S-Corp Thanks its Champions

With tax reform passing the Congress in the next few hours, S-Corp sent a note of thanks to those members of the Senate – Johnson, Daines and Inhofe – who stood up for Main Street businesses at a most critical time.  As the letter states:

Thank you for your outstanding leadership to promote tax fairness for thousands of American Main Street and family businesses throughout consideration of H.R. 1, the Tax Cuts and Jobs Act. 

Because of your efforts, the final conference agreement included a number of improvements, including provisions directly aimed at addressing the ability of pass-through businesses and their workers to remain competitive here at home and internationally.  We are confident that these key features of the bill would not have been included without your active support.

Specifically, the bill contains a new 20% deduction for pass-throughs, which, combined with lower individual tax rates, results in an effective top tax rate of 29.6% for qualified income.  Unlike early versions of the bill, the final conference report would allow businesses held in trusts and estates to use the new deduction, helping many family-owned businesses to stay in the family.  On the international front, the final bill preserves the interest charge domestic international sales corporation (IC-DISC), an essential feature of the tax code, that allows small businesses to compete on a level playing field and keep thousands of high paying manufacturing, seafood, and agriculture jobs here in the United States.  

We will have more to say about the tax bill passing Congress in the future, but for now, we’re focusing on those members who really did stand with Main Street.

S-Corp Comments to Tax Reform Conferees

General:  Neither the House nor the Senate bills live up to the promise of the 25-percent pass-through rate proposed in the Framework.  The Senate bill doesn’t even have a pass-through rate.  Pass-through businesses employ the majority of workers and earn the majority of business income.  They represent approximately one-third of the entire American economy.  Yet neither the House nor the Senate bills devote anything close to these percentages for tax relief towards the pass-through sector.  The Senate bill in particular comes up short, even with the improvements made on the Senate floor.  To fix this, conferees should devote a proportional amount of revenue to reducing the pass-through rate as it does to reducing the C corporation rate.

Wide Rate Variance:  The corporate rate in both House and Senate bills is 20 percent. With one small exception, this rate applies to all C corporations.  By contrast, the House and Senate bills would tax S corporations (and other pass-through businesses) at wildly divergent top rates.  The House bill would tax an S corporation manufacturer operating in Wyoming with shares held in trust at 29 percent, while the Senate bill would tax that same company at 42 percent.  That same business operating in California owned by active investors would pay Federal tax of around 40 percent in the House bill, whereas the Senate bill would tax this business at a rate of around 35 percent.  This accounts for the additional marginal tax rate attributable to the repeal of SALT deductions for pass-through businesses.  If the business was an engineering firm rather than a manufacturer, it would pay even higher rates.  There is simply no good policy rationale for this variance, or for taxing pass-through businesses at rates more than twice those applied to C corporations.  To fix this, we recommend the following:

  • Trusts:  Many family businesses will pay higher taxes under the Senate bill – and potentially the House bill – because it precludes trusts and estates from using the deduction.  This is not a small issue – every family business subject to the estate tax has these trusts.  They are designed to help the business survive from one generation to the next and have nothing to do with income taxes.  Most of these trusts already pay tax at the highest rates.  Just as importantly, it would be incredibly unfair for all the income of a closely held business to suddenly become taxable at a much higher rate, just because the owner died unexpectedly, and the stock is now owned by his or her estate.  This exclusion will hurt a majority of multi-generational family-owned businesses, including wholesalers, distributors, contractors, and manufacturers.  These large pass-through businesses employ nearly 20 million workers and are the cornerstone of local economies nationwide.  Solution:  Allow trusts and estates to benefit from the pass-through deduction in the Senate.
  • Guardrails:  The House bill offers a 25 percent top rate, but the guardrails preclude most businesses from getting that rate, or anything close to it.  Businesses with active ownership would pay rates at least 10 percentage points higher.  Solution:  Rather than use the badly flawed 70/30 concept, conferees should look at a ratio that varies based on the payroll and other expenses incurred by the business – the higher these expenses are compared to revenues, the more profits the business can claim.  This would be an excellent way to both prevent abuse and make sure that this tax relief actually gets to the bona fide ongoing businesses that are intended to benefit.
  • SALT:  Both bills would repeal the State and Local income tax deduction for pass-through businesses, but not for C corporations.  As noted above, this has the effect of raising marginal rates of pass-through businesses by up to 5 percentage points, exacerbating the rate differential between S and C corporations.  Solution:  Owners of pass-through businesses should be able to deduct state and local income taxes paid on their pass-through business income.
  • Sunset: As amended by the Finance Committee, the Senate bill would now sunset the pass-through deduction after the year 2025, resulting in significant tax hike on pass-through businesses.  This tax hike, not only relative to the Senate bill prior to 2026, but also relative to current law.  The former obviously is due to the loss of the 23 percent pass-through deduction beginning in 2026. The latter is due, with one exception, to all the Senate base broadening provisions are made permanent and would have the effect of permanently increasing the taxable income of pass-through businesses.  These revenue raisers include the new cap on interest deductions, repeal of the Section 199 manufacturing deduction, repeal of the IC-DISC, and numerous other provisions affecting both C corporations and pass-through businesses.  As currently constructed, the Senate bill is “corporate-only tax reform” with all the provisions affecting C corporations made permanent, while only provisions benefiting individuals and pass-through businesses made temporary.   Solution:  Make the pass-through business deduction permanent, just as the reduction in the C corporation rate to 20 percent is made permanent.


The Senate and House bills move business taxation from a world-wide system to a modified territorial system –  reserved for C corporations only.  S corporations and other pass-through entities are not included.  This exclusion puts S corporations with overseas operations at a distinct disadvantage.

The Senate bill in particular would harm S corporations with international operations.  The bill applies the “GILTI” tax to S Corporations, but S Corporations are precluded from the deduction in Section 250. The net effect is that not only are S corporations blocked from territorial treatment, they are required to pay tax on their foreign source income immediately at the highest marginal rates.  Finally, the Senate bill limits the pass-through deduction to domestic income only. Foreign income earned by an S corporation would be subject to the top 38.5 percent rate.

Example:  Under the Senate bill, a C corporation with a CFC operating in the UK would pay the 20 percent UK corporate tax.  Assuming no further inclusions under the GILTI regime, it would be able to pay the remainder back to the US with no additional tax.  When the C corporation pays that income as a dividend to its shareholders, they would be taxed at 23.8 percent.

S Corporations with branch operations in the UK would pay the 20 percent tax to the UK and then the US tax immediately at the new pass-through tax rates.  They would be allowed a Foreign Tax Credit for the taxes paid in the UK against their personal income, but this would be subject to limitations.  There would be no opportunity to defer paying the US tax.  There is also a 20 percent basis reduction for the UK tax taken as a credit.  This income would then be subject to the top, 38.5 percent rate, as foreign-source pass-through income does not qualify for the pass-through deduction in the Senate bill.

Alternatively, an S corporation with a CFC would pay the 20 percent UK tax and its shareholders would be taxed at 23.8 percent (without any credit) on 100 percent of the dividend income when that is repatriated, regardless of whether the dividend was distributed to the shareholders.  In other words, an S corporation with a CFC is treated worse than a C corporation CFC under the new territorial system.

Solution:  Conferees should allow S corporations with CFCs to participate in the territorial system on the same basis as C corporations.  The result would be similar treatment for all types of business operating overseas.

Pass-Through Community Letter to Finance Committee

Yesterday 42 Main Street trade groups, including the National Beer Wholesalers Association, the Independent Community Bankers of America, the Associated Builders and Contractors, and the S Corporation Association sent a letter to Chairman Hatch calling for tax reform that treats Main Street businesses fairly.  As the letter states:

While the bill’s 17.4 percent deduction is a welcome effort to lower rates on all pass-through businesses, the provision is both temporary and too low.  The deduction’s 50-percent payroll limitation would leave behind pass-through businesses that do not add direct payroll at a one-to-one ratio as they grow while blocking trust and estate income from the deduction would hurt multi-generation family businesses.  The fraction of pass-through businesses that do get the full deduction would be subject to a 32 percent effective marginal rate, well short of the 25 percent rate forecast in the Framework and significantly higher than the 20 percent rate applied to C corporations. 

The disallowance of the State and Local income tax deduction would increase this gap further, raising effective tax rates on pass-through businesses operating in States with income taxes.  Meanwhile, the proposed limitation on a businesses’ ability to deduct active pass-through losses would discourage entrepreneurial activity, business formation and investment, as would the exclusion of pass-through businesses from the new, territorial regime on international income.     

As a result of these provisions and others, we are concerned that the Senate bill would increase the tax burden on many pass-through businesses relative to current law, while the bill’s rate disparity with C corporations creates a significant competitive disadvantage for many more. 

Meanwhile, the American Institute of Certified Public Accountants (AICPA) weighed in with similar concerns, arguing:

The AICPA has long championed parity in the marginal income tax rates between C corporations and pass-through entities. The proposal to create a 17.4% deduction on qualified business income limited to 50% of wages would create a pass-through rate trending to the low- to mid-30% range for many taxpayers. In comparison, a corporate tax rate of 20% would result in a strong incentive for businesses to operate as a corporation as opposed to a pass-through entity. Currently, pass-throughs generate more than 50% of business income reported to the Internal Revenue Service (IRS) because their single-tax regime is tax-efficient. Providing an effective rate on pass-throughs at 32% and above will dampen this growth segment of the U.S. economy and push many taxpayers into the corporate double-tax regime.

Pass-throughs are the preferred form of entity for most small and new businesses and the proposed rate disparity would discourage their formation. The Tax Code should not drive taxpayers’ decisions on how to form their businesses. Under the principle of neutrality, it is important to minimize the effect of the tax law on a taxpayer’s decision. Congress should encourage businesses to make decisions motivated by economic and business factors such as interest rates, supply and demand, inflation, technology, and human capital, rather than by tax considerations.

All these groups support comprehensive tax reform that helps all employers compete, regardless of how they are organized.  With some adjustments, the Senate draft can be that bill.  These letters are designed to identify what adjustments are necessary and to be supportive of those Senators fighting for Main Street businesses.

Potential Tax Hikes in the Senate Bill

After two weeks of consideration, many observers still do not understand how the Senate bill would increase taxes on a large number of family-owned S corporations.  For example, one writer recently noted:

Flow through firms get a big tax rate cut under the Senate tax reform bill.  The 39.6 percent income tax rate on mature flow through firms is reduced to 31.8 percent in the Senate bill.  This, combined with the 3.8 percent SECA/NIIT tax, results in a tax reform rate of about 36 percent on flow through firms.

To reach this conclusion, however, this analysis simply ignores many of the provisions in the Senate bill.  To make the point clear, here is a breakdown of how the Senate bill would apply to a large family business, starting with the best case scenario.  For comparison purposes, we include an effective marginal rate on C corporations that includes the 20 percent rate in the Senate bill, a five-percentage point effective marginal rate for the second layer of tax, and any applicable base broadening.  We do not include any benefit from the bill’s expensing provision – such a benefit would apply to C and S corporations alike, is wholly dependent on specific facts and circumstances, is a timing benefit only, would be mitigated by the loss limitation provisions in the bill, would not benefit mature companies with consistent levels of capital expenditure, etc.  In other words, its effects are simply too complicated to generalize.

Best Case:  The headline benefit for S corporations in the Senate bill is a 17.4 percent deduction applied against qualified pass-through income.  That deduction is not available to personal services businesses and its size can be no more than 50 percent of the businesses W-2 wages paid to employees (not owners).  The deduction also doesn’t apply to shares of an S corporation held by an EBST, an estate, or other type of trust.  Finally, the Senate bill does not repeal the Obamacare taxes, so inactive shareholders of an S corporation would have to pay the additional 3.8 percent tax.  Under the single class of stock rule, that tax would have the effect of increasing tax distributions for active and inactive shareholders alike.

On the base broadening side of things, the Senate bill would eliminate the Section 199 deduction, cap interest deductions, repeal the IC-DISC, and disallow deductions for most state and local income taxes.  (The bill includes many other base broadening provisions, including a new loss limitation rule that raises more than $100 billion on pass-through businesses, but this analysis focuses on just those four.)

So with all that in mind, the best case scenario under the Senate bill would be where the business:

  • Has active owners only;
  • Is not a personal services business;
  • Is not eligible for Section 199;
  • Has no trust ownership;
  • Resides in a no-income-tax state;
  • Has low levels of interest expenses; and
  • Has no export income.

Here’s the resulting effective marginal rate:

Has a mix of active and inactive owners;Compared to current law, this S corporation is considerably better off, with an effective marginal rate nine-percentage points below current law.  That rate is almost seven points higher than the new C corporation rate, but it’s a significant tax reduction nonetheless.  That’s the best case scenario, however, and it would apply to a small percentage of family-owned S corporations.  What would happen with a more likely set of facts where the business:

  • Is not a personal services business;
  • Is eligible for Section 199;
  • Has 50 percent trust ownership;
  • Resides in an average income tax state;
  • Has low levels of interest expenses; and
  • Has no export income?

Here is the resulting effective marginal rate calculation:

Here is an “even worse” case set of facts where the business:In this case, not only is the S corporation much worse off compared to the C corporation (16.5-percentage points higher), its effective marginal rate is basically unchanged compared to current law.  But what about the DISC repeal and the interest deduction cap?  The Senate interest cap is much lower than the House version and will affect a significantly larger population of businesses.  Moreover, since the marginal rate applied to the interest deduction is higher in the Senate bill for pass-throughs, it will hit them harder than C corporations.  And this doesn’t even consider the fact that, given the single class of stock rule, the corporation would have to make tax distributions at the rate of 42.3 percent in order to fully reimburse its shareholder trusts for their additional tax attributable due to the inapplicability of the 17.4 percent deduction to them.

  • Has a mix of active and inactive owners;
  • Is not a personal services business;
  • Is eligible for Section 199;
  • Has 50 percent trust ownership;
  • Resides in an average income tax state;
  • Is above the interest cap by ten percent of income; and
  • Has 20 percent export income

Here is the resulting effective marginal rate calculation:

Finally, we did a “Best Case Scenario” so let’s do a worst case one as well.  Move the company to California, increase debt limit excess to 30 percent of income, and increase trust ownership to 100 percent:This scenario demonstrates why the pass-through community is so concerned with the Senate bill.  There is simply no way this business can continue as is.  It would have to put itself up for sale or convert to C corporation status and change its ownership structure and governance practices to avoid the double corporate tax, just like most existing C corporations do today.  Neither option is an improvement over current law and either way the business would be at a competitive disadvantage compared to public C corporations.

This may be a worst case, but there are many S corporations in California and other high tax states with high levels of trust ownership and debt.  In other words, this example is reality for many family S corporations today.  For S corporation owners, we encourage you to analyze the impact of these proposals on your own tax situation now. This is not a situation where we can afford to wait until after this legislation is passed to “learn what is in it.”

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