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.
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.
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.