Business Community Comes Out in Support of S Corp Reforms…

A broad coalition of business groups came out in support of S corporation reforms today, writing to House of Representatives in support of HR 4453, the S Corporation Permanent Relief Act of 2014.  The House is expected to vote on this measure tomorrow.

As Wire readers know, making permanent the five year recognition period for built-in gains has been a priority of the S Corporation Association for years, and while we’ve been successful in reducing the recognition period on a temporary basis, this is the first time either the House or the Senate has considered a permanent fix.  Given the current softness of the economy, particularly when it comes to business investment levels, acting now makes perfect sense.

Unlike public corporations, these closely-held businesses have little or no access to the capital markets. Instead they rely on banks, relatives, and their own savings to fill their investment and working capital needs. An overly long built-in gains recognition period makes this disadvantage worse by preventing converted S corporations from accessing their own capital and putting it to better use.

Locking up a company’s capital for an entire decade is simply unreasonable.  Past Congresses have recognized that a decade is too long and voted to reduce the recognition period on three separate occasions, but those temporary measures have expired and the 10-year rule is back in effect. 

You can read the entire letter here.

…And Against Buffett Tax

In another trade group letter, more than thirty business groups, including the US Chamber of Commerce, the National Association of Manufacturers, the Restaurant Association, and the S Corporation Association, wrote to Senate leaders expressing their strong opposition to the Buffett tax provision included in the student loan bill (S.2432) pending before the Senate.  As the letter states:

Included in S. 2432, the Bank on Students Emergency Loan Refinancing Act, the Buffett tax is a permanent $73 billion tax increase on taxpayers and business owners to pay for new federal spending.  This new tax would be imposed on top of the other taxes business owners must currently pay, resulting in an increase in both the amount they pay and the complexity involved in calculating how much they owe.

As outlined in the bill, the Buffett tax requires those making over $2 million per year to pay a minimum 30 percent effective tax rate on all adjusted gross income.  For taxpayers making between $1 million and $2 million, the bill includes a phase-in period that results in marginal tax rates well in excess of existing tax rates.  While the Buffett tax does make some allowance for charitable contributions, the value of all other deductions and credits, including Section 179 small business expensing and other business deductions, would be reduced or eliminated under this tax. 

The business community’s opposition helped to defeat the legislation, which lost on a procedural vote 56-38 (60 votes were necessary for the legislation to move forward).

So the Buffett tax has stalled for the moment, but the effort to raise tax rates on Main Street businesses will continue.  The Senate has repeatedly attempted to pay for new spending in the past couple years by raising tax rates on individuals and pass-through businesses.  The current Senate leadership supports significantly higher tax rates and that support has already resulted in the tax hike on S corporations following the fiscal cliff negotiations, as well as the new 3.8 percent investment tax used to help pay for health care reform. Both of these tax increases took effect at the beginning of 2013 and resulted in top rates for Main Street businesses rising from 35 percent to nearly 45 percent.

Now they want more, and they will continue to press for more, until the business community steps up and says “enough.”  If it makes sense to reduce tax rates on corporations to “make American businesses more competitive” why doesn’t that same argument apply to pass-through businesses employing the majority of private sector workers?  As we have made abundantly clear, pass-through businesses pay more in taxes, they employ more people, and they are the heart and soul of nearly every community in America.  The S corporation community is 4.6 million strong.  It’s time the Senate started to appreciate that.

BIG Tax Relief on House Floor

It’s a big week for S corporations!  The House is scheduled to vote on several small business tax items, including permanently higher section 179 expensing limits and S corporation modernization legislation too!

The S corporation bill, newly-named the S Corporation Permanent Tax Relief Act of 2014, will bundle together HR 4453 (permanent 5-year BIG period) and HR 4454 (basis adjustment for charitable contributions). We expect the bill to be considered by the Rules Committee later today with debate and a vote on the bill to take place Thursday.

Making the five-year recognition period for built in gains permanent has been an S-CORP priority for years, and while we have been successful at enacting temporary reductions in the past, this week’s action marks the first time either the House or the Senate has considered a permanent fix.

By way of background, here are some of the documents we have developed over the years to support the shorter holding period as well as the charitable donation provision:

The case for the shorter five-year recognition period is strong and is certain to help encourage business investment.  As Jim Redpath testified early this year:

I find the BIG tax provision causes many S corporations to hold onto unproductive or old assets that should be replaced. Ten years is a long time and certainly not cognizant of current business-planning cycles. Many times I have experienced changes in the business environment or the economy which prompted S corporations to need access to their own capital, that if taken would trigger this prohibitive tax. This results in business owners not making the appropriate decision for the business and its stakeholders, simply because of the BIG tax.

We are recirculating the business community letter to allow additional groups to sign on is support of BIG tax relief.  We’ll post the letter tomorrow and we will be working with our House allies to ensure the vote on Thursday is as broad as possible.

Senate to Vote on Buffett Tax

While the House is working to reduce the tax burden for S corporations, the Senate is seeking to raise them.  This week, the Senate will consider legislation to provide student loan relief paid for with our old friend, the so-called “Buffett Tax”.

We’ve criticized both the theory and execution of the Buffett tax in the past (here, here and here), and all those arguments still apply:

  • The federal tax code is already steeply progressive;
  • The tax code already has three distinct income taxes – the regular income tax, the Alternative Minimum Tax, and the Affordable Care Act investment tax.  The Buffett Tax would be a fourth!
  • Much of the Buffett tax will fall on the owners of pass-through businesses; and
  • For sales of S corporations, the Buffett tax would eliminate the benefit of the lower tax on capital gains.

The Tax Foundation agrees with our concerns, and posted a nice analysis of the provision when it was introduced last month.   Here’s what they had to say about the structure of the tax:

Besides the 30 percent effective tax rate in the Buffett rule, there is a phase-in of the tax over $1,000,000 of AGI. This phase-in creates a spike in taxpayer’s marginal tax rate of over 50 percent. Our current tax code is no stranger to hidden marginal tax rates caused by phase-ins and phase-outs. However, these are not positive aspects of the code. They obscure peoples’ true tax burden, add unnecessary complexity, and create marginal tax rate cliffs that incentivize people to change behavior to avoid them.

The Buffett Tax vote is tomorrow.  We doubt it will receive the 60 votes necessary for this poorly thought out policy to move forward, but it will be interesting to see who votes to raise taxes on Main Street businesses in order to increase federal spending.

Anti-Tax Reform in the President’s Budget

The President’s budget is out, and for the second year in a row it seeks to redefine tax reform to fit its own purposes.

The vast majority of policymakers view tax reform as embracing two fundamental goals:

  • Increased simplicity for both taxpayers and the IRS; and
  • Lower marginal tax rates imposed on a broader base of income.

The President’s budget , however, would take us in exactly the opposite direction. Rather than simplify the tax code, it would make it more complicated, and rather than move towards lower rates and a broader base of income, it would selectively lower and/or raise rates based on priorities that have little to do with simplicity or overall economic growth.

Corporate-Only Tax Reform: The business community is united behind the premise that tax reform should be comprehensive and address the tax treatment of individuals, pass-through businesses and corporations. Nonetheless, the Obama Administration continues to push Congress to consider budget-neutral, corporate only tax reform instead.

Under this approach, Congress would eliminate business tax expenditures and use the new revenue to offset lower rates on C corporations. A 2011 Ernst & Young study made clear the challenge corporate-only tax reform presents to pass-through businesses. According to E&Y, a broad policy of eliminating business tax expenditures while cutting only corporate rates would raise the tax burden on pass-through businesses by approximately $27 billion per year- and that doesn’t include the additional hit to pass throughs from their increased marginal tax rates beginning as of January 2013. The most affected industries include agriculture and mining, followed by construction, retail trade, and manufacturing.

This shift in the tax burden happens because pass-through businesses use the same business deductions as their C corporation counterparts. So, if a simple reform package eliminated the Section 199 manufacturing deduction in order to offset a reduction in corporate tax rates, a manufacturer organized as a C corporation would lose the use of that deduction, but they would get a lower corporate rate in return. It is a mixed bag.

For the S corporation manufacturer down the street, however, there is nothing but downside. They too would lose the use of Section 199, but unlike their C corporation competitor, the resulting higher tax base is not offset by lower tax rates. Instead, tax rates on the pass-through manufacturer just went up. Corporate-only tax reform represents a double whammy on pass-through businesses’ higher tax rates imposed on a broader base of income.

To address this challenge, some advocates have suggested allowing pass-through businesses a deduction on their income, or even separating pass-through business income from individual income and taxing it at different rates. While these options might mitigate the adverse impact of corporate-only tax reform on pass-through businesses, it also inflicts serious damage to the tax reform effort in general.

Prior to the 1986 Tax Reform Act, the tax rates on individuals and pass-through businesses were significantly higher than the tax rate imposed on C corporation income. Here is how tax attorney Tom Nichols described the situation during his testimony before the Ways and Means Committee last year:

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. These provisions included Internal Revenue Code (the “Code”) Sections 302 (treating certain redemptions of corporate stock as dividends) and 304 (treating the purchase of stock in related corporations as dividends), as well as Code Sections 531 (imposing a tax on earnings retained inside the corporation other than for the reasonable needs of the business) and 541 (imposing a tax on the undistributed income of personal holdings companies deriving most of their gross income from investments).

In other words, business owners began making decisions based on the tax code and not on the needs of their business. The 1986 Tax Reform Act ended this dynamic. Corporate-only tax reform would restore it. It is literally ”anti-tax reform.”

Buffett Tax: The Buffett Tax is again included in the President’s budget submission as a means of raising revenue while ensuring that the tax code is more progressive and fair. Despite the frequency with which the President and others talk about the need for the Buffett Tax, the arguments in favor of the tax are uniformly weak.

Congressional Budget Office (CBO) analysis makes clear that the federal tax code is already strongly progressive. According to the CBO, the top 1 percent of taxpayers in 2009 paid an effective tax rate of 29 percent, or nearly three times the effective tax rate paid by moderate income taxpayers (11 percent).

Moreover, we already have three tax codes for individual income, not counting the payroll tax system used to finance Social Security and Medicare. That is, we already impose three distinct tax rate structures on three distinct definitions of income earned by individuals and pass-through business owners:

  1. The Individual Income tax
  2. The Alternative Minimum Tax (AMT)
  3. The Affordable Care Act Investment Tax

By any reasonable standard, tax reform should seek to reduce rather than to increase the number of tax codes we impose on families. Yet proponents of the Buffett Tax would impose yet a fourth tax code, this time on families and pass-through businesses earning in excess of $1 million dollars.

Under the Buffett Tax, families and business owners earning that much in income would need to calculate their taxes four different ways! First, they would calculate their taxes under the Individual Income tax, then under the new Investment Surtax, then under the AMT, and then, after adding all those taxes together, they would need to calculate their overall Buffett Tax liability and see if it is higher.

On this basis alone, Congress should reject the Buffett Tax concept.

For S corporations and other pass-through businesses, however, there are other reasons for rejecting the Buffett Tax. As discussed above, S corporations must make quarterly distributions sufficient for their shareholders to pay taxes on the business income. The Buffett Rule would exacerbate this challenge by forcing an S corporation to calculate and distribute additional earnings, even if only one of its shareholders has (or might have) income subject to the Buffett Tax. The result would be to drain additional capital and resources from S corporations seeking to build up their equity and working capital.

Finally, perhaps the most dramatic and unfair consequence of the Buffett Tax for closely-held business owners would occur in the context of a sale of the business. The current federal tax rate for sale transactions is 20 percent (before taking into account the 3.8 percent additional tax on net investment income). The Buffett Tax would increase this tax rate for taxpayers making more than $1 million, even if that higher income was triggered by a once in a lifetime transaction involving the sale of a business built up over decades, effectively punishing entrepreneurs for starting and building a successful business.

By definition, both corporate-only tax reform and the Buffett Tax would make the tax code more, not less, complex. They are anti-tax reform and should be rejected by Congress.

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