Tax Reform Rehash

The release of Finance Committee tax reform discussion drafts on cost recovery and international tax have laid bare a reality that’s been hiding just below the surface for two years now the visions for reform embraced by the key House and Senate tax writing committees are dramatically different and move in opposite directions.

The international drafts are a good example. The Ways and Means draft would move the tax treatment of overseas income towards a territorial system, while the Baucus draft would move towards a more pure worldwide system by largely eliminating deferral. Here’s how the Tax Foundation described it:

Of the 34 most advanced countries, 28 use a territorial tax system, while only 6, including the U.S., use a worldwide tax system with deferral. No developed country imposes a worldwide tax system without deferral, though some have tried it with near disastrous effects.

Exactly how the two committees could bridge these broad differences in vision is unclear.

For pass-through businesses, the differences are just as stark. Neither committee has released details on overall rates or the treatment of pass-through businesses, but both have made clear the general direction they plan to take.

The Ways and Means Committee seeks comprehensive reform where the top rates for individuals, pass- through businesses, and corporations would be lowered and the differences between them reduced, helping to restore the rate parity that existed from 2003 to 2012. Other provisions in Chairman Camp’s draft would seek to close the differing treatment of partnerships and S corporations, creating a stronger, more coherent set of pass-through rules.

Finance Chairman Max Baucus, on the other hand, appears to actively oppose rate reductions for individuals and pass-through businesses even as he constructs his reform package around a core of cutting rates for C corporations. The inherent inconsistency of lowering corporate rates to make US businesses more competitive while simultaneously defending significantly higher rates on pass-through businesses is stark. The Baucus draft does make a vague reference to “considering” the impact on pass-through businesses, but it is clear that consideration amounts to nothing more than increased small business expensing or something similarly limited.

So the Finance Committee would cut corporate rates and ask S corporations and other pass through businesses to help pay for them. In the end, C corporations would pay a top rate of 28 or 25 percent, while pass-through businesses would pay rates 13 to 20 percentage points higher.

How do they justify this disparate treatment? The double tax on corporate income is often raised as leveling factor. As the Washington Post recently reported, “Today, the Treasury estimates, as much as 70 percent of net business income escapes the corporate tax.”

But “escaping” the corporate tax is not the same as escaping taxation. The simple fact is that pass through businesses pay lots of taxes, and they pay those taxes when the income is earned. The study we released earlier this year found that S corporations pay the highest effective tax rate (32 percent) followed by partnerships (29 percent) and then C corporations (27 percent on domestic earnings).

These findings include taxes on corporate dividends, so some of the double tax is included. They do not include capital gains taxes due to data limitations. Including capital gains would certainly close the gap between C and S corporations, but enough to make up 5 percentage points of effective tax? Not likely. Meanwhile, the study focused on US taxes only, so it doesn’t attempt to capture the effects of base erosion or the ability of C corporations to defer taxes on foreign income for long periods of time.

All in all, the argument against pass through businesses is based on some vague notion that these businesses are not paying their fair share. The reality is just the opposite. By our accounting, they pay the most. That means that, all other things being equal, today’s tax burden on S corporations makes them less competitive than their C corporation rival down the street.

Real tax reform would seek to make all business types more competitive by lowering marginal rates while also helping to level out the effective tax rates paid by differing industries and business structures. That’s the basis behind the three core principles for tax reform embraced by 73 business trade associations earlier this year: reform should be comprehensive, lower marginal rates and restore rate parity, and continue to reduce the double tax on corporate income.

These principles are fully embraced by Chairman Camp and the Ways and Means Committee. They appear to have been rejected by the Finance Committee. Which begs the question: What exactly is the goal of the Finance Committee in this process? Is it just to raise tax revenues? You don’t need “reform” to do that.

Whatever their goal, the gap between the House and the Senate is enormous, and unlikely to be closed anytime soon. Chairman Camp continues to press for reforms that would improve our tax code, but he’s going to be hard pressed to find common ground with what’s being outlined in the Senate.

Extenders

With the timeline for tax reform being pushed back, there is a bit more discussion of what to do about tax extenders. The whole package of more than 60 provisions expires at the end of the year and to date there’s been little discussion regarding how or when to extend them. As the Tax Policy Center noted this week:

It isn’t unusual for these mostly-business tax breaks to temporarily disappear, only to come back from the dead a few months after their technical expiration. But this time businesses are more nervous than usual. Their problem: Congress may have few opportunities to continue these so-called extenders in 2014. This doesn’t mean the expiring provisions won’t be brought back to life. In the end, nearly all will. But right now, it is hard to see a clear path for that happening.

While the future is murky as always, a few points of clarity do exist:

  • Nothing will happen before the end of the year. The House will recess this weekend and not return for legislative business until mid-January. Even if it took up extenders promptly after returning, which is highly unlikely, the soonest an extender package can get done would be February or March.
  • Coming up with $50 billion in offsets to replace the lost revenue will also be a challenge. Congress is tackling a permanent Doc Fix right now, which requires nearly three times that level of offsets. Coming up with an additional $50 billion will not be easy.
  • The lack of an AMT patch also is hurting urgency for the package. Congress permanently addressed the Alternative Minimum Tax earlier this year, which is good news, but that action also removed one of the most compelling catalysts for moving the annual extender package. Annually adopting the AMT patch protected 20 million households from higher taxes. That incentive is now gone.

All those points suggest that the business community has a long wait before it can expect to see an extender package move through Congress.

Or does it? One of the most popular extenders is the higher expensing limits under Section 179. This small business provision allows firms to write-off up to $500,000 in capital investments in 2013, as long as their overall amount of qualified investments is $2 million or less.

Beginning in 2014, these limits will drop to $25,000 and $200,000 respectively.

You read that correctly. Starting January, business who invest between $25,000 and $2 million in new equipment will no longer be able to write-off some or all of that cost in year one. Talk about an anti-stimulus. Coupled with the loss of bonus depreciation, the R&E tax credit, and the 5-year holding period for built in gains, and the expiration of extenders will have a measurable effect on the cost of capital investment for smaller and larger businesses alike.

This reality is beginning to sink in both on Main Street and the investment community, where certain industries rely on these provisions as a core part of their business plans in coming years. It’s too soon to see how much momentum the loss of these provisions will generate in coming months, but cutting the expensing limit from $500,000 to $25,000 in one year is bound to attract somebody’s attention.

S-CORP Opposes Senate Sequestration Bill

The Senate is voting today on legislation to swap the sequester spending cuts with a package evenly divided between other spending cuts and targeted tax hikes.

The core tax hike in this package is our old friend b the Buffett Tax.B Webve previously pointed out the serious flaws in both the premise and the execution of the Buffett Tax.B B The provision contained in S. 388 suffers from all these flaws.

How would it work?

In this case, the bill would impose a new, minimum tax of 30 percent on taxpayers earning $5 million or more.B The minimum tax would begin to phase-in once a taxpayerbs income rises above $1 million. B In effect, the new tax would result in three distinct tax codes, each with its own rate schedule and definition of income:

  • The Individual Income Tax
  • The Alternative Minimum Tax
  • The New Fair Share Tax

So, if enacted, shareholders of successful S corporations and other taxpayers would be forced to calculate their taxes three different ways.B First, theybd have to calculate their regular income tax, then theybd have to calculate their liability under the AMT, and then, finally, theybd have to calculate their new Fair Share tax obligation.B In the end, they would pay whichever is greater.

For successful S corporations and other pass-through businesses, this policy would just add to the long list of tax challenges they face.B C corporations would not pay the Buffett Tax just as they donbt pay the individual AMT (there is a corporate AMT, but it doesnbt seem as pervasive).B And unlike C corporations, the top rates on pass-through businesses just went up from 35 percent to a high of nearly 45 percent.

At a time when the rest of Washington is focused on tax reform, the Senate is considering policies that move in exactly the opposite direction.B This is anti-tax reform, but apparently it polls well, so itbs in the package. B The Senate will defeat this effort to swap lower spending for higher taxes today, and at some point, serious minds will assert themselves and begin to consider serious efforts at comprehensive tax reform that lowers the rates and broadens the base.B In the meantime, we have this.

bCorporate-Onlyb Tax Reform

Itbs hard to distinguish bcorporateb tax reform advocates with bcorporate-onlyb advocates these days.B We like the former and work closely with them to support comprehensive tax reform b reform that includes individuals, pass-through businesses and C corporations.B On the other hand, the latter group seems to spend as much time pushing for higher taxes on pass-through businesses as they do calling for lower rates on C corporations.B They are definitely not our friends.

So, which category does this group fall into?

We are writing as a group of academic and consulting economists who believe that the U.S. corporate income tax rate should be reduced from its current 35 percent level to one that is competitive with the rates in almost all other major industrial countriesb&.Such a move would likely lead to a more efficient allocation of resources, increased investment and employment in the United States, and higher wages.

Letbs be clear.B We agree that the 35 percent corporate rate is too high and should come down.B Moreover, many of the 20 economists who signed the letter are our friends and agree with us nine times out of ten on what constitutes bgood tax policy.b

That being said, what about the rates imposed on pass-through businesses?B The letter is silent on them despite the fact that those businesses that earn most of the business income and employ most of the workers?B Their top rate is closer to 45 percent, not 35 percent. That higher rate also bundermines job creation and reduces wages,b doesnbt it?

You bet it does, but this economist statement fails to acknowledge even the existence of Americabs flow-through sector and it ignores the impact of the new higher rates on pass-through businesses and the 70 million workers they employ. B Worse, by limiting its focus to rate reduction for C corporations, it lends credibility to those few remaining voices who argue that the bcorporate-onlyb approach is both feasible and good policy.B The simple response is its not b Congress either tackles tax reform in a comprehensive manner or not at all.

Perhaps itbs time for a bPass-Through Business Economist Statement.b

Built-In Gains Relief in Fiscal Cliff Deal

Happy New Year everyone!

As everyone knows, the President signed into law H.R. 8, the so-called mini deal addressing the fiscal cliff yesterday.

The agreement was the result of negotiations between Vice President Biden and Senate Republican Leader McConnell and effectively reduces tax revenues over the next ten years by just short of $4 trillion dollars.

It passed the Senate easily early New Yearbs morning by an 89-8 vote and then, after a little drama with the House Republican conference, passed that body on a much closer 257-167 vote that evening.

For S corporations, the package is a mixed blessing.B Under the agreement, top rates are going up for shareholders making more than $450,000 (joint filers) starting January 1st, but those rates were going up anyway had Congress and the Administration failed to come together and now they are offset with permanent AMT relief, permanent estate tax rules, 179 expensing, and lower rates on dividends.

Bottom Line:B Compared to where tax policy would have been without an agreement, the S corporation world is in a much better place starting out 2013 with H.R. 8 signed into law.

Specific to the work webve been doing, the bill includes an extension of the five-year built-in gains (BIG) holding period for tax years beginning in 2012 and 2013! The specific language is in Section 326 (page 54) of the bill.B The bill also extends the basis adjustment to stock of S corporations making charitable contributions of property.

Many, many thanks to our congressional allies, including Sen. Ben Cardin (D-MD), Sen. Olympia Snowe (R-ME), Rep. Dave Reichert (R-WA), and Rep. Ron Kind (D-WI) for helping to ensure the BIG provision was included in the extender package.

Other highlights in H.R. 8 include:

  • Permanent extension of the marginal rates for individuals making under $400,000 and couples under $450,000;
  • Permanent extension of the PEP and Pease personal exemption and itemized deduction phase-outs for individuals making under $250,000 and couples under $300,000;
  • Permanent extension of current capital gains and dividends rates for individuals making under $400,000 and couples under $450,000.B (For those over those thresholds, the rate for both cap gains and dividends is 20 percent (plus the new 3.8 percent tax from the healthcare bill));
  • Permanent estate tax relief providing for a $5 million exemption ($10 million for couples) and a new top tax rate of 40 percent;
  • Permanent AMT relief;
  • Tax extenders, including built-in gains relief (generally for 2012 and2013);
  • One-year extension of bonus depreciation;
  • Five-year extension stimulus bill tax credits;
  • One-year extension of unemployment benefits;
  • One-year extension of the Medicare reimbursement rate for doctors (“Doc Fix”/SGR) offset with other healthcare related provisions;
  • Two-month delay in the sequester offset in part with the new tax revenue generated from the package and inpart with spending cuts; and
  • Extension of farm policies through September.

Outlook for 2013

With the fiscal cliff out of the way, attention will now shift to the upcoming debt limit fight and the possible contents of a deficit reduction package to accompany legislation to raise the debt limit.

Treasury announced in late December that federal debt had reached the current limit and that, by using extraordinary measures, it could keep overall debt under the caps only until sometime in late February or early March.B Which means that Congress, having just finished the contentious fiscal cliff fight, will have to turn almost immediately to a sure-to-be-just-as-contentious debt limit fight.

Other reasons tax policy will remain front and center in coming months:

  • Ways and Means Chairman Dave Camp has promised to consider broad-based tax reform early 2013 b bWe can and will do comprehensive tax reform this year, in 2013b;
  • The two-month delay in across-the-board spending cuts (sequester) expires on March 1st; and
  • The Continuing Resolution funding the federal government sunsets March 27th.

All these events suggest that, whether they want to or not, Congress will be knee deep in tax policy from now until all of this gets resolved. B Having just seen S corporation tax rates rise from 35 percent to nearly 45 percent, the S corporation community needs to be as active as ever in making the case why further tax hikes on pass-through employers is bad for jobs and economic growth.
Thatbs the message webll be taking to the Hillb& starting now.