The Importance of Pass Throughs

Put on your “must read” list a new paper from our friends at the Tax Foundation highlighting the importance of pass-through businesses to jobs and employment. It’s the best written and most comprehensive summary of the issue we’ve seen to date. Here’s how it starts:

Support for lowering the corporate tax rate – now the highest in the OECD – has been expressed by both Democrats and Republicans in order to improve the competitiveness of American businesses. However, they differ in their plans for the individual tax code. While Republicans have proposed lowering the top individual rate from 39.6 percent to 25 percent, in parity with the proposed corporate tax rate, Democrats are less willing to consider lowering the individual tax rate.

The implications of these policy differences are considerable because of the tremendous growth in non-corporate business forms over the past thirty years. Today, there are vastly more non-corporate businesses than traditional corporations and they now earn more net income than traditional corporations. These businesses face top marginal tax rates higher than 50 percent in some states. Thus, ignoring the top individual tax rate – even while lowering the corporate rate – means the United States will continue to expose a broad swath of business to high tax burdens.

And how it ends:

As lawmakers consider policies to improve the competitiveness of American businesses, they should not forget that individual income tax rates are just as important to business activity as the corporate rate. The various proposals to raise income taxes on high-income earners, either by increasing the top marginal rate, closing “loopholes,” limiting deductions, or implementing a minimum tax, would fall very heavily on America’s non-corporate businesses. Pass-through businesses are currently facing top marginal rates on average between 44.5 percent and 47.5 percent and as high as 51.8 percent in California. These pass-through businesses account for a large percentage of business income and employment in the United States. Raising taxes on them could curtail their hiring and other investment plans, putting more strain on an already struggling economy.

The paper adds something new to the defense of the pass-through structure. Past arguments in support of a strong pass-through sector include:

  • Best Tax Policy: S corporations are the way business income should be taxed. It’s taxed once, when the business earns the money, and then that’s it.
  • High Effective Tax Rates: As our recent Quantria study demonstrates, pass-through businesses already pay a high level of tax, and they pay it when the income is earned.
  • More Progressive: By taxing business income using the progressive individual tax rates, policymakers ensure that business income is taxed in a progressive manner, with high income shareholders paying a higher rate, and lower income shareholders paying a lower one.
  • Diversification: Pass-through businesses spread investment and employment decision making across the country and into local cities and communities. As the recent financial crisis makes clear, diversification of these actions is critically important.

Thanks to the Tax Foundation, we can now add to that list “Economic Stability.” As the Tax Foundation notes:

It is also interesting to note the relative stability of pass-through business income to the volatility of C corp income. The period between 1999 and 2010, shown on Figure 2, is a good example of how volatile corporate income can be. After the tech bubble burst in 2000, C corp income plunged 24 percent over the next two years, after adjusting for inflation, and then rebounded 119 percent by 2005. After this temporary peak, C corp income fell again by nearly 33 percent over the next five years.

By contrast, pass-through income has not experienced such wild gyrations. After the tech bubble burst in 2000, pass-through business income actually increased in 2001. In 2002, net income fell by just 2 percent but then rebounded by 5 percent in 2003. In the four years after the 2003 tax cuts, the net income of pass-through businesses grew by nearly 60 percent, after adjusting for inflation. In 2010, pass-through business income exceeded C corp receipts by 40 percent.

Is there anybody remaining in Washington who still doesn’t understand the importance of pass-through business to our economic health? If you find them, please send them this Tax Foundation paper!

Breaking Up Tax Reform

Last week, Politico Pro is reporting something we’ve been concerned about for a while:

PATH TO PASSAGE? SENATE FINANCE COULD USE SMALL BILLS TO APPROVE TAX REFORM: The universal truth of tax reform is that it is, and always will be, hard to pass. But the folks over at the Senate Finance Committee are considering various ways to more easily push tax reform legislation through Congress – including splitting a comprehensive reform bill into smaller measures. Our Kelsey Snell reported for Pros that “separating business tax reform from the more contentious individual tax code would allow [Senate Finance Committee Chairman Max] Baucus to continue debate on corporate taxes, the international tax code and the treatment of some benefits for small businesses – where there’s more agreement between the parties – without opening a battle over how much revenue should be raised through changes to the individual code.”

The news outlet subsequently filed a couple corrections that left the story’s ultimate meaning in doubt, but the notion that you can split tax reform into small bites is definitely out there. Comprehensive is just too hard, some say, so let’s do a corporate bill where there’s more agreement.

Our concern with this approach is two-fold: First, we reject the idea that you can separate out the corporate tax code without doing significant harm to the pass through business sector. Corporate-only proposals to date would either raise taxes significantly on pass through businesses or they would treat them like second class citizens, instead of the majority source of employment and business income in the United States (see story above).

Second, the “consensus” on corporate reform is less than it appears and it will depend on the same, top line question confronting comprehensive reform — should it be budget neutral or raise revenue? Until that question is answered (and you know where we stand on that), any reform effort is going to face an uphill climb.

We support corporate tax reform, but only as part of a broader effort to reform the entire tax code.

S-Corp Study in the News

Since its release yesterday, the effective tax rate study put out by S-Corp and the National Federation for Independent Business has been getting traction both on the Hill and in the media. The study shows that S Corporations pay the highest effective rates of any business type, and its results come at a critical time for tax reform.

Following the release, the Ways and Means Committee issued a statement:

The study adds to the growing momentum for tax reform expressed by Democrats and Republicans alike who have called for fixing the broken tax code for job creators of all sizes. Those calls are a stark contrast to the Administration’s most recent appeal to lower the corporate rate, while leaving the vast majority of the nation’s job creators – small businesses — struggling with high rates and a more complex tax code.

The study also grabbed the attention of a number of news outlets. Writing for The Hill, Bernie Becker shared his analysis:

[The study] serves as pushback against President Obama, who renewed his call to reform only the corporate tax code last week. GOP lawmakers, the NFIB and the S Corporation Association say that idea will leave behind the millions of businesses that organize as pass-throughs and pay taxes through the individual code.

Michael Cohn of Accounting Today said:

The results of this study come at a critical time for tax reform. House Ways and Means Committee chairman Dave Camp, R-Mich., and Senate Finance Committee chairman Max Baucus, D-Mont., are focusing on crafting a comprehensive tax reform plan that they hope to unveil this year. With the release of the study, the lobbying groups hope to provide lawmakers in Congress with their perspective on how much they believe is paid in taxes by various types of business entities.

They also positioned the study in reaction to a speech last week by President Obama highlighting his proposals for business tax reform, which mainly focused on eliminating corporate tax loopholes and increasing investment in jobs to rebuild infrastructure and encourage more manufacturing.

And writing for Politico, Kelsey Snell had this to say:

A new study from the NFIB found that S corporations will face a 31.6 percent effective tax rate this year and partnerships will see a 29.4 percent rate while the big dogs filing under the corporate code will pay an effective rate of just 17.8 percent. The study is the latest attempt to rebut President Obama’s proposal to do corporate-only tax reform to help finance a new jobs package.

Study Shows S Corps Pay Their Fair Share… And Then Some

Today, the National Federation of Independent Business and the S Corporation Association released a new study showing that S corporations pay the highest effective rates of any business type.

The study, authored by Quantria Strategies, LLC, compares the tax burden different business entities will shoulder in 2013 and finds that S corporations will pay the highest average effective tax rate (31.6 percent of their income), followed by partnerships (29.4 percent), C corporations (17.8 percent) and Sole Proprietorships (15.1 percent).

The results of this study come at a critical time for tax reform. Ways and Means Chairman Dave Camp and Finance Committee Chairman Max Baucus have made clear they intend to spend August crafting their respective tax reform plans. A better understanding of exactly who pays what will help them construct a more thoughtful and successful reform. As the study states:

While many people think of the statutory tax rate when they consider the effect of federal income taxes, the reality is that the statutory tax rate does not represent the best measure of the effect of taxes on a business. Average effective tax rates are a better measure of whether a particular industry or business form faces greater or lesser federal income taxes relative to other industries or business forms.

This is only the second time the tax burden of S corporations and other pass through businesses has been measured. A previous study by the folks at Quantria looked at firms under $10 million in receipts and came up with similar results. Every other attempt to measure effective tax rates, however, has focused exclusively on publicly-traded C corporations. As such, this study sheds important light on their respective tax burdens and policymakers should pay attention.

According to the study, S corporations will pay the highest effective tax rate of any business type in 2013: 31.6 percent. Those S corporations making more than $200,000 will pay 35 percent! In other words, the effective tax rate on successful S corporations is equal to the marginal tax rate paid by the most successful C corporations.

Moreover, the study shows that the S corporation tax burden is highly progressive, with the smallest S corporations paying 19 percent in tax, while the largest pay 35 percent. The progressive nature of pass-through taxation is one of the reasons we argue that pass-through taxation is the best means of taxing business income.

This study makes clear that pass-through businesses, especially S corporations, are paying their fair share and then some. Remember, their tax rates just went up January 1. That’s why the pass-through community is united behind the principle that reform should restore marginal tax rate parity to the tax code, so that everybody pays the same top tax rate. This study makes clear that effective tax rate parity should also be a goal.

Key members of the Ways and Means Committee understand the importance of measuring effective rates. As Congressman Dave Reichert (R-WA) stated:

The study released today by NFIB and the S Corporation Association makes clear that comprehensive tax reform is the only way to ensure we make the tax code more fair and equitable for all employers. We know Main Street businesses employ most of the workers, and this study shows they pay lots of taxes too. The President’s plan to raise their taxes further in order to cut tax rates for big business is simply a non-starter. Tax reform needs to be comprehensive, and it needs to level out the tax burden paid by businesses of all types.

Rep. Tim Griffin (R-AR) also had this to say:

This study confirms what many Americans already know: Our broken tax code is too complex and imposes an unfair burden on small businesses, the lifeblood of local economies. And with even more taxes kicking in thanks to Obamacare, we must act quickly to create a fairer, flatter, simpler tax code that encourages job growth and is easier for millions of hardworking Americans to understand.

Coupled with previous Ernst & Young studies measuring pass-through employment levels, the threat of corporate-only tax reform to the pass-through community and the adverse effects higher marginal tax rates on employment and investment, this study is going to be a centerpiece of the on-going advocacy efforts of the S Corporation Association and all the trade groups representing pass-through businesses.