Big Picture on Pass-Through Taxation

Our expectation for 2013 is continued guerrilla warfare on specific tax hike proposals coupled with the looming threat of larger tax hikes when Congress next addresses the debt limit. Add in the determination of both tax-writing committee chairmen to pursue comprehensive reform, and you have a good understanding of how we’re going to spend our time over the next year:

  • Working with the tax committees to make their tax reform proposals as business friendly as possible;
  • Fighting the Administration’s efforts to turn tax reform into another opportunity to raise taxes on Main Street Employers; and
  • Fighting specific proposals to unfairly target S corporations and raise their taxes through discrete provisions like the payroll tax hike.

The President’s State of the Union address this week did little to change this outlook. In a world where 99 percent of policymakers agree that tax reform means lower marginal rates imposed on a broader base of income, the President’s view (illustrated by last year’s corporate reform proposal and his continued support of higher marginal rates) is just the opposite – higher marginal rates coupled with more special interest tax provisions. It’s the same anti-tax reform perspective offered by Senator Chuck Schumer late last year.

It’s this difference in perspectives that’s behind the pessimism over whether Congress will tackle tax reform this year. The gap appears just too large for Congress to find common ground and it would require a very, very large catalyst to bridge it.

Well, it’s possible that just such a catalyst is right on the horizon. The combination of sequestration cuts starting next month and the need for Congress to raise the debt limit before the August break is just the sort of ”rock and a hard place” scenario that could compel action.

Here’s why. The pain, political and otherwise, from the sequestration cuts will not be felt immediately but will instead grow over time. Each month will bring additional stories of how the cuts are adversely affecting Americans and US policy. Meanwhile, we know from experience that the House of Representatives will resist raising the debt limit without some sort of accompanying deficit reduction package.

So, starting this summer, Congress will be under tremendous pressure to revisit the sequestration cuts at the same time the tax-writers are talking tax reform and the House is insisting on additional deficit reduction. All while Congress is facing a deadline to extend the “must-pass” debt limit.

For these reasons, we’re taking tax reform seriously. The debt limit-tax reform scenario may play out differently, but the risk is simply too great to do otherwise.

We Are All for Comprehensive Reform Now

Two years ago, the S Corporation Association undertook the effort to combat “corporate-only” tax reform. We support cutting the corporate rate, but tackling the corporate tax code in isolation is bad policy and bad politics, and with the help of our E&Y study on the subject, we were able to quantify just how bad it would be for businesses organized as pass-through businesses…”$27-billion-a-year-in-higher-taxes” bad.

House Ways and Means Committee Chairman Dave Camp has always understood this challenge and has been a consistent advocate for comprehensive reform. Recent comments by Senate Finance Committee Chairman Max Baucus suggest he too understands the important role pass-through businesses play in jobs and investment – at 69 percent, his home state of Montana has the highest percentage of pass-through employment in the nation, after all.

With his comments in the State of the Union, it appears the President too has converted to the church of comprehensive tax reform. Here’s what he said:

Now is our best chance for bipartisan, comprehensive tax reform that encourages job creation and helps bring down the deficit. We can get this done.

Of course, he coupled that statement with a call for raising tax rates on high-income individuals, raising taxes on the overseas operations of multinational corporations, and for continued use of the tax code to target specific industries and taxpayers, so we’re not getting too excited here.

But the word “comprehensive” remains significant. Until somebody says otherwise, we’ll assume this means the President has backed away from his corporate-only proposal of last year. Let’s hope so.

Sequestration Highlights Threat to Pass-Through Businesses

Efforts to replace the sequestration spending cuts have highlighted the on-going threat S corporations and other pass-through businesses face this Congress.

For example, on Tuesday, Senators Whitehouse (D-RI) Levin (D-MI), Harkin (D-IA) and Sanders (I-VT) introduced two bills to offset the sequester with tax hikes. The first includes tax increases necessary to postpone the sequester until October 1, while the second would raise the taxes necessary to replace it entirely. As you can see, it’s the usual suspects list of LIFO and Carried Interest tax hikes, etc.

Another list posted by Politico reported the other day includes even more items:

POSSIBLE SENATE DEM SEQUESTER REPLACEMENTS - These ideas are making the rounds:

1) closing off a variety of “offshore tax shelters”;

2) ending preferential tax treatment for many private equity and hedge fund managers;

3) taxing the exercise of stock options more heavily

AMONG THE REVENUE ESTIMATES

1) Closing Carried Interest (14 billion);

2) Closing Corporate Jet (4 billion);

3) Closing Oil & Gas Credits (21 billion)

4) Farm Direct Subsidies (5 billion);

5) Closing S Corp pass Through (76 billion);

6) New Sen. White House Tax Proposals;

a) Set Min Rate for Millionaires;

b) higher rates for Oil & Gas;

c) SubPart F changes: Focus on Passive Income, Transfer Pricing & Loans to Parent Co.

Again, it’s the usual list, but what is this?

5) Closing S Corp pass Through (76 billion);

Closing S corporations? $76 billion? That’s a new one, and the description is just vague enough that it could be anything. That said, the only S corporation tax item out there with $76 billion attached to it that we know about originates with a Congressional Budget Office report from December entitled, Taxing Businesses Through the Individual Income Tax.

Here’s the key sentence:

The Congressional Budget Office (CBO) estimates that if the C-corporation tax rules had applied to S corporations and LLCs in 2007 and if there had been no behavioral responses to that difference in tax treatment, federal revenues in that year would have been about $76 billion higher.

In other words, if Congress repealed the current tax status of around 7 million private companies and subjected them instead to the double corporate tax, the CBO says you might raise some money. But $76 billion a year?B Not likely:

Behavioral responses-for example, owners of S corporations might have reduced those corporations’ taxable income by reporting larger amounts for their compensation (which would have raised payroll taxes and lowered corporate income taxes relative to CBO’s estimate)-would have changed the amount of additional tax revenue that would have been collected. Furthermore, the estimate does not account for interactions with other tax provisions, such as the alternative minimum tax.

Later in the paper, the CBO makes clear such a policy would result in less investment, lower wages, and more debt:

Nevertheless, the trend toward pass-through entities’ accounting for a larger share of business activity has some positive aspects. For example, it has probably reduced the overall effective tax rate on businesses’ investments, thus encouraging firms to invest. (The effective tax rate combines statutory rates with other features of the tax code into a single tax rate that applies to the total income generated over the life of an investment.) The shift in activity toward pass-through firms has also reduced at least two biases associated with the current corporate income tax that influence what businesses do with their earnings and how they pay for their investments:

  • The bias in favor of retaining earnings rather than distributing them, which results from taxing dividends immediately but deferring the taxation of capital gains; and
  • The bias in favor of debt financing, which results from allowing businesses, when they calculate their taxes, to deduct from their income the interest they pay to creditors but not the dividends they pay to shareholders.

It’s clear to us that whoever added this idea to the list likely had no clue what they were proposing, but it’s also in indication of just how desperate some in Congress are for revenue that they would even list something like this.

Forcing 7 million businesses into the double corporate tax is simply bad policy. It moves the tax code in exactly the wrong direction – we should be reducing the double tax, not increasing it. That’s the way to reduce the cost of capital and make American businesses more competitive.

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