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.

Recap of a Busy Week in Tax Policy

Patent/Innovation Box

Rep. Charles Boustany (R-LA) and Rep. Richard Neal (D-MA) unveiled their proposed “innovation box” legislation aimed at keeping intellectual property registered in the United States. The bill would lower the rate on qualified income from patents and intellectual property to 10 percent, but only for firms with domestic R&E expenses. Similar laws already exist in Europe, and there are signals that this could become part of a Ways and Means international tax package later this year. Here’s Chairman Ryan on the proposal:

The proposal from Reps. Boustany and Neal can help us stem the tide and protect good American jobs. It will also help ensure the United States continues to be the world’s leader in innovation. Their plan would allow American businesses to better compete with foreign companies and keep their research and development facilities here in the U.S. This is just one piece of international tax reform, but it’s an important one. I applaud Charles and Richie for their work, and look forward to refining the proposal as we move forward on a broader plan to make America more competitive and promote high-paying jobs.

Senators Rob Portman (R-OH) and Chuck Schumer (D-NY), who authored the Senate Finance Working Group report on international reform, were also supportive. You can read their respective statements here. With support in both chambers, it appears the innovation box will be a factor in international tax negotiations later this year.

As the proposal currently stands, it doesn’t appear as if innovative pass through businesses would be eligible for the innovation box. The sponsors have made clear that the legislative text released this week is a “draft” and that they are eager for input.  We will be working with the rest of the pass through community to coordinate our comments and make sure S corporations are well represented.

 

Highway Bill & Patent Boxes

Why release the patent box draft now, just before the long August recess? We believe the goal was two-fold.  First, it is a genuine effort to get feedback on the proposal, which is a new concept for the Ways and Means Committee and they’d like to get the policy right.  Second, it helps to keep the ball moving on Chairman Ryan’s two step plan to getting international tax reforms done this year – pass a short term highway extension now and follow it up with a bigger package of highways and international tax reforms this fall.  The innovation box idea is a key “sweetener” in the larger international package, so getting it out now helps to move the overall plan forward.

For the past year, Ryan’s goal has been to combine highways, international reforms, and tax extenders into one big package Congress would enact at the end of 2015.  He believes the general desire by both parties to get a highway bill done can help push his international package over the finish line.

Senate Majority Leader McConnell, on the other hand, thinks any plan to reform taxes with this President in office is doomed to fail and wanted to get highways done and off the table at least through the elections.  So McConnell proposed to do long-term highways now with little in the way of tax policy, while Ryan advocated for addressing highways in December with as much international reform as he can muster.

The three-month extension adopted by Congress this week represents a compromise between the two positions.  It means Congress will have to revisit the issue prior to December, but it also keeps alive Ryan’s international reform efforts.

 

Built-In Gains Relief Introduced in Senate! 

Good news!  Sens. Pat Roberts (R-KS) and Ben Cardin (D-MD) introduced legislation Thursday to provide a permanent five-year recognition period for built-in gains (BIG) assets.

We’ve been advocating on BIG for years and, even after all of the leadership changes in Washington, DC over the past several elections, built-in gains relief continues to receive strong bipartisan support in both chambers. We are glad that Congress has recognized the importance of such relief by continuing to extend temporary relief – as included in the tax extender package recently adopted by the Senate Finance Committee.  Permanent BIG relief, however, is the only way to offer business owners the certainty they need, so we’ll keep working to get the Roberts/Cardin bill across the finish line.

Also in the Senate this week, the Small Business Committee adopted a “Sense of the Committee” resolution endorsing legislation introduced by Committee Chairman David Vitter (R-LA) that includes “sting” tax repeal!  Eliminating the “sting tax” has been a priority of the S Corporation Association for years and it’s a key part of the S Corporation Modernization Act introduced by Representatives Reichert (R-WA) and Kind (D-WI) last month.

Fixing this particular passive income rule has been long overdue—in fact, the Joint Committee on Taxation recommended the repeal of this termination rule back in 2001!  As with permanent BIG relief, we plan to spend this fall pushing the tax writing committees to adopt Sting Tax relief as part of any tax legislation moving this year.

 

Hillary Clinton Proposes Tax Hikes on S Corps

In her bid to reform so-called “quarterly capitalism,” presidential candidate Hillary Clinton proposed this week to hike the capital gains tax on investments held less than two years to the top individual rate of 39.6% (plus the 3.8% net investment tax), or nearly double the tax today. Under her plan, the tax rate would gradually decline for investments held between two and five years, while investments held six years or longer would get the current 20% rate.

So while all of Washington, including the Obama Administration, is working on ways to reduce the tax on investment and encourage more companies to remain here in the US, candidate Clinton would increase the cost of domestic investment instead.  Clinton did add that capital gains would be eliminated for select long-term investments in small businesses. That doesn’t sound bad, but it begs a few questions. What is her definition of “small business”? How long would the investment need to be held?

Moreover, if lower capital gains for small businesses would stimulate long-term investment, why limit it to small businesses?  Why not reduce or eliminate the capital gains rate on all domestic investments, as Senator Rubio has proposed? As the Wall Street Journal points out, this proposal may do little more than distort investment decisions in the short-term and prevent the efficient allocation of capital:

A high and sliding tax-rate scale also harms the efficient allocation of capital by expanding what economists call the “lock-in effect.” If owners of capital must wait years to pay a lower tax rate, many will decline to realize their gains solely for tax purposes. This artificially reduces the mobility of capital.

Economic growth is enhanced when capital is able to efficiently find its highest return. “Buy and hold” often works well for individual investors in specific stocks. But no economic theory says one- or two-year investments are worse than 10-year, and sometimes they’re better.

Worst of all, this would leave owners of pass-through businesses on the hook for corporate “quarterly capitalism.” Since many pass-throughs are family-owned through multiple generations, they’re already making the kinds of long-term investments that Clinton is looking to promote. Her campaign has said she is committed to producing a full tax plan, and we’ll be sure to analyze it when it becomes public.

Highway Funding and Tax Extenders Update

Highway Debate Continues

Last week, we reported on the House’s adoption of a highway trust fund (HTF) extension through December. This extension is the first step of Chairman Paul Ryan’s plan to combine a longer term HTF extension with key international tax reforms.

Meanwhile, Senate leaders want to act now, not in December, on a longer-term extension.   Majority Leader Mitch McConnell, Sen. Barbara Boxer (D-CA), and Sen. Jim Inhofe (R-OK) support a six-year highway deal which has offsets for the first three years, but does not include international tax reform.  The Senate voted 62-36 Thursday morning to begin debate on the measure.

So both the House and Senate want a multi-year bill, but McConnell wants to pass something now and avoid revisiting the issue prior to next year’s election, while Ryan would like to leverage the highway issue to get international tax reforms.  A short-term HTF extension through December gives him more time to build support for the combo package.  Rumor is he will release a detailed plan, which should track closely with the Portman/Schumer International Working Group plan, as soon as next week.

So which is it?  Will it be a multi-year HTF extension now, or HTF extension plus international tax reforms later?  The current HTF authorization expires on July 31st  so we will know next week which view prevails, and whether Congress will be debating international tax reform this fall.

Senate Finance Moves Forward on Extenders

Good news!  The Senate Finance Committee voted this week 23-3 to send a tax extender package to the Senate floor. The extensions last for two years (2015 & 2016) and include S-Corp priorities built-in gains relief and charitable contributions basis adjustment. Relative to last year’s 11th hour retroactive one-year deal, early movement on a two year extension is welcome news.

The question now is how extenders will work its way through the Congress and ultimately to the President’s desk. There was some talk about attaching extenders to the highway bill being debated by the Senate right now, but that seems remote.  Outstanding issues regarding certain provisions, including the application of the solar tax credit, appear to stand in the way.

Regarding the post-August schedule, The Hill reports:

Congress will also have to deal with a number of big-ticket items when lawmakers return from their August recess, including a Sept. 30 deadline for government funding and the recent agreement the Obama administration struck with Iran. Hatch sounded skeptical after the markup that the package of tax breaks could be added to the Senate’s highway bill, which was released Tuesday.

Even though the timeline for passing extenders may be in flux, the fact that the bill has been reported out of committee is a good sign that Congress is moving and may act well in advance of last year’s last minute extension.

Senator Thune Supports Permanent BIG Relief!

Provisions like built-in gains have been part of extenders packages for years, and we’re still fighting to make them permanent. The good news is that we have friends in high places who share that goal.  Just this week, Senator Thune (R-SD) proposed an amendment that would do just that. During the extenders markup, Sen. Thune offered up his legislation to, among other items, make permanent the five year recognition period for built in gains.  He had this to say:

“I support this legislation to ensure that American families and businesses do not find themselves facing a higher tax bill come tax season,” said Thune. “However, I believe we can do better than simply preventing a tax increase in the short term. American taxpayers deserve the certainty and predictability that only comes from making tax relief permanent, something I intend to continue to pursue on their behalf.”

As we continue working to make built-in gains relief and charitable contribution provisions permanent, Sen. Thune’s amendment shows that there is a strong constituency in the Senate for our efforts. We expect that a permanent bill on built-in gains, similar to what was proposed last year, will be introduced soon in the Senate.

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