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.

 

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.

Battle Lines on Tax Policy

The President rolled out his latest deficit reduction outline yesterday. As expected, it included several tax recommendations. In sum, the President is calling for an additional $1.5 trillion in tax collections over the next decade, including:

  • Expire Bush Tax Cuts on High Income Earners ($800 billion)
  • Cap Itemized Deductions & Exemptions at 28 percent ($400 billion)
  • Various Loophole Closers ($300 billion)

There are a number of challenges with the list. First, allowing tax provisions already set to expire to, well, expire, doesn’t raise any revenue. It’s already in current law. That $800 billion in savings doesn’t exist.

Second, the President already proposed to use the cap on itemized deductions to offset his jobs proposal released earlier this month. That package would have increased the deficit and the cap on itemized deductions was to have offset most of that cost. No man can serve two masters, and no tax provision can be both deficit reduction and a pay-for at the same time. Like the higher taxes on high-income earners, this $400 billion in savings doesn’t exist.

So the tax savings from the President’s proposal are less than claimed.

What about the “loophole” closers? Here’s the list from the OMB summary of the plan:

  • LIFO repeal ($52 billion)
  • Repeal Lower Cost of Market ($8 billion)
  • Coal Related Provisions ($2.4 billion)
  • Insurance Provisions ($12 billion)
  • International Tax Changes ($114 billion)

While the term “loophole” is certainly loaded and should not apply to many of these provisions — LIFO accounting rules, for example, are neither a loophole nor a tax expenditure — the larger challenge is that some of these are the very base-broadening measures that Ways and Means Chairman Camp says he needs to offset lower rates in tax reform.

If these provisions are used for deficit reduction instead, how is Congress supposed to lower rates? Where will the offsets come from? This is the reason Congressman Camp and others have been resisting the idea of doing tax reform within the context of a deficit reduction package.

Corporate Tax Reform

For the past half year, Washington has waited for the Obama Administration to release its so-called “White Paper” on corporate tax reform. The paper’s existence was publicly discussed and reported, as were the broad provisions it was said to contain — budget neutral, corporate only, territorial, eliminate certain tax expenditures, etc.

With the release of the President’s deficit reduction plan today, the waiting is over. We can all go home now, there’s nothing to see. Instead of a plan, the White House released a set of five “principles” the President would like Congress to follow as it grapples with the code. These are:

1) Lower tax rates;

2) Cut wasteful loopholes and tax breaks;

3) Reduce the deficit by $1.5 trillion;

4) Boost job creation and growth; and

5) Comport with the “Buffett Rule” that people making more than $1 million a year should not pay a smaller share of their income in taxes than middle-class families pay.

Number 5 is the easiest — the tax code already does that (see below). And we’re all for cutting rates and boosting job creation.

So in the spirit of articulating principles, we have three of our own that might be helpful.

  1. First, any reform of the tax code needs to address both the individual and the corporate side of the code. Most American jobs are created by employers who pay the individual rates, not the corporate rates, so Congress needs to focus on both.
  2. Next, Congress should seek to keep the top income tax rates paid by individuals and corporations at the same level. Splitting business income and taxing it at two significantly different rates would undermine tax administration and encourage business owners to plan around the higher rate. Keep it simple, keep it low, and keep it the same.
  3. And finally, Congress should seek to tax business income once, and only once. The study authored by Bob Carroll last spring made clear that the double tax on corporate earnings results in less investment and lower employment in the United States. To make American business more competitive, Congress should move business taxation towards the S corporation model, not away from it.

Those are our principles, and were working with other business groups in town to make certain tax writers in Congress understand them. By embracing these broad concepts, Congress can move the taxation of business income in a direction that helps ensure employers want to invest and create jobs in this country, not someplace else.

Warren Buffett is Wrong

The President continues to tie his efforts to raise taxes to Warren Buffett’s contention that he pays less tax than his secretary. As Buffett wrote in the New York Times earlier this year:

Last year my federal tax bill - the income tax I paid, as well as payroll taxes paid by me and on my behalf - was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income – and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

Buffett has been making this argument for years, but he has finally found a receptive ear with the Obama Administration. As the President stated yesterday:

So I am ready, I am eager, to work with Democrats and Republicans to reform the tax code to make it simpler, make it fairer, and make America more competitive. But any reform plan will have to raise revenue to help close our deficit. That has to be part of the formula. And any reform should follow another simple principle: Middle-class families shouldn’t pay higher taxes than millionaires and billionaires. That’s pretty straightforward. It’s hard to argue against that. Warren Buffett’s secretary shouldn’t pay a higher tax rate than Warren Buffett. There is no justification for it.

Here’s the problem. Warren Buffett is wrong. While only he and his secretary know their exact tax burden, we do know the numbers he presents above are incorrect and shouldn’t be used as the basis for tax policy moving forward.

How did he get it wrong? Two errors. First, he overestimates his secretary’s tax burden by using the wrong denominator. Second, he underestimates his own tax burden by ignoring the corporate taxes his company pays.

Let’s take the first. Buffett claims that his employee’s effective tax burden, including the federal income and payroll taxes, ranges from 33 to 41 percent. That’s really high.

Measuring income and payroll taxes (including the employer share) against gross income, it’s simply impossible to get an effective rate that high — and that’s for a couple with no children and no deductions where both spouses earn right at the Social Security earnings limit.

So how does Buffett get to 41 percent? Apparently he uses taxable income rather than gross income. But no credible tax policy group would use taxable income to measure somebody’s tax burden. It excludes too much income to be useful. By contrast, when the CBO calculates effective rates, it uses an expanded definition of income that includes all wages and salary plus transfer payments and in-kind benefits.

Next, Buffett under counts his tax burden by ignoring the taxes paid by Berkshire Hathaway. He claims $7 million in payments, but last year Berkshire Hathaway paid $5.6 billion in corporate taxes on $19 billion in income, an effective tax rate of 30 percent. Here’s the CBO on the types of tax they include in their calculations:

CBO estimates effective tax rates for the four largest sources of federal revenues’ individual income taxes, social insurance (payroll) taxes, corporate income taxes, and excise taxes, as well as the total effective rate for the four taxes combined. Those taxes account for over 95 percent of total federal revenues. The analysis does not include federal estate and gift taxes, customs duties, and other miscellaneous receipts. Nor does it include state and local taxes.

Buffett still owns a large share of Berkshire Hathaway, so his real tax burden likely is in the billions, not millions, and his effective rate is 30 percent, not 17 percent.

The reality, as measured by the CBO, is that our tax code is remarkably progressive, with the top one percent paying an effective rate of 30 percent while the five quintiles of income earners pay, from highest to lowest, 25, 17, 14, 11, and 4 percent respectively. (As noted, these percentages do not include state and local taxes.)

So there you have it. The President is calling for tax code that ensures the rich pay more? We already have that tax code. So perhaps Congress can now focus on the cutting rates and encouraging job creation.

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