Senate Reviews Tax Bill
Yesterday’s Finance Committee hearing on the tax bill was interesting, if only to remind viewers that it’s way too early to pass final judgement on the tax overhaul. Not that several Committee members didn’t try.
Exhibit A was a new Joint Committee on Taxation report with some selective analysis of the tax plan. Members repeatedly brought up Table 3 and the fact that so much of the “tax benefit” of the pass-through deduction will go to taxpayers making more than $1 million.
The goal of the pass-through deduction was to maintain tax parity between Main Street businesses and giant C corporations – pass-through businesses employ most of the private sector American workforce and they are an essential part of the American economy. With the top corporate rate dropping to 21 percent, something had to be done on the pass-through side.
Even after the deduction, however, pass-through businesses will still be paying effective marginal rates well above the rates paid by C corporations – 31.1 percent verse 26.0 percent in the recent Barro-Furman paper.
One reason the effective rate for pass-through businesses continues to be so high is that the benefit of the pass-through deduction is offset by the base-broadening provisions included in the plan. Senators focusing exclusively on the pass-through tax benefit are ignoring the higher taxes those businesses will pay from other provisions the tax overhaul including the loss of the SALT deduction, the active income loss limitation, and other base broadening provisions.
Table 7 makes this point. It shows the loss of the SALT deduction alone costs top earners $33 billion in 2018. That’s $15 billion more than the total pass-through deduction benefit to that same group of taxpayers.
In other words, yesterday’s tax cut critics were focusing on one provision out of this huge bill and claiming that one provision made the whole bill regressive and unfair, while ignoring all the other provisions.
That reality is demonstrated in Table 1 of the JCT report, which shows the tax code was and remains highly progressive, with lower income taxpayers paying low rates and high income taxpayers paying higher rates. How high? Last year, marginal effective rates on taxpayers making more than $500,000 exceeded 40 percent! That’s simply too high. Now, after tax reform, those taxpayers are still paying more than 40 percent.
As readers know, S-Corp has a number of concerns with the tax bill and, particularly, the pass-through deduction. But attempts to criticize the deduction as a give-away to the rich completely miss the point. The goal of the tax bill was to encourage job creation and investment. It’s hard for pass-through business owners to do that when the federal government is taking more than forty cents of every dollar they earn.
Making States More Main Street Business Friendly
(For clarity purposes, this write-up focuses on S corporations. The arguments and policy conclusions largely apply to partnerships as well.)
Like C corporations, S corporations are subject to state and local income taxes imposed on qualified business income. Unlike a C corporation where the state and local income tax is incurred and paid at the entity level, however, an S corporation remits its share of state and local income taxes in three different ways, depending on the state:
- Entity Level State & Local Tax Income Liability
- Composite/Withholding State & Local Income Tax Liability
- Individual State & Local Income Tax Liability on Business Income
The legislative history of the Tax Cuts and Jobs Act makes clear that for S corporations operating in states using method 1, those taxes would continue to be deducted at the entity level, resulting in less taxable income being passed through to the shareholders. The result is that in states that utilize that method, those taxes remain deductible.
In states where the S-Corp is required to pay under methods 2 and 3, however, those taxes would not be deductible under the new tax law (subject to the new, $10,000 limitation). The result is an increase in the effective marginal rates of those businesses of two, three, or even four percentage points, depending on the state and the level of tax.
The problem, of course, is that most S corporations are subject to State and local income taxes under methods 2 and 3.
States interested in making their tax codes more business friendly should pay attention. By shifting the incidence of tax from the shareholder to the entity, states can significantly reduce the tax burden on their resident S corporations (and partnerships), all at no cost to their treasury.
How We Got Here
Early in the debate over the Tax Cuts and Jobs Act, there was significant confusion within the business community and among members of Congress as to exactly what policy was being debated – would S corporations be able to deduct their business income taxes? Over time, it became apparent that the Tax Cuts and Jobs Act would suspend the deduction for State and local income taxes levied on S corporation income paid at the shareholder level. But what about those taxes paid at the entity level?
The final language of the new law says, “The [limitation on SALT deductions] shall not apply to … any taxes described in paragraph (1) and (2) of subsection (a) [of Section 164] which are paid or accrued in carrying on a trade or business or an activity described in section 212.” Paragraph (1) of Section 164 refers to real property taxes, while paragraph (2) refers to personal property taxes. Left out of this language is paragraph (3) [State and Local income taxes].
The Conference Report accompanying HR 1 says “Under the provision, in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.” This language makes clear that State and local income taxes paid by S corporation shareholders are no longer deductible on their Federal returns (subject to the new $10,000 limitation).
Footnote 172 of the Conference Report, however, states: “[T]axes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.”
So, taxes paid by the entity are deductible, while those paid by the shareholder are not. This outcome results in two disparities for S corporations.
First, S corporations operating in states where State and local income taxes are paid at the shareholder level are disadvantaged compared to businesses operating in the state as C corporations. Under the new law, C corporations continue to deduct these taxes while S corporation do not. No policy rationale for this distinction has ever been articulated.
Second, those same S corporations are disadvantaged compared to S corporations operating in other states with 1) no State or local income taxes or 2) an entity-level tax that remains deductible.
Activity by the States
In recent weeks, two states have announced efforts to address this disparity by shifting their taxation of S corporations from a shareholder-level tax to an entity-level tax.
The first state to move was Connecticut, where the Governor proposed, as part of a broader package of reforms, to shift the incidence of the state income tax on business income from the shareholders to the business entities. You can access the legislative proposal and related materials here:
- Text of SB 11
- Tax Analysts, Connecticut Finds a SALT Workaround That Would Actually Work
- CBIA Testimony on SB 11
The Connecticut proposal includes the following three key changes:
- Impose a tax on pass-through businesses equal to the individual state income tax rate of 6.99 percent;
- Give pass-through owners a tax credit equal to the amount (6.99 percent x 93.01 = 6.5 percent) to protect them being double-taxed on their business income; and
- Adopt rules to recognize similar tax credits from other states to business owners living in Connecticut.
The proposal’s effect would be to reinstate the SALT deduction on pass-through business income by adopting method 1 and apply the tax at the entity rather than the shareholder level. The math works like this:
As you can see from the table, for S corporation owners who do not qualify for the new 20-percent pass through deduction, their taxes go up under the new tax overhaul – from 39.6 percent to 39.8 percent. The Connecticut proposal would eliminate this tax hike and replace it with a small reduction. For businesses that qualify for some or all the new 20-percent pass through deduction, their rate would be lower.
Having reviewed the approach taken by Connecticut, our advisors have suggested several friendly amendments. Specifically, we recommend the proposal:
- Allow for S corporations and other pass-through businesses to elect out of the new, entity-level tax. There are a number of reasons why a pass-through business may choose not to be taxed at the entity level. They should be given that flexibility.
- Change the refundable credit for tax paid by a pass-through entity to a credit that can be carried forward indefinitely.
- Add clarifying language for pass-through ownership with multiple tiers.
- Limit the credit for taxes paid to other states to residents and part-year residents, as is the current credit for personal income taxes paid to other states.
- Clarify the way the tax on S corporations should be computed by referencing the S corporation provisions, instead of the partnership provisions.
You can read the full summary of proposed amendments here, and the resulting legislative text here.
Connecticut has now been joined by New Jersey, where a bipartisan group of Senators announced this month they would introduce legislation along the same lines as Connecticut’s SB 11.
The business community should support these efforts. There is no policy rationale for allowing one group of businesses – C corporations – to deduct their state and local taxes while blocking other businesses – S corporations and other pass-throughs – from doing the same. These taxes are an obvious cost of doing business and should be treated as such.
To be clear, our support doesn’t mean this is the best of all policies. Writing in Forbes, Howard Gleckman of the Tax Policy Center observed that these proposals were “intriguing” but also noted:
By flipping the tax treatment of partnerships and the like on their head—effectively taxing the entity but not the owner, such a plan raises a million questions. Here are just three: How will out-of-state business owners be treated? What is being billed as a plan aimed at helping the owners of pass-through firms effectively open the door to something very different—double state-level taxation of partnerships and similar businesses? And what should we call these firms? After all, once they are taxed at the business level, they really are not pass-throughs anymore.
The first question is answered by the proposals – they would recognize the tax credits passed on to S corporation shareholders by other states when they shift to an entity level tax. The more states that adopt this policy, the less concerning the out-of-state shareholder issue will be. Those credits largely address the second concern as well, by ensuring that the shareholders of affected S corporations are shielded from the double tax.
The third concern is more philosophical but also more challenging. If the new tax law forces states to abandon pass-through tax treatment, it continues the general trend started by the tax overhaul to shift business activity out of the correct pass-through model. That’s not good for tax policy, nor is it necessarily good for the Main Street business community, but it’s a trend driven by the tax overhaul itself, not the pass-through SALT fix.
An Opportunity for Other States
As noted, shifting the incidence of S corporation taxation at the state level from the shareholder to the entity can result in a significant reduction in the effective marginal tax rates paid by S corporations operating in that state. The reforms under consideration in Connecticut and New Jersey would comport with the structure of the new tax overhaul and can be enacted in a manner that has no net effect on a state’s tax collections.
To help encourage these efforts, S-Corp has put together the following resources:
Encouraging states to shift to entity-level taxes is not S-Corp’s preferred policy. The correct policy is for the Federal Tax Code to allow pass-through owners to continue to deduct these taxes as a legitimate business expense. We will continue to press for this change at the Federal level. In the meantime, however, the States have it within their power to address this new disparity and make their respective tax policies more attractive to their own Main Street businesses. They should exert this authority and take advantage of this opportunity.
Business Community Rallies around Aggregation
Treasury has its hands full with the new tax overhaul. As technical comments from the US Chamber, AICPA and S-Corp make clear, the list of necessary guidance for the business community is long and growing.
Common to all three lists is the issue of aggregation. This technical sounding challenge looms large for businesses trying to calculate their pass-through deduction for 2018. For many of them, the question of whether to aggregate or not could mean the difference between getting the full 20-percent deduction or not.
To emphasize the importance of this issue, more than 40 trade groups, including the US Chamber of Commerce, the National Restaurant Association, the Farm Bureau, and the S Corporation Association, wrote to the Treasury Department today and asked for rules granting pass-through business owners the ability to aggregate (or group) multiple legal entities together when calculating the new deduction. As the letter notes:
Allowing taxpayers to aggregate or “group” legal business entities together for purposes of calculating the pass-through deduction is vital to making the deduction fair and workable. Main Street businesses often utilize multiple legal entities for non-tax business reasons. For example, family businesses are often organized in a “brother-sister” structure, where their operations are housed in one entity and their real estate in another. Another common practice is for a business to place all its payroll, finances, and insurance in a “common paymaster” entity in order to streamline payroll operations, while housing actual production operations elsewhere.
Section 199A permits owners of pass-through businesses to deduct up to 20 percent of qualified business income. Certain services businesses are precluded from this deduction, however, while even eligible businesses are subject to two alternative limitations, one based on the businesses’ payroll and another on a combination of payroll and capital.
Absent aggregation, the application of these limitations would treat similar businesses differently depending on how they are organized. For example, a manufacturing business housed in a single S corporation may be eligible for the full deduction, while a similar business utilizing the common paymaster model described above may be eligible for none of it, despite having the same robust levels of payroll and investment.
The illustration below highlights the challenge. This brother-sister set-up is a common practice operating companies use to manage their risk, costs, and ownership needs.
In this example, Company A houses the operations and employees, while Company B houses the business’ capital assets. This business is a real, operating company with robust levels of employment and investment. It should get the full deduction.
When you combine this organizational structure with the employment and investment guardrails, however, the result is a smaller deduction than if all the businesses employment and assets were housed in a single legal entity. Artificially limiting the pass-through deduction based on the unintended interaction of business structures and the new guardrails was clearly not Congress’ intent. Treasury should establish broad grouping rules to address this challenge.
It has little to lose taking this approach. Allowing businesses to aggregate or group under Section 469 would not open the door for gaming. As the business community letter states:
Allowing aggregation or grouping will not open the new deduction to gaming opportunities because the wage and investment limitations provide a strict cap on the size of the deduction, regardless of how it is measured, while the new rules could ensure that income from excluded service activities is not taken into account for purposes of the calculation.
On the other hand, blocking businesses from grouping is unlikely to save the Treasury revenues. Pass-through businesses who are in danger of not getting the full deduction have options – they can reorganize their business operations in order to access the full deduction, or they can convert to C status and get the new 21 percent tax rate. In either case, Treasury unlikely to gain any additional revenues, but the businesses themselves will be worse off. Again, the business letter makes the case:
Failure to allow aggregation will force many affected businesses to reorganize, utilizing a different combination of pass-through structures or reorganizing as C corporations. Moving business activity from one form to another, particularly a form that is going to be taxed at just 21 percent, will not save the Treasury revenues, but it will impose significant transaction costs on these businesses. They will be forced to change not just their legal organization, but also how they operate and their ownership structure. The net result will be less investment and job creation.
Now that the tax overhaul is enacted, Washington’s overriding concern should be to ensure the new law works for taxpayers and the economy. Allowing pass-through businesses to group entities together under Section 469 would prevent a massive amount of dislocation in the economy, and allow real businesses with real operations to get the full deduction Congress voted them.
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