Pass Thru Rates & Enforcement

As Congress returns to tackle tax reform, one area of consensus continues to be ensuring that Main Street is treated fairly by establishing a new, low top rate on pass through businesses.  But separating business and individual rates brings its own challenges.  As BNA reported last week:

Economists and tax accountants note that taxing pass through income at rates distinct from the individual income scale would open up incentives for taxpayers to route their income through the lowest rate path. Treasury Secretary Steven Mnuchin recently said tax reform legislation would include rules to prevent people from gaming the tax rate meant to spur business investment.  

From S-Corp’s perspective, creating a unique rate for pass through businesses requires two essential steps:

  • First, you have to define the new pass through tax base correctly.
  • Second, you have to include enforcement rules to reduce or eliminate the opportunity for individuals to recharacterize their wage and salary income as business profits in order to access the lower tax rate.

The first of these challenges is fairly straightforward.  A rate applying to pass through businesses should mirror the tax base for corporations and be broadly defined, embracing all the active business income earned by businesses organized as pass throughs.  H.R. 116 from Representative Vern Buchanan (R-FL) is a nice example of how this should be done.

The second challenge is more problematic and has been with us since Congress eliminated the wage cap on Medicare taxes back in 1993.   Exactly how do you distinguish returns from an owner’s personal labor from returns on his/her investments in capital and employees?  It’s not easy and, more importantly, getting it wrong has the potential to completely undo the benefits of tax reform to Main Street businesses.

By way of example, a provision in the Camp tax reform draft would have established a strict, 70/30 ratio of wages to business profits for all pass through businesses.  S-Corp and the rest of the Main Street business community pushed back hard, arguing that a fixed ratio recharacterizing business profits as wages was unfair and would hurt pass through businesses with lots of employees and capital investments.

This same argument applies if the Committee would add the 70/30 rule to the House Blueprint.  Ostensibly, the Blueprint has a top rate structure of 33 percent for wages, 25 percent for pass through businesses, and 20 percent for C corporations.  But applying the 70/30 test broadly to active owners means in reality the top rate for S corps and partnerships would be closer to 31 percent, 11 percentage points higher than the C corp rate.  We’re not perfectionists when it comes to rate parity, but having an effective rate more than 50 percent higher than competing C corps isn’t rate parity in anybody’s book.

Moreover, the strict 70/30 rule has the potential to turn the Blueprint from a tax cut to a tax hike for many pass through businesses.  To understand the threat, look at how coupling the Blueprint with the 70/30 rule would affect this particular S corporation manufacturer.

Tax Reform Example

As you can see, not only does the 70/30 rule result in this manufacturer paying significantly more than a similar C corporation, it means the Blueprint could be an actual tax hike on this manufacturing company.  Under current law, they pay $1.16 million in taxes.  Under the Blueprint, they would pay $60,000 more.  The Blueprint’s lower rate is fully offset by the loss of state and local tax deductions, Section 199, and the ability to write-off interest expenses.

You can see a full discussion of these issues in this presentation, but the simple fact is that if Congress is going to establish a separate rate for pass through businesses, it needs to get the enforcement challenge right.  Getting it wrong means completely undoing the benefit of lower rates and the other pro-business provisions in the Blueprint.  More on this to come.

 

2704 Study Highlights Threat from Proposed Rule

This week, the S Corporation Association along with several other trade groups released a new study highlighting the threat the pending Section 2704 rules pose to family businesses and their employees.

Authored by former Clinton economist Dr. Robert Shapiro and entitled “An Economic Analysis of Proposals to Limit the Recognition of Valuation Discounts for Transfers of Interests in Large Family Businesses,” the study finds that family-controlled businesses are a significant source of earnings and employment in the US economy.  According to the study:

  • Large family businesses account for 31.8 percent of U.S. business revenues, 30.7 percent of U.S. private employment, and 31.1 percent of U.S. payrolls.
  • Large family businesses have less employee turnover, leaner cost structures, and smaller debt burdens; they also invest at higher rates and over longer time horizons than comparable non-family businesses.

Meanwhile, the pending section 2704 rules would hurt the ability of these family businesses to grow and create jobs.  The study finds that:

  • Limiting valuation discounts under the Proposed Rule would increase estate taxes for large family businesses by $633.3 billion, in present discounted dollars, over the next 46 years.
  • To prepare for this additional burden, these businesses would divert resources, equivalent to the additional tax they will owe, from their normal business investments.
  • The projected reductions in their investments in equipment and machinery would reduce GDP growth, in 2016 dollars, by $2,476 billion from 2016 to 2062.
  • This slower growth also would reduce job creation over the next decade by 105,990 jobs.

The study was sponsored by the S Corporation Association and several other groups, including the Real Estate Roundtable, the Associated Builders and Contractors, and the Independent Community Bankers of America, with a goal of highlighting the threat these pending rules pose to family businesses and their employees.

With the Trump Administration actively seeking ideas on how Treasury can reduce red tape and encourage investment and growth, withdrawing these 2704 rules should be job one.  A record number of opponents weighed in during the official comment period last fall, yet the rules continue to perplex family businesses and their advisors as they make succession plans.  This one is easy, and S-Corp will be working on it until it’s done.

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