The S Corporation Association has sent a letter to the two congressional tax committees asking them to support efforts to pull Treasury’s proposed section 385 regulations released back on April 4th. The comment period for these regs doesn’t close until July 7th, and we intend to submit lengthy comments outlining our numerous concerns with the regulations and how they will hurt Main Street businesses.
But in the meantime, we believe it is important for policymakers to have a better sense of just how far these regulations extend and the costs they will impose on businesses of all stripes operating in the United States. As our letter points out:
At publication, these proposed regulations were described as a response to the base erosion practices of certain companies, but this description fails to capture the true breadth of their impact. Our understanding is that Prop. Treas. Reg. §1.385-1 is intended to apply to any loan between members within a “modified expanded group,” as defined in the rule, which can include not only corporations, but partnerships and individuals as well. That’s it. No inversion or base erosion activity is required. As such, it would apply to a broad array of common business practices conducted in the purely domestic context.
These costs will be borne by C corporations, partnerships, and individuals alike. However, it is the S corporation community that is in particular danger, as recharacterizing the debt of an S corporation can have implications far beyond just turning deductible interest into taxable dividends.
And while this rule applies to all types of corporations, it poses a particular threat to S corporations. Unlike a C corporation, an S corporation is not allowed to have more than one class of stock. Otherwise, it can lose its S election. As drafted, the proposed section 385 regulations have the potential to disqualify a large percentage of S corporations by recharacterizing regular business loans as equity, thereby creating a second class of stock, as well as potentially violating the shareholder eligibility rules under subchapter S.
The 385 regulations completely blindsided the business community, but the more we explore their implications, the worse they appear. Congress needs to take a hard look at this issue. Tax reform is an important effort, but it could take years. These regulations have the potential to hurt investment and job creation starting right now. With the economy limping along, it’s exactly what we don’t need.
Debt, Equity, and Corporate Integration
The Senate Finance Committee resumed its exploration of the corporate integration approach to tax reform this week, this time focusing on the need to balance out the tax treatment of debt versus equity. To get a visual of why that’s important, take a look at this nice chart from the CBO.
There is simply no excuse for having a tax code that imposes this ridiculously broad range of effective tax rates. Effective rates should be about the same regardless of what you invest in or how you finance the investment. So the lines on this chart need to be shorter and more level across different types of business. Corporate integration can help get us there.
That’s what the pass-through business community has been saying for five years – tax business income once, tax it at reasonable rates, and then leave it alone. Chairman Hatch (R-UT) put in a plug for our Main Street principles letter in his opening statement:
You don’t have to take my word for it. A large coalition of small business associations, including the National Federation of Independent Businesses and the S Corporation Association, recently sent a letter to the leaders of the Finance Committee and the House Ways Means Committee stating: “Congress should eliminate the double tax on corporate income. … The double corporate tax results in less investment, fewer jobs, and lower wages than if all American businesses were subject to a single layer of tax. A key goal of tax reform should be to continue to reduce or eliminate the incidence of the double tax and move towards taxing all business income once.” Without objection, a copy of that letter will be included in the record.
So the Main Street Business Community is on board, but what about the rest of the business community? Eliminating the double tax on corporations is obviously in the interest of corporate shareholders, but do the companies they own see it that way?
Later in the hearing, Sen. Dean Heller (R-NV) asked the panel why they thought corporate integration proposals had failed in the past: Here’s the response of Mr. John Buckley, former counsel at the Ways and Means Committee:
I think it has failed…largely because of opposition from the corporate community, or indifference, that they do not want to have an incentive to distribute earnings. They would prefer to grow their business and retain earnings. And also because there have been other alternatives that have been far more attractive to the business community—otherwise known as a corporate rate reduction.
A corporate rate cut would certainly reduce the effective tax on corporate equity investment, and as long as pass-through businesses get the same top rate, we would support it. But when it comes to making the US business sector more competitive, you have to look at both levels of corporate tax. That means tax reform needs to cut rates for C corporations and pass-through business alike, and it needs to eliminate the double tax. That would be real reform that helps bring businesses and capital back into the United States. We’re looking forward to more from the Finance Committee on this.
Remember the pass-through mantra for tax reform? All business income should be taxed once, it should be taxed at the same top rate, and then we should leave it alone! Well, that mantra was on display Tuesday when a panel of tax experts explored the benefits and costs of corporate integration. Here’s Dr. Michael Graetz:
“In the 1990s, principally because of its administrative advantages, the Treasury Department recommended taxing business income once—at the business level. This form of integration was advanced by President George W. Bush in 2003, but Congress instead simply lowered shareholders’ income tax rates on dividends. That approach is no longer apt today. Locating the income tax at the shareholder level would be more progressive and, given the mobility of business capital and operations, makes much more sense in today’s global economy.”
And Prof. Bret Wells:
“From a tax policy perspective, I think this committee needs to say ‘we need to preserve one level of efficient tax on active business income.’ Having that taxed at the shareholder level assures individual progressivity. That’s a wonderful goal. And if we take the distortions out of who the owner is, whether that’s a foreign-based multinational, or a pension, or others, that creates the tax symmetry that I think the system needs…Corporate integration absolutely is the vehicle to get us there. Whether it is the dividends-paid deduction regime, or other forms of integration. But I think it is absolutely a wonderful first step.”
Amen to that. But corporate integration is not just about reducing layers of tax – it’s also about restoring economic efficiency. The current corporate code distorts decision-making, hurts job creation, and limits investment. Again, here’s Prof. Wells:
“By having a corporate integration regime, the company would get a deduction currently and there would be an offsetting withholding tax, and that would ensure that the company makes the most efficient decision as to what to do with that income. There would not be a double-tax cost. The decision of what to distribute to shareholders or to invest in the business would be solely one based upon the right economics for that company.”
The hearing also did an excellent job of highlighting some of the political challenges of integration, including the loss of relative tax benefits for 401k’s, charities, and insurance products. Not that the tax on those entities goes up under integration – it remains unchanged. The tax on investments they compete with, however, will be reduced, so they could lose some of their comparative advantage. This is a key political challenge the Committee will have to overcome if they are going to move forward on integration. Here, Mr. Wells again did a great job of framing the argument:
“From my perspective, this is not a disadvantage to anyone. When you take a distortion away from a group of taxable shareholders, and you make them not suffer a double tax, then those that are benefited because the other person is suffering a double tax—an inefficient tax system—could say ‘that’s a relative disadvantage to me.’ But what I think this committee ought to understand, and what I think the corporate inversion phenomenon is getting us to understand, is if we allow one group the opportunity to erode the corporate tax base as a subsidy, whether that’s an inbound earnings stripping advantage, whether it’s that particular technique, then what’s going to be the result of that is that they will be the source of market inefficiency going forward.”
So there you have it – at a hearing on corporate integration, two of the key witnesses repeated the refrain the Main Street Business community has been singing for five years — tax business income once, tax it at reasonable rates, and then leave it alone! That’s the reason we cheer corporate integration efforts and look forward to reviewing the details of the Finance Committee plan when they are released.
Tax Policy Center: Only About One Quarter of C Corp Stock is Owned by Taxable Shareholders
Last fall, we reviewed two studies from Treasury and CRS on the effective tax rates of different business entities. The full reviews can be read here and here, but one of our key observations was how wildly different the estimates for how much the second layer of tax on corporate income adds to effective tax burdens.
You’ll recall that Treasury estimated dividend and capital gains taxes on C corporation shareholders adds about 9 percentage points to the corporate effective rate. As we pointed out, Treasury made some very interesting assumptions to get there.
CRS appears to agree with us on that matter. Their estimate for shareholder level taxes is about one-fourth of Treasury’s, or just 2.3 percentage points. CRS lists the lower rates on capital gains and dividends, tax exempt shareholders, and capital gains that are passed on as part of an estate as the primary reasons for the lower estimate.
Seems like a disagreement that large might be worth more study, no? Now the Tax Policy Center has released a paper that does just that. One of the keys to identifying the second layer of tax is estimating the percentage of corporate shareholders who are taxable. This week, writing in Tax Notes, Steven Rosenthal and Lydia Austin suggest that past estimations have vastly overstated that percentage:
After adjusting the data in several important respects, we estimated that taxable accounts held only 24.2 percent of C corporation equity in taxable accounts in 2015. Our exercise revealed that the share of U.S. stocks held by taxable accounts declined sharply over the last 50 years, by more than two-thirds.
As they explain, past estimates of the percentage of taxable C corp shareholders—including Treasury’s paper from last fall, which used a 2004 paper from James Poterba to determine the second layer of tax—used as much as twice this amount.
The Fed reported that in 2015, households directly owned 37.3 percent of corporate equity. Households owned another 13 percent indirectly through mutual funds (and more through ETFs and CEFs). In total, the Fed reported that households owned more than 50.3 percent of the value of outstanding U.S. stock.
The economics literature generally uses the Fed’s figures for household ownership, including both direct and indirect holdings, as a measure of equities held in taxable accounts. James M. Poterba added stock owned directly by the household sector with stock beneficially held through mutual funds — and estimated that the taxable household share of corporate equity was 57.2 percent in 2003. In so doing, Poterba counted stock owned by IRAs and nonprofits in his taxable sector.
If Treasury is doubling the amount of taxable shareholders in C corps, it stands to reason that they are also doubling the effective tax that second layer imposes on corporations. So their estimates would be off by at least a factor of two. That’s a huge discrepancy, and one that Treasury and others should thoroughly address when weighing in on business tax reform.
For five years, the S Corporation Association and its allies have asked tax writers to pursue business tax reform that taxes all business income just once and at the same, reasonable top rates. That’s the correct way to tax business income and more than 100 trade groups, including the largest trade groups in the country representing millions of employers, have signed on to this premise.
And for five years, we’ve watched as the tax code moved in exactly the opposite direction.
Instead of preserving rate parity, the combination of the Fiscal Cliff and the implementation of the Affordable Care Act resulted in pass through businesses paying at a top rate nearly 10 percentage points higher than C corporations. Instead of reducing the double corporate tax, President Obama signed into law new polices that raised shareholder taxes dramatically. The result is that the effective marginal tax on business investment today is significantly higher than it was just a few years ago.
No wonder companies and capital are fleeing the United States.
In recent months, however, we have seen signs of hope. First, Finance Chair Orrin Hatch (R-UT) announced he was working on a plan to eliminate the double corporate tax. His plan isn’t due out until June so we haven’t seen the details, but the fact that the Chairman and his staff are spending time and resources pursing policies to create a single layer business tax is promising. A properly constructed integration plan has the potential to address many of the ills the business community faces.
And just this week, Congressman Vern Buchanan (R-FL) introduced legislation on the issue of rate parity. Entitled the Main Street Fairness Act, the bill would cap the top pass through business tax rate at the top corporate rate. Under the Buchanan bill, the same 35 percent top rate that applies to corporate income would also apply to successful pass through businesses. If Congress reduces the corporate rate next year, pass through businesses would get the new lower rate too.
Groups weighing in on the Buchanan bill include the National Association of Manufacturers, the National Retail Federation, and the Associated Builders and Contractors. You can read more about the Buchanan bill here. You can read the S Corporation Association letter on the bill here.
We would like to see the Buchanan bill expanded to apply to all active pass through income, and Congress still needs to repeal the 3.8 percent Affordable Care Act tax that applies to some S corporations and other businesses. We don’t want those concerns, however, to detract from the fact that of the three core Main Street Business principles we outlined five years ago – tax reform should be comprehensive, restore rate parity, and end the double tax — two of those principles are being actively pursued by senior members of the tax writing committees.
That’s a positive sign, and something we plan to build upon in the coming months.