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.

Nobody Here But Us Unicorns

Last week, National Public Radio ran a story suggesting that while business groups are focused on the pending rate hikes and the impact they will have on jobs and investment, actual business owners are less concerned. According to NPR:

We wanted to talk to business owners who would be affected. So, NPR requested help from numerous Republican congressional offices, including House and Senate leadership. They were unable to produce a single millionaire job creator for us to interview.

 

So we went to the business groups that have been lobbying against the surtax. Again, three days after putting in a request, none of them was able to find someone for us to talk to.

The White House jumped on the story, joking that opposition their “Millionaire Surtax” was “bogus.” As White House Spokesman Jay Carney told reporters:

And it’s what you all write in your stories when you say, the President and Democrats support this surtax, or this way of paying for job-creating measures or tax cuts; Republicans say no because it will hurt small business. Well, one news organization decided to ask the leadership offices of the Republicans on the Hill whether or not — or just to give them an example of the small businesses that would be affected. And for three days they got nothing. And there’s a reason for that. Because, as the Treasury Department has done in its study, the simple fact of the matter is, is that less than 1 percent of all small businesses would be affected by this kind of request that millionaires and billionaires pay a little bit more. That’s just a fact.

So next time you write a story, or produce a spot that cites that opposition, I think a second sentence might be worth adding, which is that it’s bogus.

This week, Senate Majority Leader Harry Reid joined the chorus, stating on the Senate floor:

Republicans have opposed our plan to pay for this legislation with a tiny surtax on a tiny fraction of America’s highest earners. The tax would only apply to the second million the wealthiest Americans earn.

But Republicans say the richest of the rich in this country - even those who make millions every year - shouldn’t contribute more to get our economy back on track. They call our plan a tax on so-called “job creators.” Yet every shred of evidence contradicts this red herring.

 

National Public Radio went looking for one of these fictitious millionaire “job creators.” A reporter reached out to business groups, the anti-tax lobby and Republicans in Congress hoping to interview one of these millionaires. Days ticked by with no luck.

 

Millionaire job creators are like unicorns - impossible to find.

That’s because only a tiny fraction of people making more than $1 million - about one percent - are actually small business owners. And only a tiny fraction of that tiny fraction is traditional job creators. Most of those business owners are hedge fund managers or wealthy lawyers.

 

They don’t do much hiring. And they don’t need more tax breaks.

 

A couple points of clarification. First, the Treasury report cited by the Majority Leader doesn’t say that only 1 percent of people who make more than $1 million are small business owners – it says that only 1 percent of all small business owners make more than $1 million. The report actually says that 84 percent of people who make more than $1 million had some income from a flow-through business income.  That’s 84 percent, not 1 percent.

As we have pointed out before, the number of firms is irrelevant. What matters is the volume of activity. The report showed that people making more than $1 million earned 39 percent of all flow-through income. Similarly, the Joint Committee on Taxation estimates that 34 percent of all active flow-through business income would be hit by the tax.

Second, the surtax proposed in the Senate in recent months is only one of three marginal rate hikes set to begin January 1, 2013. The other two are the expiration of the lower 2003 tax rates (including the restoration of the Pease deduction phase-out, which is effectively a 1.2 percent surtax) and the imposition of the new 3.8 percent tax on investment income. Shareholders of profitable S corporations today pay a 35 percent tax on their business income. If the surtax before the Senate is adopted, that top rate will rise to 50 percent beginning in 2013.

These proposed tax hikes will hit shareholders with as little as $200,000 in income. The rhetoric is all about millionaires and billionaires, but the policy being pushed will affect business owners with just a fraction that much income.

2013 Rates Married/Single

36%  $250,000/$200,000

39.6%  $390,050/$390,050

3.8% Surtax $250,000/$200,000

5.1% Surtax $1 Million/$1 Million

Does it make a difference? Ask the Administration and those members of Congress eager to cut the corporate rate. Why cut the corporate rate? Because the current 35 percent rate is out of synch with the rest of the world and it makes our large businesses less competitive. So what’s different about flow-through businesses? They employ more Americans and contribute more to economic output than those firms that pay the corporate rate. Marginal rates affect their competitiveness too.

Or ask Christina Romer, the former Chair of President Obama’s Council of Economic Advisors who’s done an enormous amount of work in this area. The paper she co-wrote with her husband back in 2007 found that tax cuts and hikes not targeted at fiscal stimulus, as the surtax and other pending 2013 tax hikes certainly are not, have a large impact on economic output. As summarized by David Henderson of the Hoover Institute in Forbes:

The Romers carefully sift through all federal tax cuts and tax increases from 1947 to 2005 to figure out, based on the discussion at the time, whether the changes in tax policy were motivated by a desire to offset the business cycle or by other goals. When they strip out the tax changes meant to offset the business cycle, they find that the other tax changes were highly effective. A tax decrease of 1% of GDP raised GDP by about 3%, and, symmetrically, a tax increase of 1% of GDP reduced GDP by about 3%.

 

So how big is the proposed tax cliff awaiting flow-through businesses in 2013? The Reid 5.1 percent surtax is estimated to raise $24 billion in 2013, while the Obama 3.8 percent surtax would raise $20 billion that year. Meanwhile the expiration of the top two rates is another $35 billion. Add them all up, and the total hit is $79 billion, or about 0.5 percent of projected GDP for 2013. These estimates come from different reports, so there may be interaction not represented in the total, but the scale of what is being proposed is significant and disturbing.

Another point of clarification. The businesses affected by these tax hikes are not limited to “hedge fund managers or wealthy lawyers.” Eighty-one percent of all manufacturers in this country are organized as flow-through businesses. Meanwhile, one of the key findings of the Ernst & Young study we requested last spring was that larger flow-through businesses — those with 100 or more employees — accounted for one in six private sector jobs. That’s a lot of people working for so-called “unicorns.”

We’re not sure what steps NPR took to find business owners affected by the surtax, but it’s not surprising that taxpayers with large businesses to run are wary of spending time showing their personal tax returns to NPR. But the evidence from Treasury and the Joint Committee on Taxation is clear: the cumulative rate hikes under consideration to begin in 2013 are large and they will impact a significant percentage of overall business income. That’s what S-CORP is worried about.

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