Tax Reform Plan Forthcoming

After months of meetings, the so-called Big Six are preparing to release some sort of summary of their work the weekend of the 23rd.  The Ways & Means Republicans have a retreat that weekend, and Chairman Brady intends to use the time to sell the plan.  The idea is to get the Committee R’s comfortable, and then move on to the broader membership and the public.

What’s in the plan?  Recent conflicting accounts over rates suggests it’s still a moving target, but there are a few areas that seem firm.

For starters, we expect it will include a combination of specifics, options, and principles.  Where specifics are lacking, it could be due to ongoing disagreements, but it also could be out of a desire to give the committees some flexibility to craft their own plans within a certain framework.

Moreover, since the demise of the border adjustment and the $1 trillion in revenues it provided, the overall size of the package should significantly smaller, which means top tax rates will be higher than what was in the House Blueprint and many other beneficial provisions could be pared back or excluded entirely (such as the AMT repeal and full expensing).

We expect the health care tax provisions targeted for repeal in health reform to remain outside tax reform.  In other words, repeal of the device tax and investment surtax likely will have to wait for health care reform.  There should be lots of pressure on the tax writers to reconsider this approach, but we expect that’s where they will start.

Finally, paring back expensing coupled with higher tax rates on business income suggests the growth potential of the plan will be significantly smaller than the Blueprint, which means less positive economic feedback, which means less revenue from the new dynamic scoring.  It’s the opposite of a virtuous circle and in the end, key provisions in the Blueprint will have to be excised to make it all work.

Process:  The process from here resembles a game of Jenga, where everything is connected and one false move brings the whole effort crashing down.  That is because adoption of tax reform is contingent upon adoption of a budget resolution for FY 2018, but adoption of the budget resolution is contingent upon acceptance of the tax reform plan.

The latter is due to the fact that the House Freedom Caucus, representing a key voting bloc of about three dozen conservative (populist?) Republicans, has made clear they won’t support a budget until they are comfortable with the details of the tax plan it would enable.  As Politico points out, it’s putting the cart before the horse, but in practice it means that the tax writers will have to release the details of their plan before the budget resolution can move forward.

So that’s what they are going to do at the end of the month.  Will it work?  Here are some of the obstacles they will face:

House v. Senate:  While the Big Six includes both House and Senate negotiators, there is a strong chance the respective bills those bodies consider will be substantially different.  Differences between the two stopped them from releasing details just prior to the August recess, and those differences could signal fewer specifics this time around too.  In practice, both bodies will have to move their own bills anyway, so initial differences aren’t a deal killer.  But after all these months of negotiation, it does suggest getting the two bodies together on a final package won’t be easy.

Message Discipline:  The Administration continues to suffer from a remarkable lack of message discipline.  Over the last week, Treasury Secretary Mnuchin has talked about one tax reform plan, while the President has talked about a plan that sounds completely different.  How this resolves itself is anybody’s guess, but it does raise the possibility that the plan released by the Big Six at the end of the month may have one very prominent opponent.

Freedom Caucus Opposition:  The Freedom Caucus, or at least their leader, Congressman Mark Meadows, has put together a list of priorities that are difficult if not impossible to meet.  After leading the charge to kill the border adjustment and expensing, he has argued in recent weeks that tax reform should cut the corporate rate to 16 percent, among other things.  That’s well outside where Congress can go on tax rates, and begs the question of whether the Freedom Caucus will ever be satisfied with a plan that could actually pass?

Revenue Raisers:  To date, opposition has focused on big ticket items like the border adjustment and full expensing.  But the demise of the border adjustment puts increased pressure on tax writers to include lots of revenue raisers in the plan, and all those raisers have constituencies that will fight for them. Are the benefits of the plan compelling enough to overcome this opposition?  That’s a key question that will have to be answered.

So that’s the overview.  Tax reform is by no means a done deal and as the above list of concerns makes clear, there are lots of hurdles to overcome.  That said, the fact that Congress is preparing to transition from talking about tax reform to acting on it is a positive, and we look forward to seeing what they come up with.

Regarding S-Corp, we are focused on three things:  1) ensuring pass through businesses enjoy rate parity with C corporations; 2) making certain the international rules don’t penalize S corporations if the tax code transitions to territorial; and 3) making sure our modernization act is ready to be included in whatever tax bill is moving.

Expect to hear more from us on tax reform in the coming weeks.  It’s crunch time.

S-Corp Comments on 2704

Monday was the close of the comment period for Treasury Notice 2017-38, and the S Corporation Association joined several other trade groups in submitting our final comments on the pending Section 2704 rules, including our study highlighting the threat these rules pose to family businesses and their employees.
This comment period is the latest in a long saga and we hope it marks the beginning of the end.  To recap:
  • August, 2016 – Treasury issues Notice 2017-38 targeting proposed rules under Section 2704;
  • November, 2016 – The official comment period closes, with Treasury receiving a record number of comments in opposition to the rule (read S-Corp’s comments here);
  • December, 2016 – Treasury and the IRS host a hearing on the proposed rules, which lasts a record six hours (read S-Corp’s testimony here);
  • April, 2017 — Release of Trump Executive Order 13789directing Treasury to review all rules published since January 1, 2016 and identify those that are financially burdensome, unduly complex, or exceed Treasury’s authority; and
  • June, 2017 – Treasury targets eight rules for revision or repeal out of the 105 studied, including the harmful Section 2704 rules.
The study we submitted in this most recent comment period was authored by former Clinton economist Dr. Robert Shapiro makes clear that the Section 2704 rules violate all three of the criteria established in the President’s EO – they are financially burdensome, they are unduly complex, and they exceed Treasury’s authority.   They would also 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.
So now with numerous publications and comment periods behind us, the record is clear.  The proposed Section 2704 rules are harmful to family businesses and the people who work for them and need to be withdrawn.  Soon!  It has been just over a year since these rules were first published and it’s time to put them to rest.

S-Corp in the News

The Washington Examiner published a piece Monday on the implications the failed health care reform effort has for tax reform.  First among those is the continuation of the so-call Net Investment Tax that applies to investment and pass through business income.  As the Examiner notes:
And one of the taxes in particular, a tax on investments for high-income earners, hits many of the small businesses that Republicans have been trying to create new provisions to help. 
 
That would be the net investment income tax, a 3.8 percent tax surcharge on capital gains, interest and dividends for families making more than $250,000.  Repealing the tax would cut revenue by $172 billion over 10 years, according to Congress’ Joint Committee on Taxation. 
Although the tax applies to individuals, it also falls on businesses that file through the individual side of the code, a category that Republicans are hoping to privilege with a new special tax rate.
 
“It hits a broad swath of family businesses,” said Brian Reardon, President of the 
S Corporation Association. 
 
Nonmanagement partners in S Corporation businesses get hit with the 3.8 percent tax on the companies’ earnings, Reardon noted.  “It drains money from active businesses,” he said. 
 
S-Corp has been leading the charge to repeal this harmful tax since its inception seven years ago, most recently organizing a letter supporting the tax’s repeal signed by 40 national business trade groups.  The tax was initially presented during the Obamacare debate as a “Medicare” tax on high income investors, but it has nothing to do with Medicare and its burden falls on a large percentage of pass through businesses, as well as a majority of annual savings.  It’s a surtax on savings, pure and simple.
Failing to eliminate this tax as part of health care reform was a huge miss for the economy, so it must be done within the tax reform debate instead.  The business community is united around the idea of bringing down all business tax rates and moving towards rate parity, but that can’t happen with this tax in place.  It has to go.

Letter Leaves Pass Through Employers Behind

For seven years, your S-Corp team has repeated the same mantra for tax reform – tax all income once, tax it at similar reasonable rates, and then leave it alone.  If Congress wants to make the tax code simpler and encourage more job creation, this is the place to start.

A competing view is one where the largest corporations pay very low rates while everybody else – individuals and pass through businesses alike – pay rates significantly higher.  Recall that pass through businesses are taxed via the individual tax rates of their owners.  The idea is that while US corporations can always move someplace else and therefore need lower rates to stay, US citizens and private companies are less mobile.  They are effectively trapped, and we can tax them accordingly.

This view of imposing higher tax rates on individuals was embraced in a letter signed by 45 of the 48 Senate Democrats sent to President Trump, Senate Majority Leader Mitch McConnell, and Finance Chair Orrin Hatch today.  You can read the whole letter here.  According to Politico:

The Democrats who signed onto Tuesday’s letter, spearheaded by Minority Leader Chuck Schumer (D-N.Y.) Schumer and Oregon Sen. Ron Wyden, the top Democrat on the tax-writing Finance Committee, also made two blunt demands on taxes: They will not back any bill that gives new breaks to the wealthiest individuals and will not back any legislation that adds to the deficit.

“Tax reform cannot be a cover story for delivering tax cuts to the wealthiest,” the senators wrote. “We will not support any tax plan that includes tax cuts for the top 1 percent.”

The Democrats added that they “will not support any effort to pass deficit-financed tax cuts, which would endanger critical programs like Medicare, Medicaid, Social Security, and other public investments in the future.”

Our concern is that this push against rate reduction for high income individuals could end up hurting pass-through businesses, where Senate Democrats support cutting rates on the largest multinational companies, but oppose rate reduction for the successful S corporation down the street.  Keep in mind, that large S corporations already pays higher marginal rates than do C corporations – 40-plus percent versus 35 percent – and also likely pays higher effective rates as well.  Our 2013 study on effective tax rates found that large S corporations pay the highest effective tax rate of any business type – 35 percent.

And while the letter targets high-income tax payers, workers at pass through businesses could be affected too.  The burden of business taxation falls on owners and workers alike.  Here’s CRS on the issue back in 2012:

The analysis above found that the majority of pass-through income accrues to higher income earners. The income these individuals receive is the result of an ownership stake in either a sole proprietorship, partnership, or S corporation. But there are other taxpayers, namely the employees at these firms, who receive income from pass-throughs as well. If taxes are increased on passthroughs, it is possible that pass-through owners could lower wages, scale back benefits, or reduce employment in an effort to reduce the burden of the tax increase on themselves. Thus, although the majority of pass-through income is concentrated at the upper-end of the income distribution, the tax burden could be shared with lower- and middle-income taxpayers who work at these businesses.

An Analysis of Individual Tax Return Data on who bears the corporate tax burden can be utilized to understand who would bear the burden of increased pass-through taxation generally0owners (capital), or workers (labor).  The traditional analysis of the corporate tax indicates that it is capital that bears the burden. In contrast, a number of more recent theoretical studies find labor bearing the majority of the corporate tax burden. These results, however, appear to rely critically on particular assumptions (e.g., an open economy with highly mobile capital) which drive the results. When these assumptions are relaxed the burden of the corporate tax is found to fall mostly on capital, in line with the traditional analysis. (Emphasis added)

But we do live in an “open economy with highly mobile capital.”  That’s why so many US corporations are able to move their profits, IP, and headquarters overseas.  Which means the burden of the corporate tax falls increasingly on workers through lower wages and lost jobs.

We suspect this is the reason the Senate Democrat letter doesn’t oppose lowering rates on C corporations.  The letter implicitly concedes that for the US to be competitive and improve our jobs base, tax rates on corporate employers need to come down.  What is missed is that same argument applies to pass through employers as well.

For a clearer view of how much pass through employment would be affected by this approach, refer to the Treasury Department 2011 report entitled “Methodology to Identify Small Businesses and Their Owners.”  Table 15 reports that two-thirds of the income earned by pass through employers is earned by individuals making more than $500,000.  Those are the individuals targeted for high rates under the Senate Democrat letter.

How many jobs are we talking about?  There is no direct measure, but the Tax Foundation reported back in 2015 that “a significant number of employees work at large pass-through businesses. According to 2011 Census data, a combined 27.5 percent (18.1 million) of pass-through employment was at firms with more than 100 employees, and 15.9 percent (10.3 million) of pass-through employees work at large firms with 500 or more employees.”

So if the point of tax reform is to bring jobs and investment back to the US, pass through businesses – all of them – need to be part of the reform.  Successful pass through businesses employ millions of workers, and excluding them from rate cuts puts those jobs at risk.

That’s the reason we have kept the same mantra going for seven long years.  Tax all income once, tax it at similar reasonable rates, and then leave it alone.  It’s a recipe for success for C corporations and pass-through employers alike.  The business community has embraced this approach.  It is time for tax writers to do the same.

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