The Tax Foundation published its annual piece on pass through businesses this week, and as usual, there’s lots of great material in there. To begin, the Foundation updates its numbers on pass through employment and marginal tax rates. As in past years, pass through businesses employ the majority of private sector workers even though they face marginal tax rates that often exceed 50 percent! Talk about shooting yourself in the foot, economically speaking.
Robert Samuelson at the Washington Post noticed. In an op-ed last week, he highlighted some of the key metrics found in the Foundation’s report:
“Here are some of the key findings in the report:
- More than 90 percent of businesses in America are pass-through enterprises. In 2014, that was 28.3 million out of 30.8 million business establishments.
- Pass-through firms account for more than half of U.S. private-sector employment. In 2014, the number of workers at these firms totaled 73 million, compared with 54 million at C corporations.
- The total profits of pass-through firms have surpassed the profits of C corporations. In 2012, the net income was $1.6 trillion for pass-through firms and $1.1 trillion for C corporations.”
The employment figure in particular is worth emphasizing. Back in 2011, EY estimated that pass through businesses employed 54 percent of the private sector workforce. According to the Tax Foundation, that number rose to 57 percent by 2014. That’s a big jump in just three years.
The Tax Foundation report makes clear that far from being second-class citizens, pass through businesses are the dominant business structure and they are clearly the way all businesses should be taxed in the future. Here’s a nice paragraph on how pass through tax treatment should be the model for tax policy moving forward.
Proponents of [forcing large S corporations into the C corporation tax] argue that some pass-through businesses are just as large and economically significant as C corporations, and that there is little justification for creating two separate tax regimes for similar types of businesses. There is merit to this line of argument, but instead of forcing pass-throughs into the problematic double tax regime faced by C corporations, lawmakers should work to improve the C corporate tax regime, to move it closer to a single layer of tax at the same rates that apply to wages and salaries. In short, the tax code should treat C corporations more like pass-through businesses, not the other way around.
Tax it once, tax it when it’s earned, tax it at the same reasonable, low rate, and then leave it alone! We’re glad the Tax Foundation agrees.
One concern is how the Foundation continues to miss headline material right in front of them. Years ago, they did a piece on the “erosion of the corporate tax base” since 1986 that wholly ignored the fact that their numbers showed the “business tax base” (pass throughs and C corporations combined) had actually grown over that time. That statistic has become one of our principle talking points for tax reform, and we source the Tax Foundation when we use it, even though they never spelled it out.
This year’s report offers a similar opportunity for acknowledging that the glass is half-full. Consider this chart on business income.
You can see how pass through businesses have consistently earned more than C corporations in recent years. This chart fits with the Foundation’s past focus on the corporate tax base and its decline.
But think about a different chart – a better, more informative chart using the same data. One that compares business income subject to a single layer of tax versus business income subject to two layers of tax. As we know, pass throughs pay a single layer of tax on their income when they earn it, so the income represented in the blue line falls into that category.
But we also know that most – 75 percent! – of C corporation shareholders are tax-exempt or tax-deferred. They are pension funds, charities, foreign shareholders and retirement accounts. So upwards of 3/4s of the green line is actually taxed once, too. In order to measure how much business income avoids the double corporate tax, you should take three-quarters of the green line and add it to the blue line. Here are the new numbers:
So there you have it. The business community has voted with its feet for single-layer taxation, and it wasn’t close. It was a landslide of historic proportions – 9 to one!
You can quibble that not all tax-deferred shareholder income escapes the second layer of tax, but that misses the point. Single-layer taxation is the new norm for US companies. Any analysis of business taxation should begin with that premise. The double corporate tax is still harmful to jobs and investment, but only because companies and investors take such great pains to avoid it. The “classic” corporate tax structure is no longer the base case, which means we need to transition to a new way of examining business taxation that reflects the underlying reality of how businesses are taxed today.
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.
Last Friday, longtime S-CORP allies Rep. Dave Reichert (R-WA) and Rep. Ron Kind (D-WI) introduced two pieces of legislation – H.R. 629 and H.R. 630 – to extend tax provisions critical to America’s 4.6 million S corporations.
The bills would make permanent the five-year built-in gains holding period as well as a basis adjustment fix for S corporations making charitable contributions. They build off the momentum from last Congress when identical bills successfully passed the House with broad bipartisan support. These provisions are ones that we’ve championed for years, and go a long way towards making the tax rules for Main Street businesses fair and predictable.
In a joint press release, Rep. Reichert had this to say:
S Corporations are proven job creators and it is our job as legislators to make sure the tax code helps them to access the capital they need to grow, remain competitive and help get Americans back to work. I am pleased to introduce these bipartisan pieces of legislation with my colleague Congressman Kind, because our tax code should encourage growth rather than stifle it. I look forward to working with my colleagues to advance policies that help our small businesses create jobs and support families across the country.
Rep. Kind also added:
These commonsense, bipartisan bills will bring stability and simplicity to the tax code to make it easier for many small businesses to create good jobs and help sustain local communities. There are nearly 60,000 S Corporations in Wisconsin alone, so supporting these job creators is a top priority as we work to strengthen the economy in Wisconsin and across the country.
The broad support these provisions have garnered from the business community and lawmakers reflects the sentiment that these outdated tax rules just don’t make sense and permanent changes need to be made. H.R. 629 would allow S corps increased access to their own capital by providing for a permanent, five-year BIG holding period, rather than the current ten-year period these businesses must endure before they can dispose of appreciated assets without paying a prohibitive tax. As S-Corp Advisor Jim Redpath testified before the Ways and Means Committee last year:
I find the BIG tax provision causes many S corporations to hold onto unproductive or old assets that should be replaced. Ten years is a long time and certainly not cognizant of current business-planning cycles. Many times I have experienced changes in the business environment or the economy which prompted S corporations to need access to their own capital, that if taken would trigger this prohibitive tax. This results in business owners not making the appropriate decision for the business and its stakeholders, simply because of the BIG tax.
H.R. 630 is another common sense reform that would encourage S corporations to give back by permanently ensuring S corporations are able to deduct the full value of the stock they donate to charity. This provision would level out the tax treatment of such donations between S corporations and partnerships.
Improving and making permanent the rules for the businesses that drive our economy is critical and we applaud Reps. Reichert and Kind for once again introducing this legislation. We are looking forward to seeing the bills considered and adopted by the House!