Pass Through Tax Rates and the 70/30 Rule

Axios reported over the weekend that the tax plan to be rolled out by the “Big Six” Wednesday will call for a 35 percent top rate for individuals, 25 percent for pass through businesses, and 20 percent for corporations.

If true (that’s a big “if” these days with all the misinformation flying around), it’s great news.  It would mean both Congress and the Administration have committed to treating Main Street businesses fairly in tax reform.  That said, the devil is in the details here.  As S-Corp readers know, the challenge in establishing a separate rate for pass through businesses is two-fold – first you have to define the tax base correctly and second you have to make sure that any enforcement of the new, lower rate doesn’t undermine its value for real business profits.

The first challenge is simple; as S-Corp testified before the Senate Small Business Committee earlier this year:

…the tax base for pass through businesses should mirror the tax base for corporations and include all the active business income earned by S corporations and other pass through businesses.  Provisions to limit the new rate’s application based on shareholder status or the size of the business are inappropriate.  Senators Susan Collins (R-ME) and Ben Nelson (D-FL), along with Representative Vern Buchanan (R-FL), have introduced legislation that demonstrates how the pass through tax base can be defined effectively.

Enforcing the new pass through rate against cheating, on the other hand, is not simple; here is what S-Corp argued back in June:

…establishing a separate rate for pass through business income creates an enforcement challenge by taxing active pass through business income at a lower rate than individual wage and salary income.  The bigger the difference in rates, the bigger the enforcement challenge.

In addressing this challenge, Congress needs to make sure it doesn’t undermine the value of the lower rate to business owners.  Separating the return on owner’s labor from the return on their investment in the business is not easy, but guidelines to reinforce the new pass through rate should include:

  1. Exempting non-active owners from the enforcement provisions. If an owner of a pass through business does not materially participate in the operation of the business, then there is no issue.  
  2. Recognizing the investment pass through businesses make in their capital and employees. The new rule needs to recognize that some businesses make significant investments in both capital and employees and that much of the business’ profits derive from these investments.
  3. Ensuring the new rules are easier to comply with – and enforce – than the existing “reasonable compensation” rules the IRS uses today.

One idea Congress should reject completely is establishing a set ratio of wages-to-profits like the 70-30 rule left over from the old Camp tax reform draft.  S-Corp strongly opposed it then, and we oppose it now.

The premise behind the 70/30 rule is that historically, economic output is made up of about 70 percent returns to labor and 30 percent returns to capital, so that ratio should also apply to the income of pass through business owners.  This is simply wrong – while the overall economy may be divided 70/30, not every company conforms to that ratio.  Capital intensive industries would be disadvantaged by the ratio, while law and accounting firms would benefit.  Here is a simple example to illustrate the shortcomings of 70/30:

In year one, an investor buys a company for $10,000,000 that has a ten percent rate of return.  The $1 million in annual profits from the company are obviously a capital return and, since the investor doesn’t work at the business, they should be eligible for the lower 25 percent pass through rate.

In year two, however, the investor begins working at the company, earning reasonable compensation of $500,000 for his work.  Under current law, the investor pays individual income and payroll taxes on his compensation, and pays applicable pass through rate on his $1 million in profits. 

Under 70/30, however, his total income of $1.5 million would be treated as $1,050,000 wages and $450,000 profits.  In other words, $550,000 of his profits would be re-designated as wages.  Under the rate structure outlined above, this would represent a tax increase of about $75,000 (25 percent pass through rate versus 35 percent individual rate plus the 3.8 percent HI tax). 

This is obviously the wrong result and, if put into practice, would encourage owners of pass through businesses to stop working.  The higher the ratio of their profits to wages, the greater the incentive.

It could also mean the difference between a tax cut and a tax hike on these employers.  In comments to Senate Finance Committee this summer, S-Corp observed that applying a 70/30 approach to the House Blueprint’s base broadening provisions could result in an actual tax hikes for many S corporations.  Cutting taxes for large multinational C corporations while raising them on smaller Main Street businesses is not a recipe for successful tax reform, and it emphasizes the need for Congress to get the enforcement challenge right.  There are many approaches Congress could take, and we’re working to help identify them, but it is obvious a fixed ratio like 70/30 is not the place to start.

Fact Checking the Fact Checkers              

Who’s editing the “Fact Checker” feature at the Washington Post these days?  Last week the Post gave Speaker Pail Ryan “Two Pinocchio’s” for comments that were entirely factual and represent a legitimate perspective in the upcoming tax reform debate.  Here’s what the Speaker said:

“It is a terrible tax system that was written in ’86. … The headlines write themselves:  We tax our corporations at 35 percent, and successful small businesses are taxed as high as 44.6 percent.  The average tax rate in the industrialized world for businesses is 22.5 percent.”

Those numbers are correct, and they reflect the concern that the marginal tax rates we impose on American businesses puts them at a competitive disadvantage.  It’s an argument that’s been made for years.  But here’s the Post;

During his interview, Ryan rehashed several of the often-cited statistics.  But he puts them together in a misleading way.

What is misleading about citing tax rate statistics?  According to the Post, they weren’t the right statistics.  The Post prefers citing effective tax rates, not marginal ones.  But a preference is an opinion, not a fact, and their preference for measuring effective tax rates ignores the economic damage high marginal rates cause by retarding investment decisions.  Both measures are important, and both are legitimate.

Regarding the 44.6 percent top marginal rate, the Post complains the source of the statistic was a Ways and Means press release, not an actual “report” from an “independent research organization.”  Seriously?  The 44.6 percent top rate has been cited by numerous organizations for years.  It is the top marginal rate faced by pass through businesses.  Here’s the Tax Policy Center in a report on taxing entrepreneurial income:

The 44.6 percent figure is the sum of the 39.6 percent top marginal income tax rate, the 3.8 percent Medicare surtax on the investment income of high-income taxpayers, and the 1.2 percentage point increase in the marginal rate resulting from the limitation on itemized deductions.

The Post also claims the 44.6 percent rate is misleading because it only applies to a small percentage of small businesses.  That’s correct, but again it misses the point.  Back in 2011, Treasury reported that pass through employers making more than $500,000 made up just 11 percent of all pass through employers, but represented two-thirds of the total pass through employer income.  The simple fact is the 44.6 percent top rate applies to a large portion of pass through business activity and its impact on jobs and investment cannot be minimized.

Finally, the Post calls the 22.5 percent rate for the rest of the world “misleading” because the average is not weighted to reflect national incomes.  Jane Gravelle, a long-time opponent of tax reform, argues, “If we are looking at the relative taxes for making investment decisions we want countries with larger economies where more investment is feasible to be weighted more heavily.”  But again, preferring weighted over simple averages is an opinion, not a fact.  Moreover, it is misleading to minimize the outsized role smaller countries play in tax policy.  Ireland is a tiny country with five million citizens and a $300 billion economy, but its 12.5 percent corporate tax rate has had a massive impact on corporate behavior and international tax policy.

There are moments of real comedy here.  Discussing the 35 percent corporate rate, the Post writes, “Ryan’s 35 percent corporate tax figure, which comes from the OECD, is the country’s statutory rate – it is the rate in law only.”  Really?  The OECD sets tax rates in the US?  And what is this line about the 35 percent being the “rate in law only?”  So, corporations don’t have to pay it in the real world?  Tell that to the US retail industry.

When making the case for using effective tax rates, the Post cites a 2013 CBO analysis showing US businesses face the fourth highest effective tax rate in the G-20, but fails to notice that analysis supports Ryan’s argument.  It also failed to observe that two of the three countries with higher effective rates when the report was written (the UK and Japan) have subsequently cut their corporate rates, again making Ryan’s point.

Speaker Ryan’s case for business tax reform is a legitimate position shared by businesses and experts alike.  Real tax reform that sharply reduces the marginal rates paid by US businesses is long overdue.  Meanwhile, the Post gives us just one more example of why so many people simply don’t trust major media outlets.  #FakeFactChecker.

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