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.

S Corp Payroll Tax Hike Resurfaces

Last week, Senate Democrats released a paper highlighting a dozen tax increases they would like to use to offset spending cuts in the current budget negotiations. As Politico reported:

Tax expenditures topping the list include the deduction corporations take when they move operations overseas and the carried interest loophole, which allows private equity and some other investment advisers to pay the lower capital gains tax rate on some of their income.

Also on the list is our old nemesis, the S corporation payroll tax hike. Labeled the Edwards Loophole by Republicans and the Gingrich Loophole by Democrats, the issue is that some professionals are using the S corporation structure to avoid paying payroll taxes. According to the Democrats’ release:

Some wealthy business owners knowingly mischaracterize their income as business profits instead of salary to avoid Medicare and Social Security payroll taxes. Ending this loophole would save about $12 billion over the next ten years.

We have a number of objections to this characterization. First, using your S corporation to avoid payroll taxes is not a loophole, it’s tax avoidance. The current reasonable compensation rules are clear and the IRS has a history of going after offenders and winning.

Second, the proposals offered to date are worse than the existing rules. The JCT might score them as raising $12 billion over ten years, but it’s hard to see how the IRS would be able to come up with that level of enforcement.

For example, the provision defeated by the Senate back in 2012 would have replaced reasonable compensation with a “principle rainmaker” test where the IRS would have to determine whether 75 percent or more of the gross income of the S corporation is attributable to the service of three or fewer shareholders. Oh, that’s easy. As a letter signed by 38 business organizations observed:

This new approach, particularly the ”principal rainmaker” test, is neither clear nor more enforceable than existing rules. These rules have been in effect for over half a century, and the IRS has repeatedly and successfully used them to ensure that active S corporation shareholders pay themselves a reasonable wage, most recently in Watson v. US (2011).

The business community responded strongly in 2012 and that opposition remains today. We do not support the misuse of the S corporation structure to avoid payroll taxes, but any replacement to the current ”reasonable compensation” test must be easier for the IRS to enforce and for businesses to comply with.

For those who want more, here are links to the business community letter as well as a longer history of the issue:

SBA Weighs in on Corporate Tax Reform

A new study sponsored by the Small Business Administration adds to the case that corporate-only tax reform, as advocated for by the Obama Administration, would shift the tax burden on to smaller, private companies. As reported by Politico:

Cutting corporate tax rates by trimming costly breaks is a popular selling point for a tax code overhaul, but some small businesses could wind up unintended victims, an independent government agency on Wednesday said, lending support to Republican concerns.

New data from the Small Business Administration warn that the trade-off would be a double whammy to smaller businesses that file taxes as individuals.

These businesses get nothing from a corporate rate cut but they could still lose their tax breaks. The SBA study found that these businesses account for about $40 billion in tax benefits, or about one-third of the $161 billion spent each year on all business tax expenditures.

The top U.S. corporate rate is 35 percent, among the highest in the industrialized world. Although the code is riddled with breaks and loopholes that allow some companies to pay far less, others pay much more.

By contrast, the top rate for individuals, including these so-called pass-through entities, is more than 40 percent.

The study compared the value of tax expenditures for all businesses with those used by pass through and corporate businesses with annual receipts under $10 million. As the study notes:

Of the largest tax expenditure provisions utilized by all businesses in 2013, small businesses will utilize approximately $40 billion out of a total of $161 billion. The estimates indicate that small businesses will utilize approximately 25 percent of the largest business tax expenditure provisions in 2013.

So any effort to eliminate tax expenditures to pay for a lower corporate tax rate would also hit pass through businesses that pay at the individual rates. Not good. As our 2011 E&Y study made clear, such a policy would increase taxes on pass through businesses by $27 billion a year.

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