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.

2-Year Extension Set to Pass

Here’s an early Christmas present — the Senate voted this afternoon 81-19 to move forward on the tax deal cut between President Obama and congressional Republicans. We expect the package to pass intact early tomorrow.

For S corporations, the package means the top tax rate on S corporations remains at 35 percent and rates on capital gains and dividends remain at 15 percent for the next two years. On the estate tax front, the plan calls for a top rate of 35 percent and an exemption of $5 million per spouse.

Democratic opposition in the House is coalescing around the estate tax provisions, and if there is an attempt to change the bill, that’s where it’s likely to happen. Leadership there may attempt to raise the tax rate to 45 percent (from 35 percent) while reducing the exemption level from $5 million to $3.5 million. This amendment, however, or any other substantive change to the package, is unlikely to pass for a variety of reasons.

The size of the Senate majority makes it difficult for the opposition to characterize the deal as anything but bipartisan and broadly supported. Moreover, recent polls show the plan is popular with voters, too. According to Chris Cillizza:

Two new national polls out today affirm that political popularity. In a new Washington Post/ABC News poll, a whopping 69 percent support the tax package — support that cross party lines with 75 percent of Republicans backing the deal while 68 percent of Democrats and Independents offered their support.

A new Pew poll showed 60 percent supporting it including 62 percent of Republicans, 63 percent of Democrats and 60 percent of independents. The simple reality for Democrats writ large — and President Obama more specifically — is that they need a win in the eyes of the American public following a disastrous election that saw the party lose control of the House and lose ground in the Senate.

And finally, the clock is working against the opposition. Any deal blocked now will be taken up and passed by the Republicans when they take control in January. So either this week or first thing next year, a package very similar to what passed the Senate will be adopted by Congress and be signed by the President. Good news indeed!

Republican Opposition

We don’t want to overstate Republican opposition to the deal, but a number of high-profile Republicans are publicly opposing the plan, arguing that the party could do better if it waited until the New Year and the new Congress.

Republicans comprised five of the fifteen votes against cloture on Monday, four of whom appear to have opposed the deal because it could be better — Coburn (OK), DeMint (SC), Ensign (NV), and Sessions (AL).B Meanwhile, a number House Republicans have come out opposed to the package. Representative Steve King (IA) and Michele Bachmann (MN) announced their opposition earlier, and Mike Pence (IN) announced his opposition just yesterday, stating:

 

“I’ve no doubt in my mind that the first order of business for the new Congress [if the compromise does not pass] will be to enact a bill that extends all the current tax rates on a permanent basis,” Pence continued. “We’ll do it. We’ll send it to the Senate if this bill falters. There’s always time to do the right thing.”

 

Republican Presidential candidate Mitt Romney is also opposed, arguing Republicans should hold out for something permanent.

“Given the unambiguous message that the American people sent to Washington in November, it is difficult to understand how our political leaders could have reached such a disappointing agreement,” Romney wrote in an op-ed for USA Today. “The new, more conservative Congress should reach a better solution.”

We’re confident that the Republican House could pass a permanent tax bill. We’re also confident such a bill would stall in the Senate and would be opposed by the Administration. In the meantime, real taxes would be going up on real businesses and estates, starting January 1. Given the circumstances, the agreement achieved by negotiators is as good as the business community could have hoped.

The Rate Debate Continuesb&

Finance Committee Chairman Max Baucus staked out unique turf yesterday, calling for keeping tax policy stable for middle class taxpayers, allowing rates to rise for taxpayers making more than $250,000, but for taxing capital gains and dividends at 20 percent.B As BNA reports:

“I’m going for policy, and I think 20 percent for both capital gains and dividends is the right policy,” Baucus told reporters. Baucus acknowledged that the tax cut would specifically benefit the same $200,000 per year individuals that he has said should not expect to see their ordinary income tax rates cut again for 2011, but said the difference is that capital gains and dividends deserve to be treated the same under the tax code.

For wages and salary income for top-earning taxpayers, Baucus reiterated his position that Congress should focus on permanent tax cuts for only middle-class households and not entertain any temporary extensions of tax cuts for high-income individuals.

In effect, Senator Baucus is pressing for the tax policies outlined in President Obama’s budget.B That budget called for taxing dividends at 20 percent, but the rhetorical battle over the past year has allowed that fact to slip aside.B As your S corporation advocates, we feel compelled to observe the inconsistency of a policy that would keep (dividend) rates low for C corporation shareholders but would allow rates to go up for S corporation shareholders.B Why is one better than the other?

Exactly how all this gets done also is unclear.B There may be some effort in the Senate to bring up and pass a Baucus-like bill before the Senate adjourns (probably at the end of next week now), but that effort will likely be wrapped up with strict limits on debate and amendments, and the Republican minority has been successful this Congress blocking such requests.

If the Majority Leader wants to get anything done before the elections, he’ll need to set some time aside and let the Senate work its will.B With time so short, we don’t expect that to happen.

S-CORP in Wall Street Journal

With the focus on flow-through businesses and the pending tax hikes, your S-CORP team is getting more press these days.B The latest was earlier this week in the Wall Street Journal, where journalist John D. McKinnon quoted S-CORP Executive Director Brian Reardon on a story summarizing the rate debate.B As the Journal writes:

Republicans cite studies showing roughly half of all such income would be affected by raising the top two rates. Democrats say only about 3% of households reporting such income account for that half. That suggests much of the income comes from big businesses operating under small-business structures, they say. Businesses affected by the top tax rates include all sorts of concerns, from farms and manufacturers to high-tech and professional firms.

That trend has been under way for years. Congress authorized Subchapter S corporations in 1958 to encourage the growth of small companies. The popularity of pass-through entities grew in the 1980s with the lowering of individual tax rates and other rule changes.

By now, “the vast majority of employers in this country are organized as flow-throughs,” said Brian Reardon, executive director of the S Corporation Association, which represents such companies.

Later, John gets to the heart of the matter:

But the new-found importance of such enterprises-regardless of their size-means raising individual tax rates could have significant economic impacts. This week, Moody’s Economy.com said raising taxes on higher earners would reduce GDP by 0.4 percentage point in 2011, while payroll employment would be 770,000 lower by mid-2012.

As we’ve pointed out before, the debate over tax rates is really a debate about jobs.B The current obsession of policymakers over distinctions between small and large businesses or manufacturers verses professional services businesses is really beside the point.B There are S corporations and partnerships in all business sectors, and they are all employers.