Ways & Means Takes on Tax Reform

The House Ways and Means Committee began its focus on tax reform yesterday with a hearing on economic growth.  The hearing, entitled “How Tax Reform Will Grow Our Economy and Create Jobs” featured four company representatives and one hedge fund manager invited, oddly enough, by the Minority.

One of the company witnesses, Zach Mottl, is the Chief Alignment Officer for Atlas Tool Works, a multi-generation family business located outside of Chicago.  Operating in an industry with large, multinational competitors, Zach made clear the current rate structure is tilted against smaller companies like theirs that lack the international presence to shift around income:

In addition, oftentimes, tax issues affect manufacturers of different sizes in different ways, usually smaller manufacturers, like the TMA member companies, are the only companies paying a higher tax rate because we do not have the staff or the resources to develop a comprehensive global tax avoidance plan like our larger peers who actually pay far less in taxes that we do. 

Meanwhile, Representative Vern Buchanan (R-FL), a friend of the Main Street business community, had this to say:

But I want to touch on pass-through entities and make sure they don’t get lost in the mix. I got a bill, I’d like to see close to parity. When you look at corporate rates at 35% they’re not competitive, but for pass-throughs it’s as high as 44%. If you add state income tax in states like California, they’re 12-13%, it could be as high as 57%, makes absolutely no sense. So, I guess I’d like to ask some of the panelists, just your thoughts on lowering those rates, where they’re more competitive, getting it down to somewhat near the corporate rate, I don’t necessarily agree with 15%, but the difference that would make in terms of growth, in terms of jobs, and also in terms of raising wages.

As you’ll recall, Rep. Buchanan has been active on this issue for some time, advocating for a level playing field and sponsoring the Main Street Fairness Act in the last two congresses.  Here’s what we wrote when his bill was first introduced last Congress:

And just this week, Congressman Vern Buchanan (R-FL) introduced legislation on the issue of rate parity.  Entitled the Main Street Fairness Act, the bill would cap the top pass through business tax rate at the top corporate rate.  Under the Buchanan bill, the same 35 percent top rate that applies to corporate income would also apply to successful pass through businesses.  If Congress reduces the corporate rate next year, pass through businesses would get the new lower rate too.

Groups weighing in on the Buchanan bill include the National Association of Manufacturers, the National Retail Federation, and the Associated Builders and Contractors.  You can read more about the Buchanan bill here.  You can read the S Corporation Association letter on the bill here.

The good news is that the House Blueprint specifically referenced this legislation as a possible means of defining pass through business income and ensuring fairness for Main Street businesses.  As the debate proceeds, we expect lots more attention paid to the challenge of how to treat pass through businesses.  As the Buchanan bill demonstrates, there are smart folks on the Hill working to make sure we get it right.

 

Mnuchin on Pass Throughs

The same day that the House kicked off its tax reform efforts, Treasury Secretary Steven Mnuchin was talking taxes over on the Senate side.  Testifying before the Senate Banking Committee, Mnuchin was asked about their tax reform plan and the challenge of enforcing their new, 15-percent rate on businesses.

Treasury Secretary Steven Mnuchin defended the Trump administration’s push for a 15 percent pass-through tax rate during an appearance today before the Senate Banking Committee.

“We will put procedures in place … to prevent people who should be paying higher taxes from using pass-throughs to arbitrage the system,” Mnuchin said in response to questioning from Sen. Elizabeth Warren (D-Mass.). “I can assure you … we are not going to allow all pass-throughs to get that rate.”

Mnuchin added that the administration planned to put in place a system to ensure only “small and medium-sized businesses” could use the proposed pass-through rate to ensure wealthy individuals would not simply form their own companies to avoid higher personal income tax rates.

The Treasury secretary also defended the tax outline he and National Economic Council Director Gary Cohn unveiled weeks ago from charges that it would heap trillions more dollars onto the national debt.

“We would never propose a plan that we thought would cost $5 trillion,” Mnuchin said when Sen. Jon Tester (D-Mont.) asked about the cost of tax cuts Trump proposed. “Only parts of the plan were released so I don’t know how it could be responsibly scored.”

“I am concerned as to whether some of the models will attribute enough growth in dynamic scoring,” added Mnuchin, rebutting arguments that growth may not pay for the cost of Trump’s proposals, “but when we present the details we will present how we think it should be paid for.”

There are many concerning aspects of this response, but the most obvious fallacy is the notion that tax avoidance only happens with pass through businesses.  What about the 15-percent rate for corporations?  What’s to stop wealthy individuals from using the C corp structure as a tax shelter?  That’s what they did pre-1986, and that’s what they would do here too (here and here).

For six years, the pass through community has coalesced around a simple proposition that the best way to ensure economic growth and the integrity of the tax code is to tax all forms of income – individual, pass through, and corporate – at similarly low top rates, while eliminating the double tax on corporations.

As the question and response above makes clear, the further you get away from this approach, the more difficult the challenges become.  Secretary Mnuchin’s vision resembles the tax code pre-1986, when all US companies of any size were organized as C corporations and tax avoidance was rampant.

It’s a result we are eager to avoid.

Trump To Weigh In On Taxes

So what do we know about the Administration’s tax announcement scheduled for tomorrow?  First, we expect the announcement will be limited to principles and a couple key proposals – not a full blown tax reform plan.

Second, the emphasis appears to be on cutting tax rates.  We expect something similar to the Trump campaign’s proposal setting the top rates at 33 percent for families and 15 percent for businesses.

Finally, there is likely to be a call for territorial tax treatment coupled with some commentary on the need for leveling the international tax playing field.  We could see the term “reciprocal taxes” used again but, as in the past, it’s unlikely to be fully spelled-out what that means – some sort of tariff or the border adjustment provision the House is pushing.

For S corporations and the pass through business community, the good news, as reported in the Wall Street Journal, is that S corporations should be eligible for the lower 15 percent rate:

President Donald Trump on Wednesday is planning to unveil a proposal to slash the top tax rate on so-called pass-through businesses, including many owner-operated companies, to 15% from 39.6%, said White House officials familiar with the planning.

We’ve been advocating “rate parity” for pass through businesses for seven years now, so assuming the Wall Street Journal is correct, it is gratifying to see the White House embrace our message.

Exactly how to enforce the new lower rate will be a hot topic.  As the Wall Street Journal notes:

Lawmakers will struggle to fit the 15% tax rate inside budgetary and procedural constraints and it will be hard for Congress to write rules that prevent people from converting higher-taxed wages into lower-taxed business profits.

Both are good points that will have to be addressed, but for now we will focus on the positive, as it appears all three of the players in tax reform – the House, Senate and White House – support the general concept of taxing all business income at the same top rate.  That’s a vast improvement compared to where we were just a couple years ago, and should be cause for optimism in the Main Street business community.

So what does it all mean for the prospects of tax reform?  It should increase the likelihood that any tax plan passed this year would be more narrowly crafted and focus on cutting tax rates as opposed to a full-blown reform.  It has been obvious since the election that President Trump prefers a straightforward rate cut approach over comprehensive reform, and we expect tomorrow’s announcement to reflect that preference.

And it signals that reform efforts may take longer than we thought earlier this year.  The case for quick action on tax policy was predicated on the White House, the House, and the Senate coming together on the broad outlines of a plan and then working that plan through the legislative process.  With the White House reverting to something resembling their campaign proposal, we are moving away from a general agreement, not towards it.

That said, both the Congress and the White House continue to work hard on tax reform, meeting on a regular basis and raising these issues consistently.  President Trump has talked about taxes more in the last few months than his predecessor did in eight years, so it’s obviously a priority.  With everything else going on, that may be tomorrow’s most important takeaway.  Where there’s a will….

Reichert, Buchanan Present S Corp Tax Relief to Ways and Means

As our members know, S-Corp wears two hats when it comes to advocacy – one is defensive where we protect S corporations from bad tax policy.  The other is proactive and seeks to improve the S corp rules.

Both hats were on display this week before the House Ways & Means Committee. First, Rep. Dave Reichert (R-WA) discussed his S Corporation Modernization Act which makes a number of improvements to the S corporation rules, including opening the door to foreign investment into S corporations.  As Rep. Reichert told the Committee:

Reichert

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“I’ve heard from a seventh-generation family-owned company and the struggles it has faced based on the nationalities of the spouses of the family members, including family members who have had to sell their stock in the company because of current restrictions. With the number of burdens our business owners face, does it make sense to maintain yet another hurdle simply based on who someone decides to marry?”

Allowing S corporations to attract foreign investment has been an S-Corp priority for years.  The current restrictions simply make no sense, particularly if the fix is done through an ESBT structure in which the Treasury can be certain taxes will be paid.  We’ve come close to getting this policy enacted in the past, and with Rep. Reichert’s leadership, we look forward to seeing it move through Congress soon.

Second, Rep. Vern Buchanan (R-FL) was able to educate the committee on the importance of tax rate parity.  For a decade – between 2003 and 2012 – all forms of business paid the same top rate.  Today, as a result of the Fiscal Cliff and Obamacare, C corporations continue to pay the same 35 percent top rate, but the rate on pass throughs is nearly 45 percent!

In response, Rep. Buchanan has introduced legislation – the Main Street Fairness Act – which would restore rate parity by capping taxes on pass-through businesses at the top C corporation rate:

Buchanan

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“Today, the average business in Florida, a pass through, [pays] 43 percent, big corporations are at 35 percent. In many places in the country, state and federal is over 50 percent. My bill simply says lower those tax rates to nothing higher than corporate rates going forward.”

What’s the prognosis for these efforts?  Shortly after the hearing, Ways and Means Chairman Kevin Brady (R-TX) announced that he was committed to restoring regular order in the Committee, stating:

“Today’s hearing demonstrates that we are serious about considering tax legislation through an open and transparent process. We’re committed to introducing bills, considering them and moving them to the floor. The fact that over 30 Members are sharing their ideas today is a testament to our new process – and to our return after so many years to regular order.”

Does this mean a markup of member-driven proposals is in our future?  That remains to be seen, but the fact that the Committee is giving members an opportunity to speak about their respective efforts is promising, and we will continue to work with our friends on the Committee both to protect S corps from bad policies and to fight for improved rules.

 

Business Community Unites Against 385 Regs

Speaking of bad policies, some of the largest business trade groups in the world have sent Treasury a letter calling on the agency to rethink the proposed section 385 regulations it released last April 4th.  You can read the whole letter here, but the core of the letter’s message is contained in these two paragraphs:

Based on Treasury’s April 4 press release, the proposed 385 regulations are designed “to further reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping.” Nonetheless, even a cursory review of these regulations clearly indicates that they go far beyond cross-border mergers and apply to a wide range of ordinary business transactions by global and domestic companies both in and outside the United States.

Indeed, the proposed 385 regulations affect all aspects of both a company’s capital structure and the funding of its ordinary operations and fundamentally alter the U.S. tax rules on intercompany debt by overturning the well-established facts and circumstances analysis used by the courts and the Internal Revenue Service (IRS) to determine whether an instrument is debt or equity. Whether an instrument is debt or equity has significant, collateral consequences to business operations that go well beyond the interest deduction on the instrument and include the legal classification of an entity, eligibility for withholding tax exemptions under tax treaties and the ability to file a consolidated tax return. These issues present a severe impediment to the use of intercompany financing for even normal operations and will significantly increase the cost of capital and limit the amount of capital available to invest in the United States.

We noted in a previous post that these regulations pose a particularly acute threat to S corporations.  All the concerns listed above apply to S and C corporations alike, but S corporations also face the possibility that they could lose their classification and be forced back into the C corporation world.

The comment period for these proposed regulations ends on July 7th.  We intend to submit extensive comments and hope that others do as well.  Our message is simple – these regulations were not well thought out and need to be pulled.

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