Defense of the “Framework’s” Pass Through Tax Rate

The class warfare debate over the tax reform “Framework” has shifted its focus to the pass through business provisions.  John Harwood has a typically one-sided piece on the CNBC website, which includes this paragraph:

“There is no strong policy justification for the special pass-through rate in the GOP’s plan,” said Kyle Pomerleau, an analyst at the conservative Tax Foundation.  Since pass-through earnings represent around one-third of all income for the top one percent of taxpayers, Pomerleau added, the provision tilts the plan’s benefits toward the wealthy while favoring one kind of business over others.

Kyle is wrong of course.  There is s very strong policy rational for cutting rates on pass through businesses.

First, consider what would happen if Kyle got his way and the Framework established top rates of 35 percent for S corporations and 20 percent for C corporations.  With the base broadening envisioned in the Framework, the effective tax on S corporations would go up, while the effective tax on C corporations would go down.

That’s correct, a modest reduction in the pass through rate coupled with the extensive base broadening provisions envisioned in the Framework would raise taxes on family businesses across the country even as it cut taxes on larger C corporations.  That’s bad policy and bad politics.  We’ve addressed this issue back in 2011.

The only justification for such a policy is if those S corporations currently paid less than C corporations, with the framework seeking to level the playing field.  But our 2013 study on effective rates by business structure found the opposite is true – S corporations pay a higher effective tax than C corporations, even when you ignore the size disparity:

  • Sole Props:          15%
  • C Corporations:    27%
  • Partnerships:        29%
  • S Corporations:    32%

How is it possible that giant C corporations pay less tax than smaller, closely-held S corporations?  The answer is multifold, including the following:

  • Lower Rates: C corporations are taxed at lower top rates than S corporations – 35 percent verses more than 40 percent.
  • Tax Exempt Shareholders: Unlike S corporations, C corporations can have tax exempt shareholders and many do.  The Tax Policy Center reports that 75 percent of C corporation shareholders are tax exempt or tax advantaged.
  • Deferral of Tax on Overseas Income: C corporations can indefinitely defer repatriating income from their overseas operations to avoid the US tax.  S corporations have to sacrifice their foreign tax credits if they defer, so it isn’t an effective strategy for them.
  • Base Erosion Practices: C corporations can shift income overseas to avoid high US tax rates.  For S corporations, no deferral means no income shifting.
  • Less Aggressive AMT: There is a Corporate Alternative Minimum tax, but it is not as aggressive as the Individual AMT that applies to S corporations.  The fact is most successful S corporation shareholders pay the AMT, not the regular tax code.

All these factors result in S corporations paying more.  But what about the double corporate tax?  Doesn’t that increase the effective tax paid by C corporations?  The answer is that most C corporation income is never subject to the double tax.  Keep in mind that 75 percent of C corporation shareholders either don’t pay tax at all (charities, private foundations, etc.) or they are tax advantaged and pay really low rates (foreign shareholders, qualified retirement plans, etc.).  Meanwhile, SOI data shows that less than five percent of C corporations pay any dividends at all.  Warren Buffett’s shares of Berkshire Hathaway have never been subject to the second layer of tax, and they never will.

The result is that while the double tax distorts behavior and hurts investment and job creation, it doesn’t add that much to the federal treasury.  This is why 120 national trade groups endorsed restoring rate parity and eliminating the double tax as part of tax reform.

S corporations pay more now, and under a tax reform where their tax rates hold steady, they would pay more still.  Not good.

Why don’t they just convert?  This is a question we get quite often.  While most C corporations don’t pay dividends, and don’t pay the double tax, converted family owned S corporations would have no choice.  With few exceptions, S corporation shareholders are taxable U.S. residents.  It is one of the requirements for being an S corporation.

Moreover, the basic nature of closely held businesses requires dividend payments.  How else do you reward shareholders?  There’s no public market to sell your shares, and there’s no listing to track its value.  You can’t borrow against it easily, either.  So if the business doesn’t pay out dividends, why bother owning it?  And unlike a C corporation, all those dividends are being paid to taxable shareholders.

Under a Framework where pass through rates stay high, S corporations would pay more if they retain their S corporation status, and even more if they convert to C.  Talk about being stuck between a rock and a hard place.

The Framework recognizes this challenge by giving S corporations and other pass throughs a lower tax rate to match the rate reduction offered to C corporations and offset the base broadening in the plan.  It’s no giant giveaway, mind you.  Even with the lower 25 percent rate, the base broadening coupled with the 3.8 percent NIIT and the need for enforcement measures means the actual tax reduction for S corporations is likely to be modest.

But he alternative is to tell all those pass through businesses – the ones who employ most private sector workers and earn the majority of business profits – that it’s time to sell, because they won’t survive in an environment where they pay effective tax rates in the 30s, while their C corporation competition pay effective rates in the low 20s or teens.  That’s simply not sustainable, which is why it’s not in the Framework.

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