Ryan Rolls Out New Ways & Means Committee

Main Street business tax treatment was a big theme during the Ways & Means Committee’s first hearing of the year.  Its purpose was to look at the state of the economy, but key members kept raising the question of how to best treat pass-through businesses in tax reform.   Carrying the flag for S corps was our longtime S-CORP Champion Dave Reichert (R-WA):

Reichert (1:53:00): In another area where we have the ability to boost our economy – through tax reform, as has been mentioned, and which would benefit businesses large and small — what about pass-through businesses…which face a high marginal tax rate in addition to high compliance costs. How do you see the change in the tax code specifically helping those small pass-through businesses?

Economist Martin Feldstein: I think that’s a major challenge that you face as a committee and in Congress in dealing with tax reform. That lowering the corporate tax rate, where both the President and Republicans have said ‘we’ve got to get down into the twenties,’ will still leave pass-through businesses, who file through their personal tax returns, facing much higher tax rates, so somehow that has to be dealt with. And by treating the business income of individuals differently from other things, so that in effect they get the advantages of the lower tax rate that come with corporate tax reform.

Rep. Vern Buchanan (R-FL) also focused on the challenge faced by pass-through businesses:

(2:22:00): I want to bring up something my colleagues mentioned earlier, about corporate rates being the highest in the world…I think we agree that we need to do something with corporate rates. My concern is pass-through entities. You touched a little bit on effective rate, and how when you add everything the effective rate is 40 percent or more, and if you add in state income tax, the average is 49.6. So if you look to move corporate rates from 35 to 28 to 25, whatever they’re thinking about doing there, I don’t know how you can be competitive in terms of pass throughs.

One statistic I got is 99 percent of the companies registered in Florida and other places are small businesses, obviously a lot of them pass throughs. And 60 percent of job creation comes from these businesses, and many of these start-ups. In terms of reducing the rate, if you’re a pass-through company and you have seventy employees, and you’re giving half your money back to the various governments, it’s pretty hard to be able to grow your business, add equipment, add jobs, when you’re giving half of [your money] away. My point, to the professors here today, is to ask what effect lowering the rates on C corps and pass throughs would have on the economy and on creating jobs….

Economist Doug Holtz-Eakin:  It’s bad tax policy to treat business income differently depending on whether it’s a pass through or a C corporation. And that would drive you to organize your business based on tax considerations rather than business considerations; that’s the hallmark of the tax system interfering with the economy.

And finally, Representative Todd Young (R-IN) weighed in:

(3:00): I’d like to talk about tax reform…but specifically focusing on tax reform for our smaller businesses and younger firms.

 I do have some concerns, going back to the small and younger firms that, about some intimation by the President and by others in this town that we may only consider corporate reform, rather than the individual code so that those pass-through entities like S corporations and LLCs get the benefit of simplification, on one hand, and rate reduction, knowing that many of them pay over half of their profits in taxes, when you combine the taxes at different levels of government.

It bears reminding that, over the past decade, more than six out of every ten new jobs created in this country have been through these smaller firms, and this is where over half of jobs currently exist in this country.

Bottom Line:  Key members of Ways and Means, starting with the Chairman and working down from there, are fully aware of the economic importance of pass-through businesses and the threat that “corporate-only” tax reform poses to them.

 

Tax Reform Challenge in One Chart

If you’re looking for an illustration of how the tax code fails to treat business income equitably, look no further than this chart on effective marginal tax rates from the CBO (click to enlarge).

Keep in mind that the chart shows effective marginal rates, so it captures the tax on new income from a new business investment, not the average tax paid by businesses on their existing income.  If you’re looking for effective rates on existing business income, you should look at the effective rate study we released back in 2013. (Spoiler alert:  S corps pay the highest effective rate.)  Moreover, since sole props tend to be less profitable and are taxed at lower average rates, their inclusion reduces the effective marginal rate for pass-through businesses below what it would be if S corporations alone were examined.

These points aside, the chart has much to tell us.

First, look at the disparity between debt and equity investment.  Returns on equity are taxed at high levels, while returns on debt financed investment are taxed at much lower levels.  Debt-financed investment by C corps is actually subsidized under the current code!  This disparity encourages businesses to over leverage.  Not good.  Any tax reform worth doing would seek to balance out the tax treatment of debt verses equity.

Second, look at the long lines showing the range of effective marginal tax rates.  These signify the difference in effective rates depending on the industry and assets involved.  The longer the line, the greater the disparity.  The range of effective tax rates for C corps using equity ranges from 21 to 47 percent.  The range for C corp debt is from 22 percent to negative 42 percent!  Pass-through businesses also show significant ranges, if not quite as extreme.  Once again, any tax reform worth doing would seek to shorten those lines and balance out the tax treatment of investing in different types of assets.

One of our concerns with the Camp plan released last year was that it did little to balance out either the debt verses equity differential or the differing treatment among asset types.  In fact, the JCT analysis of the plan showed the Camp draft would have increased the effective tax burden on business investment.  Tax reform should encourage, not discourage, business hiring and investment while balancing out the tax burden on differing industries and business structures.

If you want a sense of how difficult that task will be, look no further than this CBO chart.

 

It’s All About That Rate

Speaking of tax rates, Bloomberg’s Richard Rubin had a nice story this week outlining the challenge tax reformers face in trying to reconcile corporate and pass through taxation.   S-CORP’s own Brian Reardon was highlighted channeling singer Meghan Trainor:

The administration’s proposals are an “absolute non-starter,” said Brian Reardon, president of the S Corp Association, a group of pass-through companies whose board of directors includes an executive from Tabasco sauce maker McIlhenny Co.

“Main Street businesses have to be an equal partner in this,” he said. “And what that means is rate parity. It’s all about the rates.”

It’s all about the rates, indeed.  You can bet that’s going to be our major theme this year as Congress takes another look at tax reform.

Tax Reform Rehash

The release of Finance Committee tax reform discussion drafts on cost recovery and international tax have laid bare a reality that’s been hiding just below the surface for two years now the visions for reform embraced by the key House and Senate tax writing committees are dramatically different and move in opposite directions.

The international drafts are a good example. The Ways and Means draft would move the tax treatment of overseas income towards a territorial system, while the Baucus draft would move towards a more pure worldwide system by largely eliminating deferral. Here’s how the Tax Foundation described it:

Of the 34 most advanced countries, 28 use a territorial tax system, while only 6, including the U.S., use a worldwide tax system with deferral. No developed country imposes a worldwide tax system without deferral, though some have tried it with near disastrous effects.

Exactly how the two committees could bridge these broad differences in vision is unclear.

For pass-through businesses, the differences are just as stark. Neither committee has released details on overall rates or the treatment of pass-through businesses, but both have made clear the general direction they plan to take.

The Ways and Means Committee seeks comprehensive reform where the top rates for individuals, pass- through businesses, and corporations would be lowered and the differences between them reduced, helping to restore the rate parity that existed from 2003 to 2012. Other provisions in Chairman Camp’s draft would seek to close the differing treatment of partnerships and S corporations, creating a stronger, more coherent set of pass-through rules.

Finance Chairman Max Baucus, on the other hand, appears to actively oppose rate reductions for individuals and pass-through businesses even as he constructs his reform package around a core of cutting rates for C corporations. The inherent inconsistency of lowering corporate rates to make US businesses more competitive while simultaneously defending significantly higher rates on pass-through businesses is stark. The Baucus draft does make a vague reference to “considering” the impact on pass-through businesses, but it is clear that consideration amounts to nothing more than increased small business expensing or something similarly limited.

So the Finance Committee would cut corporate rates and ask S corporations and other pass through businesses to help pay for them. In the end, C corporations would pay a top rate of 28 or 25 percent, while pass-through businesses would pay rates 13 to 20 percentage points higher.

How do they justify this disparate treatment? The double tax on corporate income is often raised as leveling factor. As the Washington Post recently reported, “Today, the Treasury estimates, as much as 70 percent of net business income escapes the corporate tax.”

But “escaping” the corporate tax is not the same as escaping taxation. The simple fact is that pass through businesses pay lots of taxes, and they pay those taxes when the income is earned. The study we released earlier this year found that S corporations pay the highest effective tax rate (32 percent) followed by partnerships (29 percent) and then C corporations (27 percent on domestic earnings).

These findings include taxes on corporate dividends, so some of the double tax is included. They do not include capital gains taxes due to data limitations. Including capital gains would certainly close the gap between C and S corporations, but enough to make up 5 percentage points of effective tax? Not likely. Meanwhile, the study focused on US taxes only, so it doesn’t attempt to capture the effects of base erosion or the ability of C corporations to defer taxes on foreign income for long periods of time.

All in all, the argument against pass through businesses is based on some vague notion that these businesses are not paying their fair share. The reality is just the opposite. By our accounting, they pay the most. That means that, all other things being equal, today’s tax burden on S corporations makes them less competitive than their C corporation rival down the street.

Real tax reform would seek to make all business types more competitive by lowering marginal rates while also helping to level out the effective tax rates paid by differing industries and business structures. That’s the basis behind the three core principles for tax reform embraced by 73 business trade associations earlier this year: reform should be comprehensive, lower marginal rates and restore rate parity, and continue to reduce the double tax on corporate income.

These principles are fully embraced by Chairman Camp and the Ways and Means Committee. They appear to have been rejected by the Finance Committee. Which begs the question: What exactly is the goal of the Finance Committee in this process? Is it just to raise tax revenues? You don’t need “reform” to do that.

Whatever their goal, the gap between the House and the Senate is enormous, and unlikely to be closed anytime soon. Chairman Camp continues to press for reforms that would improve our tax code, but he’s going to be hard pressed to find common ground with what’s being outlined in the Senate.

Extenders

With the timeline for tax reform being pushed back, there is a bit more discussion of what to do about tax extenders. The whole package of more than 60 provisions expires at the end of the year and to date there’s been little discussion regarding how or when to extend them. As the Tax Policy Center noted this week:

It isn’t unusual for these mostly-business tax breaks to temporarily disappear, only to come back from the dead a few months after their technical expiration. But this time businesses are more nervous than usual. Their problem: Congress may have few opportunities to continue these so-called extenders in 2014. This doesn’t mean the expiring provisions won’t be brought back to life. In the end, nearly all will. But right now, it is hard to see a clear path for that happening.

While the future is murky as always, a few points of clarity do exist:

  • Nothing will happen before the end of the year. The House will recess this weekend and not return for legislative business until mid-January. Even if it took up extenders promptly after returning, which is highly unlikely, the soonest an extender package can get done would be February or March.
  • Coming up with $50 billion in offsets to replace the lost revenue will also be a challenge. Congress is tackling a permanent Doc Fix right now, which requires nearly three times that level of offsets. Coming up with an additional $50 billion will not be easy.
  • The lack of an AMT patch also is hurting urgency for the package. Congress permanently addressed the Alternative Minimum Tax earlier this year, which is good news, but that action also removed one of the most compelling catalysts for moving the annual extender package. Annually adopting the AMT patch protected 20 million households from higher taxes. That incentive is now gone.

All those points suggest that the business community has a long wait before it can expect to see an extender package move through Congress.

Or does it? One of the most popular extenders is the higher expensing limits under Section 179. This small business provision allows firms to write-off up to $500,000 in capital investments in 2013, as long as their overall amount of qualified investments is $2 million or less.

Beginning in 2014, these limits will drop to $25,000 and $200,000 respectively.

You read that correctly. Starting January, business who invest between $25,000 and $2 million in new equipment will no longer be able to write-off some or all of that cost in year one. Talk about an anti-stimulus. Coupled with the loss of bonus depreciation, the R&E tax credit, and the 5-year holding period for built in gains, and the expiration of extenders will have a measurable effect on the cost of capital investment for smaller and larger businesses alike.

This reality is beginning to sink in both on Main Street and the investment community, where certain industries rely on these provisions as a core part of their business plans in coming years. It’s too soon to see how much momentum the loss of these provisions will generate in coming months, but cutting the expensing limit from $500,000 to $25,000 in one year is bound to attract somebody’s attention.

Forbes on Pass Through Businesses

Marty Sullivan always writes interesting and provocative pieces on tax policy, so when we saw his recent piece in Forbes on tax reform Should Small Business Have Veto Power Over Corporate Tax Reform, we read it eagerly.

It’s provocative, alright, but we do have a couple observations.

Marty argues that pass through business advocates “willfully omit the existence of the corporate double tax from their spin and howl” regarding tax reform. Really?

We don’t howl, and we don’t ignore the existence of the double corporate tax. It’s a central part of our message on how to build a foundation for good tax reform. Our Pass-Through Tax Reform letter signed by more than 70 business organizations calls for reform that embraces three basic principles:

  1. Reform should be comprehensive;
  2. Reform should restore rate parity; and
  3. Reform should reduce the double tax on corporate income.

It’s hard to ”omit” the double tax when its reduction is one of your key principles.

There are lots of other examples, but the testimony one of our advisors presented before the House Ways & Means Committee back in 2012 stands out:

First, as much as possible, the business tax system in the United States should move toward a single tax structure, and away from the punitive double tax C corporation system. Especially for closely-held businesses, a single tax system substantially reduces complexity and eliminates the opportunity and incentive for non-productive tax planning and strategizing. Moreover, it has the benefits of simplicity and transparency.

Marty should remember that testimony. He was sitting right next to him.

Marty argues that our effective rate study says that “corporations are getting away with murder.” Again, not true. The study’s focus is on the effective tax burden paid by pass through businesses. To our knowledge, this analysis has never been done before and it shows that S corporations and partnerships will pay very high effective tax rates in 2013:

  • S Corps: 32 percent
  • Partnerships: 29 percent

Large S corporations making more than $200,000 will pay even higher rates: 35 percent!

The study does calculate C corporation effective rates for comparison purposes, but makes clear there are many ways to calculate the C corporate rate and that foreign income and taxes are a complication that needs to be acknowledged. An alternative measure included in the study, looking only at domestic C corporation income, has the C corporation effective rate at 27 percent.

The study doesn’t omit the double tax either. The C corporation calculation includes dividends payments (but not capital gains taxes due to data limitations). The study finds that the dividend tax does not increase effective tax rates significantly:

Our results suggest that C corporation dividends raises their average effective tax rate by only 2 percentage points. The primary reason for this result is that C corporations do not pay significant amounts of dividends. IRS SOI data indicate that approximately 4.5 percent of C corporations paid cash dividends in 2009.

Finally, we have to say something about the title of the piece. We know writers don’t get to pick their headlines, so we’ll lay this bit of logical inconsistency at the feet of the Forbes editors.

The pass through business community is not asking to veto anything.B They are asking not to have their tax burden raised substantially on top of the tax hike they just shouldered starting 2013.B Budget neutral, corporate-only reform, as outlined by the Obama Administration, among others, would do just that. It would cut taxes for large corporations and raise them for pass through businesses.

If the point of reform is to encourage domestic job creation and investment, only reform that includes pass through businesses will get you there.B Ernst & Young reported that pass through businesses employ more people and contribute more to national income than their C corporation friends, so raising their taxes in order to cut taxes for C corporations is not going to help encourage hiring or investments.

Moreover, creating a tax code where similar business income is subjected to two very different rates – 28 percent for C corporations but nearly 45 percent for individuals and pass through businesses under the Obama plan – would encourage the gaming and income shifting prevalent in the tax shelter days before 1986. Again from Tom’s 2012 testimony:

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.

Under corporate-only tax reform, we would be right back in the pre-1986 world Tom is describing. It is anti-tax reform, in every sense.

More on Business Tax Reform

The pass through community has a new ally. In an op-ed posted on CFO.com, Douglas Stransky, a partner at the law firm Sullivan & Worcester, pushed back on President Obama’s corporate-only tax reform proposal introduced earlier this year:

If you want to stimulate the economy through tax reform, however, you should also pay attention to the tax burden on the companies creating the most jobs. According to the U.S. Small Business Administration, firms with less than 500 employees accounted for 67 percent of the new jobs since the recession ended. Those are companies led by entrepreneurs, who are building businesses around new products or services and expanding their payrolls.

Yet the discussion about corporate tax reform has only focused on large, multinational corporations, and not small businesses…The S Corp, partnership and sole proprietorship tax rate has not been the focus of corporate tax reform in Washington. But it should be. If the C Corp rate of 35 percent is reduced to 28 percent it will leave an inequity in the tax structure between large and small businesses. This is senseless, especially when it’s assumed that lower income tax rates would enable employers to have more money to reinvest in their companies and create more jobs.

…The average American thinks corporate tax reform will apply to any U.S. business. But what is being discussed will apply only to a small percentage. Small businesses are the engine of our economy. If we reform taxes for S Corps as well as C Corps, that engine will run more efficiently.

Amen, amen.

error: Content is protected !!