Pass Thru Rates & Enforcement
As Congress returns to tackle tax reform, one area of consensus continues to be ensuring that Main Street is treated fairly by establishing a new, low top rate on pass through businesses. But separating business and individual rates brings its own challenges. As BNA reported last week:
Economists and tax accountants note that taxing pass through income at rates distinct from the individual income scale would open up incentives for taxpayers to route their income through the lowest rate path. Treasury Secretary Steven Mnuchin recently said tax reform legislation would include rules to prevent people from gaming the tax rate meant to spur business investment.
From S-Corp’s perspective, creating a unique rate for pass through businesses requires two essential steps:
- First, you have to define the new pass through tax base correctly.
- Second, you have to include enforcement rules to reduce or eliminate the opportunity for individuals to recharacterize their wage and salary income as business profits in order to access the lower tax rate.
The first of these challenges is fairly straightforward. A rate applying to pass through businesses should mirror the tax base for corporations and be broadly defined, embracing all the active business income earned by businesses organized as pass throughs. H.R. 116 from Representative Vern Buchanan (R-FL) is a nice example of how this should be done.
The second challenge is more problematic and has been with us since Congress eliminated the wage cap on Medicare taxes back in 1993. Exactly how do you distinguish returns from an owner’s personal labor from returns on his/her investments in capital and employees? It’s not easy and, more importantly, getting it wrong has the potential to completely undo the benefits of tax reform to Main Street businesses.
By way of example, a provision in the Camp tax reform draft would have established a strict, 70/30 ratio of wages to business profits for all pass through businesses. S-Corp and the rest of the Main Street business community pushed back hard, arguing that a fixed ratio recharacterizing business profits as wages was unfair and would hurt pass through businesses with lots of employees and capital investments.
This same argument applies if the Committee would add the 70/30 rule to the House Blueprint. Ostensibly, the Blueprint has a top rate structure of 33 percent for wages, 25 percent for pass through businesses, and 20 percent for C corporations. But applying the 70/30 test broadly to active owners means in reality the top rate for S corps and partnerships would be closer to 31 percent, 11 percentage points higher than the C corp rate. We’re not perfectionists when it comes to rate parity, but having an effective rate more than 50 percent higher than competing C corps isn’t rate parity in anybody’s book.
Moreover, the strict 70/30 rule has the potential to turn the Blueprint from a tax cut to a tax hike for many pass through businesses. To understand the threat, look at how coupling the Blueprint with the 70/30 rule would affect this particular S corporation manufacturer.
As you can see, not only does the 70/30 rule result in this manufacturer paying significantly more than a similar C corporation, it means the Blueprint could be an actual tax hike on this manufacturing company. Under current law, they pay $1.16 million in taxes. Under the Blueprint, they would pay $60,000 more. The Blueprint’s lower rate is fully offset by the loss of state and local tax deductions, Section 199, and the ability to write-off interest expenses.
You can see a full discussion of these issues in this presentation, but the simple fact is that if Congress is going to establish a separate rate for pass through businesses, it needs to get the enforcement challenge right. Getting it wrong means completely undoing the benefit of lower rates and the other pro-business provisions in the Blueprint. More on this to come.
2704 Study Highlights Threat from Proposed Rule
This week, the S Corporation Association along with several other trade groups released a new study highlighting the threat the pending Section 2704 rules pose to family businesses and their employees.
Authored by former Clinton economist Dr. Robert Shapiro and entitled “An Economic Analysis of Proposals to Limit the Recognition of Valuation Discounts for Transfers of Interests in Large Family Businesses,” the study finds that family-controlled businesses are a significant source of earnings and employment in the US economy. According to the study:
- Large family businesses account for 31.8 percent of U.S. business revenues, 30.7 percent of U.S. private employment, and 31.1 percent of U.S. payrolls.
- Large family businesses have less employee turnover, leaner cost structures, and smaller debt burdens; they also invest at higher rates and over longer time horizons than comparable non-family businesses.
Meanwhile, the pending section 2704 rules would 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, with a goal of highlighting the threat these pending rules pose to family businesses and their employees.
With the Trump Administration actively seeking ideas on how Treasury can reduce red tape and encourage investment and growth, withdrawing these 2704 rules should be job one. A record number of opponents weighed in during the official comment period last fall, yet the rules continue to perplex family businesses and their advisors as they make succession plans. This one is easy, and S-Corp will be working on it until it’s done.
Ways & Means Takes on Tax Reform
The House Ways and Means Committee began its focus on tax reform yesterday with a hearing on economic growth. The hearing, entitled “How Tax Reform Will Grow Our Economy and Create Jobs” featured four company representatives and one hedge fund manager invited, oddly enough, by the Minority.
One of the company witnesses, Zach Mottl, is the Chief Alignment Officer for Atlas Tool Works, a multi-generation family business located outside of Chicago. Operating in an industry with large, multinational competitors, Zach made clear the current rate structure is tilted against smaller companies like theirs that lack the international presence to shift around income:
In addition, oftentimes, tax issues affect manufacturers of different sizes in different ways, usually smaller manufacturers, like the TMA member companies, are the only companies paying a higher tax rate because we do not have the staff or the resources to develop a comprehensive global tax avoidance plan like our larger peers who actually pay far less in taxes that we do.
Meanwhile, Representative Vern Buchanan (R-FL), a friend of the Main Street business community, had this to say:
But I want to touch on pass-through entities and make sure they don’t get lost in the mix. I got a bill, I’d like to see close to parity. When you look at corporate rates at 35% they’re not competitive, but for pass-throughs it’s as high as 44%. If you add state income tax in states like California, they’re 12-13%, it could be as high as 57%, makes absolutely no sense. So, I guess I’d like to ask some of the panelists, just your thoughts on lowering those rates, where they’re more competitive, getting it down to somewhat near the corporate rate, I don’t necessarily agree with 15%, but the difference that would make in terms of growth, in terms of jobs, and also in terms of raising wages.
As you’ll recall, Rep. Buchanan has been active on this issue for some time, advocating for a level playing field and sponsoring the Main Street Fairness Act in the last two congresses. Here’s what we wrote when his bill was first introduced last Congress:
And just this week, Congressman Vern Buchanan (R-FL) introduced legislation on the issue of rate parity. Entitled the Main Street Fairness Act, the bill would cap the top pass through business tax rate at the top corporate rate. Under the Buchanan bill, the same 35 percent top rate that applies to corporate income would also apply to successful pass through businesses. If Congress reduces the corporate rate next year, pass through businesses would get the new lower rate too.
Groups weighing in on the Buchanan bill include the National Association of Manufacturers, the National Retail Federation, and the Associated Builders and Contractors. You can read more about the Buchanan bill here. You can read the S Corporation Association letter on the bill here.
The good news is that the House Blueprint specifically referenced this legislation as a possible means of defining pass through business income and ensuring fairness for Main Street businesses. As the debate proceeds, we expect lots more attention paid to the challenge of how to treat pass through businesses. As the Buchanan bill demonstrates, there are smart folks on the Hill working to make sure we get it right.
Mnuchin on Pass Throughs
The same day that the House kicked off its tax reform efforts, Treasury Secretary Steven Mnuchin was talking taxes over on the Senate side. Testifying before the Senate Banking Committee, Mnuchin was asked about their tax reform plan and the challenge of enforcing their new, 15-percent rate on businesses.
Treasury Secretary Steven Mnuchin defended the Trump administration’s push for a 15 percent pass-through tax rate during an appearance today before the Senate Banking Committee.
“We will put procedures in place … to prevent people who should be paying higher taxes from using pass-throughs to arbitrage the system,” Mnuchin said in response to questioning from Sen. Elizabeth Warren (D-Mass.). “I can assure you … we are not going to allow all pass-throughs to get that rate.”
Mnuchin added that the administration planned to put in place a system to ensure only “small and medium-sized businesses” could use the proposed pass-through rate to ensure wealthy individuals would not simply form their own companies to avoid higher personal income tax rates.
The Treasury secretary also defended the tax outline he and National Economic Council Director Gary Cohn unveiled weeks ago from charges that it would heap trillions more dollars onto the national debt.
“We would never propose a plan that we thought would cost $5 trillion,” Mnuchin said when Sen. Jon Tester (D-Mont.) asked about the cost of tax cuts Trump proposed. “Only parts of the plan were released so I don’t know how it could be responsibly scored.”
“I am concerned as to whether some of the models will attribute enough growth in dynamic scoring,” added Mnuchin, rebutting arguments that growth may not pay for the cost of Trump’s proposals, “but when we present the details we will present how we think it should be paid for.”
There are many concerning aspects of this response, but the most obvious fallacy is the notion that tax avoidance only happens with pass through businesses. What about the 15-percent rate for corporations? What’s to stop wealthy individuals from using the C corp structure as a tax shelter? That’s what they did pre-1986, and that’s what they would do here too (here and here).
For six years, the pass through community has coalesced around a simple proposition that the best way to ensure economic growth and the integrity of the tax code is to tax all forms of income – individual, pass through, and corporate – at similarly low top rates, while eliminating the double tax on corporations.
As the question and response above makes clear, the further you get away from this approach, the more difficult the challenges become. Secretary Mnuchin’s vision resembles the tax code pre-1986, when all US companies of any size were organized as C corporations and tax avoidance was rampant.
It’s a result we are eager to avoid.
2704 and Family Businesses
Remember the Obama Administration’s family-business valuation rules? They were proposed back in August and resulted in such a backlash from the family business community that Treasury received nearly 29,000 comments during the 90-day comment period. That’s a record as best as we can tell.
So where do the rules stand now? Here’s the latest.
Two weeks ago, President Trump signed an Executive Order calling on Treasury to review all “significant tax regulations” issued last year and 1) identify those that are burdensome, complex or exceed Treasury’s authority, 2) issue a report within 60 days listing those identified rules, and 3) issue an action plan within 150 days on what Treasury plans to do about them. Here’s what it says:
Addressing Tax Regulatory Burdens. (a) In furtherance of the policy described in section 1 of this order, the Secretary of the Treasury (Secretary) shall immediately review all significant tax regulations issued by the Department of the Treasury on or after January 1, 2016, and, in consultation with the Administrator of the Office of Information and Regulatory Affairs, Office of Management and Budget, identify in an interim report to the President all such regulations that:
(i) impose an undue financial burden on United States taxpayers;
(ii) add undue complexity to the Federal tax laws; or
(iii) exceed the statutory authority of the Internal Revenue Service.
This interim report shall be completed no later than 60 days from the date of this order. In conducting the review required by this subsection, earlier determinations of whether a regulation is significant pursuant to Executive Order 12866 of September 30, 1993, as amended (Regulatory Planning and Review), shall not be controlling.
(b) No later than 150 days from the date of this order, the Secretary shall prepare and submit a report to the President that recommends specific actions to mitigate the burden imposed by regulations identified in the interim report required under subsection (a) of this section.
The 2704 valuation rules easily fit within the EO’s description of targeted rules. They are obviously burdensome, confusingly complex, and the case can be made that they exceed Treasury’s authority under Section 2704. A trifecta worthy of Churchill Downs.
Meanwhile, Team Trump continues to press for full repeal of the estate tax. As Trump’s lead at the National Economic Council Gary Cohn stated the other day:
We are going to repeal the death tax. The threat of being hit by the death tax leads small business owners and farmers in this country to waste countless hours and resources on complicated estate planning to make sure their children aren’t hit with a huge tax when they die. No one wants their children to have to sell the family business to pay an unfair tax.
So we expect 2704 to be on the target list released by Treasury in the next couple months and the action plan released later in the year. Since the rules are merely pending and not finalized, the obvious action is for Treasury to simply withdraw them. No action by Congress or the President is required, which makes this an easy win for the Trump Treasury team and a significant relief to the family business community across the country. More on this to come.
Tax Foundation and the Kansas Straw Man
Our friends at the Tax Foundation are generally rock solid on tax policy, but they missed the mark in a recent Politico piece. Several of their economists took a look at the situation in Kansas, where the Governor several years ago cut the pass through tax rate to zero, and applied those lessons to the pending Trump Administration proposal to cut tax rates on corporations and pass through businesses alike down to 15 percent. According to them:
Small-business advocates have suggested that these proposals will help create tax rate parity between pass-throughs and C-corporations by taxing them at the same rate. But these arguments ignore that corporate income is taxed twice, at both the business level and the shareholder level—for a combined tax of more than 50 percent. Lowering the corporate rate and continuing to tax pass-throughs at the individual income tax would move the U.S. tax code closer to treating all income equally. Enacting a lower tax rate specifically for pass-throughs would do the opposite.
Problem is, none of this is true. Neither the S Corporation Association nor the Parity for Main Street Employers coalition has endorsed the Trump plan, partly because we still don’t understand it and partly because it’s hard to see how the math works.
We don’t ignore the double tax on C corporations, either. Our tax reform principles letter, signed by 120 national Main Street trade groups, has just three key principles, one of which is to eliminate the double tax on C corporations. Far from ignoring the double tax, we made its elimination one of our goals in tax reform.
And finally, that corporate tax of “more than 50 percent” belongs in the fiction section. Yes, if you add the 35 percent corporate rate with the 23.8 percent shareholder rate, you get a combined rate that high, but very little business income is ever subject to the classic double corporate tax. As we pointed out back in January, the Tax Foundation’s own numbers show that less than 10 percent of all business income is even potentially subject to the double tax.
So the Tax Foundation is fighting straw men. To be sure, the Tax Foundation is not alone in raising these points. The Tax Policy Center has published several posts on the tax rate parity issue – here and here, for example. These papers suffer similar challenges – they ignore the economic harm of the double corporate tax, they take it on faith that C corporations pay more than pass through businesses, and they ignore the gaming opportunities C corporations will have under the new, low rate structure.
The simple fact is that the business community has largely abandoned the classic model of business taxation. Most C corporation shareholders don’t pay taxes, most C corporations don’t pay dividends, and most business income is earned under the pass through structure. Any reform pushing companies back into the harmful double corporate tax is a step backward, not forward.
The correct way to tackle tax reform is to tax all income once, tax it when it is earned, tax it at similar reasonable top rates, and then leave it alone. The business community is already there and it’s time for the tax code, and our think tank friends, to catch up.
Treasury Nominee Disappears
What ever happened to David Kautter? Wasn’t he going to be named to be the next head of tax policy over at Treasury? Politico and other outlets reported that over a month ago. Since then, nothing. No announcements, no nominating papers, nothing.
Which is too bad, because not only does Treasury need the help, but Kautter appears to understand the importance of Main Street businesses to jobs and economic growth. In 2014, he testified as an expert to the Small Business Committee at a hearing on “The Biggest Tax Problems Facing Small Businesses.” You can read his entire written testimony here, but his section on the need for a single layer of taxation for business is worth highlighting:
“As part of the process of broadening the tax base and lowering the corporate tax rate, I believe the time has come for Congress to consider a single tax rate schedule for all business income no matter what legal form a business uses to conduct business. Given the importance of small businesses to our economy, it makes little sense that income earned by unincorporated businesses (which tend to be small businesses) is subject to tax at the higher individual rates while income earned by corporations is taxed at lower corporate rates.”
He concludes with this:
“In short, what is needed is “business tax reform” not simply corporate tax reform. A single business rate schedule would move us toward a more comprehensive system of business taxation – one that applies to all businesses equally across the board. If done right, it could ease the tax burden of small businesses while increasing simplicity and fairness. And ultimately, that could provide small businesses with some of the relief they need in order to compete and thrive.”
Couldn’t have said it better ourselves. Now if we could just find him.
Small Business Economic Trends: June 2017
- NFIB - "SMALL BUSINESS OPTIMISM FADES IN JUNE"
- Wells Fargo - Small business optimism holds steady in second quarter
- Paychex - "National index at its lowest level since late 2011"
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