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.

Making States More Main Street Business Friendly

(For clarity purposes, this write-up focuses on S corporations.  The arguments and policy conclusions largely apply to partnerships as well.)

Like C corporations, S corporations are subject to state and local income taxes imposed on qualified business income.  Unlike a C corporation where the state and local income tax is incurred and paid at the entity level, however, an S corporation remits its share of state and local income taxes in three different ways, depending on the state:

  1. Entity Level State & Local Tax Income Liability
  2. Composite/Withholding State & Local Income Tax Liability
  3. Individual State & Local Income Tax Liability on Business Income

The legislative history of the Tax Cuts and Jobs Act makes clear that for S corporations operating in states using method 1, those taxes would continue to be deducted at the entity level, resulting in less taxable income being passed through to the shareholders.  The result is that in states that utilize that method, those taxes remain deductible.

In states where the S-Corp is required to pay under methods 2 and 3, however, those taxes would not be deductible under the new tax law (subject to the new, $10,000 limitation).  The result is an increase in the effective marginal rates of those businesses of two, three, or even four percentage points, depending on the state and the level of tax.

The problem, of course, is that most S corporations are subject to State and local income taxes under methods 2 and 3.

States interested in making their tax codes more business friendly should pay attention.  By shifting the incidence of tax from the shareholder to the entity, states can significantly reduce the tax burden on their resident S corporations (and partnerships), all at no cost to their treasury.

How We Got Here

Early in the debate over the Tax Cuts and Jobs Act, there was significant confusion within the business community and among members of Congress as to exactly what policy was being debated – would S corporations be able to deduct their business income taxes?  Over time, it became apparent that the Tax Cuts and Jobs Act would suspend the deduction for State and local income taxes levied on S corporation income paid at the shareholder level.  But what about those taxes paid at the entity level?

The final language of the new law says, “The [limitation on SALT deductions] shall not apply to … any taxes described in paragraph (1) and (2) of subsection (a) [of Section 164] which are paid or accrued in carrying on a trade or business or an activity described in section 212.”  Paragraph (1) of Section 164 refers to real property taxes, while paragraph (2) refers to personal property taxes.  Left out of this language is paragraph (3) [State and Local income taxes].

The Conference Report accompanying HR 1 says “Under the provision, in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.”  This language makes clear that State and local income taxes paid by S corporation shareholders are no longer deductible on their Federal returns (subject to the new $10,000 limitation).

Footnote 172 of the Conference Report, however, states: “[T]axes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.”

So, taxes paid by the entity are deductible, while those paid by the shareholder are not.  This outcome results in two disparities for S corporations.

First, S corporations operating in states where State and local income taxes are paid at the shareholder level are disadvantaged compared to businesses operating in the state as C corporations.  Under the new law, C corporations continue to deduct these taxes while S corporation do not.  No policy rationale for this distinction has ever been articulated.

Second, those same S corporations are disadvantaged compared to S corporations operating in other states with 1) no State or local income taxes or 2) an entity-level tax that remains deductible.

Activity by the States

In recent weeks, two states have announced efforts to address this disparity by shifting their taxation of S corporations from a shareholder-level tax to an entity-level tax.

The first state to move was Connecticut, where the Governor proposed, as part of a broader package of reforms, to shift the incidence of the state income tax on business income from the shareholders to the business entities.  You can access the legislative proposal and related materials here:

The Connecticut proposal includes the following three key changes:

  • Impose a tax on pass-through businesses equal to the individual state income tax rate of 6.99 percent;
  • Give pass-through owners a tax credit equal to the amount (6.99 percent x 93.01 = 6.5 percent) to protect them being double-taxed on their business income; and
  • Adopt rules to recognize similar tax credits from other states to business owners living in Connecticut.

The proposal’s effect would be to reinstate the SALT deduction on pass-through business income by adopting method 1 and apply the tax at the entity rather than the shareholder level.  The math works like this:

As you can see from the table, for S corporation owners who do not qualify for the new 20-percent pass through deduction, their taxes go up under the new tax overhaul – from 39.6 percent to 39.8 percent.  The Connecticut proposal would eliminate this tax hike and replace it with a small reduction.  For businesses that qualify for some or all the new 20-percent pass through deduction, their rate would be lower.

Having reviewed the approach taken by Connecticut, our advisors have suggested several friendly amendments.  Specifically, we recommend the proposal:

  • Allow for S corporations and other pass-through businesses to elect out of the new, entity-level tax. There are a number of reasons why a pass-through business may choose not to be taxed at the entity level.  They should be given that flexibility.
  • Change the refundable credit for tax paid by a pass-through entity to a credit that can be carried forward indefinitely.
  • Add clarifying language for pass-through ownership with multiple tiers.
  • Limit the credit for taxes paid to other states to residents and part-year residents, as is the current credit for personal income taxes paid to other states.
  • Clarify the way the tax on S corporations should be computed by referencing the S corporation provisions, instead of the partnership provisions.

You can read the full summary of proposed amendments here, and the resulting legislative text here.

Connecticut has now been joined by New Jersey, where a bipartisan group of Senators announced this month they would introduce legislation along the same lines as Connecticut’s SB 11.

The business community should support these efforts. There is no policy rationale for allowing one group of businesses – C corporations – to deduct their state and local taxes while blocking other businesses – S corporations and other pass-throughs – from doing the same.  These taxes are an obvious cost of doing business and should be treated as such.

To be clear, our support doesn’t mean this is the best of all policies.  Writing in Forbes, Howard Gleckman of the Tax Policy Center observed that these proposals were “intriguing” but also noted:

By flipping the tax treatment of partnerships and the like on their head—effectively taxing the entity but not the owner, such a plan raises a million questions. Here are just three: How will out-of-state business owners be treated? What is being billed as a plan aimed at helping the owners of pass-through firms effectively open the door to something very different—double state-level taxation of partnerships and similar businesses? And what should we call these firms? After all, once they are taxed at the business level, they really are not pass-throughs anymore.

The first question is answered by the proposals – they would recognize the tax credits passed on to S corporation shareholders by other states when they shift to an entity level tax.  The more states that adopt this policy, the less concerning the out-of-state shareholder issue will be.  Those credits largely address the second concern as well, by ensuring that the shareholders of affected S corporations are shielded from the double tax.

The third concern is more philosophical but also more challenging.  If the new tax law forces states to abandon pass-through tax treatment, it continues the general trend started by the tax overhaul to shift business activity out of the correct pass-through model.  That’s not good for tax policy, nor is it necessarily good for the Main Street business community, but it’s a trend driven by the tax overhaul itself, not the pass-through SALT fix.

An Opportunity for Other States

As noted, shifting the incidence of S corporation taxation at the state level from the shareholder to the entity can result in a significant reduction in the effective marginal tax rates paid by S corporations operating in that state.  The reforms under consideration in Connecticut and New Jersey would comport with the structure of the new tax overhaul and can be enacted in a manner that has no net effect on a state’s tax collections.

To help encourage these efforts, S-Corp has put together the following resources:

Encouraging states to shift to entity-level taxes is not S-Corp’s preferred policy.  The correct policy is for the Federal Tax Code to allow pass-through owners to continue to deduct these taxes as a legitimate business expense.  We will continue to press for this change at the Federal level.  In the meantime, however, the States have it within their power to address this new disparity and make their respective tax policies more attractive to their own Main Street businesses.  They should exert this authority and take advantage of this opportunity.

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