More on the Administration’s Budget

We weren’t the only ones who noticed the President’s budget for 2017 is bad for Main Street Employers.  Numerous outlets ran stories (CQ, Bloomberg, and Morningstar) focusing on the negative impact the President’s tax proposals would have on S corporations and other pass-through businesses.  As our friends from NFIB noted about the Administration’s proposal to expand the Net Investment Income Tax (NIIT) to all pass-through business owners:

“It’s not closing any gap,” said Nick Karellas, tax counsel at the National Federation of Independent Business. “It’s just blatantly a revenue grab on small-business owners who are actively participating in their businesses.”

The Administration’s efforts to characterize this proposal as a loophole-closer are interesting, given that Congress intentionally excluded active business owners from the tax when it was enacted back in 2010 (See below).

But the proposals go well beyond expanding the NIIT.  They include increasing payroll taxes on professional service businesses, raising the capital gains rate paid by S corporations and others to 28 percent, and establishing a 30 percent minimum “Buffett tax” on all forms of income.  Each of these tax hikes would directly impact the profitability of pass-through employers.

Following the budget’s release, Treasury Secretary Jack Lew testified before the Ways and Means Committee and attempted to characterize their tax hikes as targeted at law firms and hedge funds, despite the fact that they would apply to all businesses – manufacturers, contractors, retailers, etc.  S-Corp Champion Dave Reichert (R-WA) was having none of it:

 

“Let me just go through what I think tax reform should look like, and I don’t see it in the President’s budget, in fact I think it’s really offensive to small businesses. Tax reform should stimulate growth and efficiency by reforming America’s current complicated, burdensome system into a simpler, fairer, flatter tax code. Tax reform should promote U.S. jobs and higher wages through a more competitive international tax system. Tax reform should ensure that small businesses have a fair and competitive tax system, including the tax rate. As a result of the President’s budget, the top rate for small businesses will be 43.4 percent. They don’t get it, and I don’t get it either, Mr. Secretary. Tax reform should aggressively lower rates, and simplify the code. Even after enacting substantial increases in capital gains taxes in 2010 and again in 2013, President Obama continues to propose raising taxes on the investment American workers need to become more productive and earn higher wages…Mr. Secretary…I would like you to explain to me how raising taxes on small businesses helps the American economy grow, helps small business grow, helps create jobs? I don’t understand how you can raise taxes and create a growing economy and create jobs.”

Last year, one of our S-CORP Board Members testified on the effect of these tax hikes on his manufacturing business. McGregor Metalworking saw its effective tax rate – not marginal, effective — jump from 34 to 42 percent following the Obama-supported rate hike in 2013 that Congressman Reichert cites.  Under the new Obama plan, McGregor’s effective rate would go even higher.

 

Confusion on the NIIT

There’s lots of confusion as to why the NIIT doesn’t apply to the business income of active business owners.  Advocates eager to rewrite the history of the provision are driving this confusion, which is showing up in major publications.  Take for example this excerpt from David Wessel in the Wall Street Journal:

Lobbyists for those who benefit from the NIIT loophole will be quick to accuse the administration of attacking small business. There are a lot of truly small businesses organized as pass-throughs, but the NIIT doesn’t affect them because they don’t earn $200,000 a year. The Treasury estimates that 67% of all S-corp income and 69% of all the partnership income goes to the top 1% of taxpayers, those with income greater than $375,000 a year.

Where to begin.

Let’s start with “loophole” and some of the facts surrounding the NIIT origins.  The NIIT was enacted in 2010 as a pay-for to Obamacare.  It was a late addition to the law that the Administration proposed in February of 2010, after both the House and the Senate had passed their respective health care reforms.

From the beginning, the proposal excluded the business income of active owners.  Here’s how CongressDaily reported on the provision at the time:

President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments.  The carve-out is a concession to a range of business groups and advocates for the self-employed.

That was us.  We led a broad coalition of business groups to oppose the provision when it was first floated, and we wrote extensively on the provision once it was released. You can read our analysis here, here, and here.

Congress made several key changes to the Administration’s proposal before enacting it – they removed its connection to Medicare and they increased the tax to 3.8 percent – but the exclusion on income of active business owners remained, as our Advisory Board Chair testified back in 2012:

This net investment income tax is generally imposed on interest, dividends, annuities, royalties, rents and gains, with one very important exception. Congress recognized that this new imposition should not apply to income derived by owners directly involved in active businesses. Therefore, Congress excluded from the tax base all income derived from a trade or business unless the income was reported by a person who did not “materially participate” under the passive activity rules or the trade or business consisted of trading in financial instruments or commodities.

So exempting the business income of active owners from the “investment” tax was part of the plan from the beginning and is no way a “loophole.”

And what about “benefit”?  Why does Mr. Wessel suggest that business owners who were never subject to a tax, and not supposed to be subject to a tax, derive some benefit from not being subject to the tax?  That label assumes that Congress intended to tax the business income of active shareholders.  They didn’t, so it’s not appropriate to call it a benefit.

Finally, Mr. Wessel massively redefines “small business.”  Any attempt to define “small” is by necessity going to be arbitrary and doomed to fail, but even the Small Business Administration (SBA) puts the threshold at 500 or fewer employees.  With around 400 employees, McGregor Metalworking (the manufacturer whose effective tax rate has jumped under Obama’s policies) is considered to be a small business by the SBA.  Mr. Wessel, on the other hand, would exclude any business that has just enough profits so that, when combined with all the other income earned by the owner’s household, it exceeds $200,000.

That’s the opposition in a nutshell.  They support small business, as long as that small business creates few if any jobs and doesn’t make much money.

The Administration’s budget and its various anti-growth proposals are going nowhere this year, but as S-Corp readers understand, no bad idea ever dies in Washington.  The false notion of a NIIT “Loophole” has been conceived and it will live long after the Obama Administration closes its doors.

S-CORP Testifies

 

Ahead of the extender deadline, S-Corp was on the Hill testifying yesterday that Congress needs to act to end the extender roller coaster and make permanent these provisions, including the built-in gains relief that affects so many of our S corporations.  At a hearing hosted by the House Small Business Committee entitled “Tax Extenders and Small Businesses as Employers of Choice” S-Corp was represented by Tom Nichols, Chairman of our Board of Advisors.

Tom Nichols Testimony 12.3

Tom opened his remarks by highlighting the important role pass-through businesses play in employment and job creation, and then focused on a number of specific actions Congress could take this month to ensure they continue in this role, including making permanent the shorter, five-year holding period for the built-in gains tax.  As Tom noted:

Delaying confirmation of the five year built-in gains tax period has similarly destructive consequences. In the past several years, small business owners have asked me repeatedly whether the five-year or ten-year period will apply. The only response I could give them is that the final built-in gains period will “probably” be five years, but that they can’t count on it.

This has created a number of excruciatingly difficult situations for my clients. For example, several of my farming clients were attempting to sell agricultural land – either to raise capital or to finance their pending retirement – while farmland prices were at their peak. Unfortunately, for those in the critical 6 to 10-year “limbo” period, this uncertainty constituted a huge stumbling block, and now it appears that the optimal time for selling is gone.

I had another client who wanted to sell his business, but could ill afford to do so if the double-tax built-in gains regime was applicable. I recommended that he and the buyer reach agreement and have all the documents prepared, but wait until actual passage of the extenders legislation to sign and close the deal. His response was that he was in poor health and may not be able to wait.

As with expensing, a five-year period for the built-in gains tax is well supported by policy considerations. The built-in gains tax was originally enacted in the Tax Reform Act of 1986 and was intended to prevent C corporations from converting to S Corporation status and selling some or all of their business subject only to the single-tax S Corporation regime. To be honest, I have never understood why paying only one tax upon the sale of a business was considered a loophole to be closed. Regardless, it is generally recognized that a ten-year waiting period is much longer than necessary in order to achieve the initial policy goal. Given the uncertainties and vagaries of conducting business, business owners are extremely unlikely to elect S Corporation status with concrete plans to sell after waiting for a period of five or more years.

You can read Tom’s written analysis here.  Small and closely-held businesses play an invaluable role in creating jobs where they are most needed, despite all of the unnecessary obstacles imposed on them by Washington. But it doesn’t have to be so difficult. Failing to make business extender items like built-in gains permanent is a wholly unforced error that this Congress has the ability to fix.  Talks are going on right now.  Let’s hope they come to a happy conclusion.

 

Pass-Through Tax Rates

More on the effective tax rates pass-through employers pay.   Sitting next to Tom at yesterday’s hearing was Todd Kriegel, the CEO of Global Precision Parts. Todd’s company has a profile that many S-Corp members will find familiar—a family-owned, S corporation manufacturer with 200 employees split across three locations in Indiana and Ohio.

Also familiar to S-Corp readers is how the Fiscal Cliff resulted in a massive tax hike on Todd’s business:

GPPs current federal effective tax rate is 39.4%, far higher than our C-Corp counterparts, not to mention the Chinese companies who we really are competing against. In 2008, we had a 28.07% effective federal tax rate with the Alternative Minimum Tax. That 11.33% jump in our tax liability cost us hundreds of thousands of dollars we could have used to hire more workers for the machines we would have purchased.

Just last April, S-Corp Board member Dan McGregor of McGregor Metalworking gave similar testimony on how the effective rate on his metal-working business jumped from 33 to 42 percent as a result of the fiscal cliff!

Following the resolution of the fiscal cliff, the top tax rate on my shareholders increased to approximately 41.4 percent due to the higher 39.6 percent marginal rate plus, where applicable, the new 3.8 percent Affordable Care Act tax and the effect of the reinstatement of the Pease limitation on itemized deductions. As a result, today we have to distribute approximately 42 cents of every dollar earned so our shareholders can pay the federal, state and local S corporation tax.

Dan and Todd employ hundreds of well-paid manufacturing workers in communities — like Springfield, Ohio and Wabash, Indiana — that desperately need jobs.  And they are being forced to compete not only with Chinese companies that play by an entirely different set of rules, but also with domestic C corporations that enjoy significantly lower tax rates.  The CEO of Pfizer complains about his 25 percent effective rate?  We’re guessing Dan and Todd would swap with him in a second.

Any reform of how we tax business income needs to begin with Main Street businesses.

Brady Elected Chairman of Ways and Means

On Wednesday, the Republican Steering Committee tapped Rep. Kevin Brady (R-TX) to succeed Speaker Ryan as the committee’s chairman. Both he and his challenger, Rep. Pat Tiberi (R-OH), are strong allies of S corporations and pass-through businesses, so we excited to see him take on the gavel.

What does Brady’s ascension mean for tax policy?  The Wall Street Journal has an interview with the new Chairman this morning, where Brady makes clear he wants to move a robust tax extender package (yea!) this fall then spend next year pushing the “step one, step two” plan for tax reform outlined by Paul Ryan in the past year:

Q: What’s the first thing you’re going to try to get accomplished this year?

A: We’re going to continue to tee up pro-growth tax reform. There’s two steps we can take that are real, one of them immediate, which is to negotiate a package of permanent provisions among those [expired tax breaks]. One, because it creates certainty for the economy. Two, you get a better bang for the buck for the tax provisions. And three, it’s honest scorekeeping. It identifies what truly are permanent parts of the code. I will pick that up and see if we can’t conclude a package that works for both parties.

The second one in 2016 is to conclude discussion on international tax reform and an innovation box. It could be a significant down payment on overall tax reform, done right, allow U.S. companies to bring those stranded profits home to reinvest in the U.S. and ensure America isn’t isolated on the innovation side of the economy.

We applaud the new Chair’s focus on extenders and pressing the case for making as many of these provisions permanent as possible.  On the international front, everyone is waiting to see the revised “innovation box” proposal from Representative Charles Boustany (R-LA) and how willing the Administration is to seriously negotiate something the business community can support.  Most everyone supports making our tax code more competitive, but exactly how much progress can be made with the current Administration remains to be seen.

 

White House Opposes Rate Cuts for Pass Thrus

Speaking of the White House, recent comments by the President’s chief economic advisor make clear the gulf between the White House and Congress approaches over tax reform continues to be the principal reason Congress has been unable to do anything meaningful this year.

Jason Furman, Chairman of President Obama’s Council of Economic Advisors, spoke to the Brookings Institute Tax Policy Center earlier this week and gave the Administration’s take on tax reform, identifying the key area of disagreement with Congress:

But there was an “impasse” over whether to lower individual rates, which some Republicans argued was necessary to maintain the competitiveness of large businesses that filed through the individual side of the code.

To cut the top individual tax rate as Republicans want is impossible without tilting the tax code in favor of the rich, Furman said at Tuesday’s event.

The continued opposition of the Obama Administration to rate cuts isn’t news, but the disconnect between their insistence on corporate cuts yet opposition to similar cuts for domestic pass through businesses is head scratching.  Why is one important and economically necessary but the other just a give-away to the rich?   Recall that those pass through businesses employ more people and contribute more to the national economy than their corporate cousins.  Apparently, the opposition stems from the myth that private businesses don’t pay their fair share:

He also suggested that cutting the tax rates of businesses that filed as individuals would work against the purpose of tax reform. Furman cited Congressional Budget Office statistics indicating that the owners of those companies, known as “pass-throughs,” pay lower effective tax rates than do the owners of companies arranged as corporations, even though pass-throughs have lower rates on paper.

This is an argument the CBO has made in the past, as have recent papers from CRS and Treasury. We have a number of critiques of these papers, but the primary concern is that they fail to compare apples to apples or, in this case, businesses of similar size.  When you do that, as our study from Quantria did, you find that large S corporations pay the highest effective rate of all business types.  Policymakers need to be aware of that as they debate the future of tax reform.

 

Valuation Discount Update

Are you asking yourself what happened to those new regulations out of Treasury on minority discounts?  We are.

As we previously reported, for the past year Treasury has been working on new rules limiting the ability of family-owned businesses to apply minority discounts under certain circumstances.  Exactly what those regulations would do and when they would be released, however, has always been a mystery.

Now BNA reports that a senior IRS official this week provided a little clarity on both fronts.

Guidance on restrictions on estate valuation discounts for certain corporations and partnerships is expected very soon and won’t be based on previous administration proposals, Leslie Finlow, an IRS senior technician reviewer, said today.

Tax code Section 2704(b) gives the Treasury Department the power to issue new regulations disregarding additional restrictions on liquidations of interests if the restrictions reduce the value of the transferred interest but not the value of the interest to the transferee.

However, Finlow told certified public accountants at the American Institute of CPAs Fall Tax Division Meeting, that the Internal Revenue Service isn’t looking to a 2013 Obama administration proposal that called for further restrictions on valuations of family business interests. Instead, she said the guidance will focus on “the statute as it looks now.”

So the rules are due soon, but it appears they won’t be as expansive as previous Obama Administration budget proposals.  Something to keep an eye out for.

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