Extenders – The Post-Thanksgiving Update

Lots of noise on the extender front, but is there progress being made?  Hard to tell.  Last week, a list of potential items made the rounds that would have made some provisions permanent, some extended for 5 years, and some extended for 2 years. Specifically, the list included:

  • Permanent: All the House passed permanent provisions, including small business expensing and the shorter built-in gains recognition period but not bonus depreciation, plus changes to the American Opportunity tax credit, child tax credit, the earned income tax credit.
  • 5-Year: Bonus depreciation, the Production Tax Credit and Investment Tax Credit, and the Work Opportunity Tax Credit.
  • 2-Year: All the other extender provisions that were previously included in the Senate Finance Committee-report bill.

In other words, the package looked a lot like the starting point Ways & Means Republicans would choose for negotiations.  Then this week a competing list was circulated that kept the basic structure but added some extraneous provisions, including:

  • Indexing the refundable tax credits;
  • A 2-year delay on the Affordable Care Act “Cadillac Tax”; and
  • A 2-year holiday from the medical device tax in exchange for additional funding for the ACA risk corridors.

These items, in particular the risk corridor proposal, are highly controversial and would require concessions on the part of Republicans to move.  In other words, this package looks like something the House Democrats might put together in response to the initial list.

Regardless of who put the lists together, they give outsiders like S-Corp a sense of where the sides line up.  What’s unclear is how active these talks are, and who’s involved.  At various times in the past couple days, we’ve heard that that the real talks have yet to begin, that a proposed deal was already submitted to the White House, and that the tax writers had taken it as far as they could and it was up to congressional leaders now. Finally, Bloomberg reported yesterday that talks between congressional leaders have stalled, at least for the moment, over the indexing issues.

The big picture here is that Congress may (finally) be getting serious about ending the multi-year roller coaster ride of extenders.  These provisions expired at the end of last year, and while we’re running right up against the end of the tax year for most families and businesses, it’s gratifying that at the very least “permanence” and “multi-year extensions” are still on the table.  Let’s hope they get off the table and on to the President’s desk.


Treasury’s Move to Stop Inversions

The recent wave of Inversions and related corporate buyouts are yet another reminder that the US tax code is broken. The Pfizer and Allergan announced deal is the largest buyout in pharmaceutical history and, as the Wall Street Journal notes, the US corporate tax rate was a leading motivator:

[Pfizer CEO] Mr. Read has railed against high U.S. corporate tax rates, which he says puts American-based companies like Pfizer at a competitive disadvantage to their overseas rivals. Pfizer’s tax rate is about 25%, the highest among its Big Pharma peers, according to Evercore ISI.

Of course, many pass throughs and domestic corporations pay effective tax rates exceeding 30 percent, so 25 percent looks pretty good to them.  But we digress.  In an attempt to stem the tide, Secretary Lew announced new Treasury guidance last week. According to Politico and the Financial Times, these rules won’t do much:

Treasury officials think the third country rule is likely to have the most teeth. And administration officials swear up and down that Pfizer’s talks with Allergan aren’t why we’re seeing the new rules now. “We’re really not focused on particular companies or particular transactions,” one Treasury official said.

Fair enough, because experts like Steve Rosenthal at the Tax Policy Center say the new rules wouldn’t be much of an impediment to a Pfizer deal. “These measures are technical changes around the edges,” Rosenthal told The Financial Times. “It’s a welcome mat for Pfizer to combine with Allergan and strip its earnings.”

In fairness, Secretary Lew conceded that the limited scope of the rules comes from the fact that Congress, not the Treasury Department, is in the best position to curb inversions by reforming how we tax businesses.  That’s true, but it’s also true that the largest obstacle to tax reform continues to be the White House, which refuses to consider lowering the rate for individuals and pass-through businesses.  Did we mention that many of these businesses already pay higher rates than Pfizer?

S Corporations Hit by Tax Hikes

Our friends at McGladrey LLP have a new survey out of mid-market firms showing just how hard those companies have been hit by the tax rate hikes championed by President Obama and his allies in Congress.

Recall that in the run-up to the Fiscal Cliff, Ernst & Young released a paper on our behalf that predicted the higher rates set to begin in 2013 would hurt investment and job creation by significantly hiking taxes on mid-sized employers.  Over the long-term, E&Y estimated the U.S. would lose 710,000 jobs.

Now McGladrey’s survey shows just how those job losses and lower investment levels emerge.   According to them:

While middle market companies are adding jobs, and have been for several years, some have had to reduce their workforces over the past year. More than 50 percent of the middle market companies that reported having cut jobs (56 percent) said the 2013 tax reform bill was a factor in their decision to take these actions.

McGladrey defines “mid-market” as businesses with revenues between $10 million and $1 billion.  Census Department statistics make clear that firms in that revenue range are a huge source of employment in the U.S. and an important part of the economy.  Raising tax rates on these employers made little sense back in 2012 and even less sense now.

Another key finding in the survey provides additional support to the Harvard study on bonus depreciation we highlighted last week.  As you’ll recall, the study found that US companies responded strongly to the investment incentive, with privately-held companies responding strongest of all.

The McGladrey study reveals the other side of that coin.  When investment incentives are allowed to expire, as Section 179, the R&E tax credit, and bonus depreciation are right now, then firms respond by reducing their investments.  According to McGladrey:

Half of all companies that reported cutting back on research and development (R&D) said that the reform law had influenced their decision to do so. Not surprisingly, the manufacturing industry – a key component of the middle market – reported the most severe impacts. More than three-quarters (78 percent) of middle market manufacturers said that the R&D tax credit’s expiration had led to an increase in their tax bills, and 63 percent of manufacturers that reported having cut R&D over the past year said  the tax credit’s expiration contributed to their decisions to do so.

So there you have it.  We now have prospective and retrospective evidence that hiking rates on Main Street employers hurts investment and job creation.  With the debate over tax reform focused almost wholly on large multinational companies, the McGladrey survey is a solid reminder that tax reform needs to embrace the whole business community, not just publicly traded companies.

Tiberi Introduces Bonus Depreciation Bill

This week Ways and Means Member Pat Tiberi (R-OH), one of our more vocal S-Corp champions, introduced legislation (H.R. 4196) to extend 100 percent bonus depreciation through the rest of this year. Bonus depreciation allows businesses of all sizes to immediately expense the cost of property purchased and placed into service. S-Corp Advisor Tom Nichols spoke of the advantages of expensing in his testimony before the Ways and Means hearing last week.

“Probably the most important of these proposals for most closely-held businesses would be the possibility of extending and/or expanding the option of expensing investments in capital equipment under, among other provisions, Sections 179 and 168(k) of the Code. Most closely-held business owners intuitively evaluate their business on the basis of cash flow, rather than financial statement net income. This is especially important for them because they often do not have access to substantial cash reserves or credit, especially in times of stress where cash flow is threatened.

I learned this lesson early in my career. A client, who had just earned his first million dollars, had then spent the money on equipment and other capital expenditures that were sorely needed in his rapidly-growing business. He called me after the end of the year to discuss the “problem” raised by his accountant that he now owed income tax. Trained as I was in tax law and accounting, I calmly explained to him that the reason he owed tax was that these capital expenditures still had value at the end of the year and would be depreciated for tax purposes only as they were consumed in the business over the next several years. Less calmly, he said to me ‘Tom, you don’t understand. I have no cash.’

Over the years, I have come to more fully appreciate the wisdom of his statement. Most closely-held business owners correctly think of money spent on equipment and other capital expenditures as still at-risk in the business, and as not “earned” until it comes back to the business in the form of collections upon sales. From a tax policy perspective, allowing businesses to deduct their equipment and other capital expenditures makes more intuitive sense when you consider the fact that the seller of the equipment or other item will be required to take the entire sales proceeds into income. This is consistent with the perspective of many closely-held business owners, i.e., that it is the seller that experiences the income in this transaction.”

Observers know that this provision was allowed to lapse at the end of 2011 when tax extenders were left out of the payroll tax extension package, despite the support of the Congress, the business community, and the Administration and broadly within the business community. Congressman Tiberi agrees, saying at the time of the bill’s introduction:

“I’ve heard time again from small business owners in Ohio, that extending bonus depreciation is the single, biggest factor in allowing their businesses to grow this year,” said Congressman Tiberi, Chairman of the Ways and Means Subcommittee on Select Revenue Measures. “Allowing job creators to use these tools for capital reinvestment is a common-sense way to encourage job creation.”

With real tax reform still at least a year away, we’re glad to see Mr. Tiberi, and other S-Corporation allies like Rep. Erik Paulsen (R-MN.), continuing to push this important issue.

Hassett and Viard Agree with Us

Great piece by Glenn Hubbard and Kevin Hassett in the Wall Street Journal earlier this week.  Here’s the core of their argument:

First, U.S. tax policy can no longer treat the U.S. as a closed economy. Capital and business activity are increasingly mobile across national boundaries and highly responsive to variation in the net tax paid across locations. Second, the word “business” is not synonymous with “corporation” pass-through (noncorporate) businesses are almost as important in the aggregate as old-fashioned corporations. Third, economic research has stressed that both corporate taxes and investor-leveltaxes on dividends and capital gains contribute to the tax burden on corporate equity. Investors factor in the total capital tax, both individual and firmlevel, when making decisions.

Sound familiar? It should to Washington Wire readers, since we’ve been pointing this out for a year. Tax “reform” that ignores the importance of pass through businesses to employment and income and ignores the effect shareholder taxes have on business investment decisions is mindless and counterproductive. Here’s more from the authors:

Mr. Obama’s plan, as if designed by Rip Van Winkle, is blind to this major shift and is thus a weak tonic for the flagging economic recovery. While the president proposes reducing the corporate tax rate, other changes that are portrayed as “loophole closing” on multinational firms make his plan a net increase in corporate taxes collected.

Mr. Obama, ignoring the second reality, would also raise taxes on noncorporate business, in the interest of requiring the “rich” to pay for the “privilege” of being an American, to paraphrase a recent statement by Treasury Secretary Tim Geithner. Noncorporate business accounts for 36% of business receipts, 44% of business taxes, and 54% of private-sector employment.

A unifying characteristic of the many types of noncorporate businesses is that their owners pay taxes at individual rates. A substantial body of economic research has found that changes in individual marginal tax rates clearly impact noncorporate firms’ investment levels, hiring practices and wages.

And finally:

A 21st-century business tax policy would recognize the roles of globalization, the side-by-side organizations of corporate and noncorporate business, and double taxation of corporate equity returns. Mr. Obama’s tax reform proposal takes a wrong turn in each area and appears motivated by a poor understanding of the impact of capital taxation on business behavior and the welfare of middle-class Americans.

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