S Corporations Hit by Tax Hikes

Our friends at McGladrey LLP have a new survey out of mid-market firms showing just how hard those companies have been hit by the tax rate hikes championed by President Obama and his allies in Congress.

Recall that in the run-up to the Fiscal Cliff, Ernst & Young released a paper on our behalf that predicted the higher rates set to begin in 2013 would hurt investment and job creation by significantly hiking taxes on mid-sized employers.  Over the long-term, E&Y estimated the U.S. would lose 710,000 jobs.

Now McGladrey’s survey shows just how those job losses and lower investment levels emerge.   According to them:

While middle market companies are adding jobs, and have been for several years, some have had to reduce their workforces over the past year. More than 50 percent of the middle market companies that reported having cut jobs (56 percent) said the 2013 tax reform bill was a factor in their decision to take these actions.

McGladrey defines “mid-market” as businesses with revenues between $10 million and $1 billion.  Census Department statistics make clear that firms in that revenue range are a huge source of employment in the U.S. and an important part of the economy.  Raising tax rates on these employers made little sense back in 2012 and even less sense now.

Another key finding in the survey provides additional support to the Harvard study on bonus depreciation we highlighted last week.  As you’ll recall, the study found that US companies responded strongly to the investment incentive, with privately-held companies responding strongest of all.

The McGladrey study reveals the other side of that coin.  When investment incentives are allowed to expire, as Section 179, the R&E tax credit, and bonus depreciation are right now, then firms respond by reducing their investments.  According to McGladrey:

Half of all companies that reported cutting back on research and development (R&D) said that the reform law had influenced their decision to do so. Not surprisingly, the manufacturing industry – a key component of the middle market – reported the most severe impacts. More than three-quarters (78 percent) of middle market manufacturers said that the R&D tax credit’s expiration had led to an increase in their tax bills, and 63 percent of manufacturers that reported having cut R&D over the past year said  the tax credit’s expiration contributed to their decisions to do so.

So there you have it.  We now have prospective and retrospective evidence that hiking rates on Main Street employers hurts investment and job creation.  With the debate over tax reform focused almost wholly on large multinational companies, the McGladrey survey is a solid reminder that tax reform needs to embrace the whole business community, not just publicly traded companies.

S Corp Meets with House Leadership

S Corporation Association Board Member Dan McGregor participated in a small business roundtable with House Republican leadership yesterday as part of our ongoing effort to educate policymakers on the important role pass-through businesses, and particularly S corporations, play in job creation and investment.

Dan is Chairman of McGregor Metal Working, a group of metal-stamping companies located in the Springfield, Ohio area. It’s been a family-owned business since 1965 and began as an eight-person tool and die shop. Today, they employ 365 workers and have clients in the auto, agriculture, and lawn and garden industries.

A key part of Dan’s message yesterday was that higher tax rates means lower retained earnings, which means less capital to invest and create jobs.

Ironically, Dan’s trip to the Capitol occurred on the same day that FedEx founder Fred Smith argued that it’s a “myth” that McGregor Metalworking and similar pass-through businesses are an important source of jobs:

“The reality is the vast majority of jobs in the United States are produced by capital investment in equipment and software that’s not done by small business. It’s done by big business and the so-called ‘gazelles,’ the emerging companies like the new fracking oil and gas operations. It is capital investment and equipment and software that’s the solution to our economic problems, not the marginal tax rates of individuals.”

The ignorance of this statement is remarkable, especially given the source. As readers of our E&Y study know, fifty-four percent of all private sector jobs come from pass-through businesses — one quarter of all private sector jobs are at an S corporations.

Moreover, it’s hard to believe there’s a more capital-intensive industry than metal stamping, and for a private business like McGregor, there are few viable options for raising capital other than retained earnings.

If McGregor wants to grow, it needs to earn a profit and reinvest those profits in the business. Raising taxes on McGregor — as proposed by the President — would increase McGregor’s effective tax rate sharply, which means less retained earnings and less ability to invest and grow. As the President is fond of saying, “It’s just math.”

So the President can push for higher taxes on a million or so private businesses, and billionaires like Fred Smith and Warren Buffett can support him, but don’t pretend it’s not going to affect real people and real jobs. It will. It already has.

CBO Weighs In

S corporations sure are popular these days.  Unfortunately, they’re popular in the same way that big Tom Turkey is popular around Thanksgiving. Yesterday, the Congressional Budget Office added to the feeding frenzy, releasing a report entitled “Taxing Businesses Through the Individual Income Tax.”

There’s actually good stuff in there, like how S corporations help to reduce the cost of business investment and how they reduce the tax code’s bias toward too much debt , but it’s all for naught. Those big government types tying on their napkins and sharpening their knives will only see this:

The Congressional Budget Office (CBO) estimates that if the C-corporation tax rules had applied to S corporations and LLCs in 2007 and if there had been no behavioral responses to that difference in tax treatment, federal revenues in that year would have been about $76 billion higher. 

You can hear them drooling already — $76 billion a year will pay for lots of new government. But if there is no change in behavior?  And if there’s no interaction with the AMT?  That’s akin to saying, if there was no structural federal deficit, we wouldn’t need all these tax hikes.

Let’s start with the behavior. For a sense of just how much taxpayer behavior would change if all pass-through businesses were suddenly subject to the double corporate tax, go back to pre-1986 tax reform and see how they behaved. Tax sheltering ruled the day then, and we expect it would return to prominence again in a double tax world. Here’s S-Corp Advisor Tom Nichols’ testimony before the Ways and Means Committee earlier this year:

Prior to the TRA ‘86, successful business owners were regularly engaged in the tax planning process in order to minimize the substantial burdens under the double taxation regime. Since that time, and with the migration of closely-held business activity to pass-through taxation treatment, business owners are no longer engaged in an ongoing struggle to navigate the heavy impositions of the double tax system. They are less focused on tax planning than they were before the TRA ‘86, and more focused on running their business.

The AMT exception is particularly important, too.  Just about every other business owner we know pays the AMT, so pretending it doesn’t play a significant role is less than credible. Moreover, why didn’t the CBO calculate the impact of the AMT? E&Y did in our study on the impact of higher rates on jobs and investment. They found that of the 2.1 million business owners with incomes high enough to pay the top two rates, 1.2 million of them already pay the AMT.

If E&Y can make that calculation, why can’t the CBO?

So the take-away for the “tax the rich” crowd will be that they’re losing $76 billion a year by allowing pass-through businesses. But that number’s not real. Congress will never collect it.

On the other hand, the higher cost of capital is real. Here’s how E&Y put it:

The income of C corporations is instead subject to two levels of tax (the “double tax”), first when income is earned at the corporate level, and again when the income is paid out to shareholders in the form of dividends or retained and later realized by shareholders as capital gains.

The double tax affects a number of important economic decisions. In particular, the double tax:

  • Increases the cost of capital, which discourages investment and reduces capital formation and economic growth.
  • Increases the cost of equity finance, which encourages greater leverage among C corporations.

The flow-through form provides an important benefit to the economy by reducing the economically harmful effects of the double tax and therefore allowing for a greater opportunity for job creation and capital investment. Moreover, the flow-through form provides businesses with flexibility that may better match their ownership structure requirements and capital needs.

Bottom Line: All businesses should be taxed as S corporations, not the other way around. It would mean more investment, more jobs and higher wages.

Isn’t that the whole point?

Retained Earnings v. Distributions

Speaking of myths, one of the arguments we’ve heard from reporters and others in recent days is that because wages are deductible, hiring will not be impacted by higher tax rates.

This argument reflects a basic misunderstanding of how pass-through businesses, including S corporations, are taxed. S corporation shareholders must pay taxes on any income earned by the business, whether the income is distributed to the shareholders or not. This is an important feature of S corporation taxation that many observers fail to grasp completely, and it’s critical to understanding the concern that higher marginal rates will result in less job creation.

Here’s an example:

Start with a two-shareholder S corporation where each owner has a 50 percent interest. If the S corporation makes $200 dollars in a quarter, each shareholder would be required to pay taxes on the $100 in earnings attributed to them, regardless of whether the shareholders actually received any distribution!

Most S corporations make sure to distribute at least enough earnings each quarter to cover the shareholder’s taxes. In this case, both shareholders are in the 35 percent bracket, so the business would distribute $35 to each to cover their taxes, and retain the remaining $130 as working capital for the business.

Under the President’s approach, next year the marginal rates on our shareholders will rise to 39.6 percent, so the business would need to distribute $40 to both shareholders. As a result, the business’ working capital is reduced to $120.

But these higher statutory rates are only one of three rate hikes facing pass-through businesses next year. There’s also the marginal impact of reinstating the Pease cap on itemized deductions. That has the effect of raising the marginal rate by 1.2 percent.

And then there’s the imposition of the new 3.8 percent investment surtax enacted as part of health care reform. That only applies to shareholders who don’t work at the business, but it’s another 3.8 percent on top of the other two tax hikes.

The net result will be to raise the top marginal rate on S corporation shareholders from 35 percent to around 45 percent (not including state and local taxes). With those rates, our business’ working capital would be reduced from $130 to $110, a reduction of 15 percent!

Interestingly, that’s just about the same percentage that E&Y estimated the cost of capital would rise for pass-through businesses if the President gets his way on tax rates. Think of it as a reverse sale — instead of 15 percent off that new equipment, next year it’ll be 15 percent more.

And that’s why higher rates cost jobs. Higher rates mean lower after-tax earnings and less money to invest in jobs and equipment. Period.

Health Reform Investment Taxes Will Hit S Corps

The IRS waited until a Friday afternoon after the elections to release 159 pages of proposed regulations on the new 3.8 percent investment tax. While the rule is not final, the IRS is telling taxpayers to rely on this temporary guidance until they can get around to making them final. Here’s what the IRS says:

Taxpayers may rely on the proposed regulations for purposes of compliance with section 1411 until the effective date of the final regulations.

Just to remind folks distracted by the fight over extending the Bush tax cuts, two of the new taxes enacted to pay for health care reform will take effect beginning January 1:

  • A 3.8 percent tax on all net investment income for taxpayers earning more than $250,000 ($200,000 if you’re single); and
  • An additional .9 percent Medicare tax on salaries and wages for taxpayers making more than $250,000 ($200,000 if you’re single).

The rule released Friday addresses the investment tax. Forbes has a nice write up together with some examples of how taxpayers might be impacted. For S corporations, income from the business is not subject to the new 3.8 percent investment tax if the taxpayer is active in the business and the income is active rather than passive in nature. Here’s the Forbes example:

Example: Walter White owns an interest in two S corporations. Both corporations are engaged in the active conduct of a trade or business, and neither corporation is a trader in financial instruments. Walter spends 520 hours on S Corporation 1, but only 40 hours on S corporation 2. Under the Section 469 regulations, absent an election to group the two activities, Walter would materially participate in S Corporation 1, but not S Corporation 2.

Assuming the interests in the two corporations represent an appropriate economic unit, Walter may group them together for purposes of testing material participation. Because Walter spends 560 hours on the combined activity, he materially participates in both S corporations and neither activity is passive to Walter. As a result, income earned in the ordinary course of the trade or business of both SB Corporation 1B and SB Corporation 2B will not be considered net investment income.

We’ve commented on these new taxes previously, but suffice it to say that this guidance should make clear to policymakers that we’re not returning to the 1990s tax rates next month — we’re going well beyond.

 

Senate Defeats S-Corp Tax Hike

Good news for job creators! The Senate just voted against moving forward on legislation that would increase taxes on S corporations by $9 billion. The legislation was opposed by a broad coalition of business groups, led by the S Corporation Association, including the US Chamber of Commerce and the National Federation of Independent Business. A motion to close debate and proceed to the bill was defeated on a party-line vote — 52-45. (Sixty votes are required to end debate in the Senate.)

This is the second time in two years the business community has successfully blocked legislation to increase payroll taxes on S corporations and partnerships. Two years ago, a similar provision was blocked from moving forward on a 56-40 vote. This time, S-Corp was joined by 37 other business groups on a letter to Senate leadership detailing the negative impact this tax increase would have on closely-held businesses, and we’re happy to see that the Senate stood with us.

Just How High Can Rates Go?

A question we’re hearing increasingly raised, particularly by policymakers seeking to raise taxes, is just how high marginal rates can go before they start to impede economic growth and become counter-productive. That is, begin to cost the government revenue rather than raising it.

For example, Ezra Klein of the Washington Post polled several prominent economists back in 2010 and got some hair-raising responses:

  • Emmanuel Saez ,University of California at Berkeley: Revenue maximizing rate “means a top federal income tax rate of 69% (when taking into account the extra tax rates created by Medicare payroll taxes, state income tax rates, and sales taxes) much higher than the current 35% or 39.6% currently discussed.”
  • Brad DeLong, University of California at Berkeley: “At 70%.”
  • Dean Baker, Center for Economic and Policy Research: “It would be somewhere around 70 percent and possibly a bit higher.

These responses would be “fall out of your chair” funny if they weren’t being taken so seriously in Congress. Which makes the Alan Reynolds piece in today’s Wall Street Journal so important. Reynolds takes an in-depth look at a couple of recent papers, the first by Peter Diamond from MIT and Emmanuel Saez from Berkeley, and the second by Saez and Thomas Piketty of the Paris School of Economics, that form the intellectual foundation for these claims. Here’s Reynolds:

The authors arrive at their conclusion through an unusual calculation of the “elasticity” (responsiveness) of taxable income to changes in marginal tax rates. According to a formula devised by Mr. Saez, if the elasticity is 1.0, the revenue-maximizing top tax rate would be 40% including state and Medicare taxes. That means the elasticity of taxable income (ETI) would have to be an unbelievably low 0.2 to 0.25 if the revenue-maximizing top tax rates were 73%-83% for the top 1%. The authors of both papers reach this conclusion with creative, if wholly unpersuasive, statistical arguments.

But the ETI for all taxpayers is going to be lower than for higher-income earners, simply because people with modest incomes and modest taxes are not willing or able to vary their income much in response to small tax changes. So the real question is the ETI of the top 1%.

So what is the real tax responsiveness of this top 1%?

A 2010 study by Anthony Atkinson (Oxford) and Andrew Leigh (Australian National University) about changes in tax rates on the top 1% in five Anglo-Saxon countries came up with an ETI of 1.2 to 1.6. In a 2000 book edited by University of Michigan economist Joel Slemrod (“Does Atlas Shrug?”), Robert A. Moffitt (Johns Hopkins) and Mark Wilhelm (Indiana) estimated an elasticity of 1.76 to 1.99 for gross income. And at the bottom of the range, Mr. Saez in 2004 estimated an elasticity of 0.62 for gross income for the top 1%.

A midpoint between the estimates would be an elasticity for gross income of 1.3 for the top 1%, and presumably an even higher elasticity for taxable income (since taxpayers can claim larger deductions if tax rates go up.)

But let’s stick with an ETI of 1.3 for the top 1%. This implies that the revenue-maximizing top marginal rate would be 33.9% for all taxes, and below 27% for the federal income tax.

Just as a reminder folks, we’re at a top rate of 35% now, and scheduled to hit almost 45% at the end of the year, so this has direct consequences to the pass-through community and S corporations. Congress will be debating rates as early as this fall, and unlike the corporate rate debate, where there seems to be some consensus over what the rate should be in the future, the debate over the top individual rates is all over the map. For that debate, papers like the Diamond/Saez paper have their audience. That’s what makes the Reynolds response so important.

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