S Corp Payroll Tax Hike Resurfaces

Last week, Senate Democrats released a paper highlighting a dozen tax increases they would like to use to offset spending cuts in the current budget negotiations. As Politico reported:

Tax expenditures topping the list include the deduction corporations take when they move operations overseas and the carried interest loophole, which allows private equity and some other investment advisers to pay the lower capital gains tax rate on some of their income.

Also on the list is our old nemesis, the S corporation payroll tax hike. Labeled the Edwards Loophole by Republicans and the Gingrich Loophole by Democrats, the issue is that some professionals are using the S corporation structure to avoid paying payroll taxes. According to the Democrats’ release:

Some wealthy business owners knowingly mischaracterize their income as business profits instead of salary to avoid Medicare and Social Security payroll taxes. Ending this loophole would save about $12 billion over the next ten years.

We have a number of objections to this characterization. First, using your S corporation to avoid payroll taxes is not a loophole, it’s tax avoidance. The current reasonable compensation rules are clear and the IRS has a history of going after offenders and winning.

Second, the proposals offered to date are worse than the existing rules. The JCT might score them as raising $12 billion over ten years, but it’s hard to see how the IRS would be able to come up with that level of enforcement.

For example, the provision defeated by the Senate back in 2012 would have replaced reasonable compensation with a “principle rainmaker” test where the IRS would have to determine whether 75 percent or more of the gross income of the S corporation is attributable to the service of three or fewer shareholders. Oh, that’s easy. As a letter signed by 38 business organizations observed:

This new approach, particularly the ”principal rainmaker” test, is neither clear nor more enforceable than existing rules. These rules have been in effect for over half a century, and the IRS has repeatedly and successfully used them to ensure that active S corporation shareholders pay themselves a reasonable wage, most recently in Watson v. US (2011).

The business community responded strongly in 2012 and that opposition remains today. We do not support the misuse of the S corporation structure to avoid payroll taxes, but any replacement to the current ”reasonable compensation” test must be easier for the IRS to enforce and for businesses to comply with.

For those who want more, here are links to the business community letter as well as a longer history of the issue:

SBA Weighs in on Corporate Tax Reform

A new study sponsored by the Small Business Administration adds to the case that corporate-only tax reform, as advocated for by the Obama Administration, would shift the tax burden on to smaller, private companies. As reported by Politico:

Cutting corporate tax rates by trimming costly breaks is a popular selling point for a tax code overhaul, but some small businesses could wind up unintended victims, an independent government agency on Wednesday said, lending support to Republican concerns.

New data from the Small Business Administration warn that the trade-off would be a double whammy to smaller businesses that file taxes as individuals.

These businesses get nothing from a corporate rate cut but they could still lose their tax breaks. The SBA study found that these businesses account for about $40 billion in tax benefits, or about one-third of the $161 billion spent each year on all business tax expenditures.

The top U.S. corporate rate is 35 percent, among the highest in the industrialized world. Although the code is riddled with breaks and loopholes that allow some companies to pay far less, others pay much more.

By contrast, the top rate for individuals, including these so-called pass-through entities, is more than 40 percent.

The study compared the value of tax expenditures for all businesses with those used by pass through and corporate businesses with annual receipts under $10 million. As the study notes:

Of the largest tax expenditure provisions utilized by all businesses in 2013, small businesses will utilize approximately $40 billion out of a total of $161 billion. The estimates indicate that small businesses will utilize approximately 25 percent of the largest business tax expenditure provisions in 2013.

So any effort to eliminate tax expenditures to pay for a lower corporate tax rate would also hit pass through businesses that pay at the individual rates. Not good. As our 2011 E&Y study made clear, such a policy would increase taxes on pass through businesses by $27 billion a year.

Cliff Notes II

With less than 200 days left before Washington leads the economy over the fiscal cliff, the Joint Committee on Taxation (JCT) has offered up more evidence that Congress needs to act to extend the current tax rates for everyone, including those business owners with higher incomes. As Bloomberg reports:

President Barack Obama’s plan to raise tax rates for the top 2 percent of U.S. households would mean higher taxes on the people who report 53 percent of business income reported on individual returns, according to the Joint Committee on Taxation.

According to the JCT, in 2013 nearly 1 million business owners (940,000) will have incomes that put them into the top two tax rates — 36 or 39.6 percent.  Perhaps more significantly, this policy would raise marginal rates on more than half of all pass-through business income (53 percent). When you couple this finding with the fact that more than half of all business income is earned by pass-through businesses, the bottom line is that proposals to raise taxes on upper income taxpayers would hike rates on more than one quarter of all business activity in the United States.

Senate Finance Committee Ranking Member Orrin Hatch (R-UT) requested the analysis and observed:

This independent analysis is further irrefutable proof of why we simply cannot allow the President to have his way by raising taxes on small business. With our economy as weak as it is, it makes absolutely no sense to hit more and more small businesses with a tax hike.

Proponents of raising taxes point to the relatively small percentage of taxpayers affected (3.5 percent) and argue that it won’t hurt the economy. But raising marginal tax rates on that much economic activity is bound to meaningfully reduce investment and job creation.

Moreover, the size of the tax hike is daunting. The highest marginal federal tax rate today is 35 percent. Starting next January, the top rate rises to 44.7 percent! That’s the 39.6 percent rate, plus the 3.8 percent surtax from the Affordable Care Act, plus another 1.3 percent from the return of the Pease phase-out. Put another way, a business whose shareholders pay the top marginal rate would see the after-tax return on a dollar of its income drop from 65 cents to just over 55 cents– a decrease of 15 percent.

As we’ve said before, this debate is the difference between focusing on who’s being taxed and whats being taxed. In this case, what’s being taxed is a very large percentage of overall business activity in the country. In our view, this is the more compelling perspective. Considering the weak job creation numbers recently, the economy seems to agree.

Corporate-Only Reform Takes One on the Chin

Tom Barthold of the Joint Committee on Taxation made the case to the Super Committee last week against attempting to reform the corporate side only.

It would be very difficult to wall off a number of provisions and say we’ll have one set of rules if you’re this type of entity and a potentially different set of rules if you’re another type of entity.

Later, in an exchange with Senator Rob Portman (R-OH), Barthold went into more detail:

SEN. PORTMAN: If you lowered the corporate rate and did so by getting rid of the some of the existing preferences, and those preferences also applied to the pass-throughs, it would seem unfair, and they would still have a relatively high rate and yet they would not get the advantage any of the changes in preferences.

How would you address this apparent inequity to be sure that there are smaller businesses who are pass-throughs and organized not as C corps do not find themselves disadvantaged by corporate reform?

MR. BARTHOLD: Well, Senator Portman, I noted earlier that I thought that it would be technically extremely difficult to wall off the elimination of preference items to one business entity and not — that it would create a lot of behavioral questions that you might or might not want to address about are you forcing people to change their choice of their preferred business entity, or would you try to prohibit people from switching entity form.

As to other options, you know, I imagine you could think of things that you might do that could provide a new preference of some sort for the pass-through — for pass-through entities. You know, we could explore options with you on that.

But one of the reasons I emphasized that business income is taxed as a C corporation and business income is also taxed on the individual return was to make exactly that, you know, that point that you have to — you want to think of business income when you look at some of the reforms that you might have in mind and not just —

SEN. PORTMAN: But, Mr. Barthold, my time is short, and I apologize. One way to do it, it seems to me, is look at the C corps separately so you wouldn’t apply it to individual rates; you’d just apply it to the —

MR. BARTHOLD: But it’s very difficult to wall that off. I mean, C corporations participate in partnerships, for example, on research ventures with individuals and other non-C corporations.

This last point by Dr. Barthold is worth expanding. As Barthold observes, having two approaches to income and loss for businesses would be difficult generally, but nearly impossible for partnerships between C corporations and pass-through businesses.

How would you allocate income and loss for a partnership in a world with two sets of rules? Perhaps just as importantly, how would you enforce those rules, knowing investors could play one off on the other?

That Three Percent Generates Lots of Jobs

The Super Committee hearing also reminded us what the talking point is for raising taxes — only a small percentage of taxpayers pay the top rates, we’re told, so it’s okay. Here’s Finance Chairman Baucus on Thursday:

SENATOR MAX BAUCUS (D-MT): I’d just like to just address a bit this point that the top two rates — they were raised, hurt small business. It is true that, as you — as has been mentioned here already today, that 50 percent of small business income is subject to the top two rates, but it is not true that 50 percent of small businesses — that employers are subject to the top two rates. In fact only 3 percent are.

And it’s also — isn’t it true, Mr. Barthold, that, again, only 3 percent of taxpayers with pass-through business income are subject to the top two rates? Is that correct?

MR. BARTHOLD: That’s — I believe that’s a statistic —

SEN. BAUCUS: About 3 percent of taxpayers — not 50 percent but 3 percent of taxpayers.

The “3 percent” argument is in a similar vein as the Treasury study released earlier this year that defined away much of the small business sector. The goal is to minimize the population of individuals and businesses subject to the tax increase to make the hike look more palatable.

How to respond? As Stephen Entin from IRET observed before the Finance Committee two weeks ago, it’s the difference between worrying over “who” you’re taxing versus “what” you’re taxing.B In this case, both measures are in our favor.

The “what,” as Senator Baucus points out, is fifty percent of pass-through income, or approximately one quarter of all business income earned in the United States.

The “who” are an extremely large number of employers, who in turn employ a sizable percentage of the workforce. The NFIB surveyed its members and found that over 30 percent of firms with between 20 and 250 employees would see their taxes increase if rates went up for those making more than $250,000.

Our Ernst & Young study had similar findings. It found that approximately one-sixth of all private sector workers — 20 million — are employed at pass-through businesses with one hundred or more employees. In other words, successful firms most likely to be subject to the top rates.

So it may be only three percent of all taxpayers, but that three percent represents a very sizable number of employers who generate a ton of investment and business activity and, in turn, employ literally millions of workers.

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