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.
More Debate over SALT
The same week our Parity for Main Street Employers group released its model pass-through SALT reform bill, critics of state SALT fixes fired a couple salvos that are worth noting. First, the IRS announced it plans a new rule putting the kibosh on the SALT charitable “workaround” being considered by several states.
IRS Notice 2018-54 has no direct impact on the S-Corp’s proposed pass-through SALT fix. Legal scholars can debate the validity of the charitable workaround (a couple recent papers that do a surprisingly good job of that, here and here), but the pass-through fix recently proposed by New York does not depend on swapping a tax for a charitable contribution. Instead, it would shift the incidence of the tax from the owner (where it is not deductible under the tax overhaul) to the business (where it is). It’s still a tax – it’s just being paid by a different taxpayer.
That’s the key element that was missed in the second salvo, an article from the Tax Foundation arguing that New York’s proposed pass-through fix is poorly thought out and unlikely to work. Here’s how they describe the plan:
Under current law, pass-through businesses (S corporations, partnerships, LLCs, and sole proprietorships) are not subject to an entity-level tax, unlike C corporations, which pay corporate income taxes. Instead, their income passes through to owners, who report it on their individual income tax forms (ownership-level taxes). In order to extend a SALT deduction cap avoidance option to pass-through business owners in the event that the charitable contribution recharacterization scheme fails, New York officials propose to change all that. (Emphasis added.)
Describing the proposal as an effort “to extend a SALT deduction cap avoidance option” allows the Tax Foundation to avoid stating clearly what New York is doing – restoring the SALT deduction for pass-through businesses. This reform has nothing to do with the charitable fix. It has everything to do with leveling the playing field with C corporations, who continue to fully deduct their state and local income taxes under the tax overhaul.
There are other flaws to the Tax Foundation’s analysis:
- They assert that “unincorporated businesses don’t pay entity-level taxes almost by definition.” Not true – pass-throughs pay many entity level taxes (sales, property, and income) and those taxes remain deductible to the business. Tennessee, for example, imposes a 6.5 percent entity-level income tax on pass-through businesses, and those taxes are deductible under the new law.
- The Tax Foundation argues that the New York proposal would result in higher state taxes for business owners. Not true. The approach outlined by New York is to collect the same amount of revenue from the business while protecting the owner from double taxation. There should be no net tax increase. The reason credits passed on to the owners are less than 100 percent of the entity-level tax paid is to reflect the lower, after-tax income allocated to them by the business.
- The Foundation references some tweets from Professor Hemel of the University of Chicago arguing taxing the income at the entity will not restore the SALT deduction because the full amount of income will still show up on the owner’s K-1. We disagree. Entity level state taxes are deducted in determining the ordinary taxable income on the federal K-1. An S corporation in Tennessee already pays entity level income taxes and those taxes reduce the income that shows up on its owner’s Federal K-1. It’s the reduction of K-1 income that makes the entity level tax “deductible.”
The Tax Foundation raises legitimate concerns about the proposal, including a possible-negative effect on out-of-state owners. This challenge is real and can be divided into three camps of owners – those that live in states with no income taxes, those that live in states like Colorado that already recognize the credits included in the New York plan, and those that live in states with income taxes that don’t recognize the credits. Taxpayers in the first two camps should benefit; those in the last camp are in danger of double taxation. The new law adopted by Connecticut addresses this issue by recognizing out-of-state credits allocated to Connecticut business owners. Other states will need to follow suit to protect their taxpayers.
They also raise concerns about complexity. How complex the plan is really depends on the organization and ownership of the business. For an S corporation operating in the same state where the owners reside, there’s no complexity, it’s straightforward. For a partnership with multiple layers of ownership and owners spread out in multiple states, it could get very complex. An entire industry of SALT accountants exists to do nothing but calculate the state and local tax liabilities of pass-through businesses.
One reason our model legislation makes this reform an election is to address these concerns. Businesses with out-of-state owners and/or complex ownership structures can simply opt out of the entity level tax and sidestep these issues. As part of our comments to New York, we intend to press that point.
The Tax Foundation concludes that the “proposal is, in short, a mess.” Wrong again. It’s the new pass-through rules on SALT that are a mess, not our response to it. Why are corporations allowed to deduct state taxes levied on their income, but not S corporations? No policy explanation was articulated during the tax overhaul debate, largely because there is no good explanation. Business expenses are business expenses, regardless of the business’ form. You won’t find a justification for the disparity in the Tax Foundation paper either. They simply ignore it. Yet this lack of parity and fairness is at the base of our SALT reform efforts. It’s the 800-pound gorilla that the Tax Foundation ignores.
Connecticut Moves on SALT Fix for Pass-Throughs
When the dust settled on last year’s tax overhaul, pass-through businesses were confronted with new rules for deducting State and local taxes – if they paid the taxes at the entity level, they could deduct them. If the taxes were paid at the owner level, they could not.
So, S-Corp asked, “Why not give Main Street businesses the option to pay state and local income taxes at the entity level?” That would preserve their ability to deduct those taxes and make the adopting state that much more attractive to Main Street employers. Moreover, the tax overhaul allows C corporations to deduct these taxes as legitimate business expenses, so parity demands that S corporations and partnerships deduct them too.
As we reported previously, the folks in Connecticut had the same idea and they adopted it just Wednesday night. As described in the local press:
The bill would ensure Connecticut remains competitive under the new federal tax regime, Barnes said, by “establishing a revenue neutral tax on pass-through entities offset by a personal income tax credit that will provide Connecticut’s small business owners with favorable federal tax treatment.”
“If all such income is taxed at the maximum federal rate of 37 percent, this proposal would shield an estimated $600 million from federal taxation and would thereby return an estimated $222 million to Connecticut taxpayers,” Barnes testified.
This reform was supported by the Connecticut Business and Industry Council and it now heads to the Governor’s office for his signature. Since Governor Dan Malloy was the one who originally proposed the Connecticut SALT fix, the chances are good he’s going to sign it.
What does this mean for Main Street businesses in Connecticut? For successful businesses electing the entity-level tax, it would reduce their effective tax rates by 2.8 percentage points. If that doesn’t sound significant, think about the reaction you’d get from corporate America if you proposed to increase the corporate rate from 21 to 23.8 percent? That’s the difference this proposal makes to Connecticut employers.
One challenge to the Connecticut reform is that it doesn’t appear to be elective, but rather all Connecticut pass-through businesses would be required to pay an entity level tax. That means lower taxes for in-state owners, but out-of-state owners could face higher taxes. The simple summary is:
- Connecticut owners benefit;
- Owners in no-income-tax states benefit;
- Owners in states (like Colorado) that already recognize the new Connecticut tax credits benefit; but
- Owners in states that do not recognize the new Connecticut credits will see higher taxes.
This table should give you an idea of the benefits and risk. It assumes an owner of a Connecticut pass-through living in a state that has a six percent income tax and doesn’t recognize the new tax credits in the bill.
As you can see from the table, the Connecticut reform is a significant benefit to the in-state owner but a potential tax hike to the out-of-state owner. S-Corp had strongly recommended that states make the SALT fix an election for this very reason. No sense hiking taxes on your out-of-state investors. The fix is to make it an election and/or for the affected states to recognize the Connecticut tax credits. We are going to continue to push for both.
That said, S-Corp sees the adoption of the Connecticut reform as an overall positive and a step forward for pass-through parity. One down, forty-nine to go.
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.
