Brady Plan and Pass Throughs

The Wall Street Journal featured S-Corp Board member Clarene Law last week in a story focused on the new tax rates for pass through businesses in the House tax reform plan.  As the story notes:

Clarene Law said a lower tax rate on pass-throughs would free up capital to add rooms to her hotels in Jackson, Wyo. or buy new air conditioners and washing machines.

“25% if it’s pure, not all cobbled up with a bunch of surtaxes, it would be a great benefit,” said Ms. Law, chief executive officer of Elk Country Motels Inc. Her businesses own more than 400 hotel rooms and generate revenue of more than $10 million a year, she said.

What does Clarene mean by a “pure” 25-percent rate?  The priority of the pass through community is making certain that the new, 25-percent rate is real and robust.  It should apply to all forms of active pass through business income just as the new 20-percent rate applies to all forms of active corporate income.

The concern here is twofold.  First, when Congress has considered special rates for closely-held businesses in the past, they typically have limited the application of the new rate or deduction based on industry and income.  For example, back in 2012, the House considered a special, 20-percent deduction for small business income, something you would expect the Main Street community would support.

However, the legislation included several carve-outs – various versions of it imposed limit on revenues, a cap on the number of employees, and excluded certain industries from the deduction.  In the end, most of the business community chose not to support the effort.

So for the new, 25-percent rate, how Congress defines the tax base is extremely important.  In our communications with Members of Congress, we have emphasized that the pass through tax rate base should:

  • Target active business income, rather than active shareholders.  Previous efforts to create a separate, pass through tax rate defined the tax base by looking at the shareholder, rather than the business.  That’s the wrong approach.  If a business makes income manufacturing steel, the income is the same regardless of whether the shareholder is active or passive.  The base needs to be broad, and focused on the income, not the shareholder.
  • Not be limited by industry or income.  Some early versions of a lower pass through rate would have excluded financial services companies from the lower rate.  This approach is also wrong – there is no valid policy reason to exclude pass through businesses operating in the financial services area. The tax base for the pass through rate should mimic the C corporation tax base, avoid excluding certain industries, and be as broad as possible.

The second challenge is how does Congress prevent cheating without undermining the value of the new 25-percent rate?  Under the Brady plan, the top tax rate on salaries and wages will be 33 percent, while the top rate for pass through businesses will be 25 percent.  For owners that also work at the business, there will be an incentive to allocate as much of their total income as possible as business profits rather than wages and salaries.

This is an old issue – it dates back to 1993 when Congress removed the salary cap on Medicare Payroll taxes – and we have addressed it many times in the past.  The larger rate differential in the House plan, however, raises the stakes, and lawmakers are eager to find a solution.

The challenge is how exactly do you distinguish between business income and wage income for active business owners?  Here’s the JCT on the existing rules:

A shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages, but generally is not subject to FICA tax on amounts that are not wages (such as distributions to shareholders). Nevertheless, an S corporation employee is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wages.

A significant body of case law has addressed the issue of whether amounts paid to shareholders-employees of S corporations constitute reasonable compensation and therefore are wages subject to the FICA tax, or rather are properly characterized as another type of income that is not subject to FICA tax.

In the past, S-Corp has maintained that any attempt to legislate in this area should pass a simple test – are the new rules clearer, more accurate at differentiating wages from profits, and more enforceable than the existing rules?  If not, then the new approach should be rejected.  To date, all the proposed solutions have failed this test.

So, as the Committee is working through these issues, the S Corporation Association and its allies are up on the Hill, educating members about the importance of addressing both these challenges fully and appropriately.  With lower rates, estate tax repeal, AMT repeal, expensing, and territorial on the table, the Brady bill has the potential to completely re-craft how pass through businesses pay tax, so it’s definitely worth the pass through business community’s time to help get this right.

Expect lots more on this in the coming weeks.

S-Corp on Section 385

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.

CBO effective rates

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.

S-CORP News Clips

Small Business Confidence Survey

You’ll remember back in June we profiled three small business surveys from NFIB, Wells Fargo/Gallup, and Thumbtack. Together, these surveys, with different sample populations and varying methods, provide the most complete picture of the small business landscape today. When we examined their findings during the summer, we saw words like “lukewarm”, “uninspiring”, and “more of the same” to describe the private business environment.

For the third quarter of 2015, it’s “more of the same” again.  With minor variations, all three surveys show that business owners are no more confident today than they were during the summer. In particular, economic uncertainty is cited as a top concern:

  • NFIB notes that over 20% of businesses that think it is a poor time to expand cite political uncertainty;
  • 20% of Wells Fargo/Gallup respondents cite the economy or government as their top concern; and
  • Economic conditions had the most business owners worried in Thumbtack’s survey, which had over 6,000 respondents.

So government action, and inaction in some cases, is hurting the small business sector and retarding investment and job creation.  Maybe policymakers on the Hill and in the agencies should take note.

 

Where are the Democratic Tax Plans?

Most Republican presidential candidates have released a tax plan in one form or another to date. They range from Sen. Rubio’s detailed legislative proposal that he co-wrote with Sen. Lee (R-UT) to op-eds in the Wall Street Journal and elsewhere from candidates Chris Christy, Jeb Bush, Donald Trump, and others.  The details vary, but a common theme in all the plans is the need to use the tax code to stimulate investment and job creation.

On the other hand, no candidate on the Democratic side has released a comprehensive plan. Secretary Clinton and Senator Sanders (D-VT) have released targeted proposals calling for profit sharing, as well as higher taxes on financial transactions and capital gains, but not only are these not comprehensive reforms, they would also, as Peter J. Reilly at Forbes writes, only serve to make the tax code more complicated.  Tax policy was largely missing from the recent debate, too.  Other than some vague references to higher taxes for the wealthy—particularly from Sanders — tax policy was a no-show.

Our friends at the Tax Foundation have been scoring and writing on all the Presidential plans.  You can access their chart here.  We expect that as the campaign matures, we’ll see more robust proposals from the Clinton campaign and others in the Democratic field.  Tax policy is always a key part of any presidential run, and we expect 2016 to be no different.

 

Et Tu, CRS? 

Last month, Treasury (or at least the bulk of their tax economist team), released a study on pass through businesses and the taxes they pay.  We raised concerns with the Treasury approach here and here.

Now CRS also has a paper focused on pass through businesses and the challenge they present to reforming the corporate tax code.  As BNA summarized, the basic message of the paper is this:

The 35 percent statutory corporate tax rate tends to be higher than the average marginal statutory rate for noncorporate business, estimated to average about 27 percent, according to data from the Internal Revenue Service. In addition, effective corporate tax rates are higher in most cases and for most assets than effective rates for passthroughs, and administrative and compliance costs would be lower if tax provisions such as depreciation and inventory accounts were harmonized across organizational forms.

As with the Treasury paper that preceded it, however, the lower effective (or average) rate for pass through businesses in the CRS paper is almost entirely due to the inclusion of lower-income sole props and other pass through businesses in their calculation.  In other words, they’ve compared the effective tax rate of Wal-Mart to the handy man down the street and found, not surprisingly, that Wal-Mart pays a higher rate.

One interesting aside is the CRS estimate for shareholder level taxes.  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.

What’s missing from both the CRS and Treasury analyses is a comparison of likes – a large C corporation to a large S corporation in the same industry.  That comparison would inform policymakers as to the respective tax burden of different business forms and help them make better policy decisions, but you are not going to find that sort of comparison in either the CRS or Treasury papers.   Based on our previous work, we’re confident the S corporation in that analysis would pay the higher effective rate.

GOP Leadership Fight Will Continue, Implications for Tax Reform

Well that didn’t go as planned.

House Majority Leader Kevin McCarthy’s surprising withdrawal from the Speaker’s race Thursday put an end to John Boehner’s carefully orchestrated plan to pass a raft of difficult bills this month, turn over the Speakers’ gavel to McCarthy on the 29th, and ride off into the sunset.

We still expect Boehner to successfully negotiate deals on spending, debt limit and highways, but where does all the turmoil leave tax policy?  Our friends at Tax Notes asked around and got this response:

Tax observers said McCarthy’s withdrawal makes it more difficult to achieve any kind of complicated tax legislation by the end of the year.

“Today’s news probably makes it even harder to do anything complicated, and more likely we get another short one- or two-year [extenders bill] at the end of the year,” a tax lobbyist said.

When asked about how the tax agenda for this year would be affected, a House Democratic aide said, “The Republican party has bigger issues to sort out.”

A renewed focus on extenders would be nice.  It’s almost November, and they expired January.

But the Tax Notes story was written before the entire Republican apparatus turned its attention towards recruiting Ways & Means Chair Paul Ryan to replace John Boehner as Speaker.  If anybody has a chance to placate the so-called Freedom Caucus members, it would be Ryan, but he has made clear he isn’t interested in the job – he really likes being in charge of tax and entitlement policy.

So it’s unlikely he agrees to run, but it’s also unlikely the pressure coming from Republican leadership abates anytime soon.  Which means tax policy, and extenders in particular, will take a back seat until the Republican leadership question is resolved.

 

International Tax Reform Off the Table, For Now

In a related development, Ryan has officially given up trying to negotiate an international tax reform package with Senator Chuck Schumer.  As The Hill reported last Friday:

Ryan, the House Ways and Means chairman, and Sen. Charles Schumer (D-N.Y.) have held discussions for weeks over a potential deal that would have something for both parties — long-term and robust funding for highways, and more generous tax rules for multinational corporations.

The two powerful lawmakers had always faced a number of difficult hurdles in striking a deal, including an Oct. 29 deadline on highways and opposition from key Senate Republicans.

But aides to Ryan and Schumer also acknowledged on Friday that they had not bridged significant policy differences in negotiations, most notably over how much to spend on highways.

These negotiations had always been accompanied by a fair amount of skepticism, particularly among Senate leadership, but Ryan, Schumer, and others put in an enormous effort to construct a plan that could improve how we tax overseas operations while appealing to Republicans and Democrats alike.  It now appears that plan will have to wait until the 2016 elections and after.

 

More on Treasury’s Effective Rate Study

Having recently put out a paper on effective tax rates, we can confidently say that determining effective tax rates is really, really complicated.  This is particularly true for C corporations, where foreign income and foreign tax payments play such large roles.

That said, in a perfect world, an effective tax rate would measure the actual tax paid by a taxpayer in a particular year divided by the real income of the taxpayer in that same year.

The Treasury Department agrees.  Back in 2012, as part of an interesting discussion on tax burdens and effective tax rates in the President’s “Framework” on corporate tax reform, Treasury emphasized that its measure of effective marginal tax rates for corporations used “economic income” as the denominator.

In their more recent study, however, Treasury appears to use “taxable income” as the denominator, at least for C corporations.  From our perspective, that really undermines the whole point of doing an effective rate analysis.  Here’s why:

Take two businesses, one a manufacturer and one a retailor.  They both make $100 and pay a 35% tax rate.  The only tax benefit they receive is a Section 199 deduction of 9% for production income.

Manufacturer Retailor
Net Income $100 $100
Section 199 Deduction $9 $0
Taxable Income $91 $100
Tax Rate 35% 35%
Tax $31.85 $35
Effective Tax Rate According to Treasury 35% 35%

If you were the retailor in this example, you’d be a little annoyed that the Treasury Department was claiming your average tax rate was the same as the manufacturer who pays less in taxes on the same income.  Using “taxable income” removes the effect of most the business tax expenditures – bonus depreciation, accelerated depreciation, Sections 199 and 179, etc – from the analysis.  That’s obviously not the correct result, but apparently that’s the result Treasury reports in their paper.

So if Treasury is not measuring the effect of most tax expenditures on tax burdens, what are they measuring?  Setting aside tax credits and other adjustments, they are essentially measuring the effect of progressive rate schedules.  Think about it this way – if nearly all C corporation income was taxed at the 35 percent tax rate in 2011, while one third of pass through income was taxed at rates below 35 percent, then the “average” tax rate for pass through businesses will be pulled down by the lower rates.

But those lower rates are generally earned by shareholders of smaller, less profitable businesses.  What about big S corporations where shareholders do pay the top rates?  Our study showed that large S corporations pay the highest effective at 35 percent.  What does the Treasury study say about that?  It doesn’t.  The paper doesn’t break down average tax rates by company size, so there’s no means of comparing apples to apples, or in this case large S corporations to similar sized C corporations.

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.

 

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