House Bill & S Corps

The House tax reform bill to be considered this week has a headline top rate of 25 percent for S corporations and other pass-through businesses, but in many cases the real rate is significantly higher.  S corporation owners need to pay attention.

Here are some of key details:

  • Professional Services: First, the 25 percent rate doesn’t apply to professional service businesses.  Specifically, the bill excludes businesses engaged in “the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or investing, trading, or dealing in securities, partnership interests, or commodities.”

As you can see from the attached breakdown of S corporations by industry, this exception would preclude a large percentage of S corporations from the lower 25 percent rate.  These businesses range from one-man accounting firms (whose income is due to their personal labor and probably should not get the lower rate) all the way up to large engineering and consulting firms with worldwide operations and thousands of employees.  It’s a remarkably broad exclusion.

The resulting top tax rate on these businesses (including state taxes) would be the new individual income tax rate schedule prescribed in H.R. 1, amplified by the loss of the State and Local Tax deduction plus the expansion of Payroll Taxes to now include all of their S corporation profits.  The actual rate depends on what state the business resides in, but for the majority of states, this top rate is going up.

For example, the current top marginal rate (including state taxes) on income in Wisconsin is 45.4 percent:

  • (39.6% * 1.03) + [(1- 39.6%) * 7.65%] = 40.788% + 4.62% = 45.4%

Under the new rules, accounting for the loss of the State and Local Tax Deduction and the new application of SECA taxes to S corporation profits, the new top rate would be significantly higher – more than 50 percent:

  • 6% + (92.35% * 3.8%) + 7.65%) = 50.8%

This is just a marginal rate calculation, and it doesn’t include the other base-broadening measures included in the bill.  For many businesses, the net result will be a significant increase in taxes.

  • 70/30: Second, for the active owners of non-professional services corporations, the bill imposes a separate limitation on the 25 percent pass-through rate.  It would cap an active owner’s profits at 30 percent of the sum of their wages and profits from the business.  It works like this — if the owner of a successful printing shop pays himself a market wage of $300,000 and has additional profits of $700,000, for total business income of $1 million, the bill would recharacterize 70 percent of that total as wages subject to the higher individual rates and treat just $300,000 of his income as profits eligible for the lower rate.

The top rate that would apply to this mixture of wages and profits varies depending the state, but it appears to be about the same as the top rate under current law.  Using Wisconsin again as the example (current combined top rate is 45.4 percent), the new top rate under H.R. 1 using the 70/30 mix is 45.3 percent.

  • {70% * [39.6% + (92.35% * 3.8%) + 7.65%]} + {30% * (25% + 7.65%)} = 70% * 50.7593% + 30% * 32.65% = 35.53151% + 9.795% = 45.3%

You’ll notice the rate calculation just got really complicated, and that the difference between current law and H.R. 1 is the loss of the State and Local Tax Deduction combined with the expanded application of Payroll Taxes (the Obamacare .9% surtax).  The net result of all these changes is that the top marginal rate on this business is not going to be significantly different than it is today, because of the limited application of the lower 25 percent rate.

Depending on the amount of base broadening that this business is subject to, its total tax hit could be lower, the same, or higher than what the business pays under current law.  For higher income tax states, the top marginal rate will go up significantly, even with the lower headline 25 percent rate.  In no respect, however, will it be comparable to tax reduction applied to C corporations, who get a flat 20 percent rate with no guardrails.

  • Return on Capital Option: Third, H.R. 1 offers S corporations an alternative to the 70/30 rule for their active shareholders, but it will be of little help to most taxpayers.  This calculation takes into account a portion of the capital an owner has invested in the business and establishes a target rate of return.  Active owners of S corporations who don’t like the result they get from 70/30 can elect to use this formula instead.  As described by KPMG:

The alternate method essentially would allow the 25% rate to apply to a deemed return (short-term AFR plus 7%) multiplied by the owner’s share of the adjusted tax basis of any property described in section 1221(a)(2) which is used in connection with the business…

As of today, this deemed return rate would be 8.38%.  The actual definition of property that would be included has been a moving target over the last couple of days, but as of Friday it doesn’t appear to include inventory and accounts receivable. The above language may include intangibles, but that’s unclear.  For a few businesses – those with high capital costs and low margins, for example – this alternative may get them close to the promised headline rate of 25 percent.  But for many others, it will obviously fall short.

Looking at the formula from the standpoint of policy, several things seem clear.  First, the higher return a business earns, the worse it does under this formula.  So, businesses engaged in high tech or other cutting edge industries would do worse, while franchises and other high capital, low return businesses may do well.

Second, a business’s investment in its human capital is valued at nothing.  Many of the most valuable businesses created within the last two decades would be penalized because their primary investment is in people, not things.  This policy comes at a time when everyone recognizes that economic activity is moving towards service businesses.

Third, it appears that intangibles are or could be included in the measure of capital.  But first generation businesses still run by their original owners don’t have intangibles, since they have never been priced into a sale.  So those businesses would be penalized.

Finally, the true measure of an owner’s “investment” in a business is the value of the business as a whole to a prospective buyer.  This is the value that would be taxed under the gift and estate tax rules, and that’s the opportunity cost the owner is incurring by not selling the business and using the capital for another purpose.  Any measure of capital less than the value of the entire business is obviously short-changing the owners.

  • Single Class of Stock Rule: Finally, S corporations are allowed just one class of stock, which means that all distributions of income or loss must to proportional to ownership shares.  In practice, this means that any S corporation distribution to shareholders must be pro-rata, even those distributions made to cover the tax liabilities of the business.

As a matter of practice, most S corporations make tax distributions equal to the marginal tax of their highest taxed shareholder.  The interaction of the single class of stock rule with the 70/30 rule means that any business with a combination of active (70/30) and inactive (25 percent) shareholders will have to make distributions equal based upon the highest tax rates, draining money from the business as if all the shareholders paid the high rates.  This fact dramatically reduces the benefit of the 25 percent rate to multi-shareholder S corporations.

So, for S corporation owners, depending on what state you live in, your company’s industry, whether you work in the business or are a passive owner, and whether your co-owners do the same, your taxes under H.R. 1 could go up, down, or stay about the same.  That is a significant challenge by itself, but it’s compounded by the fact that all C corporations, regardless of industry or their ownership makeup, are getting significant rate cuts in this bill, resulting in a general reduction in their overall tax burden and lower marginal effective tax rates on their investments.

H.R. 1 is just at the beginning of the legislative process and there will be opportunities for change, but with so much room for improvement and a short legislative window, it needs to come quickly.

S-CORP Response to H.R. 1

WASHINGTON, D.C. – S-CORP has been a vocal supporter of the House Republican Blueprint and the unified tax reform framework.  We have serious concerns though about the pass-through provisions in the tax reform draft released today.  They fall well short of parity with the new 20-percent corporate rate, and, absent amendment, would result in tax hikes for a broad range of pass-through businesses.  We look forward to working with the Committee and House leadership to address these concerns and move forward on tax reform.

We support the new 25-percent pass-through rate, but the guardrails that accompany the rate would severely limit its application to just a fraction of all active pass-through business profits.  This ratio would take the business income of hundreds of thousands of pass-through businesses and treat them as if they are wages, subjecting them to rates nearly 20 percentage points above the rate applied to corporate profits.  The bill also appears to expand the application of Obamacare taxes on S corporations.

The election to calculate an alternative “return on capital” does not appear to provide a reasonable estimate of true business profits.  The capital calculation is limited to depreciable property and appears to be significantly less than the real investment an owner has in a business, while the proposed rate of return is well below ten-percent and would shortchange the ROI of many capital expenditures.

Our initial assessment is that many Main Street businesses will face higher taxes under this legislation than under current law.  We are committed to continuing to work with the Committee to address these concerns and look forward to a pass-through rate that achieves better parity with the new, 20-percent corporate rate as we believed was part of the House Blueprint and unified framework.

Can Main Street Businesses Just Convert? No!

Nor Should They.  Here’s Why. 

If tax reform results in a top C corporation rate that is far below the top rate offered to pass through businesses, couldn’t pass-through businesses just switch to C status to access the lower rates?  Put another way, would forcing closely-held pass-through businesses into the C Corporation double tax system improve the tax code and help the economy?  The answer to both questions is an emphatic no.  Here are the main points:

  1. It’s the opposite of tax reform.  Forcing businesses into the double corporate tax is effectively “anti-tax reform” in that it would return us to the pre-1986 era, when the top corporate tax rate was significantly lower than the top individual rate and using the C corporation for tax shelters and gaming dominated taxpayer behavior. We should be moving away from, not toward, the double tax system.  It distorts economic behavior and reduces investment and job creation.
  2. It’s a tax hike either way.  The combination of 70/30, a 25 percent pass through rate, a top wage rate of nearly 40 percent, and base broadening would result in higher taxes businesses that remain pass through.  For those that convert to C status, they would get the lower corporate rate but because their shareholders are, by definition, taxable, they would be subject to the full second layer of tax on their dividends, so their total combined tax would approach 40 percent.  This combination of a 40 percent effective rate and base broadening results in a tax hike. Either way.
  3. The double tax applies to the sale of closely-held C corporations too.  When a pass-through owner sells his or her business, capital gains tax treatment is typically available for a significant portion of the gain.  Similarly, shareholders selling their stock of publicly traded corporations are subject to a single tax at the capital gains rate.  But most purchasers of closely-held C corporations insist upon an asset sale at the corporate level, which means that the gains are taxed twice, first at the corporate rate and again at the capital gains rate.  Even with the lower corporate tax rate, that combination still means a total effective tax of nearly 40 percent. This extra tax “wedge” can be critical for a shareholder hoping to sell his or her business and live off the proceeds.

It is Anti-Tax Reform

  • Under today’s rules, shareholders of an S corporation that makes $100 dollars would pay up to $44 to the federal government, regardless of whether the business distributes any earnings. (This amount is the total of the 39.6 percent federal tax, plus the new 3.8 percent investment tax, plus the reinstatement of the Pease limitation on deductions.)
  • A C Corp, on the other hand, pays only $35, but then is faced with a choice — either retain the remaining $65 of income at the firm and avoid the second layer of tax or pay out a dividend and pay another $15 in taxes (the 20 percent dividend tax plus the 3.8 percent investment tax), for a total tax of $50.

You’ll notice that the C Corp has a very strong incentive to keep its post-tax income within the firm and not pay that second layer of tax.  Tax Attorney Tom Nichols hit this point in his testimony before Ways and Means:

When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent.   This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher. 

This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations.  Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.

Tax reform that lowers both marginal and effective tax rates on C corporations while raising effective tax rates on pass-through businesses should be deemed “anti-tax reform.”  They will return us to the world Tom describes above, reversing the broad changes made by Congress in 1986 and creating a tremendous incentive for taxpayers to shelter their income within the corporate structure while taking steps to avoid paying the second layer of tax.

Either Way, It’s a Tax Hike

Advocates for “they can just convert” need to check their math, because the only thing they are offering successful pass through businesses is a tax hike, whether they convert or not.

Consider the scenario where the top marginal rate for C corporations drops to 20 percent, while the blended rate on pass through businesses is 19-23 percentage points higher (assuming a 70/30 rule, a top individual rate of 39.6%, and the NIIT tax of 3.8 percent).

  • Under that framework, successful pass through businesses will likely face a tax hike whichever business form they choose.  Those that remain a pass through face a top tax rate not much lower than their current rate, but it would be applied to a broader definition of income, resulting in a tax hike.
  • Those that convert to C corporation could pay lower rates initially, but only if they stop paying dividends and never sell the business.  For those that pay dividends, the combination of the 20 percent corporate rate, the 23.8 percent second layer, and the base broadening would result in a substantial tax hike.
  • All C corporations, including newly converted C corporations, would face a strong incentive to hoard earnings within the company.  A C corporation that retains earnings would pay just 20 percent, while one that distributes them would pay nearly 40 percent. The economic distortion caused by this imbalance is going to be large and harmful.

The winners from this approach would be C corporations that don’t pay dividends, have large numbers of tax exempt shareholders, and/or are publicly traded and therefore have liquid markets where their shareholders can sell their stock. The losers will be pass-through businesses and those C corporations, public or private, that have to pay dividends.  Tax reform should move businesses away from the harmful double corporate tax, not towards it.

The Double Tax Applies to Business Sales

The “they can just convert” argument also ignores the penalty closely-held C corporations face when they are sold.   As part of the trade-off for enacting lower tax rates, the 1986 Tax Reform Act imposed the double tax on asset sales by closely-held C corporations, which means a C corporation sale is subject to a combined top federal tax rate of over 50 percent.  Under the framework’s rate structure, the combined tax would be lower, but still nearly 40 percent, a very high rate.

This double tax makes switching to C corporation status a difficult decision for entrepreneurs who might sell their business someday.  Many business sales are tied to the retirement of the owner, where the proceeds are used to fund their retirement, so rates that high are a threat to their retirement security.

It’s different for publicly held corporations.  Individual stockholders can sell some or all of their interest at any time, often at higher multiples, on public markets.  Business to business acquisitions can be done with stock, often on a tax-free basis, once again giving public C corporations a tax advantage over private ones.

Conclusion

Arguing that pass through businesses can just “convert” simply is not credible.  Some businesses might be in a position to switch to C corporation status, but there are higher taxes and difficult tax and succession challenges waiting on the other side.  Given that pass through businesses employ more than half the private sector workforce, how does any of this make sense?  More broadly, how does forcing more companies into the inefficient and investment-stifling double tax model make America’s companies more competitive, or America a more attractive place to invest?  Sounds like a plan to do the exact opposite.

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