The Tax Foundation published its annual piece on pass through businesses this week, and as usual, there’s lots of great material in there. To begin, the Foundation updates its numbers on pass through employment and marginal tax rates. As in past years, pass through businesses employ the majority of private sector workers even though they face marginal tax rates that often exceed 50 percent! Talk about shooting yourself in the foot, economically speaking.
Robert Samuelson at the Washington Post noticed. In an op-ed last week, he highlighted some of the key metrics found in the Foundation’s report:
“Here are some of the key findings in the report:
- More than 90 percent of businesses in America are pass-through enterprises. In 2014, that was 28.3 million out of 30.8 million business establishments.
- Pass-through firms account for more than half of U.S. private-sector employment. In 2014, the number of workers at these firms totaled 73 million, compared with 54 million at C corporations.
- The total profits of pass-through firms have surpassed the profits of C corporations. In 2012, the net income was $1.6 trillion for pass-through firms and $1.1 trillion for C corporations.”
The employment figure in particular is worth emphasizing. Back in 2011, EY estimated that pass through businesses employed 54 percent of the private sector workforce. According to the Tax Foundation, that number rose to 57 percent by 2014. That’s a big jump in just three years.
The Tax Foundation report makes clear that far from being second-class citizens, pass through businesses are the dominant business structure and they are clearly the way all businesses should be taxed in the future. Here’s a nice paragraph on how pass through tax treatment should be the model for tax policy moving forward.
Proponents of [forcing large S corporations into the C corporation tax] argue that some pass-through businesses are just as large and economically significant as C corporations, and that there is little justification for creating two separate tax regimes for similar types of businesses. There is merit to this line of argument, but instead of forcing pass-throughs into the problematic double tax regime faced by C corporations, lawmakers should work to improve the C corporate tax regime, to move it closer to a single layer of tax at the same rates that apply to wages and salaries. In short, the tax code should treat C corporations more like pass-through businesses, not the other way around.
Tax it once, tax it when it’s earned, tax it at the same reasonable, low rate, and then leave it alone! We’re glad the Tax Foundation agrees.
One concern is how the Foundation continues to miss headline material right in front of them. Years ago, they did a piece on the “erosion of the corporate tax base” since 1986 that wholly ignored the fact that their numbers showed the “business tax base” (pass throughs and C corporations combined) had actually grown over that time. That statistic has become one of our principle talking points for tax reform, and we source the Tax Foundation when we use it, even though they never spelled it out.
This year’s report offers a similar opportunity for acknowledging that the glass is half-full. Consider this chart on business income.
You can see how pass through businesses have consistently earned more than C corporations in recent years. This chart fits with the Foundation’s past focus on the corporate tax base and its decline.
But think about a different chart – a better, more informative chart using the same data. One that compares business income subject to a single layer of tax versus business income subject to two layers of tax. As we know, pass throughs pay a single layer of tax on their income when they earn it, so the income represented in the blue line falls into that category.
But we also know that most – 75 percent! – of C corporation shareholders are tax-exempt or tax-deferred. They are pension funds, charities, foreign shareholders and retirement accounts. So upwards of 3/4s of the green line is actually taxed once, too. In order to measure how much business income avoids the double corporate tax, you should take three-quarters of the green line and add it to the blue line. Here are the new numbers:
So there you have it. The business community has voted with its feet for single-layer taxation, and it wasn’t close. It was a landslide of historic proportions – 9 to one!
You can quibble that not all tax-deferred shareholder income escapes the second layer of tax, but that misses the point. Single-layer taxation is the new norm for US companies. Any analysis of business taxation should begin with that premise. The double corporate tax is still harmful to jobs and investment, but only because companies and investors take such great pains to avoid it. The “classic” corporate tax structure is no longer the base case, which means we need to transition to a new way of examining business taxation that reflects the underlying reality of how businesses are taxed today.
Dear S-CORP Member:
Perhaps no election more than this one embraced the notion that the only constant is change. What a difference a few electoral votes make!
Under the widely-expected Clinton Administration, we were bracing to do battle on one major issue after another. Higher tax rates, more harmful regulations, more hostility towards markets. 2016 was the “Year of Playing Defense” and 2017 promised to be more of the same.
Not that we were ready to throw in the towel. A little preparation and lots of shoe leather advocacy can do wonders. In 2016, we continued to establish our Parity for Main Street Employers group as the voice of the pass through business community, while simultaneously fending off two major Treasury regulations targeted directly at our members
Those two rules—the related party loan rules put out under Section 385 and the family business valuation rules put out under Section 2704—consumed an enormous amount of our time and resources. For each, we took a leading role, framing the arguments, identifying the messengers, and educating tax writers about the threat these rules posed to the business community. In the end, we won an outright victory on 385—Treasury rewrote them with a full exemption for S corporations! —while we positioned ourselves to continue the fight on 2704 under a prospective Clinton Administration.
But, we don’t face a Clinton Administration this year. Instead, Trump won and everything changed.
To read the full letter, please click here.
Last month’s elections so dramatically changed the outlook for tax policy in 2017 that we’re still trying to catch up. The outlook for the proposed 2704 regulations in particular has done an about-face, going from appearing almost inevitable to having the Chairman of the Ways and Means Committee, along with others, targeting them for elimination quickly next year.
But they are not dead yet, and the regulatory process moves on. Today, the IRS hosted its public hearing on the proposed rules, and the family business community arrived in force—S-CORP in particular. We submitted our formal comments back on October 17th, which you can read here, while today we had four witnesses address the panel – S-Corp President Brian Reardon, Board Member Clarene Law, and Board Advisors Chris Treharne and John Porter.
Nearly 40 tax attorneys, CPAs, and other tax experts weighed in on the rules, but the real star was Clarene Law. She was one of the few business owners to make the trip to DC to testify, and her story of building a successful hotel business in Jackson, Wyoming over the past half century got directly to the challenge these rules pose to real business owners. As she told the panel:
I started Elk Country Motels as a 28-year old back in 1962. My funding came from my mother and father — a housewife and blue collar road construction worker – who had little money but lots of pride. They trusted me with their life savings of $10,000 and enabled me to purchase a small, 17-room motel- 12 cabins and rooms above the office…,
Over 50 years later, our small business has grown and provided my extended family and employees with a stable living. Today we manage 450 rooms, all in Jackson and employ over 100 people.
Continuing this family business is of the utmost importance to me. I have high hopes of passing it onto my children and grandchildren. I feel we can only accomplish my wish for succession with favorable tax consideration which acknowledges legacy businesses such as ours….
The proposed regulations under Section 2704 have the potential to severely disrupt these plans. Ownership of Elk Country Motels and our other limited liability companies is divided between my 3 children, myself, my husband and our trusts—all minority interests.
The IRS’ application of family attribution could result in all these interests being valued as if they were controlling, preventing the use of legitimate valuation discounts and leading to estate tax increases that the next generation would have to bear.
This could force my descendants to sell the business in order to pay the taxes. After 55 years of operation, this family would like to stay in business and not just sell out to corporate America.
Longtime S-Corp advisor Chris Treharne of Gibraltar Business Valuations focused his remarks on the technical challenges the rules would pose to appraisers:
“While I understand Treasury’s perception of abuses associated with third-party owners inasmuch they may affect the inability to liquidate an ownership interest or the entity, I am again concerned that inflexible, “bright-line” rules may be potentially abusive, too… I encourage Treasury to identify and adopt alternate, more flexible language that accomplishes its goals of preventing taxpayer abuse without imparting inflexible constraints on legitimate ownership structures and strategies.”
The remainder of comments were almost universally opposed, with a number of speakers recommending that Treasury radically revise and then reissue the proposed rules in order to give stakeholders another opportunity to weigh in with comments.
For his part, S-Corp President Brian Reardon focused his comments on what happens next year:
“Looking forward, it is clear these rules need to be withdrawn. Over 28,000 comments have been received by Treasury during the comment period, and with few exceptions, they all were opposed. That is an extraordinary outpouring of opposition by the business community and Treasury needs to be responsive.
It is also clear that Congress needs to rewrite section 2704. Family attribution is a fatally flawed concept, whether it’s applied broadly, per our reading of these rules, or narrowly, as written into the underlying 2704 statute.
The S Corporation Association intends to continue to work with stakeholders and tax writers to achieve both of these goals, and we appreciate the willingness of both Treasury and the Congressional tax writers to listen to our concerns.”
With the comment period officially over, Treasury is now tasked with wading through the 28,000 comments and either adjusting the rules to reflect the concerns raised, or explain in detail why they went in a different direction. It’s a laborious process that could literally take years, which is a frightening notion. Meanwhile, the new Administration is expected to kill these rules quickly upon taking office. We hope so. Innumerable hours and dollars already have been wasted trying to protect family businesses from an unwarranted change in how they are valued. It’s time for closure and moving on.