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.
