We weren’t the only ones who noticed the President’s budget for 2017 is bad for Main Street Employers. Numerous outlets ran stories (CQ, Bloomberg, and Morningstar) focusing on the negative impact the President’s tax proposals would have on S corporations and other pass-through businesses. As our friends from NFIB noted about the Administration’s proposal to expand the Net Investment Income Tax (NIIT) to all pass-through business owners:
“It’s not closing any gap,” said Nick Karellas, tax counsel at the National Federation of Independent Business. “It’s just blatantly a revenue grab on small-business owners who are actively participating in their businesses.”
The Administration’s efforts to characterize this proposal as a loophole-closer are interesting, given that Congress intentionally excluded active business owners from the tax when it was enacted back in 2010 (See below).
But the proposals go well beyond expanding the NIIT. They include increasing payroll taxes on professional service businesses, raising the capital gains rate paid by S corporations and others to 28 percent, and establishing a 30 percent minimum “Buffett tax” on all forms of income. Each of these tax hikes would directly impact the profitability of pass-through employers.
Following the budget’s release, Treasury Secretary Jack Lew testified before the Ways and Means Committee and attempted to characterize their tax hikes as targeted at law firms and hedge funds, despite the fact that they would apply to all businesses – manufacturers, contractors, retailers, etc. S-Corp Champion Dave Reichert (R-WA) was having none of it:
“Let me just go through what I think tax reform should look like, and I don’t see it in the President’s budget, in fact I think it’s really offensive to small businesses. Tax reform should stimulate growth and efficiency by reforming America’s current complicated, burdensome system into a simpler, fairer, flatter tax code. Tax reform should promote U.S. jobs and higher wages through a more competitive international tax system. Tax reform should ensure that small businesses have a fair and competitive tax system, including the tax rate. As a result of the President’s budget, the top rate for small businesses will be 43.4 percent. They don’t get it, and I don’t get it either, Mr. Secretary. Tax reform should aggressively lower rates, and simplify the code. Even after enacting substantial increases in capital gains taxes in 2010 and again in 2013, President Obama continues to propose raising taxes on the investment American workers need to become more productive and earn higher wages…Mr. Secretary…I would like you to explain to me how raising taxes on small businesses helps the American economy grow, helps small business grow, helps create jobs? I don’t understand how you can raise taxes and create a growing economy and create jobs.”
Last year, one of our S-CORP Board Members testified on the effect of these tax hikes on his manufacturing business. McGregor Metalworking saw its effective tax rate – not marginal, effective — jump from 34 to 42 percent following the Obama-supported rate hike in 2013 that Congressman Reichert cites. Under the new Obama plan, McGregor’s effective rate would go even higher.
Confusion on the NIIT
There’s lots of confusion as to why the NIIT doesn’t apply to the business income of active business owners. Advocates eager to rewrite the history of the provision are driving this confusion, which is showing up in major publications. Take for example this excerpt from David Wessel in the Wall Street Journal:
Lobbyists for those who benefit from the NIIT loophole will be quick to accuse the administration of attacking small business. There are a lot of truly small businesses organized as pass-throughs, but the NIIT doesn’t affect them because they don’t earn $200,000 a year. The Treasury estimates that 67% of all S-corp income and 69% of all the partnership income goes to the top 1% of taxpayers, those with income greater than $375,000 a year.
Where to begin.
Let’s start with “loophole” and some of the facts surrounding the NIIT origins. The NIIT was enacted in 2010 as a pay-for to Obamacare. It was a late addition to the law that the Administration proposed in February of 2010, after both the House and the Senate had passed their respective health care reforms.
From the beginning, the proposal excluded the business income of active owners. Here’s how CongressDaily reported on the provision at the time:
President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed.
That was us. We led a broad coalition of business groups to oppose the provision when it was first floated, and we wrote extensively on the provision once it was released. You can read our analysis here, here, and here.
Congress made several key changes to the Administration’s proposal before enacting it – they removed its connection to Medicare and they increased the tax to 3.8 percent – but the exclusion on income of active business owners remained, as our Advisory Board Chair testified back in 2012:
This net investment income tax is generally imposed on interest, dividends, annuities, royalties, rents and gains, with one very important exception. Congress recognized that this new imposition should not apply to income derived by owners directly involved in active businesses. Therefore, Congress excluded from the tax base all income derived from a trade or business unless the income was reported by a person who did not “materially participate” under the passive activity rules or the trade or business consisted of trading in financial instruments or commodities.
So exempting the business income of active owners from the “investment” tax was part of the plan from the beginning and is no way a “loophole.”
And what about “benefit”? Why does Mr. Wessel suggest that business owners who were never subject to a tax, and not supposed to be subject to a tax, derive some benefit from not being subject to the tax? That label assumes that Congress intended to tax the business income of active shareholders. They didn’t, so it’s not appropriate to call it a benefit.
Finally, Mr. Wessel massively redefines “small business.” Any attempt to define “small” is by necessity going to be arbitrary and doomed to fail, but even the Small Business Administration (SBA) puts the threshold at 500 or fewer employees. With around 400 employees, McGregor Metalworking (the manufacturer whose effective tax rate has jumped under Obama’s policies) is considered to be a small business by the SBA. Mr. Wessel, on the other hand, would exclude any business that has just enough profits so that, when combined with all the other income earned by the owner’s household, it exceeds $200,000.
That’s the opposition in a nutshell. They support small business, as long as that small business creates few if any jobs and doesn’t make much money.
The Administration’s budget and its various anti-growth proposals are going nowhere this year, but as S-Corp readers understand, no bad idea ever dies in Washington. The false notion of a NIIT “Loophole” has been conceived and it will live long after the Obama Administration closes its doors.
The idea that corporate-only tax reform isn’t so bad because Main Street businesses can elect C corporation status has been argued for years. But should Congress reduce the corporate tax rate with the expectation that pass-through businesses will just switch to C status to access the lower rates? The answer is no. Here are the main points:
- It’s the opposite of tax reform. The corporate-only approach to tax reform is effectively “anti-tax reform.” It will return us to the pre-1986 era, when corporate tax rates were significantly lower than individual rates and tax gaming and income sheltering were rampant.
- It increases the negative effect of the double corporate tax. Everyone agrees the double corporate tax hurts investment and job creation. Forcing pass-through businesses (who employ the majority of private sector workers) into the double tax would make it worse.
- It penalizes business owners when they sell their business. For many business owners, the sale of their business is their retirement plan. The tax code recognizes this by taxing any gain from the sale of a pass-through business at the capital gains rate of 24 percent. On the other hand, any gain from the sale of a closely-held C corporation is taxed twice at a combined rate of over 50 percent! This double tax punishes entrepreneurs who have spent a lifetime building their business.
1. Corporate-Only = Anti-Tax Reform
S-Corp Advisor Tom Nichols hit this point in his testimony before the Ways and Means Committee in 2013:
When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent. This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher.
This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations. Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.
Efforts to lower the corporate rates while holding steady individual and pass-through rates should be deemed “anti-tax reform.” They will return us to the world Tom describes above, effectively reversing the broad changes made by Congress in 1986 and creating a tremendous incentive for taxpayers to organize their income to take advantage of the lower corporate rates and then shelter that income from additional tax.
2. The Double Tax is the Problem
Any tax reform worth the name would seek to reduce or eliminate the double corporate tax by integrating the corporate tax code with the individual tax code.
Here’s what EY had to say about the double corporate tax in the study they did for us back in 2011:
In addition, the flow-through form helps mitigate the economically harmful effects of the double tax on corporate profits, in which the higher cost of capital from double taxation discourages investment and thus economic growth and job creation. Moreover, double taxation of the return to saving and investment embodied in the income tax system leads to a bias in firms’ financing decisions between the use of debt and equity and distorts the allocation of capital within the economy. As tax reform progresses, it is important to understand and consider all of these issues with an eye towards bringing about the tax reform that is most conducive to increased growth and job creation throughout the entire economy.
By forcing pass-through businesses into the corporate tax while increasing tax rates on shareholders, the tax reform envisioned by the Obama Administration moves in the opposite direction and will hurt job creation and investment. Under the Obama Administration’s plan:
The top marginal rate for pass-through businesses remains at 44 percent;
- The corporate rate drops to 28 percent;
- The tax on dividends increases to 28 percent; and
- All these rates apply to a broader base of income.
Today, shareholders of an S corporation making $100 pay a top tax of $44 regardless of whether the income is distributed to shareholders or retained by the business. How would the Obama proposal affect that company?
- Under the Obama plan, S corporation income would still pay a top marginal rate of 44 percent, only on a broader base of income. The taxes on pass-through businesses would go up.
- Meanwhile, the Administration would cut the corporate tax rate to 28 percent while raising the dividend rate to 28 percent, so a C corporation would pay an initial tax of $28 plus another $20 for any dividends paid to taxable shareholders. These rates would apply to a broader base of income too, so it’s difficult to say whether any particular corporation would end up paying more or less tax under the Obama plan.
Under these rules, an S corporation could convert to C and reduce its initial tax bite from $44 to $28. It would then face a choice: Either retain its income at the firm and avoid the second layer of tax, or pay out a dividend and trigger another $20 in taxes (28 percent of $72) for a total tax hit of $48. Again, this combined rate would apply to a broader base of income.
In other words, the only way the S corporation lowers its tax burden by converting to C is if it then stops any dividend payments and keeps the income within the corporate structure. Tax reform should seek to reduce this type of distortionary incentive, not increase it. The double tax on corporations makes US businesses less attractive to investors and less competitive in the world marketplace. Forcing more businesses into the harmful double tax simply makes no sense.
3. Double Tax Applies to Business Sales
The “they can just convert” argument also ignores the penalty that closely-held C corporations face when they are sold. Closely-held C corporations currently face a combined federal tax rate of more than 50 percent when they are sold, versus just 24 percent for the sale of the business by an S corporation. Under the Obama approach of lower corporate rates but higher capital gains rates, the effective tax would be 48 percent.
This double tax makes switching to C corporation status a non-starter for entrepreneurs who might want to sell their business someday. Many business sales are tied to the retirement of the owner, where the proceeds are used to fund his or her retirement, so rates that high are a threat to their retirement security. It’s different for publicly held C corporations. Individual stockholders can sell their stock at any time, often at higher multiples as the stock of a public company enjoys a more liquid market.
So arguing that pass-through businesses can “just convert” simply is not credible. Some businesses might be in a position to switch to C status, but there are higher taxes waiting on the other side, along with unproductive tax complexity that does nothing to enhance business productivity. Given that pass-through businesses employ more than half the private sector workforce, how does any of this make sense? More broadly, how does forcing more companies into the inefficient and investment-stifling double tax model make America’s companies more competitive? Sounds like a plan to do the exact opposite.
The President’s budget is out and, as we have in the past, we will start with a disclaimer. Congress requires the President to issue a budget every year, and every year the President (regardless of party) complies with a ridiculously long and labored set of phone book-like documents outlining the budget. And every year Congress yawns and says it’s dead on arrival. So take our commentary below with a grain of salt, as most of the provisions in this budget are going nowhere, fast.
That said, the budget includes a couple tax proposals that caught the attention of our members, including:
- A higher, 28 percent tax rate on capital gains and dividends;
- A mandatory 28 percent tax on appreciated assets when the owner dies;
- A new 30-percent minimum tax (Buffett tax) on high-income individuals; and
- Applying self-employment taxes to the business income of professional services businesses.
We addressed the so-called Buffett tax and Gingrich-Edwards loophole when they were first proposed in prior budgets. The capital gains proposals, on the other hand, are new. The President first talked about them in his State of the Union Address this year. You can read the White House explanation here and a more detailed Treasury Department summary here.
The basic premise is that wealthy people don’t pay their fair share and need to pay more in taxes. This, of course, is nonsense. The federal tax code has many faults, but the lack of progressivity is not one of them. According to the Congressional Budget Office, the tax code is remarkably progressive and has been for a long time.
The CBO’s estimates on who pays what are from 2010, so they don’t include the recent hike in capital gains and individual tax rates enacted as part of the 2013 fiscal cliff deal. Combined with the Affordable Care Act taxes put in place that year, capital gains rates increased from 15 to nearly 24 percent. The new proposal would raise them again to 28 percent, or nearly double their level from just three years ago.
These higher rates work against the Administration’s 2012 framework to reduce corporate tax rates. What’s the point of reducing the corporate tax rate from 35 to 28 percent if you’re just going to hike the tax paid by corporate shareholders at the same time? As the CBO pointed out back in December, the marginal effective tax rate on corporate investments includes both layers of the corporate tax.
In 2012, the combined marginal rate on corporate investment was 45 percent (the 35 percent corporate tax plus the 15 percent shareholder tax times the remaining corporate income). After health care reform and the fiscal cliff, today’s marginal tax on C corporation investment is 50 percent. If Congress agreed with the President and cut C corporation rates while also hiking capital gains and dividend rates, the net result would be a 48 percent marginal tax. You’ll notice that’s higher than when we started, which begs the question of how all this is supposed to make the U.S. a more attractive place to invest?
The capital gains tax hike is bad for pass-through businesses too. For many business owners, selling the business is their retirement plan. One of the advantages of S corps and partnerships is that their owners get capital gains treatment when they sell the business. The President’s proposal would raise the tax on those sales to 28 percent.
For owners who choose to pass their business on to their children or employees, the proposal would force them (their estates, really) to pay the capital gains tax at the time of their death, along with any estate tax that is owed. The Administration used this example:
The largest capital gains loophole – perhaps the largest single loophole in the entire individual income tax code – is a provision known as “stepped-up basis.” Stepped-up basis refers to the fact that capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the “tax basis” of inherited assets used to compute the gain if they are later sold is immediately increased (“stepped-up”) to the value at the date of death – making the capital gain income forever exempt from taxes. For example, suppose an individual leaves stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is “stepped up” to the $50 million gain when he inherited it – so no income tax is due on the sale, or ever due on the $40 million of gain. Each year, hundreds of billions in capital gains avoid tax as a result of stepped-up basis.
Let’s take a step back. There are two reasons for stepped-up basis. The secondary reason is to ease record keeping. Ask the American Farm Bureau how hard it is to keep track of basis from one generation to the next. The Administration “solves” the record keeping challenge by forcing the estate (heir, really) to recognize any capital gain when the owner dies.
So if the stock left to an heir in the Administration’s example is a pass-through business, the estate is going to need to raise around $10 million to pay the capital gains tax. For most estates, coming up with that sort of cash without selling or liquidating the business is simply out of the question, so the proposal will result in an increase in the number of private businesses sold at the death of the owner or, most likely, when the owner is still alive and able to plan the transaction. Warren Buffett will love this proposal.
But record keeping is the secondary reason for stepped up basis. The primary reason is the existence of the estate tax. That $10 million owed by the estate is in addition to the estate tax already owed on the business. Since the resolution of the fiscal cliff in 2013, the estate tax owed in the Administration’s example is 40 percent on the value of the estate over $5 million, or $18 million. The tax code recognizes this liability by giving the heir of the estate a step-up in the basis of the assets they just inherited (and the estate just paid tax on). The Administration ignores this dynamic in their write up and proposal.
So under the President’s plan, the heir inherits a $50 million business but also (in effect) inherits a $28 million tax bill. What business could survive that sort of tax hit?
The Administration claims their proposal includes protections to ensure that no “small” business would have to be sold to pay the tax, but we’re skeptical. Congress tried to protect family businesses from the estate tax back in the 1990s, and it was your basic disaster. Almost no businesses were able to jump through the necessary hoops to gain the protection, and the qualified family-owned business provision was scrapped.
But those are just minor details and quibbles compared to the scale of the tax envisioned by the President – over 50 percent in the example above! Thomas Piketty would be proud. The new Republican Congress will never go along with these ideas, of course, so they only serve to remind us of just how far apart Congress and the Administration are on tax policy. It’s just one more reason to be skeptical of tax reform or any other broad tax policy being enacted this year.