S-CORP Clips | October 1-10

A compilation of the business tax related stories that caught our eye

 

Administration on Tax Reform

The President’s economic advisors have been unusually busy in recent weeks.  National Economic Council Director Jeffrey Zients was firm in his conviction that tax reform could get done in the new Congress, citing the “remarkably overlapping” approaches of Obama’s plan and the Camp draft.

It is true there are some common themes in the Camp and Administration proposals, but also there are major – and fatal – differences as well, including:

  • The Camp Draft is budget neutral while the Administration’s plan would raise revenue;
  • The Camp Draft adopts a territorial tax system while the Administration appears to strengthen our world-wide system; and
  • The Camp Draft is comprehensive while the Administration plan would reduce rates on corporations only – an approach rejected by Democrats and Republicans alike.

Add to those differences the fact that the Administration’s draft landed with a thud when it was released back in 2012 and has barely been discussed since, and the idea of House Republicans and the Obama Administration coming together on tax reform in the next Congress seems laughably remote.

Meanwhile, Council of Economic Advisers Chair Jason Furman spoke in New York the other week on tax reform, offering additional context to the Administration’s tax reform proposal and addressing some of the concerns that have been raised.  We’ll have more to say about this later, but this paragraph caught our eye:

On the economic merits, it is important to remember that C corporation income is partially taxed at two levels while pass-through income is only taxed at one level. As a result, today C corporations face an effective marginal rate that is 6 percentage points higher than that on pass-through businesses. Although the President’s Framework would cut and simplify taxes for small business, including small pass-through entities, for larger businesses we should be moving towards greater parity—with the goal of equal effective rates on an integrated basis, a goal that would not be served by parallel reductions in individual and corporate tax rates.(Emphasis added)

That’s not exactly true.  Recall that our study on effective tax rates released last year found that S corporations face the highest effective tax rate of any business type.  Those estimates were based on real businesses and actual tax returns.

The numbers Jason is referring to are based on hypothetical future investments.  They can be found in a three-year-old Treasury analysis under the heading of “Effective Marginal Tax Rates on New Investment.”  Jack Mintz authored a comprehensive critique of these estimates for the Tax Foundation last February, some of it pretty damning.

For our purposes, we will just point out that Treasury’s analysis, correctly done, would be appropriate if you wanted to measure the tax burden on marginal investment decisions – should we build that new facility, should we buy that piece of equipment, should we use debt or equity? – but it doesn’t support the notion that C corporations today pay a higher effective rate than pass-through businesses.  You need to estimate average effective tax rate to make that claim, which is what our study does.

Jason is right to point out that the double tax on corporations hurts US competitiveness.  That’s the reason the pass-through business community advocates for its reduction as an essential goal of tax reform.  There’s little point in reforming the tax code if the result doesn’t reduce the tax on investing in the United States, and the best path to achieving that is to tax business income once at reasonable rates and then leave it alone.  That’s how S corporations are taxed today, and real reform would move C corporations in that direction.

 

Ryan on S Corporations

Contrast the Administration’s approach with that of Representative Paul Ryan (R-WI), a leading contender to take the gavel as the next Chairman of the Ways and Means Committee.  He recently gave a speech at an event hosted by the Financial Services Roundtable in which he made clear the importance of improving the tax code for all businesses, including S corporations and other pass-through businesses. Here’s what he had to say:

“Tax reform is one of those things that we don’t know if we’re going to be there at the end of the day, because we want to make sure that, as we lower tax rates for corporations, we do the same for pass throughs.

You know, a lot of people in the financial services industry – banks – are subchapter S corporations.

Where Tim [Pawlenty] and I come from, “overseas” is Lake Superior, and Canadians are taxing all of their businesses at 15 percent. And our subchapter S corporations, which are 90 percent of Minnesota and Wisconsin businesses, are taxed at as high as a 44.6 percent effective rate.

So we have to bring all these tax rates down, but we have a problem with the Administration being willing to do that on the individual side of the tax code.”

We’ve been beating the “comprehensive tax reform” drum for three years now and it’s nice to see key policymakers embrace the message.

 

American Progress on S Corp Payroll Taxes

Meanwhile, Harry Stein of the Center for American Progress is out published a report with broad recommendations on how to best reform the tax code. Among its suggestions is one to close the “Edwards-Gingrich loophole,” an issue we’ve covered extensively in the past. On that subject, the S Corporation Association has developed the following position:

  1. We don’t support using the S corporation structure to avoid payroll taxes.  We represent businesses that comply with the law, not sneak around it.
  2. It’s not a loophole, its cheating.  This issue is often described as a loophole, but that’s not accurate.  Underpaying yourself in order to avoid payroll taxes is already against the rules.
  3. The IRS has a long history of successfully going after taxpayers who abuse the S corporation structure.  The current S corporation rules on this have been in place since 1958.
  4. Any “fix” needs to improve on the current rules.  That means they need to be easier to enforce and they need to target wage and salary income only.  Employment taxes should apply to wages only, not investment (including business) income.

 

S-Corp Payroll Tax Hike Re-Emerges

Both the Camp discussion draft and the President’s budget include provisions to expand the application of payroll taxes to S corporation income.

The White House proposal is an expanded version of efforts that failed in the Senate in 2010 and 2012, where 100 percent of income from a professional services businesses – law, accounting, consulting, etc. – organized as an S corporation, general or limited partnership, or an LLC taxed as a partnership, would be subject to SECA taxes.

The Camp provision, on the other hand, is a whole new approach that is dramatically broader than anything considered to date.  It would reach beyond professional services businesses and would impact all S corporations, including manufacturers and other producers.  The draft would:

  • Bring S corporation business income under self-employment taxes (SECA);
  • Create a new 70-30 rule, whereby 70 percent of an active shareholder’s wage and business income derived from the S corporation would be subject to payroll taxes;
  • Credit the active shareholder with any FICA taxes paid on the S corporation wages;
  • Apply to all S corporations, not just professional services businesses; and
  • Apply the same 70-30 rule to partnerships.

Another area of difference between the two plans is their revenue estimates.  The Obama provision is narrower – it applies to professional services businesses only – yet Treasury estimates it will raise $38 billion over ten years!  The Camp provision is significantly broader – it applies to all S corporations – but the JCT says it will only raise $15 billion.  What gives?

We’re not sure, but since the new 70/30 rule applies to both S corporations and partnership income, it appears the Camp proposal would both raise and lose revenue, with the net effect resulting in a $15 billion tax hike. Under current rules, a significant portion of partnership income is fully subject to payroll taxes – particularly among large law and accounting firms – which means the new 30 percent exclusion would have the effect of lowering collections on those businesses.  That’s good for partnerships, but bad for S corporations, because it means the tax hike on them is significantly larger than $15 billion.

The Committee claims their approach is simpler than current rules, but we don’t see it.  Consider the case of an owner of a large manufacturing plant with dozens of employees and millions in capital investments.  This is not a rare example – drive around any sizable town and you’ll see dozens of them.   He pays himself a market-based salary of $250,000 and the business makes $750,000 in profit.  Under the current rules, his salary is subject to FICA while the business income is not.  Since he’s paying himself a market wage, the business income is, by definition, a return on the capital invested in the business and should not be subject to payroll taxes.

The Camp proposal, however, would do just that.  Under the provision, the owner would need to aggregate his salary and business income ($250,000 + $750,000 = $1 million) and then multiply the result by 70 percent.  That’s the amount of his total income that would be subject to payroll taxes ($700,000).  The owner would then subtract out the salary income that has already been subject to FICA ($700,000 – $250,000 = $450,000).  That’s the amount of the owner’s business income that would be subject to SECA taxes.  It’s not simple, and it’s certainly not fair.

Moreover, the Camp approach appears to severely limit the benefit of excluding domestic manufacturing income from the new 10-percent surtax.  As advertised, the Camp plan would tax S corporation “producers” at a top rate of 25 percent.  But the draft also appears to apply the same 70/30 rule to production income as it does to payroll taxes.  That means, in the example above, the owner would pay a 25 percent rate on $300,000 of his business income, but 35 percent on the rest.  Suffice it to say that the C corporation down the street doesn’t face this byzantine approach to marginal tax rates.  The combination of the 10 percent surtax and the 70/30 applied to active shareholders presents a strong incentive for the owner of this business to retire, convert to C corporation status, or sell the business entirely.

Finally, it’s important to address the origins of the 70/30 rule.  According to the Committee’s section-by-section:

The provision’s distinction between net earnings from self-employment and other income not subject to SECA reflects the fact that over the last several decades, the portion of Gross Domestic Product (GDP) attributable to labor has remained remarkably constant at approximately 70 percent, while the portion of GDP attributable to capital has held steady at roughly 30 percent. The 30-percent deduction recognizes that a portion of the distributive share of a partnership, LLC or S corporation represents earnings on invested capital. 

In other words, since the nation’s income is divided 70/30 between labor and capital, that ratio should also apply to the business income from an S corporation or partnership.  We’re not so sure.  Take the example above.  The GDP definition of “income” is not limited to the combined $1 million in business and salary income attributed to the owner.  It also includes all those wages paid to the other workers.  Those wages are included in the GDP calculations, but the Committee ignores them in applying the 70/30 rule to S corporations.

As we pointed out, since the owner in our example pays himself a market wage, any business earnings beyond that amount are a return on capital.  So taxing that income as a return on labor is simply not correct.  Not every S corporation has lots of capital – some have little, while others have tons.  Applying a one-size-fits-all 70/30 rule to all S corporations does not accurately capture this diversity, and it certainly doesn’t justify a massive increase in the application of payroll taxes to business income.

As readers know, we’ve been fighting this issue for a decade now, ever since Vice President Dick Cheney chastised Senator John Edwards for using the S corporation structure to avoid payroll taxes on the income from his law practice.  Over the decade that followed, S-Corp has developed the following position on the issue:

  1. We don’t support using the S corporation structure to avoid payroll taxes.  We represent businesses that comply with the law, not sneak around it.
  2. It’s not a loophole, its cheating.  This issue is often described as a loophole, but that’s not accurate.  Underpaying yourself in order to avoid payroll taxes is already against the rules.
  3. The IRS has a long history of successfully going after taxpayers who abuse the S corporation structure.  The current S corporation rules on this have been in place since 1958.
  4. Any “fix” needs to improve on the current rules.  That means they need to be easier to enforce and they need to target wage and salary income only.  Employment taxes should apply to employment.

Measured against those rules, the two proposals put forward here fall short.  They ignore the distinction between employment and investment, and they unfairly raise taxes on business owners who are fully complying with the law.  They might successfully raise revenues, but they don’t appear to contribute to fairness or simplicity.

S-CORP Testifies

S corporation tax policy took center stage on the Hill earlier this month.

Carrying the S-CORP flag before the House Ways and Means Select Revenue Subcommittee was Tom Nichols, the Chairman of S-CORP’s Board of Advisors. The hearing focused on pass through business taxation issues and, in particular, the merits and shortcomings of the “Pass Through Draft” that Chairman Camp released earlier this year.

From the beginning, Tom’s testimony hit the high notes of the advocacy we’ve been conducting for the past two years:

“Tax Reform needs to be comprehensive and address the individual, pass through, and corporate tax codes at the same time. Congress should continue to foster progress toward a single level tax system for all businesses, and continue to strive to keep the tax rates paid by businesses and individuals as low as possible.

In this regard, the bipartisan Tax Reform Act of 1986 stands out as an excellent template for Tax Reform. It expanded the tax base by eliminating numerous preferences and privileges for specific taxpayer groups, thereby creating room to dramatically decrease the tax rates for C corporations, pass through businesses and individuals alike.

This approach allowed many, if not most, owners and managers to get out of the tax planning business and immerse themselves in the operations of their real businesses instead. It is my hope that the current Tax Reform effort will build on the policies and lessons learned in 1986.”

Tom went on to highlight provisions in the discussion draft that would help S corporations, including those provisions taken from H.R. 892, the S Corp Modernization Act of 2013. This legislation has been an S-CORP priority for years and forms the core of “Option 1″ in the draft.

While the panel expressed some reservations regarding the more aggressive “Option 2,” Tom did highlight several positive ideas incorporated in the reform, including making public-private ownership the new, improved line of demarcation between pass-through and C corporation tax treatment. That’s a reform that can and should be included in any tax reform package.

This hearing is one of several we expect over the course of the summer, all leading up to the possible House consideration of tax reform sometime this fall. As we’ve observed previously, others have argued that enacting tax reform is just too big a lift this year, and that little will happen. We’re not so sure about that. Congress needs to raise the debt limit, and it needs to address the long-term deficit picture. How that happens is anyone’s guess, but there’s a confluence of fiscal policies all coming to a head this fall together with two very determined chairs of the tax-writing committees which suggests consideration of a big package that includes tax reform should not be discounted. We’re certainly not.

New York Times on Tax Reform

The New York Times has weighed in with a couple of tax reform stories in recent days.

The first, entitled “In Tax Overhaul Debate, Large vs. Small Companies,” focuses on the possible rift between US-based multinational corporations and privately-held businesses over the goals of tax reform.

As we have noted before, we believe this rift is overstated. Yes, there are a couple large corporations that argue Congress should cut their taxes while making private companies pay more, but these businesses are a distinct minority and their voice is falling on deaf ears among tax-writers. The vast majority of the business community is united behind a tax reform effort that would lower rates on all forms of business while broadening the tax base.

The NY Times piece featured a couple of S-CORP Board members making this case, as well as the need to reduce high effective tax rates as the best means of encouraging increased investment and job growth. As the story notes:

Companies that switched said the simpler, generally lower single-tax rules gave them a leg up and helped them grow.

McGregor Metalworking Companies, a family-owned business in Ohio and South Carolina, had 80 employees when it converted in 1986 and now has a work force of 370.

“It has been a real force for reinvestment,” said Dan McGregor, 69, chairman of the company, which has seven shareholders.

This impact is not for metalworking companies alone. As our first Ernst & Young study made clear, the existence of pass-through businesses in the US means more investment, higher wages, and more jobs than if every business was subject to the double tax. That’s the reason why Principle Three in the Main Street Coalition’s Principles for tax reform calls for tax reform to reduce the existing double tax.

The second story appeared over the weekend and gets right to the heart of the challenge over tax reform,  i.e. the looming battle between those firms and industries that pay a high effective tax and those that do not:

Corporate taxes burst into the spotlight last week, with the release of a Senate committee report on Apple’s tactics to reduce its tax payments. More quietly, but perhaps more significantly, the House Ways and Means Committee has begun work on a potential overhaul of the tax code. Edward D. Kleinbard, a tax expert and former Democratic Congressional aide, said he had been impressed so far by the seriousness of the committee’s work.

The effort has a long way to go, but if it succeeds, both liberal and conservative tax experts hope it will reduce the statutory rate while also eliminating tax breaks. The net effect could be to close the gap between companies that pay relatively little in taxes and those that pay much more. The market, rather than the tax code, would then play a bigger role in determining companies’ success and failure.

As the Times notes, done correctly, tax reform will help level the playing field between those companies and industries currently paying little or no tax, and those that are currently shouldering a much higher tax burden.

Lastly, we should point out that a reader of these Times articles might come away thinking that pass-through businesses, including S corporations, pay a lower effective tax rate than their larger competitors. We’re confident that’s not the case. Previous work has shown that S corporations pay the highest effective tax of any business structure, and their marginal tax rates just went up, not down. Meanwhile, as the second Times story made clear, the news is full of stories about how our largest corporations pay little or no tax.

More on this to come.

error: Content is protected !!