taxes for the owners. By minimizing compensation, owners maximize their profits. A taxpayer who 

is the sole owner of an S corporation could achieve that 

result by claiming that the fair market value of his or her 

services was lower than it actually is.33

How multiowner S corporations respond to the incentive 

to report compensation of officers that is less than labor 

income depends on the number of owners and their 

respective roles. If all owners contribute services roughly 

in proportion to their ownership shares, the incentive is 

to report compensation that is less than labor income 

regardless of the number of owners. However, if one 

owner performs a share of the services that is disproportionate to his or her ownership share, the incentives 

would be mixed. Avoiding the FICA tax remains a priority, but so is receiving fair compensation for services 

performed (see Box 1). 

CBO estimated that underreporting by S corporations 

declined as the number of owners increased from one to 

six. Underreporting was not observed in CBO’s estimates 

among S corporations with six or more owners. When 

imputing total labor income to sole proprietorships and 

partnerships, CBO based the imputation on the relationship between compensation of officers and characteristics 

of the business for S corporations, correcting for the 

underreporting found in the S corporation data. 

31. The lack of empirical evidence reflects both methodological and 

conceptual challenges. Most researchers do not have access to data 

that could provide information on the labor and capital components of self-employment income. Tax analysts also differ as to 

which items should be characterized as labor income and which as 

a return on capital. For example, many managers of investment 

funds receive a portion of their compensation in the form of a 

share of profits known as “carried interest.” For tax purposes, carried interest received by general partners is treated as investment 

income not subject to the SECA tax. Tax experts disagree, though, 

on the nature of carried interest. The carried interest of fund managers has been characterized as labor income by people who object 

to its treatment as capital gains (see Victor Fleischer, “Two and 

Twenty: Taxing Partnership Profits in Private Equity Funds,” New 

York University Law Review, vol. 83 [2008]) and as capital income 

by people who defend the current treatment (see David Weisbach, 

“The Taxation of Carried Interests in Private Equity,” Virginia 

Law Review, vol. 94, no. 3 [May 2008]).

32. S corporations are legally indistinguishable from other corporations except in the way they are taxed under federal law (and the 

law of most states)—namely, they are not subject to the corporate 

income tax but rather pass their income through to their owners. 

Those owners may number no more than 100 and may not 

include other for-profit businesses or nonresident aliens.

33. Privately held C corporations (that is, corporations that are subject 

to the corporate income tax) also face incentives to misreport reasonable compensation. In the case of C corporations, however, the 

underreporting of reasonable compensation not only reduces the 

FICA taxes of owners but also increases corporate income tax liability (because the business will have fewer expenses to deduct). 

The two somewhat offsetting incentives presented by the corporate income tax would never be faced by sole proprietorships or 

partnerships. Therefore, the statistical analysis focused solely on 

S corporations.
14 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

Continued

Box 1.

How the Number of Owners Affects Incentives to Mischaracterize Labor 

Income Under a Reasonable Compensation Standard

The intent of the reasonable compensation standard 

that applies to owners of S corporations is to subject 

labor income to Federal Insurance Contributions Act 

(FICA) taxes but to exclude capital income. One 

practical result of the standard is to provide owners of 

S corporations with an incentive to mischaracterize 

labor income as capital income, thereby minimizing 

their FICA tax liability. Single-owner firms can 

respond to that incentive without constraint (other 

than enforcement by the Internal Revenue Service). 

Multiowner firms, however, face some internal 

constraints on such behavior that limit their opportunities to mischaracterize income. Those constraints 

are a function of the number of owners and the 

extent to which the labor contribution of those owners is similar to their capital contributions. The two 

examples below illustrate contrasting cases when a 

firm has two owners.

Mary and John are owners of an S corporation that 

earns $100,000 in a year, half of which is paid out in 

labor costs (compensation of officers and FICA taxes) 

and half of which is passed through to the owners as 

profits. Mary owns 80 percent of the shares and 

receives a corresponding share of the passed-through 

profits. John contributes 80 percent of the labor and 

is compensated accordingly. Each owner can leave the 

company if dissatisfied with his or her share of the 

combined return on capital and labor. When income 

is properly characterized, Mary’s after-tax income is 

$36,257, and John’s is $32,526 (see the top panel of 

the table). 

Mischaracterizing labor income as capital income 

would increase their combined after-tax income from 

$68,783 to $75,000, but one of the two owners 

would be worse off. John’s after-tax income would 

drop by more than half, whereas Mary’s would nearly 

double. It is impossible in those circumstances to 

mischaracterize the nature of the income without 

causing John’s after-tax income to decline. It would 

not be in John’s self-interest to go along with a plan 

that did not accurately characterize the nature of the 

income for each owner. 

In contrast, if both Mary and John owned 50 percent 

of the shares and contributed 50 percent of the labor, 

then all income could be characterized as a return on 

capital, and both Mary and John would be equally 

better off (see the bottom panel of the table). With 

labor income mischaracterized as capital income, the 

combined after-tax income of the two owners would 

increase by $6,218—with each owner receiving half 

of that amount ($3,109). In that scenario, both 

owners would be better off if they claimed that all of 

their income was derived from capital.

The difference between the two examples is the disparity between labor and capital contributions—a 

difference of 60 percentage points in the first example 

(an 80-20 split) and none in the second example (a 

50-50 split). How disparate can the labor and capital 

contributions be before it becomes impossible to 

make both owners better off? In this particular case—

a very special one in which there are only two owners 

and each owner receives the same before-tax 

income—the greatest such disparity is slightly less 

than 10 percentage points. Specifically, when Mary 

provides 54.52 percent of capital and 45.48 percent 

of labor, mischaracterizing labor income makes her 

better off by $6,539 but makes no difference for 

John. Examples with more owners, or examples in 

which owners receive differing amounts of before-tax 

income, will have different break-even points than 

this example. Nevertheless, the fundamental principle 

still holds—namely, that mischaracterization is easier 

when each owner contributes shares of labor and capital to the firm that are roughly equal to one another.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 15

CBO

Box 1. Continued

How the Number of Owners Affects Incentives to Mischaracterize Labor 

Income Under a Reasonable Compensation Standard

Income of Owners of a Two-Person S Corporation Under Two Scenarios

(Dollars)

Source: Congressional Budget Office.

Notes: For simplicity, this example assumes a 25 percent income tax rate and no other income or deductions. Employees and 

employers each pay 7.65 percent of wages in FICA taxes.

FICA = Federal Insurance Contributions Act.

9,289 37,157 0 0

711 2,843 0 0

40,000 10,000 80,000 20,000 ______ ______ ______ ______

Total Before-Tax Income 50,000 50,000 80,000 20,000

2,322 9,289 0 0

10,000 2,500 20,000 5,000

FICA Tax (Employer's and employee's shares) 1,421 5,685 0 0 ______ ______ ______ _____

Total Tax Liability 13,743 17,474 20,000 5,000

After-Tax Income 36,257 32,526 60,000 15,000

23,223 23,223 0 0

1,777 1,777 0 0

25,000 25,000 50,000 50,000 ______ ______ ______ ______

Total Before-Tax Income 50,000 50,000 50,000 50,000

5,806 5,806 0 0

6,250 6,250 12,500 12,500

FICA Tax (Employer's and employee's shares) 3,553 3,553 0 0 ______ ______ ______ ______

Total Tax Liability 15,609 15,609 12,500 12,500

After-Tax Income 34,391 34,391 37,500 37,500

Income When Owners’ Labor Contributions

Differ from Their Capital Contributions

Individual Income Tax

On wages

On passed-through profits

Are the Same as Their Capital Contributions

Income When Owners’ Labor Contributions

From wages (Officers’ compensation)

Employer’s share of FICA

From passed-through profits

John

Mischaracterization of Income

Before-Tax Income

Proper Characterization of Income

Mary John Mary

Individual Income Tax

On wages

On passed-through profits

Before-Tax Income

From wages (Officers’ compensation)

Employer’s share of FICA

From passed-through profits
16 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

The estimates of labor income in CBO’s analysis are 

somewhat uncertain, however. Some of that uncertainty 

is common to other studies using similar statistical 

techniques. The results are also sensitive to some of the 

underlying assumptions used in this analysis. For 

example, CBO assumed that sole proprietorships and 

partnerships have the same characteristics as S corporations that are in the same industry and of similar size. 

However, the corporate structure of such firms may make 

them inherently different from unincorporated firms.

Calculating Labor’s Share of the SECA Tax Base 

When Labor Income Exceeds Net Business Income

Estimates of the share of labor income that is included in 

the SECA tax base depend on the treatment of losses. In 

most cases, net business income is positive and exceeds 

the amount of labor income attributed to a sole proprietorship or partnership. In those cases, nonlabor income 

is positive and can be interpreted as capital income. 

When net business income is negative (that is, when the 

firm’s expenses exceed its receipts), nonlabor income is 

also negative. Even when net business income is positive, 

it is occasionally less than estimated labor income, which 

also means that nonlabor income is negative. 

The interpretation of those negative measures of nonlabor income is not straightforward and presents 

challenges for calculating labor’s share of the tax base. For 

example, the tax code sometimes allows losses that are not 

truly economic. One such instance is when small businesses are allowed to deduct the full costs of equipment 

immediately, rather than over the lifetime of the asset. 

Attributing losses caused by such deductions entirely to 

capital would overstate labor’s share of the SECA tax base. 

To avoid such overstatements, CBO adopted a rule that 

was designed to minimize the differences between the 

FICA and SECA tax bases—namely, that for each taxpayer, labor income is summed across all entities and 

added to the tax base first (conforming to FICA procedures). If nonlabor income summed across all entities is 

positive, then it is attributed to capital and added to the 

tax base without any adjustment to labor income. If total 

nonlabor income is negative, however, labor income is 

reduced by that amount and nothing is attributed to 

capital. (The implications of that rule with respect to the 

results presented below are examined in Appendix B.)

Shares of Income from Labor and Capital 

CBO allocated three different measures of noncorporate 

business income between labor and capital. As the 

income measure narrowed, the share attributable to labor 

income increased (see Figure 2). In 2004, the shares 

derived from labor were as follows:

 52 percent of the positive amount included in 

adjusted gross income for income tax purposes,

 58 percent of the amount subject to the HI tax, and 

 73 percent of the amount subject to the OASDI tax.34

CBO found that labor income represented a higher 

share of the SECA-HI tax base for sole proprietors than 

for partners. Among partners in different types of 

partnerships, the split between labor and capital income 

varied considerably, according to CBO’s estimates. In 

2004, 65 percent of the SECA-HI tax base for nonfarm 

sole proprietors was derived from labor (see Table 6). For 

farm sole proprietors, labor’s share was virtually the 

same—64 percent. Among partners, the share of labor 

income was highest for LLC members—53 percent. 

For partners in general partnerships, 43 percent of the 

SECA-HI tax base was labor income. For partners in the 

remaining types of entities, labor’s share was less than 

35 percent. That finding is not surprising in the case of 

partners in limited partnerships (34 percent), given the 

traditional restrictions on material participation (which 

gives rise to labor income) by limited partners. 

However, the low share of labor income in the SECA-HI 

base for limited liability partners (20 percent) may seem 

34. Many studies have assumed that 65 percent of proprietors’ income 

comes from labor. In its analysis of macroeconomic activity, CBO 

has relied on that figure. The labor shares estimated in this report, 

however, are shares in a tax base and thus are not directly comparable to labor shares of proprietors’ income generally. If methods 

used to impute labor income in this report were extended to all 

proprietors’ income, they would generate a labor share between 

48 percent and 63 percent. That is lower than the assumption of 

65 percent used in other studies largely because the derivation of 

that figure implicitly treats income attributable to partners that 

are not individuals differently than such income was treated in 

this analysis.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 17

CBO

Figure 2.

Labor and Capital Shares of the Business Income of Profitable Sole 

Proprietorships and Partnerships in Various Tax Bases, 2004

(Billions of dollars)

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act; HI = Hospital Insurance (Medicare Part A); OASDI = Old-Age, Survivors, and Disability 

Insurance.

surprising considering that most partners in those 

entities are very involved in the day-to-day operation of 

their business. Much of the explanation lies in the high 

gross income of LLPs, which are found largely in the 

professional services industry. Evidence from CBO’s 

analysis of S corporations indicates that labor income 

increases as gross receipts rise, but at a slower rate. As a 

result, labor’s share of income could be expected to be 

smallest among partnerships with the highest gross 

receipts. In 2004, LLPs averaged $1.6 million in gross 

receipts, and all other partnerships averaged $0.4 million.35 Despite the small labor percentage, however, 

average labor income per partner was twice as high for 

LLPs as for any other type of partnership. Furthermore, 

LLPs had the highest net income per partner of all the 

entity types, despite not having a disproportionate share 

of assets on their books. The most likely explanation for 

those results is that the net income of LLPs mostly represents a return on intangible capital, such as the reputation 

of the brand, research and development, and established 

institutional procedures (for example, having templates 

for legal documents).

Comparing the FICA and SECA Tax Bases

Three different measures of the components of noncorporate business income provide insight into the extent 

to which the SECA-OASDI and -HI tax bases deviate 

from the standards of the corresponding FICA tax bases: 

 The percentage of the labor component that is 

included in the HI tax base (100 under FICA, 

assuming no employer-paid health insurance), 

 The percentage of the capital component that is 

included in the HI tax base (zero under FICA), and

Income Tax SECA-HI SECA-OASDI

0

100

200

300

400

500

600

52%

48%

58%

42%

73%

27%

Labor

Capital

35. Because of the limit on the number of owners an S corporation 

can have, the sample of S corporations used to calibrate the imputation of labor income did not have any firms with gross receipts 

as high as those of the largest partnerships (including many LLPs). 

Thus, the resulting imputation of labor income to partnerships 

with high gross receipts could reflect insufficient information 

about the proper relationship of labor and gross receipts at that 

level.
18 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

 The percentage of the capital component that is 

included in the OASDI tax base (also zero under 

FICA).36

In 2004, approximately 65 percent of capital income was 

included in the SECA-HI tax base (see Table 7). For sole 

proprietors and limited liability partners, that figure 

exceeded 80 percent. For owners of all other types of 

partnerships, however, the figure was less than 50 percent. Only 3 percent of capital income was offset by 

negative nonlabor income, and almost one-third was not 

accounted for on Schedule SE (the form on which SECA 

tax liability is calculated). When only income below the 

OASDI ceiling was considered, the share of capital 

income included in the tax base dropped to 26 percent 

(see Table 8).

Unlike the FICA-HI tax base, which includes all labor 

income, the SECA-HI tax base includes less than half 

(44 percent in 2004) of the labor income from unincorporated businesses, CBO estimates. Only nonfarm sole 

proprietors and limited liability partners included 

more than half of their labor income in the SECA-HI 

base; owners of all other entity types included less than 

30 percent of their labor income (see Table 7). Offsetting 

negative income accounted for more than 45 percent of 

the labor income excluded from the SECA-HI tax base.37

Overall, the SECA-HI tax base was roughly 76 percent 

of what the FICA tax base would have been if owners 

had been taxed on their correctly reported reasonable 

compensation (see footnote 27 for the derivation of that 

number). That percentage varies considerably by entity 

type, however. The SECA-HI tax bases for partners in 

limited partnerships, LLC members, and farm sole proprietors were each less than half of the corresponding 

FICA tax base. For partners in LLPs, in contrast, the 

SECA-HI tax base was more than double what it would 

have been under FICA.

Alternative Options for Defining the 

SECA Tax Base

The SECA tax base could be modified in a number of 

ways. The following options would either clarify the tax 

treatment of different types of partnerships or include less 

capital income in the SECA tax base (and make the 

SECA tax base more similar to the FICA tax base in that 

regard). The options use three different approaches to 

measure self-employment income. One of those 

approaches, a material participation standard, would 

standardize the SECA tax base across different types of 

partnerships. The other two approaches, a reasonable 

compensation standard and a safe-harbor exclusion for 

capital, would seek to reduce capital income in the tax 

base—the former by focusing on a more accurate measure of labor income, and the latter by allowing taxpayers 

to use a simple rule for calculating excludable capital 

income. 

Although those approaches have been combined in some 

proposals, CBO analyzed each approach separately. The 

three approaches were based on options described in publications of the staff of the Joint Committee on Taxation, 

the American Institute of Certified Public Accountants, 

and the American Bar Association’s Section of Taxation. 

(See Appendix C for details.) Other approaches and 

combinations of approaches are also possible.

All of the estimates presented below assume that the 

options—if enacted—would not affect the supply of 

labor or the rate of saving. Such effects might well occur, 

but they would probably be noteworthy only in the 

case of the reasonable compensation standard. CBO did 

consider various other behavioral responses, some qualitatively and others quantitatively: how taxpayers would 

characterize their self-employment income (as labor or 

capital), how they would characterize their partnership 

participation (as material or nonmaterial), and how firms 

36. The percentage of the labor component subject to the OASDI tax 

is not measured. Unlike the HI tax, the OASDI tax is capped, so 

labor income in excess of the OASDI maximum is not taxed. The 

difference between the respective labor components of the FICA 

and SECA tax bases probably results from differences between 

wage earners and self-employed people in the distribution of 

earnings above and below the OASDI maximum rather than differences in the way labor income is taxed under FICA and SECA. 

37. That percentage is computed from values in the last row of the 

labor income panel of Table 7: Specifically, the amount in 

column 3 (27 percent) is divided by the amount in column 2 

(56 percent). Those results are very sensitive to how negative 

income is handled in the calculation. CBO deemed capital and 

labor income that is offset by negative nonlabor income to be 

excluded from the SECA tax base, even if that income was 

reported by an entity whose net income was accounted for on 

Schedule SE (see Appendix B for more details). Such offsets are 

not available under the FICA tax, so including such income in the 

SECA tax base would obscure a major difference between the two 

tax bases. 
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 19

CBO

Table 8.

Shares of Labor and Capital Income Included in the SECA Tax Base Relative to the 

FICA Tax Base, 2004 

(Percent)

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act; FICA = Federal Insurance Contributions Act; HI = Hospital Insurance (Medicare 

Part A); OASDI = Old-Age, Survivors, and Disability Insurance.

a. Specifically, the tax base of employees with no employer-provided health insurance.

would allocate their investments (between tangible and 

intangible assets).

The Material Participation Standard

The income tax code treats owners who are material 

participants (that is, actively involved in a firm’s 

management) differently than nonmaterial (or passive) 

participants for purposes of allowing business losses. In 

this option, material participants—regardless of a firm’s 

form of organization—would be treated the way general 

partners are under current law, and nonmaterial participants would be treated the way limited partners are under 

current law. By applying the same test to all multiowner 

entities, this option would clarify the SECA tax obligations of limited partners and LLC members.

The primary test for material participation is whether an 

individual engages in the operation of a business for more 

than 500 hours during a given year. If the person is the 

primary or only participant in operating the company, 

lower hourly thresholds apply. Furthermore, if the person 

has met any of the applicable criteria in 5 of the past 

10 years (3 in the case of personal service partnerships), 

then he or she is deemed a material participant in the 

current year as well.38

This option would impose SECA taxes on the passedthrough share of the business income of limited partners 

who are material participants, thereby capturing the labor 

income associated with their material participation.39

However, the option would exempt the passed-through 

share of business income of general partners who are not 

material participants—amounts that presumably would 

primarily include capital income. Among limited partnerships and LLCs that currently follow the regulations 

proposed by the Treasury in 1997, it is unlikely that any 

partners would have more of their income subject to the 

SECA tax under this option. Some partners, however—

specifically, LLC members who provide fewer than 

500 hours of labor but who have the authority to sign 

binding contracts on behalf of the company—would 

have less income subject to the SECA tax.

Effects on the Tax Base. Replacing the distinction 

between general and limited partners with a material 

100 0 0

Under current law 44 65 26

Under a material participation standard 45 69 27

Under a reasonable compensation standard 34 0 0

Under a safe harbor for capital 42 62 25

Share of Capital Income

Included in the HI Tax Base HI Tax Base OASDI Tax Base

Share of Labor Income

FICA Tax Basea

SECA Tax Base

38. “Personal service partnerships”—–the term used in the regulations—are essentially partnerships in what is referred to as the 

professional services industry elsewhere in this report. The details 

of the test for material participation can be found at Internal Revenue Service, “Passive Activity Loss ATG—Exhibit 4.1: Material 

Participation” (December 2004), www.irs.gov/businesses/small/

article/0,,id=146837,00.html. 

39. Under current law, the material participation standard is lower 

for real estate rental activity than for other activities. Qualifying 

under that lower standard does not conform to the spirit of this 

standard for SECA tax purposes—it would include income properly classified as passive in the tax base. Therefore, under this 

option, no passed-through real estate rental income in excess of 

what was already included under current law was deemed to be 

subject to the SECA tax. 
20 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

participation standard would have increased the 

SECA-HI tax base, on net, by approximately 3 percent in 

2004, CBO estimates.40 The income of material participants that was added to the SECA tax base would have 

exceeded the newly excluded income of nonmaterial participants—largely because the income of nonmaterial 

participants who are not limited partners is generally not 

reported on Schedule SE, despite the requirement that it 

be included in the SECA tax base. For example, only 

about 14 percent (or $3 billion) of the income of passive 

general partners was accounted for on Schedule SE in 

2004, in CBO’s estimation.41 Excluding that $3 billion 

under the material participation standard would have 

been more than offset by including the nonpassive 

income of limited partnerships and LLCs under the 

standard.

Effects on the Taxation of Capital Income. Under the 

material participation standard, the amount of capital 

income of material participants that became subject to 

the SECA tax would exceed the capital income of nonmaterial participants that would no longer be taxed. 

Overall, CBO estimates, the share of such income 

included in the SECA-HI tax base would have increased 

from 65 percent to 69 percent in 2004 (see Table 8). 

Only among partners in general partnerships would the 

included share of capital income have declined, and then 

by just 4 percentage points—from 34 percent under current law to 30 percent under the option (see Table 9, 

columns 1 and 2). Among limited liability partners, there 

would have been virtually no change; about 88 percent of 

their capital income would have been included in the 

SECA-HI tax base under both current law and this 

option. But among owners of the other entity types, the 

share of capital income included in the SECA-HI base 

would have increased: by 7, 15, and 23 percentage points 

for LLC members, partners in limited partnerships, and 

partners in other partnerships, respectively. Considering 

only amounts below the OASDI ceiling would have 

raised the share of capital income included in the tax base 

from 26 percent to 27 percent. (Those amounts are not 

shown in the tables.)

Effects on the Taxation of Labor Income. A material 

participation standard would have increased the share 

of labor income included in the SECA-HI tax base by 

almost 2 percentage points in 2004, CBO estimates—

from just below 44 percent to just above 45 percent (see 

Table 8). Even among members of partnerships (the 

entity types that are directly affected), the share would 

have increased only from 22 percent to 25 percent (not 

shown in the tables). The increase among partners would 

have been approximately 2 percentage points if negative 

nonlabor income was not allowed to offset labor income. 

In the most extreme case—that of partners in limited 

partnerships—an additional 13 percent of labor income 

would have been accounted for on Schedule SE under the 

material participation standard (see Table 9), but nearly 

half of that increase would have been offset by negative 

nonlabor income. Hence, only 7 percent of the labor 

income of partners in limited partnerships would have 

been added to the SECA-HI tax base. Only among 

partners in general partnerships would the share of labor 

income accounted for on Schedule SE have declined 

under this option (by 5 percentage points). Because the 

share offset by negative nonlabor income also would have 

declined, however, the share included in the SECA-HI 

tax base would still have increased, on net, by almost 

3 percentage points. 

Certain Effects on Behavior. CBO’s estimates of the 

effects of a material participation standard on labor and 

capital income do not account for certain actions that 

taxpayers can take to minimize their SECA tax liabilities. 

Although specific rules determine whether a taxpayer is a 

material participant, there is also a “facts and circumstances” test that partners—particularly those who are 

close to the hours threshold—can apply instead, which 

may result in a more advantageous classification. Under 

current law, partners with positive net income have an 

incentive to classify themselves for income tax purposes as 

nonmaterial participants (so that passive losses from other 

entities have some income to offset); partners with net 

losses have an incentive to classify themselves as material 

participants (so that those losses can offset any other type 

40. CBO estimated the changes to the tax base under this standard 

(and the other policy alternatives). Official revenue estimates of 

legislative proposals are prepared by the staff of the Joint Committee on Taxation. Such estimates would link the changes in the tax 

base to changes in revenue and might also incorporate different 

imputation methodologies and behavioral assumptions than CBO 

used in this report. 

41. Under current law, 67 percent of nonpassive general partnership 

income was accounted for on Schedule SE in 2004 instead of the 

mandated 100 percent. Because the material participation standard would not increase the taxable share of such income, CBO 

assumed the same level of compliance as under current law. The 

agency adopted a similar assumption with respect to guaranteed 

payments for all types of partnerships.
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 21

CBO

Table 9.

Changes in Shares of Capital and Labor Income in Self-Employment Income 

Under a Material Participation Standard, by Type of Entity, 2004

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act; HI = Hospital Insurance (Medicare Part A); LLC = limited liability company; 

LLP = limited liability partnership; * = between zero and 0.5 percentage points.

of income). This option would probably reinforce the 

incentives under current law for SECA-averse taxpayers.42

Because, in all likelihood, most partners are SECA-averse, 

the above estimates might overstate the amount of capital 

income that would become subject to SECA taxes under 

this option. Specifically, partners without passive losses or 

other business gains do not have any incentive under current law to misclassify themselves, but they would have 

such an incentive if the material participation standard 

was applied to the SECA tax. 

The Reasonable Compensation Standard

Under current law, S corporations and C corporations 

are required to report reasonable compensation earned 

by their shareholders, and FICA tax liabilities are computed on those amounts. This option would apply the 

same standard to sole proprietorships and partnerships, 

 Nonfarm 94 -1 99 0

 Farm 82 * 91 0

 General 34 -4 38 -4

 Limited 30 15 32 17

 LLCs 48 7 50 8

 LLPs 88 * 88 *

 Other 17 23 18 24

65 4 68 5

 Nonfarm 57 * 84 0

 Farm 29 * 49 0

 General 24 3 52 -5

 Limited 16 7 26 13

 LLCs 21 3 44 7

 LLPs 54 1 68 1

 Other 9 4 93 -11

44 1 71 1

Partnerships

(Including amounts offset by losses)

Sole Proprietorships

Partnerships

All Types of Entities

Sole Proprietorships

Difference Between

(Percent) (Percentage points) (Percent) (Percentage points) 

All Types of Entities

Accounted for on Schedule SE

Current Law

Included in the SECA-HI Tax Base

Labor

Capital

Participation Standard Current Law

Difference Between

Current Law and a Material

Participation Standard

Current Law and a Material

42. Beginning in 2013, a tax rate of 3.8 percent will be applied to the 

passive partnership income of higher-income taxpayers as an 

“Unearned Income Medicare Contribution.” For the affected 

taxpayers, that change will greatly reduce their incentive to 

misclassify income. 
22 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

including in the SECA tax base only the reasonable 

compensation paid to their owners. As a result, all capital 

income (as defined in this report) would be eliminated 

from that tax base.

Effects on the Tax Base. Imposing a reasonable compensation standard on unincorporated businesses in general 

would have decreased the SECA-HI tax base by 58 percent in 2004, CBO estimates. The SECA-OASDI tax 

base would have been reduced by roughly 52 percent 

under such a standard. 

The smaller tax bases would result primarily from the 

exemption of capital income. In addition, even though 

more labor income from unprofitable firms would 

become subject to SECA, a reasonable compensation 

standard would create an incentive for some people to 

mischaracterize labor income as capital income, which 

would further reduce the tax base. Sole proprietors and 

partners would face the same incentives and opportunities to underreport reasonable compensation as owners of 

S corporations do under current law. 

Under this standard, any income that sole proprietors 

could characterize as capital would be excluded from the 

SECA tax base. Unless the sole proprietors were Social 

Security seekers (that is, people who have little or no 

wage income but want to maximize their future Social 

Security benefits), they would find it beneficial to characterize as much income as possible as capital income and 

thus minimize their SECA tax liability. A sole proprietor 

could do that by claiming that the value of his or her services was lower than it actually was. Without a detailed 

record of precisely what services were performed, such 

a claim would be difficult for the IRS to refute, and 

the typically small amount of revenue at stake would 

probably make IRS challenges rare. 

How partnerships would respond to such incentives to 

mischaracterize income would depend on the number of 

partners and their respective roles. If all partners contributed services roughly in proportion to their ownership 

shares, the incentives would be the same as those for sole 

proprietors. However, if one partner performed a share 

of the services that was disproportionate to his or her 

ownership share, the incentives would be mixed (see 

Box 1 on page 14).43 The incentives would become more 

complex as the number of partners increased. Above 

some threshold, it would become too difficult to satisfy 

all the partners by underreporting their compensation, 

and the incentive would disappear. 

In this report, CBO simulates the effects of using a reasonable compensation standard to determine the SECA 

tax base in two steps: first, by imputing labor income to 

sole proprietorships and partnerships (and allocating 

each partnership’s total labor income among the various 

partners) and, second, by imputing the amount of compensation that would be reported if compliance levels 

approximated those observed among S corporations 

(where the standard is in effect). The results for sole 

proprietors and partners differ sharply—an outcome 

driven by the observation that underreporting of reasonable compensation is greater among S corporations that 

have one owner than among S corporations that have 

multiple owners. Thus, if the reasonable compensation 

standard was limited to partnerships, the reduction in the 

SECA-HI tax base in 2004 would have been much 

smaller—only 26 percent instead of the 58 percent drop 

when sole proprietors are included.

Effects on the Taxation of Capital Income. By design, 

no capital income would have been subject to either 

SECA-HI or -OASDI taxes under a reasonable compensation standard (see Table 8). The exclusion of capital 

income by itself would have been enough to result in a 

smaller tax base for every type of entity. 

Effects on the Taxation of Labor Income. CBO’s analysis 

of S corporations suggests that many taxpayers would 

probably respond to a reasonable compensation standard 

by underreporting labor income. CBO thus estimates 

that the share of labor income that would have been 

included in the SECA-HI tax base under this option 

would have been 10 percentage points lower than under 

current law—barely one-third of the total (see Table 10). 

In the case of partnerships, however, the included share 

of labor income would have increased by about 21 percentage points, from 22 percent to 44 percent. (Among 

partnerships with more than five owners, CBO estimates, 

the included share would have been 100 percent.) The 

share of labor income included by sole proprietorships 

would have declined by 27 percentage points, from 

56 percent to 29 percent. The lower inclusion rates for

43. Although Box 1 presents examples for S corporation owners with 

FICA tax liability, the incentives would be the same for partners 

subject to the SECA tax under reasonable compensation standards. 
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 23

CBO

Table 10.

Changes in Shares of Capital and Labor Income Included in the SECA-HI Tax Base 

Under Three Options, by Type of Entity, 2004 

Source: Congressional Budget Office.

Note: SECA = Self-Employment Contributions Act; HI = Hospital Insurance (Medicare Part A); * = between zero and 

0.5 percentage points.

sole proprietorships are primarily responsible for the 

overall lower inclusion rate for labor income. 

Certain Effects on Behavior. The ability to characterize 

labor income as capital income to the extent that a 

reasonable compensation standard allows would lower 

the price of an owner’s labor and probably induce owners, 

particularly those who work part time, to increase their 

hours of work. Furthermore, by removing capital from 

the SECA tax base, a reasonable compensation standard 

would lower the effective tax rate on capital and probably 

induce more investment. 

The Safe-Harbor Calculation of Capital Income

This option would allow partners and sole proprietors to 

use a standard formula—a safe-harbor rule—to determine the amount of income that would be deemed 

excludable from the SECA tax base as deriving from 

capital. To determine their capital base, taxpayers would 

begin by summing up their capital assets, in the same 

manner that partnerships currently do when reporting 

their balance sheet to the IRS. To calculate their safeharbor exclusion, taxpayers would then apply to the 

capital base a rate of return equal to 150 percent of the 

maximum applicable federal rate.44 Those augmented 

rates of return were 5.99 percent in 2001 and 5.37 percent in 2004.

Certain types of assets would be excluded from the 

capital base. Assets that generate interest, dividends, 

and capital gains would not be counted because those 

sources of income are already excluded from the calculation of the SECA tax base under current law. Cash would 

be excluded in order to prevent sole proprietors from 

excluding capital income that was not generated by their 

business. Because there is no legal distinction between a 

sole proprietor’s personal holdings and those of his or her 

business, owners would otherwise be able to include all 

of their bank accounts and financial instruments on the 

balance sheet of their business and receive a correspondingly larger safe-harbor exclusion. (Mingling personal 

assets with business assets is much less likely in partnerships; a member of the partnership would probably prefer 

to keep his or her personal accounts separate from those 

of the business rather than giving the other partners a 

potential claim on those accounts.)

65 94 43

Material participation standard 4 -1 8

Reasonable compensation standard -65 -94 -43

Safe harbor for capital -2 -2 -2

44 56 22

Material participation standard 1 * 3

Reasonable compensation standard -10 -27 21

Safe harbor for capital -2 -2 -2

Percentage-Point Difference Between Current Law and a:

Current Law (Percent)

Percentage-Point Difference Between Current Law and a:

Current Law (Percent)

Capital

Labor

All Types of Entities Sole Proprietorships Partnerships

44. Applicable federal rates are calculated by the Internal Revenue 

Service to determine imputed interest that must be taxed or may 

be deducted in situations where below-market interest rates are 

being charged. The highest rates are calculated for instruments 

having a term of nine years or more. CBO applied the exclusion at 

the entity level, meaning that if the safe-harbor exclusion for one 

entity exceeded the taxable income of that entity, the unused portion could not be applied to the taxable income of another entity.
24 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

Under this option, the capital base would exclude most 

intangible assets (which account for the difference 

between the market value of a firm and the book value of 

the owner’s capital account). Thus, firms that rely heavily 

on tangible assets would have a greater share of their capital income excluded than would firms that rely heavily 

on intangible assets. Designing and implementing a 

measure of intangible assets that could be used in a safeharbor calculation would be difficult, however. It would 

require an estimate of each firm’s market value, which 

would be highly imprecise in the absence of a public 

clearinghouse (analogous to the stock market) for the sale 

of unincorporated businesses.

The safe-harbor approach would also increase the administrative burden on sole proprietors (and certain smaller 

partnerships), who would have to begin reporting balance 

sheet information. However, only firms that chose to 

use the safe-harbor exclusion would have to file that 

information.

Effects on the Tax Base. Adopting the safe-harbor 

exclusion would have reduced the SECA-HI tax base by 

approximately 4 percent in 2004, CBO estimates—a 

much smaller reduction than would have occurred under 

a reasonable compensation standard.45 Approximately 

45 percent of the decline would have been attributable to 

income from partnerships, even though such income 

accounted for less than 25 percent of the tax base. That 

discrepancy reflects the extent to which partnerships are 

more capital-intensive than sole proprietorships (because 

of their larger size and the industries in which they are 

found, particularly real estate). 

Effects on the Taxation of Capital Income. Most of the 

estimated decline in the SECA tax base would have 

resulted from the exclusion of capital income. CBO estimates that the share of capital income included in the 

SECA-HI tax base would have declined from 65 percent 

to 62 percent in 2004 (see Table 8). The share of capital 

income included in the SECA-OASDI tax base would 

have decreased by 1 percentage point (from 26 percent to 

25 percent).

A safe-harbor exclusion, with its fixed rate of return on 

the capital account, would not prevent substantial 

amounts of capital income from being taxed, for two 

reasons. First, the potential exclusion—that is, 5.37 percent of the capital account of profitable businesses in 

2004—would have accounted for only 25 percent of 

capital income in the SECA-HI tax base, probably 

because the exclusion does not account for the return on 

intangible assets. That shortfall was most pronounced 

for limited liability partners and nonfarm sole proprietors. Second, even for owners of entity types for which 

the potential exclusion approached or exceeded capital 

income (partners in limited partnerships and members of 

LLCs), the safe-harbor exclusion would have had small 

effects. Those owners would not have been able to use 

more than 60 percent of the potential exclusion because 

their income was not subject to tax under current law 

(that is, the income was either offset by losses or was not 

reported on Schedule SE in the first place). For partners 

in limited partnerships and members of LLCs, that share 

reached 84 percent and 78 percent, respectively.

Effects on the Taxation of Labor Income. In cases where 

the safe-harbor amount exceeded capital income, it 

would also have excluded some labor income. As a result, 

the share of labor income included in the SECA-HI tax 

base would have decreased slightly, from 44 percent to 

42 percent (see Table 8). Because the exclusion reduces 

both labor and capital income, the split between labor 

and capital income would have remained virtually the 

same as under current law. 

Certain Effects on Behavior. CBO’s estimates do not 

account for changes in firms’ portfolios in response to a 

safe harbor. Using a uniform rate of return for computing 

the excludable amount of income would reduce firms’ 

incentive to maximize the return on their assets. A firm 

realizing a rate of return that was higher than the safeharbor amount—say, 10 percent—would be able to 

exclude only a portion of its capital income from its 

SECA tax base, whereas a firm realizing no return on its 

capital would be able to shelter some of its labor income 

from the SECA tax. Thus, the safe harbor would probably induce firms to invest more money in tangible capital 

and less money in intangible capital than would otherwise be optimal. That outcome would tend to reduce the 

SECA tax base even more.

45. CBO’s estimate assumes that affected firms are limited to those 

that would be required to file balance sheets under current law 

(including sole proprietorships that would meet the criteria for 

filing a balance sheet if they were a one-owner S corporation). 

A safe-harbor exclusion would probably spur firms that are not 

required to file balance sheets to do so in order to claim the 

benefit, further shrinking the tax base.
CBO

Appendix A:

Imputing Labor Income to the Self-Employed

Analyzing the taxation of labor and capital 

income through the self-employment tax involves 

distinguishing between those two components of the 

Self-Employment Contributions Act (SECA) tax base. 

However, because taxpayers do not report those two types 

of income separately on Schedule SE of their tax return 

(the form on which SECA tax liability is calculated), separating out that income can be difficult. Most taxpayers 

probably do not even know which portion of their business income results from their own labors and which 

results from their investments in capital. Even though 

analysts generally agree that the SECA tax base includes 

both labor and capital income, few analysts have 

attempted to measure those two portions of the tax base. 

In this report, the Congressional Budget Office (CBO) 

isolates labor’s share of the SECA tax base by focusing on 

the differences between that tax base and the Federal 

Insurance Contributions Act (FICA) tax base. Labor 

income is defined as the portion of a self-employed person’s business income that would be subject to the FICA 

tax if the business was incorporated and its owner was 

treated like other employees. 

To determine labor’s share of the SECA tax base, CBO 

had to identify the labor income of partners and sole proprietors. To do that, CBO first identified a population 

that was similar to the self-employed but that reported 

labor compensation on their tax return. The labor 

income of that population was statistically related to 

variables that are reported by partnerships and sole proprietorships. Next, those relationships were applied to tax 

data reported by sole proprietorships and partnerships 

to derive an imputation of labor income. Because the 

imputation was done at the entity level, a third step was 

necessary to distribute labor income among individual 

partners. Those three steps resulted in estimates of the 

labor content of sole proprietorship and partnership 

income in the individual income tax base. 

Although all labor income of sole proprietors is included 

in the SECA tax base, some types of partnership income 

may be excluded. To isolate the portion in the SECA tax 

base, CBO had to identify the specific business entities 

contributing to each individual’s tax base (along with 

their associated labor income) in a fourth step.

Step 1: Statistically Analyze a 

Population Similar to the 

Self-Employed 

Sole proprietorships and partnerships do not report the 

labor income of their owners to the Internal Revenue 

Service (IRS). However, other types of business entities 

are required to report compensation paid to their officers 

(or owners). That information can be used to derive estimates of the labor income of sole proprietorships and 

partnerships.

By law, corporations must report as “officers’ compensation” the reasonable compensation of their owners. To 

the extent that such compensation was reported accurately, it would reliably measure labor income. However, 

that compensation is frequently reported inaccurately, 

and the incentive to misreport it differs for C corporations and S corporations.1

 Because the incentives for 

S corporations to misreport reasonable compensation 

are virtually identical to those that a sole proprietorship 

or partnership would face under the same reporting 

1. The theory behind the different incentives and the extent of 

misreporting are described in Nicholas Bull and Paul Burnham, 

“Taxation of Capital and Labor: The Diverse Landscape by Entity 

Type,” National Tax Journal, vol. 61, No. 3 (September 2008).
26 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

requirement, CBO focused on S corporations in its analysis of reasonable compensation. That analysis consisted 

of two parts: relating reported officers’ compensation to 

other variables that are also reported on tax documents 

filed by sole proprietorships and partnerships, and estimating the amount by which officers’ compensation was 

underreported. In combination, those two parts produce 

the imputation parameters used in the next step of the 

analysis.

Relating Officers’ Compensation to Other Variables 

CBO used regression techniques to relate reported officers’ compensation to explanatory variables including 

gross receipts and several measures of firms’ inputs. 

Officers’ compensation was expected to rise with gross 

receipts, because the role of management expands as a 

firm’s income increases. The other relationships with the 

firm’s inputs were more ambiguous. Employees’ labor (as 

measured by wages and salaries) could be either a complement to or a substitute for the labor of owners. Similarly, 

capital (as indirectly measured by variables such as depreciation and repairs) could be either a complement to or a 

substitute for labor. 

The data for this portion of the analysis came from a 

subsample of the IRS’s Statistics of Income (SOI) sample 

of corporate tax returns. The S corporation database used 

in the analysis included 216,804 tax returns from 2000 

through 2004. In addition to the variables described 

above, CBO used dummies for each year, for profitable 

firms, and for 33 industries. All dollar amounts were 

converted to logs. 

CBO estimated the imputation parameters in three 

stages. First, the agency used a probit regression to estimate the probability of a firm’s reporting nonzero 

amounts of compensation. Second, CBO ran a linear 

regression using only the returns with nonzero values to 

estimate the amount of compensation. That regression 

corrected for selection bias that might arise because the 

sample omits records that reported officers’ compensation 

of zero when the true figure was positive. CBO tested the 

results by applying the coefficients to the S corporations 

in the sample to determine whether, in total, they replicated the actual amount of officers’ compensation 

reported. In fact, the log of the predicted total equaled 

the log of the reported total, but when converted back to 

levels, the predicted total fell far short of the reported 

total. In the third stage, therefore, CBO adjusted the 

predicted levels to better correspond to the reported 

amounts. Firms were put into six classes of gross receipts, 

and a linear regression was estimated using the reported 

amount (in levels, not logs) as the dependent variable and 

the amount predicted in the second step as the explanatory variable. CBO applied the coefficients from each 

class to the amounts predicted in the second stage, and 

the results matched the reported total.2

Estimating Underreported Income

The technique that CBO used to estimate underreporting of compensation by S corporations hinges on 

the assumption that underreporting is systematically 

related to the number of shareholders in a firm. As 

illustrated in Box 1 on page 14, the ability to make all 

shareholders better off by underreporting compensation 

depends on each shareholder’s contribution of labor 

being roughly proportional to his or her contribution of 

capital. As the number of shareholders increases, that 

condition becomes more difficult to meet.

In this technique, CBO constructed a series of dummy 

variables that represent the incremental disincentive to 

underreport compensation associated with each additional shareholder; there was a dummy variable for all 

firms with two or more shareholders (sh2), another for 

firms with three or more shareholders (sh3), and so on up 

to nine or more shareholders (sh9).3

 Coefficients were 

estimated on each variable in the second stage of the statistical process described above. The interpretation of the 

coefficient on shx is the amount by which average compensation per owner is higher for an S corporation with 

x shareholders than for one with x-1 shareholders. The 

coefficient should always be positive, so variables with 

negative or insignificant coefficients were eliminated 

until only those with significant positive coefficients 

2. CBO used a similar three-stage technique to impute to sole 

proprietorships a capital account potentially eligible for the safeharbor exclusion. In that case, only single-owner S corporations 

were used to estimate the regressions. Depreciation deductions 

proved to be the primary driver of the imputation.

3. Using shx for firms with exactly x shareholders would not represent an incremental effect and is thus inconsistent with the 

hypothesis that underreporting necessarily declines with the 

number of shareholders.
APPENDIX A THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 27

CBO

remained.4

 Ultimately, sh2, sh3, and sh6 were retained, 

meaning that no underreporting by firms with six or 

more owners could be statistically detected.

Step 2: Apply That Analysis to 

Partnerships and Sole Proprietorships

In this step, CBO applied the parameters that it estimated in the first step to a sample of sole proprietorships 

and partnerships to determine two amounts: the amount 

of owners’ compensation that would be reported by each 

entity, assuming the level of compliance observed among 

S corporations, and the total amount of labor income, 

assuming full compliance with the reasonable compensation standard. Some of the data for this analysis came 

from a subsample of sole proprietorships that includes all 

the Schedule Cs and Fs in the SOI sample of individual 

income tax returns. In 2001, 71,158 such forms were 

included in the sample; in 2004, the figure was 83,707. 

The rest of the data were drawn from the SOI Partnership file, consisting of a sample of Form 1065s filed by 

all multiowner unincorporated businesses. In 2001, the 

sample included 21,695 partnership returns; in 2004, the 

figure was 23,836.

For the “observed compliance” imputation, CBO applied 

the parameters of the first-stage probit regression to each 

sole proprietorship and partnership in the samples to 

estimate the probability that the firm would report its 

owners’ compensation. On the basis of the resulting 

probabilities, firms were randomly selected to receive an 

imputation of a compensation amount. Values of shx

were then calculated for each partnership (they are always 

zero for sole proprietorships), and the parameters of the 

linear regression (from the second stage of Step 1) were 

applied. Finally, firms were classified by gross receipts, 

and the imputed amounts were adjusted by the parameters estimated in the third stage of the first step. 

As a simple illustration, assume that the second stage of 

the first step yielded the following equation:

Log (officers’ compensation) = 1.04 + 0.70*Log 

(gross receipts) + 0.24*sh2.

Based on the above equation, a sole proprietorship with 

$100,000 of gross receipts (and selected to receive a positive amount) would receive an imputation of reasonable 

compensation under observed compliance of $8,947. 

A two-person partnership with the same amount of 

gross receipts, in contrast, would receive an imputation 

of $11,374 because partnerships face more barriers to 

underreporting compensation (represented by the 

coefficient on sh2) than do sole proprietorships.

For the “full compliance” imputation, CBO repeated 

some of the stages in step 1, with modifications. The 

first-stage probit equation was skipped—an amount was 

imputed to all sole proprietorships and partnerships. 

Furthermore, the values of the dummy variables, shx,

were set equal to 1 for all firms, even those with fewer 

than x owners (to ensure that the underreporting 

observed among S corporations with fewer than x owners 

was not transmitted to partnerships or sole proprietorships). As with the “observed compliance” imputation, 

CBO applied the parameters of the second-stage linear 

regression to estimate an amount of labor income. 

Returning to the simple example, the labor income of the 

aforementioned sole proprietorship would be $11,374—

the same amount as for the two-person partnership 

because the underreporting has been disregarded. Finally, 

the results were adjusted by the third-stage parameters.

Step 3: Distribute Income from 

Partnerships to Individual Partners

Because labor income was imputed at the partnership 

level but the SECA tax is imposed at the individual level, 

it was necessary to distribute the imputed labor income 

among the individual partners. In practice, the distribution of partnership income among partners is reported to 

the IRS and taxpayers on Schedule K-1, which serves the 

same function for partners as a W-2 does for employees. 

CBO had access to all Schedule K-1s filed during 2001 

and 2004. Among other items, the K-1s include information on a partnership’s type of entity, ordinary business 

income, guaranteed payments, net rental income, and 

portfolio income. 

Imputed labor income from the partnership returns was 

distributed among the owners listed on a partnership’s 

K-1s in the same proportion as ordinary business income. 

Then, whenever possible, CBO linked the K-1s to the 

4. That practice compromises the ability to interpret all of the 

coefficients clearly, but it is necessary to avoid implausible (that 

is, negative) imputation amounts.
28 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

individual income tax returns of each owner, making that 

information available for Step 4 (described below). 

However, unlike the K-1s, only samples of the tax returns 

of partnerships and individual taxpayers were available. 

Because of the way in which partnerships and individuals 

were sampled, those cases of direct transmission via a K-1 

were largely limited to high-income partners of large 

partnerships.

To ensure that every partner represented in the sample of 

individual taxpayers received an imputation of labor 

income, CBO had to attach a value for labor income to 

every K-1, including those issued by partnerships not 

included in the SOI Partnership file. That was accomplished by linking the K-1s from each partnership not in 

the sample to a similar partnership that was in the sample. Partnerships in the sample were deemed similar to 

those in the unmatched K-1 population on the basis of 

several factors: number of partners, whether net income 

was positive or negative, the presence and relative importance of portfolio income, and the presence and relative 

importance of rental income. CBO then applied the ratio 

of labor income to net business income from the sampled 

partnership to the net business income on the unmatched 

K-1s to derive an estimate of labor income. 

Partnerships in the sample were used for that purpose 

as often as their sampling weight dictated. Thus, if a 

sampled partnership had a weight of 3 (meaning it represented itself and two unsampled partnerships), it was 

used to assign amounts of labor income to the K-1s of 

two unsampled partnerships.5

Step 4: Identify Labor Income in the 

SECA Tax Base

At this point, all partnership and sole proprietorship 

income subject to the individual income tax have been 

associated with an entity type and disaggregated 

between labor and capital income. However, not all 

partnership income reported by individual taxpayers is 

included in the SECA tax base. Furthermore, in the case 

of a married couple filing a joint income tax return, each 

self-employed spouse must file a separate Schedule SE. 

Therefore, CBO developed a procedure to identify each 

spouse’s partnership and sole proprietorship income that 

was included in the SECA tax base. 

CBO measured the aggregate SECA tax base by using 

information reported on Schedule SE. On that form, 

taxpayers report all self-employment income but do not 

distinguish between income from sole proprietorships 

and partnerships. The self-employed also file several other 

forms with their income tax returns, which provide information about the sources of their income:

 Sole proprietors report their net income on Schedule 

C or, if they are farmers, on Schedule F. The SOI data 

include information on up to three Schedule Cs and 

two Schedule Fs but do not identify which spouse was 

the owner.

 Partners report net income on Schedule E. Although 

Schedule E does not disaggregate partnership income 

by spouse, entity type, or pass-through item (that is, 

proportional shares of business income, guaranteed 

payments, or rental income)—the information needed 

to determine whether that income should be reported 

on Schedule SE—those data were imputed in Step 3.

To identify each business contributing to each spouse’s 

SECA tax base (and the labor income associated with 

each), CBO had to test various combinations of businesses that potentially produce the income that is 

reported on each Schedule SE. If, after attributing sole 

proprietorship income to the SECA tax base, a surplus of 

potential self-employment income from partnerships 

remained, then partnership income was added to the 

SECA tax base in the following order:

1. Any entity type that accounted for at least 85 percent 

of the tax base,

2. General partnerships,

3. Limited liability partnerships, 

4. Limited liability companies, 

5. Limited partnerships, and

6. Other partnerships.

5. CBO used the same technique to transmit other information 

about partnerships to individual partners—specifically, the type of 

entity, the amounts of specific pass-through items (guaranteed 

payments and proportional shares of business and rental income), 

and the capital account potentially eligible for the safe-harbor 

exclusion.
APPENDIX A THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 29

CBO

CBO was able to identify the type of self-employment 

income on just over 40 percent of Schedule SEs (accounting for 75 percent of the SECA tax base) because 

combinations of income reported on Schedules C, F, 

and E matched self-employment income reported on 

Schedule SE.

Because not all nonpassive partnership income from 

Schedule E is reported on Schedule SE, CBO used 

Schedule K-1s to help determine the source of the selfemployment income of taxpayers with partnership 

income that cannot otherwise be reconciled with Schedule SE. By using amounts from the K-1s to represent 

income from partnerships instead of the amounts from 

Schedule E, CBO was able to identify the source of selfemployment income (distinguishing between income 

from sole proprietorships and partnerships) on an 

additional 20 percent of Schedule SEs (accounting for an 

additional 6 percent of the SECA tax base). 

CBO could not fully identify the sources of income on 

the remaining 40 percent of Schedule SEs (accounting 

for 19 percent of the SECA tax base). Most sources of 

income could be at least partially identified, however, 

leaving only 6 percent of the SECA tax base in 2004 that 

could not be associated with either sole proprietorships or 

partnerships (that share was 7 percent in 2001). Some of 

the rest was probably wages earned by clergy, but that 

share could not be determined.

Using the available data, CBO could not distinguish 

between general partners and limited partners in a limited partnership. As a result, references to income from 

limited partnerships in this report include the income of 

both types of partners.

CBO

Appendix B:

Allocating Negative Nonlabor Income Between

Labor and Capital

In this analysis, the Congressional Budget Office 

(CBO) had to allocate self-employment income 

between labor and capital. CBO assumed that reasonable 

compensation was a good proxy for labor income (see 

Appendix A for a description of the methodology used to 

estimate reasonable compensation for sole proprietorships and partnerships). Any nonlabor income—that is, 

net business income in excess of reasonable compensation—was attributed to capital. Calculating labor’s share 

of the Self-Employment Contributions Act (SECA) tax 

base was then a simple matter of division. For example, if 

labor income from a limited liability company (LLC) was 

$80,000 and capital income was $20,000, labor’s share 

was 80 percent. In some cases, however, the imputed reasonable compensation of a business exceeded its reported 

net income, resulting in negative values for nonlabor 

income. In those cases, attributing the negative nonlabor 

income to capital is both theoretically imprecise and 

difficult to interpret in practice. 

Negative nonlabor income is only properly attributable to 

capital when it reflects real economic losses. For instance, 

training new employees in advance of an expansion might 

cause an owner to incur expenses in excess of receipts. A 

sudden drop in sales could also result in negative capital 

income. But sometimes, certain provisions in the tax code 

cause nonlabor income to be negative. For example, the 

ability of small businesses to expense the cost of equipment (that is, to deduct those costs immediately rather 

than over the lifetime of an asset) results in net taxable 

income that is less than economic profits. As a result, 

nonlabor income may be negative. To the extent that 

such deductions exceed economic depreciation, they cannot properly be attributed to capital. Finally, taxpayers’ 

errors undoubtedly explain some of the negative values. 

Some of those errors are inadvertent, but others involve 

the deliberate understatement of receipts or overstatement of expenses. None of that is properly attributed 

to capital. Unfortunately, identifying the negative nonlabor income that is properly attributed to capital is not 

possible with available data.

As a more practical matter, attributing negative nonlabor 

income to capital causes labor’s share of the tax base to 

exceed 100 percent—a result that is difficult to interpret. 

For example, if labor income from an LLC is estimated to 

be $80,000 but net business income is only $60,000, 

then -$20,000 would be attributed to capital. Under 

those assumptions, labor’s share of total income would be 

133 percent ($80,000 divided by $60,000) and capital’s 

share would be -33 percent. 

CBO adopted a rule to avoid that interpretation problem 

and to minimize unreasonable differences between the 

Federal Insurance Contributions Act (FICA) and SECA 

tax bases. For each taxpayer, labor income is summed 

across all entities and added to the tax base first (conforming to FICA procedures). If total nonlabor income is 

positive, it is attributed to capital and added to the tax 

base without any adjustment to labor income. If total 

nonlabor income is negative, however, labor income is 

reduced by that amount and nothing is attributed to capital. Applying that rule to the previous example results in 

$60,000 of labor income (the original $80,000 minus the 

$20,000 of losses), which is 100 percent of the SECA tax 

base. 

Overall, the only effect of such a rule is to cap labor’s 

share at 100 percent. The rule has much bigger implications, however, when calculating labor’s share by type of 
32 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

Table B-1. 

Comparing Methods of Calculating Labor’s Share of the Tax Base in the Presence 

of Negative Nonlabor Income

Source: Congressional Budget Office.

entity. Because negative nonlabor income from one type 

of entity can offset capital income from a different type, 

entity types with less negative nonlabor income will have, 

under CBO’s assumptions, a larger share of labor income 

(and those with more negative nonlabor income will have 

a smaller share) than if all nonlabor income was attributed to capital. 

The rule also affects the distribution of the overall SECA 

tax base among entity types. For example, suppose a taxpayer has an interest in two businesses: a sole proprietorship from which he or she derives $40,000 of labor 

income and $30,000 of nonlabor income, and an LLC 

from which he or she derives $20,000 of labor income 

and -$10,000 of nonlabor income (see Table B-1). If the 

negative nonlabor income of the LLC is attributed to 

capital, the LLC’s contribution to the SECA tax base is 

also reduced by that amount. As a result, labor’s share of 

the LLC income is 200 percent. Under CBO’s assumption, the -$10,000 instead offsets some of the capital 

income of the sole proprietorship, reducing it from 

$30,000 to $20,000. That change increases labor’s share 

of the sole proprietorship’s income from 57 percent to 

67 percent but reduces labor’s share of the LLC’s income 

to the cap of 100 percent. It also reduces the sole proprietorship’s contribution to the SECA tax base and 

increases the LLC’s contribution. If the LLC’s negative 

nonlabor income exceeded the sole proprietorship’s 

$30,000 of capital income, the excess would offset labor 

income—prorated between entity types—and labor’s 

share of the SECA tax base would be 100 percent for each 

entity.

Sole Proprietorship 40,000 30,000 70,000 57

Limited Liability Company 20,000 -10,000 10,000 200

All Types of Entities 60,000 20,000 80,000 75

Sole Proprietorship 40,000 20,000 60,000 67

Limited Liability Company 20,000 0 20,000 100

All Types of Entities 60,000 20,000 80,000 75

Income (Dollars) Labor's Share

Negative Nonlabor Income Is Attributed to Capital of Same Type of Entity 

Negative Nonlabor Income Offsets Capital Regardless of Type of Entity 

Labor Capital Total (Percent)
CBO

Appendix C:

Description of Tax Organizations’ Options for 

Modifying the SECA Tax Base

This report analyzes three different strategies for 

making the Self-Employment Contributions Act (SECA) 

tax base look more like the Federal Insurance Contributions Act (FICA) tax base: a material participation 

standard for partnerships and limited liability companies 

(LLCs), a reasonable compensation standard, and a 

safe-harbor exclusion for capital income. Different 

combinations of those strategies have been included in 

options put forth by selected tax organizations: the staff 

of the Joint Committee on Taxation (JCT), the American 

Institute of Certified Public Accountants (AICPA), and 

the American Bar Association’s (ABA’s) Section of Taxation. The details of each of those options are presented 

here, along with a brief discussion of how the findings of 

this Congressional Budget Office (CBO) report apply to 

the specific combinations presented. 

The Joint Committee on Taxation

In its 2005 volume on options for simplifying the tax 

code, the JCT staff presented an option with two primary 

goals: to clarify the treatment of LLC members and 

reflect the evolving definition of limited partners, and to 

reduce opportunities for owners of S corporations to 

avoid FICA taxes by mischaracterizing labor income as 

capital income.1

 To accomplish those goals, lawmakers 

could make S corporation owners (but not owners of privately held C corporations) subject to SECA taxes rather 

than FICA taxes, under the same rules that apply to 

partners and LLC members. Those rules would create 

three classes of partners/owners, each of which would 

calculate their SECA tax base differently. Which class a 

partner/owner fell into would depend on his or her level 

of participation in the firm and the firm’s industry, as 

follows:

 Nonmaterial participants would include their 

reasonable compensation for services rendered to the 

business;

 Material participants outside of service industries

would include their guaranteed payments for services 

rendered plus their proportional share of business 

income; and

 Material participants in service industries would include 

their guaranteed payments for services rendered, their 

proportional share of business income, and their 

proportional share of investment income.2

The material participation standard described by the JCT 

staff is the same one analyzed in this report—that is, the 

standard applied in the passive loss rules for income tax 

purposes. JCT’s option did not include a safe-harbor 

exclusion for capital income.

1. See Joint Committee on Taxation. Options to Improve Tax 

Compliance and Reduce Tax Expenditures, JCS-02-05 (January 27, 

2005), p. 95.

2. The inclusion of investment income was designed to prevent 

partnerships from using loans and rental arrangements to disguise 

labor income as investment income. The feature was not considered in this report because it moves the SECA tax farther from the 

FICA tax rather than closer to it. 
34 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

In general, CBO’s analysis of the material participation 

standard applies to this option. However, requiring 

nonmaterial participants to include their reasonable compensation would increase the share of labor income in 

the SECA tax base (compared with the share under a 

freestanding material participation standard) and would 

also mitigate somewhat the loss of revenue. 

The American Institute of Certified 

Public Accountants

A 1998 proposal from the AICPA is more focused on 

reducing the amount of capital income in the SECA tax 

base.3

 It would create two classes of partners and would 

determine the SECA tax base of each, as follows:

 Partners contributing less than 100 hours of work during 

the year would include their guaranteed payments for 

services rendered; and

 Partners contributing 100 or more hours of work during 

the year would include their guaranteed payments for 

services rendered and their proportional share of business income but would subtract an amount representing capital income.

Sole proprietors would also be eligible to claim an exclusion for capital income. The proposed exclusion is more 

generous than the safe-harbor exclusion analyzed in this 

report. It would assume a rate of return equal to 150 percent of the highest applicable federal rate, just as the 

version in this report would, but would apply it to the 

entire amount of the partner’s capital account—that is, 

all assets reported on Schedule L minus liabilities. That 

amount would include financial assets that generate interest, dividends, and capital gains—all sources of income 

that are already excluded from the SECA tax base. It 

would also include items (such as cash) that a sole proprietor could mischaracterize as business assets when they 

are, in fact, personal assets. Such assets are excluded in the 

version analyzed in this report.

Because both the material participation standard and 

the safe harbor for capital in the AICPA’s option differ 

from those analyzed in this report, CBO’s findings can 

be applied only loosely. In CBO’s analysis, the material 

participation standard would increase the shares of both 

capital and labor income in the SECA tax base, whereas 

the safe harbor would have the opposite effect. The net 

effect of combining those two strategies, even for material 

participants only, is unclear.

The American Bar Association’s 

Section of Taxation

Unlike the options from JCT and the AICPA, a 2002 

proposal by the ABA’s Section of Taxation would not 

explicitly create two or more classes of taxpayers.4

 Instead, 

it would give partners the choice of excluding from the 

SECA tax base either their income in excess of reasonable 

compensation or the safe-harbor amount of capital 

income described by the AICPA. In principle (although 

not in the proposed statutory language), sole proprietors 

would have the same choice.

CBO’s findings imply that given a choice between a 

reasonable compensation standard and a safe harbor for 

capital, the vast majority of businesses would choose the 

former. Hence, CBO’s analysis of the reasonable compensation standard applies most closely in this case.

3. American Institute of Certified Public Accountants, “Legislative 

Proposal Regarding Tax on Self-Employment Income Under 

Section 1402 of the Internal Revenue Code of 1986” 

(February 19, 1998).

4. American Bar Association, Section of Taxation, “Tax Rules 

Governing Self-Employment Income of Limited Liability 

Companies and Partnerships” (May 29, 2002), available at 

www.americanbar.org/content/dam/aba/migrated/tax/pubpolicy/

2002/020529c.authcheckdam.pdf. 
THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX 35

CBO

List of Tables and Figures

Tables

1. Income Subject to SECA Tax 3

2. Distribution of the SECA Tax Base, by Type of Entity, 2004 6

3. Distribution of Partnership Income in the SECA Tax Base, by Degree of 

Participation and Pass-Through Item, 2004 8

4. Share of Net Income or Loss Included in the SECA Tax Base, by Type of 

Entity, 2004 9

5. Share of Partnership Income or Loss Included in the SECA Tax Base, by 

Degree of Participation and Pass-Through Item, 2004 10

6. Taxable Labor Income as a Share of the SECA Tax Base, by Type of Entity, 2004 11

7. Shares of Capital and Labor Income Included or Not Included in the SECA-HI 

Tax Base, by Type of Entity, 2004 12

8. Shares of Labor and Capital Income Included in the SECA Tax Base Relative to the 

FICA Tax Base, 2004 19

9. Changes in Shares of Capital and Labor Income in Self-Employment Income 

Under a Material Participation Standard, by Type of Entity, 2004 21

10. Changes in Shares of Capital and Labor Income Included in the SECA-HI 

Tax Base Under Three Options, by Type of Entity, 2004 23

B-1. Comparing Methods of Calculating Labor’s Share of the Tax Base in the 

Presence of Negative Nonlabor Income 32

Figures

S-1. Labor and Capital Shares of the Business Income of Profitable Sole 

Proprietorships and Partnerships Included or Not Included in the 

SECA-HI Tax Base, 2004 vi

1. Distribution of Partnership Income in the SECA Tax Base, by Type of 

Entity, 2001 and 2004 7

2. Labor and Capital Shares of the Business Income of Profitable Sole 

Proprietorships and Partnerships in Various Tax Bases, 2004 17
36 THE TAXATION OF CAPITAL AND LABOR THROUGH THE SELF-EMPLOYMENT TAX

CBO

About This Document

This Congressional Budget Office (CBO) report was prepared at the request of the former 

Ranking Member of the Senate Budget Committee. In keeping with CBO’s mandate to provide 

objective, impartial analysis, the report makes no recommendations.

Paul Burnham of CBO’s Tax Analysis Division wrote the paper under the direction of Frank 

Sammartino and Janet Holtzblatt. Tom Woodward, formerly of CBO, contributed to the 

development of the methodology in its early stages. Robert McClelland, Kevin Perese, and 

Christopher Williams of CBO provided useful comments, as did Susan Nelson of the Office of 

Tax Analysis in the Department of the Treasury and Laura Kalambokidis of the University of 

Minnesota. (The assistance of external reviewers implies no responsibility for the final product, 

which rests solely with CBO.)

Christine Bogusz edited the report, and Maureen Costantino and Jeanine Rees prepared it for 

publication. An electronic version is available on CBO’s Web site (www.cbo.gov).

Douglas W. Elmendorf 

Director

September 2012