Proposed 199A Rules Released
It’s not late Friday afternoon, so why is Treasury releasing important new rules on the pass-through deduction? We’re not sure, but we like it!
The rules themselves look pretty good too, and our members’ initial reaction to the rules was mostly positive. Here’s the statement S-Corp released earlier today:
“Treasury’s proposed rules are a good start to making the pass-through deduction workable for Main Street businesses. There are many important details to clarify and we have specific concerns about some of the definitions and reporting requirements, but the overall approach taken by Treasury is positive and should be applauded. Our goal is to make certain the 20-percent deduction is available to real businesses with real employees. We think these rules are a good beginning, and we will use the comment period to clarify our remaining concerns.”
Today’s release was broader than what we expected, and appears to be designed to give most businesses the details they need to file next year, including a refined definition of “trade or business,” clarification on which industries are “specified services” and therefore precluded from the deduction, and a new approach to when business owners may aggregate or group together separate legal entities to calculate the deduction.
S-Corp has championed the aggregation issue since the beginning of the year and the proposed rules are generally consistent with our recommendations. They cut a middle ground between a narrow interpretation severely limiting the ability of owners to aggregate and a broad approach with few limitations, as under Section 469. The resulting approach looks like a good-faith effort to allow owners to aggregate groups of businesses when it is appropriate.
Here are some of the details:
- The rule defines what qualifies as a trade or business, and then requires that any aggregated group only include trades or businesses.
- The same group of owners must own a majority stake of each business in the aggregated group. Owners are allowed to apply family attribution rules to measure their ownership stake, and minority owners may rely on the ownership of the entire group to qualify for aggregation.
- None of the aggregated businesses may be a “specified services” business.
- Each business in the aggregated group must meet at least two of the following three factors:
- Provides products and services that are the same or customarily provided together;
- Shares facilities or centralized business elements (personnel, accounting, purchasing etc.); and
- Operates in coordination with, or reliance upon, other businesses in the aggregated group (supply chain, vertical integration, etc.).
- Owners of the same businesses are not required to coordinate their aggregation approach, so each may choose different groups.
- Aggregated groups must be consistent year to year, with proposed rules on when owners are allowed to adjust a group.
Left out of the rule was guidance on how to address tiered ownership and how to stop owners from gaming the rules by disaggregating their businesses. Moreover, while the proposed rules better defined the population of “specified services” that don’t qualify for the deduction, many business activities remain in limbo, not sure which side of the line they fall. That’s not Treasury’s fault – it’s the concept of a specified services that’s problematic, not the rules that follow. One bit of good news is that Treasury narrowly defined when a business’ “principal asset is the reputation or skill of one or more of its employees.” That language has always been impossible and should be discarded by Congress.
In other good news, the proposed rules clarify that Electing Small Business Trusts get the deduction, just like any other owner of a pass-through business.
Treasury has set a 45-day comment period on the rules and scheduled a public hearing at the IRS on October 16th. S-Corp will be providing detailed comments on the rules and expects to testify on the 16th as well. Getting these rules right is our number one priority for the year. The proposals out of Treasury today are a good start – we will be working with them and the Hill over the next two months to make sure the details are just as good.
Pass-Through Parity Briefing
The S Corporation Association participated in a Hill briefing Tuesday highlighting new work for Ernst & Young on the challenge of establishing parity for pass-through taxation.
The analysis, authored by Robert Carroll of EY, focused on all the complexities confronting pass-through businesses under the Tax Cuts and Jobs Act, and the resulting matrix of possible tax outcomes for pass-through businesses. As the table shows. Effective tax rates on successful S corporations (and other pass-through businesses) are consistently higher than the average C corporation, even after adjusting for the double corporate tax and other variables.
These findings are particularly important right now, as Treasury and the Office of Management and budget are working on regulations that would detail how business owners are to calculate the new 20-percent pass-through deduction under Section 199A. The EY analysis demonstrates that how Treasury determines the deduction should be calculated could mean the difference between getting the full deduction or none at all for some businesses.
The briefing, held in the Capitol Visitors Center with about 75 attendees, began with Senator Ron Johnson (R-WI) summarizing the last fall’s tax debate and the need for Congress to continue to focus on reforming how businesses are taxed. As summarized in BNA:
Congress should consider taxing C corporations like pass-through businesses—at the individual owner level—to create a more level playing field between the two types of entities, Sen. Ron Johnson (R-Wis.) said July 31 at an event on Capitol Hill.
The 2017 tax law (Pub. L. No. 115-97) didn’t take this approach, but Johnson said he still believes that such a change would offer the best solution for simplifying and rationalizing the tax code. The senator said he hasn’t received a revenue score for the proposal but expects it would raise money that could be put toward other tax code changes.
Dr. Carroll then presented his analysis, followed by a panel of discussants including Richard Rubin of the Wall Street Journal, Doug Holtz-Eakin of the Americans for Tax Reform, and Brian Reardon of the S Corporation Association. You can watch the entire briefing here:
S-Corp’s New York SALT Comments
Today the S Corporation Association submitted comments to the New York Department Taxation and Finance on their proposed SALT fix for partnerships.
Following hard on the heels of the new Connecticut SALT fix, New York asked stakeholders for feedback on their draft to restore the State and local tax deduction for New York partnerships. In its comments, S-Corp made clear its support for the proposal with the following three improvements:
- “Expand the UBT to include S corporations as well as partnerships. There are 410,000 S corporations in New York State, employing more than two million people. These S corporations face the same challenges with the new policy as partnerships and they should be included in the reform.
- Allow for S corporations and other pass-through businesses to elect out of the UBT on an annual basis. There are several reasons why a pass-through business may choose not to be taxed at the entity level. They should be given that flexibility. Making the UBT an election is essential to avoiding unintended and unnecessary hardships.
- Maintain current levels of revenue. The purpose of this reform should be to restore legitimate business deductions to New York’s Main Street community, not to raise new revenues.”
With the New York legislature out for the year, this proposal will have to wait until next year, but the request for comments demonstrates that the state-based fix to the SALT mess continues to have legs in New York and elsewhere.
You can read the full S-Corp comments here. Other affiliated groups submitting comments include our Parity for Main Street Employers coalition and the STAR Partnership.
The effort to restore SALT deductions continues!
Tax Breaks for Job Creators
Center for Budget and Policy Priorities (CBPP) got itself into a lather the other day noting that the new, 20-percent deduction for pass-through businesses will reduce revenues by twice what the federal government spends on Pell Grants.
What’s the link between the Pell Grant program and the business income deduction? None. There is no link. The CBPP could have just as easily compared the deduction to spending on our national defense or agriculture programs.
Moreover, while the CBPP makes certain to highlight the 7.7 million beneficiaries of the Pell Grant program, they ignore the 73 million employees who work for pass-through businesses. Those workers earn around $2 trillion a year in wages. To borrow the CBPP’s simple-minded premise, that’s bigger! Nine-times more employment and seventy-times more monetary benefit. And unlike a Pell Grant, those pass-through jobs continue from one year to the next, providing a safety-net of economic security for tens of millions of families across the country. But no matter. For the CBPP, government spending is always more important than private sector jobs.
Also missing from their post is any notion of the actual taxes pass-through owners pay. The CBPP laments that the “pass-through tax break is extremely regressive: a full 61 percent of its benefits are expected to go to the top 1 percent of households by 2024” but fails to note that those households will continue to pay enormous amounts of tax – more than $500,000 a year.
That’s typical of left-of-center tax analysis. The opponents of tax relief never focus on tax burdens, just tax benefits. To the left, everybody is a beneficiary.
So, the CBPP is upset that taxpayers employing the majority of private sector workers and paying high levels of tax get a reduction in a bill designed to, wait for it, cut taxes and promote jobs. Go figure.
This is an age-old battle – the CBPP will always want higher tax burdens on job creators to fund more government spending. That’s who they are. But we reject the idea that the United States is merely a country of beneficiaries. It’s a country of entrepreneurs and risk takers and workers and creators – the types of people that start businesses and make investments and create jobs. That’s the population targeted by the pass-through deduction in the Tax Cuts and Jobs Act.
These businesses are the very backbone of the American economy and to keep them and their workers dynamic and growing, we need a federal tax code that maintains parity between big public corporations and Main Street businesses. That’s why the pass-through deduction was included in the Tax Cuts and Jobs Act, and that’s why the Main Street business community is committed to making the deduction work for all employers, including making it permanent.
Mass S-Corp Conversions? Not Yet, But Wait ‘til the Deduction Expires
The headline is eye-grabbing, but what does it mean?
A new study by Penn Wharton predicts a “mass conversion” of pass-through businesses to C corporation under the new tax law. Specifically, the study finds that 235,780 pass-throughs representing 17.5 percent of all pass-through income will convert to C corporation in response to the new rules.
What sort of businesses are most likely to convert? Those professional services businesses that don’t qualify for the new deduction. Faced with a choice between paying the pass-through rate of around 40 percent and a corporate rate half that much, they are understandably attracted to the lower rate, particularly if they have the ability to defer paying out dividends.
Key points reported by the authors:
- “We project that the Tax Cuts and Jobs Act (TCJA) will cause 235,780 U.S. business owners—77 percent of whom have incomes of at least $500,000—to switch from pass-through entity owners to C-corporations, primarily to take advantage of sheltering their income from tax by converting to C-corporations.
- The biggest switchers include doctors, lawyers and investors, especially if owners can afford to defer receipt of business income to a later year. Other business owners, who are qualified to use the 20 percent deduction for pass-through business income, including painters, plumbers, and printers, are more likely to remain as pass-through entities.
- We project that about 17.5 percent of all pass-through Ordinary Business Income will switch to C-corporations.”
So we’ve come full circle. The C corporation is the new tax avoidance vehicle for highly-paid professionals, just like it was pre-1986.
But what about the headline? We’re not sure how “mass” this conversion is, given that there are more than four million S corporations and nearly that many partnerships and LLCs. Their estimate is less than five percent of the total population here. Less than one percent if you include sole proprietors.
Moreover, we already knew the new tax bill shifted the equilibrium between pass-throughs and C corporations. Every S corporation we work with is considering converting. We have yet to hear of a C corporation going the other way.
For S-Corp, the news here is less about doctors and accountants and more about what it says will happen if the pass-through deduction is allowed to expire. This study makes clear the dramatic separation in outcomes for those pass-through businesses that get the deduction and those that don’t. For businesses that get the deduction, entity choice is a close call. For those that don’t, there really is no decision—they will all be C corporations.
A 21-percent corporate rate without an off-setting pass-through deduction will push the business community in the wrong direction—towards the harmful double corporate tax rather than away from it.
Which is why the law’s authors need to start pressing for permanence now. The deduction is slated to expire in eight years, which might seem like a long time, but multi-generation businesses plan in decades, not years. For them, the temporary nature of the deduction plays a significant role in their planning right now.
So pass-through businesses are converting, just not “massively”. The real “mass” conversion is yet to come, but only if Congress fails to act.
NOTE: The Penn Wharton study has some good data, but they have the rates wrong. The double tax on C corporations under the old law was 50.5 percent, not 58.8 percent. Under the new law, it’s 39.8 percent, not 44.8 percent. And that rate is only achieved by C corporations that pay out all their earnings immediately to fully taxable shareholders, which we know doesn’t really happen in the real world. Businesses that need to distribute all their earnings to taxable shareholders are called S corporations. By overstating the top corporate rate, the authors get the relative rate story wrong—its pass-through businesses that pay the higher amount under the new rules, not C corporations.
