Should Main Street Businesses Elect C Corp Status? No!

The idea that corporate-only tax reform isn’t so bad because Main Street businesses can elect C corporation status has been argued for years. But should Congress reduce the corporate tax rate with the expectation that pass-through businesses will just switch to C status to access the lower rates?   The answer is no.  Here are the main points:

  • It’s the opposite of tax reform.  The corporate-only approach to tax reform is effectively “anti-tax reform.” It will return us to the pre-1986 era, when corporate tax rates were significantly lower than individual rates and tax gaming and income sheltering were rampant.
  • It increases the negative effect of the double corporate tax.  Everyone agrees the double corporate tax hurts investment and job creation.  Forcing pass-through businesses (who employ the majority of private sector workers) into the double tax would make it worse.
  • It penalizes business owners when they sell their business.  For many business owners, the sale of their business is their retirement plan.  The tax code recognizes this by taxing any gain from the sale of a pass-through business at the capital gains rate of 24 percent.  On the other hand, any gain from the sale of a closely-held C corporation is taxed twice at a combined rate of over 50 percent!  This double tax punishes entrepreneurs who have spent a lifetime building their business.

1.   Corporate-Only = Anti-Tax Reform

S-Corp Advisor Tom Nichols hit this point in his testimony before the Ways and Means Committee in 2013:

When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent.   This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher.

This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations.  Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.

Efforts to lower the corporate rates while holding steady individual and pass-through rates should be deemed “anti-tax reform.”  They will return us to the world Tom describes above, effectively reversing the broad changes made by Congress in 1986 and creating a tremendous incentive for taxpayers to organize their income to take advantage of the lower corporate rates and then shelter that income from additional tax.

2.    The Double Tax is the Problem

Any tax reform worth the name would seek to reduce or eliminate the double corporate tax by integrating the corporate tax code with the individual tax code.

Here’s what EY had to say about the double corporate tax in the study they did for us back in 2011:

In addition, the flow-through form helps mitigate the economically harmful effects of the double tax on corporate profits, in which the higher cost of capital from double taxation discourages investment and thus economic growth and job creation. Moreover, double taxation of the return to saving and investment embodied in the income tax system leads to a bias in firms’ financing decisions between the use of debt and equity and distorts the allocation of capital within the economy. As tax reform progresses, it is important to understand and consider all of these issues with an eye towards bringing about the tax reform that is most conducive to increased growth and job creation throughout the entire economy. 

By forcing pass-through businesses into the corporate tax while increasing tax rates on shareholders, the tax reform envisioned by the Obama Administration moves in the opposite direction and will hurt job creation and investment.  Under the Obama Administration’s plan:

The top marginal rate for pass-through businesses remains at 44 percent;

  • The corporate rate drops to 28 percent;
  • The tax on dividends increases to 28 percent; and
  • All these rates apply to a broader base of income.

Today, shareholders of an S corporation making $100 pay a top tax of $44 regardless of whether the income is distributed to shareholders or retained by the business.  How would the Obama proposal affect that company?

  • Under the Obama plan, S corporation income would still pay a top marginal rate of 44 percent, only on a broader base of income.  The taxes on pass-through businesses would go up.
  • Meanwhile, the Administration would cut the corporate tax rate to 28 percent while raising the dividend rate to 28 percent, so a C corporation would pay an initial tax of $28 plus another $20 for any dividends paid to taxable shareholders.  These rates would apply to a broader base of income too, so it’s difficult to say whether any particular corporation would end up paying more or less tax under the Obama plan.

Under these rules, an S corporation could convert to C and reduce its initial tax bite from $44 to $28.  It would then face a choice: Either retain its income at the firm and avoid the second layer of tax, or pay out a dividend and trigger another $20 in taxes (28 percent of $72) for a total tax hit of $48.  Again, this combined rate would apply to a broader base of income.

In other words, the only way the S corporation lowers its tax burden by converting to C is if it then stops any dividend payments and keeps the income within the corporate structure.  Tax reform should seek to reduce this type of distortionary incentive, not increase it.  The double tax on corporations makes US businesses less attractive to investors and less competitive in the world marketplace.  Forcing more businesses into the harmful double tax simply makes no sense.

3.    Double Tax Applies to Business Sales

The “they can just convert” argument also ignores the penalty that closely-held C corporations face when they are sold.  Closely-held C corporations currently face a combined federal tax rate of more than 50 percent when they are sold, versus just 24 percent for the sale of the business by an S corporation.  Under the Obama approach of lower corporate rates but higher capital gains rates, the effective tax would be 48 percent.

This double tax makes switching to C corporation status a non-starter for entrepreneurs who might want to sell their business someday.  Many business sales are tied to the retirement of the owner, where the proceeds are used to fund his or her retirement, so rates that high are a threat to their retirement security.  It’s different for publicly held C corporations.  Individual stockholders can sell their stock at any time, often at higher multiples as the stock of a public company enjoys a more liquid market.

So arguing that pass-through businesses can “just convert” simply is not credible.  Some businesses might be in a position to switch to C status, but there are higher taxes waiting on the other side, along with unproductive tax complexity that does nothing to enhance business productivity.  Given that pass-through businesses employ more than half the private sector workforce, how does any of this make sense?  More broadly, how does forcing more companies into the inefficient and investment-stifling double tax model make America’s companies more competitive?  Sounds like a plan to do the exact opposite.

 

Lew Punts on Tax Reform, Inversions

Secretary Lew gave his tax reform speech this morning.  It lasted maybe 10 minutes and he didn’t take questions afterwards.  Given the buzz the speech’s announcement created on Wall Street and in tax policy circles, the event itself was a major disappointment.

The Obama Administration is beginning to resemble an old Brian Regan comedy routine about how passengers on an airplane get excited when the pilot comes on the intercom, even though the pilot never has anything good to say.  Just a variation on the same old theme that the flight will be delayed because….

This Administration never appears to say anything new either.  Faced with a raft of inversions, Lew used this speech to plug the Administration’s two-year old “business tax reform” outline that went nowhere two years ago, and has even less momentum today.

Raising the overall tax burden and increasing the penalty of our worldwide system is a non-starter for both political and policy reasons.  From the pass through perspective, the Administration’s “business tax reform” plan is nothing more than corporate tax reform in disguise, with little or nothing to help S corporations and partnerships.  The plan appears to offer lower tax rates for C corporations and higher tax burdens for everybody else.

Lew did tamp down expectations that Treasury would take strong administrative action to address inversions.  In the speech, Lew announced Treasury would act “in the very near future” but also made clear whatever action they took would not be sufficient to fix the problem.  Congress must act, he cautioned.

But action by Congress is also in doubt.  Majority Leader Harry Reid earlier had signaled the Senate might take up inversion legislation when the Senate returns this week, but disagreements among key Democratic tax writers over the best approach may kill that effort.

So there you have it – after the President took ownership of the tax inversion issue by announcing his Treasury Department would address them administratively, Secretary Lew is now lowering expectations and attempting to toss the ball back into Congress’ court, where most observers believe it belonged the entire time.

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