The Senate Finance Working Groups reports are done and publicly available! Many congrats to the Committee members and their staff for continuing the progress on tax reform. You can check out the reports here. The Business Income Tax report drafted by Sens. John Thune (R-SD) and Ben Cardin (D-MD) is the one of most interest to us. We have to admit, the first few pages were bit a disappointing, as the introduction could lend the impression that pass through taxation (multiple business entities) is somehow a bad thing.
Our tax system also promotes inefficiency by incentivizing businesses to make decisions based on tax considerations, rather than for business reasons. This has manifested itself in the area of business entity choice. Consider that over the past few decades, since enactment of the Tax Reform Act of 1986, there has been movement en masse away from C-corporation status to status as an LLC, S corporation, partnership, or other pass-through business.
With the experience of our members behind us, we actually see that businesses don’t change their behavior to choose an entity type; they choose an entity type so they don’t have to change their behavior. S corporations would stop paying dividends if they were forced into the double corporate tax. C corporations would scramble for funding if they lost the ability to access public markets. Partnerships would rewrite their ownership agreements if they lost the ability to formalize complex ownership relationships. Having multiple structures in which to organize your business is a positive aspect of the tax code.
The report then embraces number of principles for tax reform. We were disappointed to see that the number one principle wasn’t lower tax rates for all employers, but focused specifically on lowering the corporate tax rate.
Simply put, the U.S. corporate tax rate needs to be competitive with the nations with whom we compete in the global economy. The OECD median statutory corporate tax rate is 25 percent, a reduction of 5 percentage points since 2004.
The term “corporate tax rate” is mentioned more than a dozen times in the principles. The higher tax rates many pass through business pay are not mentioned at all. There is one reference to pass through businesses in the principles section – highlighted as a ‘distortion’, but only to suggest “that pass-through businesses are not harmed by efforts to lower the corporate tax rate.” That’s a pretty low bar. Simply not harming pass-through businesses should not be confused with actually improving the tax code to make those businesses more competitive.
Other parts of the report reference the need for pass through businesses to “benefit” from tax reform, which is clearly helpful, as is the accurate reflection of our basic challenge:
To summarize, pass-through businesses fear that they could find themselves with the worst of both worlds: no rate reduction combined with higher effective tax rates from base-broadening efforts. This is a valid concern and one that any business tax reform effort needs to consider with the utmost seriousness.
The Working Group summed up their debate over pass-through businesses in this way:
“Members of the Business Income Tax Working Group were not able to resolve the treatment of pass-through businesses in business tax reform, one of the most vexing challenges in business tax reform, given the constraints the group faced. However, members of the group believe that any tax reform effort must fully take into account the concerns and opinions of America’s pass-through businesses. Business Income Tax Working Group members strongly urge the chairman and ranking member to examine the options above, in addition to any other approaches the committee may consider, to ensure that pass-through businesses are treated equitably, should the Finance Committee decide to move forward on business tax reform.”
The “constraint” faced by the working group is the Obama Administration’s total opposition to reducing tax rates for individuals. The “options above” referred to the list of alternatives considered by the working group in lieu of individual rate cuts, including the Grant-Thornton business equivalency rate idea. We examined this proposal at length previously and, of all the alternatives to individual rate cuts, to us it appears the closest to embracing the pass through principles endorsed by more than 100 trade groups earlier this year.
So, all in all, a mixed bag. The working group makes clear the challenge pass through taxation poses to the goal of overall tax reform, but they failed to recognize that pass through taxation is also the key to the solution. Taxing business income once, when it is earned, and at a reasonable rate is the way we should tax all business income. The sooner we embrace that model, the sooner we can achieve the more competitive business tax structure policymakers are seeking.
Highway Funding & International Tax Reform
The outlook for highways and international tax reform is coming into focus. Senate Majority Leader Mitch McConnell announced that the Senate will take up a short-term highway bill as soon as next week, but downplayed pairing the extension with more aggressive international tax reforms and completely ruled out raising gas taxes.
Let me just say we’re not going to raise the gas tax. We’re not going to raise the gas tax,” McConnell said. “The environment committee has come out with a six-year bill … but there is considerable skepticism that you could pay for a bill of a six-year duration.
McConnell (R-Ky.) also said he was “skeptical” about the prospect of using a bipartisan plan from Sens. Chuck Schumer (D-N.Y.) and Rob Portman (R-Ohio) to overhaul some corporate taxes as a way to pay for crumbling highways, bridges and public transportation and said it would be too difficult to take on something so ambitious with just three weeks before the deadline.
So short term highway extension this month, but no international reforms. What about the longer term outlook?
On that front, there is a concerted effort to pair highways and international reforms, and that the new international report from Senators Portman (R-OH) and Schumer (D-NY) clearly outlines what they have in mind. As the Examiner reported this week:
Ryan, the chairman of the powerful tax-writing House Ways and Means Committee, said at a breakfast event hosted by Politico in Washington that he was optimistic about a deal to reform international taxation that would include a one-time surge of revenues from deferred taxes of multinationals’ earnings.
Such a deal isn’t possible in the next two weeks before the highway trust fund is expected to be exhausted, the Wisconsin Republican said, and Congress will have to pass a short-term funding patch through the end of the year.
But the agreement on taxing overseas earnings announced Wednesday by Sens. Rob Portman, R-Ohio, and Chuck Schumer, D-N.Y., “gives me a bit of hope” that a six-year infrastructure funding deal can be reached, he explained.
The report itself calls for moving to a territorial tax system, creating a patent or innovation box to incent the development and retention of domestic intellectual property, and taxing existing balances of overseas corporate income to pay for both the international reforms and offset the cost of highway funding. That latter bit has been endorsed by a number of Democrats and Republicans, including Portman and Ryan, while others have expressed strong opposition to using “deemed” repatriation for anything other than tax reform.
The key remaining question is how long the extension considered this month will be – just through the end of the year or through the 2016 elections? Late today, reports surfaced that Rep. Ryan was working on an $8 billion extension that would last through the end of the year. This runs counter to what Senate leaders have supported—an 18-month extension that would push international tax reform into 2017. When discussing the extension in The Hill, Ryan responded to that difference:
“Mitch and I have the same long term goals, we want comprehensive tax reform and we want a long term highway bill,” he said. “They have their body to deal with, we have ours to deal with. We…think we should do a long term highway bill and we think tax reform is the best way.”
Ryan did specify how he plans to pay for his proposed temporary highway funding extension, saying only “I think we’ll be able to put together a package that kind of innocuous, boring stuff that shouldn’t be a surprise to people.
“We’ll post it when we have it ready,” he said.
If this passes, that would mean fewer revenue offsets this month, with an enhanced possibility for the prospect of international tax reforms to gain traction before December. Of course, we’ll be watching the short-term patch closely, particularly to see what Rep. Ryan comes up with to find the needed $8 billion.
Extenders are back under discussion, thankfully. Rumor is that the Senate Finance Committee will take up a 2-year extender package in the next couple weeks, while Chairman Ryan said Thursday that he’s looking for Ways & Means to move extenders in September.
This accelerated time table is good news—at least when compared to last year’s delay in an agreement until the very end of December. Another positive is the emphasis on making at least some of these provisions permanent. There is no reason the R&E tax credit, higher 179 expensing limits, and shorter built-in gains recognition period expire every few months. That said, there is opposition to the House has made to enact these very extensions permanently. According to Politico:
Democrats are opposed to efforts to make extenders permanent, arguing that the revenue losses must be offset. Republicans are quick to note that quirks of legislative scoring allow the cuts to be temporarily renewed — often cumulatively surpassing the 10-year “permanent” scoring window — without counting as a revenue loss.
Bottom line is that we expect to see action on extenders, at least at the committee level, soon. Our hope is that this new activity results in a package adopted by Congress well before the end of the year. Fingers crossed.
More on Tax Reform
We’ve previously commented on Chairman Paul Ryan’s desire to do as much as he can this Congress to lay the groundwork for comprehensive tax reform in 2017. Now, in the Wall Street Journal, he gives us a better sense of what that groundwork looks like.
“There’s a big difference between our view and the president’s view. He believes we should have higher tax rates on individuals. We think they should be lower. And when eight out of 10 businesses in America are what we call pass-throughs, LLCs, sole proprietors, sub S corporations, their top effective tax right now because of this president is 44.6%.
The international average tax rate on businesses is 25%. So we have to get these rates down across the board. That is something that the administration doesn’t share with us. So there’s an impasse.
The question is what can we do in the meantime that gets us a step in the right direction.
And as we’re looking at that, we’re looking at the international system. We want to move to an exemption system [where companies can repatriate foreign earnings without paying U.S. taxes on them]. We want to make every day a repatriation day for firms.”
Rep. Ryan’s remarks included his refusal to enact business tax reform without lowering the rates for pass-throughs, saying that corporate-only reform would “exacerbate the disparity” in rates between C corporations and pass-throughs. Amen to that!
Ryan told the Journal audience that the Ways and Means Committee intends to address expired tax deductions, credits, and incentives “as early as possible in the fall” to avoid a repeat of last year’s legislative process in which “taxpayers had to wait until December 11 to find out if these provisions were being extended.” He also emphasized that some temporary tax provisions, such as the research and experimentation credit and enhanced section 179 expensing, should be extended permanently.
With comprehensive reform unlikely until 2017, extenders and international reform appear to be the next-best options for action this year. S-Corp has commented extensively on the unique place S corporations with foreign operations have in the Tax Code (here, here, and here) and we’ll be spending the next several weeks highlighting those comments with the Ways and Means Committee and other tax writers.
Highway Trust Fund Funding
For months now, we’ve been hearing of an idea to use deemed (read “forced”) repatriation of overseas corporate earnings to help pay for a multi-year extension of the highway funding. To give readers an idea of the challenge, policymakers would need to raise $92 billion in new revenues to keep highway funding level for six years. According to the JCT, a properly structured repatriation could raise twice that amount.
At a June 24th hearing, the Ways and Means Subcommittee on Select Revenue Measures more closely analyzed the use of repatriation for highways and the net result was to leave attendees even more in doubt that this was the best source of the funding.
Chairman Reichert cautioned against standalone repatriation in his opening statement:
“However, as you will hear today, current repatriation proposals are not that simple nor are they without serious policy implications. That is why we are having this hearing-to drill down on what people mean when they say repatriation and how the different forms of repatriation work. A key, but often overlooked, part of this is that repatriation includes taxing earnings that have been reinvested abroad.
“What we know to be true is that repatriation cannot be done as a standalone; it must be part of a transition to a more competitive system. I expect to hear today that, taken outside of the context of a transition, mandatory repatriation would be a tax increase. A tax increase that American companies would be forced to pay unlike their foreign competitors.”
In his testimony, Curtis S. Dubay, Research Fellow in Tax and Economic Policy at The Heritage Foundation, echoed Rep. Reichert:
“If Congress changed repatriation policy as a stand-alone measure to cover a hole in the HTF, it would create less incentive to change the tax policy from a worldwide system to a territorial system. Instead, Congress should focus on establishing a territorial system and reserve changes to repatriation policy for aiding that sizable improvement to the tax code.”
Meanwhile, several large trade groups, including the National Association of Manufacturers and the National Retail Association, submitted strong statements against using repatriation for highways, leading Republican Tom Reed to observe that “If the stakeholders are going to be adamantly against [repatriation], it’s going to be difficult.”
So, if repatriation will not be used for funding the HTF, what will? And would any of these measures affect businesses? Deloitte’s summary of hearings from the previous week touch on a wide variety of potential funding sources:
Witnesses at the hearings – who, in addition to former Transportation Secretary LaHood, included president of the American Trucking Association and former Kansas Gov. Bill Graves, CBO officials, and think tank policy analysts – discussed a variety of other options for long-term funding, including mileage-based user fees, financing mechanisms such as Build America bonds and municipal bonds, devolving infrastructure responsibility to the states, public-private partnerships, and raising money from oil drilling rights on some federal lands. However, they noted that these methods would generally take time to implement and/or scale up and so were not immediate solutions.
Without a consensus, another short-term extension seems likely-the signal from Rep. Ryan is that it’s “unavoidable.”
Where the top 2016 Candidates Stand on Taxes-So Far
Wondering what the presidential candidates are doing on the tax front. With official announcements from Hillary Clinton and Jeb Bush in the past week, we thought it would be a good time to review where the major candidates stand:
- Rubio’s plan, which we analyzed in an earlierWashington Wire, is the most in-depth. Check out thescoring from our friends at the Tax Foundation for a refresher-in short, it’s one of the most pro-growth, pass-through friendly plans we have seen in a while.
- The Tax Foundation also looked at Rand Paul’s plan, which would be a complete overhaul of the current code in favor of a flat tax on individuals and a type of VAT on corporations. While the Tax Foundation determined Paul’s plan would bring over 9% of additional growth in the economy over 10 years, the revenue loss, even using dynamic analysis, is over $1 trillion!
- Rand Paul is not the only candidate with a flat tax proposal-Ben Carson has one, as does Sen. Ted Cruz.
- Christie’s plan came in the form of a Wall Street Journal Op-Ed. It appears to be a close cousin to Rubio-Lee, and would reduce the marginal individual rate to 28%.
- Mike Huckabee would scrap the income tax altogether in favor of the “FairTax,” a national sales-tax. He ran on this platform in 2008, when he generated some early momentum against Sen. John McCain.
- Republican contenders Jeb Bush and Scott Walker have yet to release their own tax plans. It’s still early, so we’ll be sure to provide analyses as these campaigns heat up.
- On the Democratic side, neither Hillary Clinton nor Sen. Bernie Sanders have released full plans. During her campaign announcement last week in New York, Clinton promised to rewrite the tax code so that it “rewards hard work, and not quick equities trades or money stashed away overseas.” The only specific so far is a $1,500 tax credit for each apprentice that a business hires-a measure similar to bills introduced by Sens. Tim Scott and Cory Booker as well as Sens. Maria Cantwell and Susan Collins.
- As for Sanders, all indications from his interviews and record in the Senate point to increasing revenue for the government. During an interview on Charlie Rose, Sanders said that he would raise the marginal tax rate for individuals “above 50%.” Ouch.
Family Business Valuation under Attack?
In a development that could harm valuations of S corporations and other family-owned businesses, the Treasury Department appears poised to issue guidance limiting discounts under section 2704. Such action has been hinted at for a while, but people began to pay real attention following comments from Catherine Hughes, head of Estate and Gift Tax Attorney-Advisor at Treasury, before the ABA’s Estate Planning breakfast back in April.
It’s not exactly clear what the Treasury has in mind, but Hughes referred the ABA audience to proposals the Administration included in their annual budget offerings prior to 2014. We took a hard look at those proposals back in 2013, and if you’re looking for an indicator of where Treasury is headed, that’s a good place to start. MPI, a business valuation and advisory firm, has a nice overview on their blog.
For months, we’ve been hearing that tax writers would like to couple some version of tax reform with a long-term highway bill. What the tax reform package would look like was unclear (international, patent box, extenders?) as was the funding source for the highway bill (deemed repatriation?).
Back-to-back hearings on highway funding next week should shed a little light on the latest thinking. Both the House Ways and Means and Senate Finance committees are holding hearings exploring the various options Congress could use to pay for highways. As Senator Hatch pointed out, “While many in Congress agree we should aim for a long-term highway bill, the problem is often agreeing on how to pay for it.” As usual, it’s all about the payfors.
The Ying-Yang of Tax Reform
McConnell focused on the challenges, particularly in bridging the policy gulf between President Obama and Republican Congress. “The President is not interested in revenue neutrality, and he’s not interested in treating all taxpayers the same, so I don’t think we’ll get there on comprehensive [tax reform].”
Ryan, meanwhile, continued to accentuate the positive. “The question is: Can we take a couple of steps in the right direction?” Ryan made clear he believes the answer is “yes”, particularly with international tax policy and extenders. So international, extenders, and highways? Something to watch.
Tax Foundation on Revenue Neutral Corporate Tax Reform
The Tax Foundation released another study on pass through businesses this week. You’ll recall they put out a really great paper on pass-through taxation in January that focused on the state of the pass through business community. Our summary – it’s large, dynamic, and employs a lot of people!
This new study dives right into the policy debate over corporate tax reform. Should Congress enact deficit neutral legislation that cuts the rates for C corporations only? According to the Tax Foundation, the answer is “no” unless you’re willing to raise taxes on pass through businesses in the process. They conclude “the impact of the elimination of business tax expenditures for pass-through businesses with no rate offset could reduce the size of the economy by 0.5 percent [or $84 billion in the long-run].”
Small Business Confidence
There’s a growing number of small business confidence surveys out there.
The Grand Daddy is NFIB’s Small Business Optimism Survey, which has been reporting quarterly since 1973 and monthly since 1986. NFIB uses a sample of nearly 4,000 small businesses, typically with a 15% response rate, and releases the information on the second Tuesday of each month.
This week’s survey gives a lukewarm assessment of the economy—“it’s moving ahead, but at an uninspiring pace” while the outlook for Q3 is “more of the same.” Two bright spots came in earnings and wages, which posted their best survey readings since October 2005 and January 2008, respectively.
A second survey, from Wells Fargo and Gallup, has been released on a quarterly basis since 2003. Their data is drawn from over 600 phone interviews with small business owners. While optimism among small businesses recorded a slight decline this Spring, overall “there’s more certainty in today’s economy than at this time last year, and we’re seeing more promising trends,” according to Lisa Stevens, head of Small Business at Wells Fargo.
Finally, there’s a brand new survey from Thumbtack, which focuses on hard-to-reach businesses such as seasonal employers and large swath of sole proprietors. Using their online community of professionals, Thumbtack is able to receive over 10,000 responses to their survey. The populations might be different, but Thumbtack’s results mirror those of NFIB—business owners are “somewhat positive” about the economy. Exploring the state-level results reveals some interesting data, particularly the discrepancies in ease of hiring and doing business in states with low regulatory burden compared to those with more red tape, typically in the Northeast and on the West Coast.
We’ll be keeping track of these surveys in future posts. Perhaps it’s time for a survey of the surveys?