Should Main Street Businesses Elect C Corp Status? No!

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.

 

S-Corp Payroll Tax Hike Re-Emerges

Both the Camp discussion draft and the President’s budget include provisions to expand the application of payroll taxes to S corporation income.

The White House proposal is an expanded version of efforts that failed in the Senate in 2010 and 2012, where 100 percent of income from a professional services businesses – law, accounting, consulting, etc. – organized as an S corporation, general or limited partnership, or an LLC taxed as a partnership, would be subject to SECA taxes.

The Camp provision, on the other hand, is a whole new approach that is dramatically broader than anything considered to date.  It would reach beyond professional services businesses and would impact all S corporations, including manufacturers and other producers.  The draft would:

  • Bring S corporation business income under self-employment taxes (SECA);
  • Create a new 70-30 rule, whereby 70 percent of an active shareholder’s wage and business income derived from the S corporation would be subject to payroll taxes;
  • Credit the active shareholder with any FICA taxes paid on the S corporation wages;
  • Apply to all S corporations, not just professional services businesses; and
  • Apply the same 70-30 rule to partnerships.

Another area of difference between the two plans is their revenue estimates.  The Obama provision is narrower – it applies to professional services businesses only – yet Treasury estimates it will raise $38 billion over ten years!  The Camp provision is significantly broader – it applies to all S corporations – but the JCT says it will only raise $15 billion.  What gives?

We’re not sure, but since the new 70/30 rule applies to both S corporations and partnership income, it appears the Camp proposal would both raise and lose revenue, with the net effect resulting in a $15 billion tax hike. Under current rules, a significant portion of partnership income is fully subject to payroll taxes – particularly among large law and accounting firms – which means the new 30 percent exclusion would have the effect of lowering collections on those businesses.  That’s good for partnerships, but bad for S corporations, because it means the tax hike on them is significantly larger than $15 billion.

The Committee claims their approach is simpler than current rules, but we don’t see it.  Consider the case of an owner of a large manufacturing plant with dozens of employees and millions in capital investments.  This is not a rare example – drive around any sizable town and you’ll see dozens of them.   He pays himself a market-based salary of $250,000 and the business makes $750,000 in profit.  Under the current rules, his salary is subject to FICA while the business income is not.  Since he’s paying himself a market wage, the business income is, by definition, a return on the capital invested in the business and should not be subject to payroll taxes.

The Camp proposal, however, would do just that.  Under the provision, the owner would need to aggregate his salary and business income ($250,000 + $750,000 = $1 million) and then multiply the result by 70 percent.  That’s the amount of his total income that would be subject to payroll taxes ($700,000).  The owner would then subtract out the salary income that has already been subject to FICA ($700,000 – $250,000 = $450,000).  That’s the amount of the owner’s business income that would be subject to SECA taxes.  It’s not simple, and it’s certainly not fair.

Moreover, the Camp approach appears to severely limit the benefit of excluding domestic manufacturing income from the new 10-percent surtax.  As advertised, the Camp plan would tax S corporation “producers” at a top rate of 25 percent.  But the draft also appears to apply the same 70/30 rule to production income as it does to payroll taxes.  That means, in the example above, the owner would pay a 25 percent rate on $300,000 of his business income, but 35 percent on the rest.  Suffice it to say that the C corporation down the street doesn’t face this byzantine approach to marginal tax rates.  The combination of the 10 percent surtax and the 70/30 applied to active shareholders presents a strong incentive for the owner of this business to retire, convert to C corporation status, or sell the business entirely.

Finally, it’s important to address the origins of the 70/30 rule.  According to the Committee’s section-by-section:

The provision’s distinction between net earnings from self-employment and other income not subject to SECA reflects the fact that over the last several decades, the portion of Gross Domestic Product (GDP) attributable to labor has remained remarkably constant at approximately 70 percent, while the portion of GDP attributable to capital has held steady at roughly 30 percent. The 30-percent deduction recognizes that a portion of the distributive share of a partnership, LLC or S corporation represents earnings on invested capital. 

In other words, since the nation’s income is divided 70/30 between labor and capital, that ratio should also apply to the business income from an S corporation or partnership.  We’re not so sure.  Take the example above.  The GDP definition of “income” is not limited to the combined $1 million in business and salary income attributed to the owner.  It also includes all those wages paid to the other workers.  Those wages are included in the GDP calculations, but the Committee ignores them in applying the 70/30 rule to S corporations.

As we pointed out, since the owner in our example pays himself a market wage, any business earnings beyond that amount are a return on capital.  So taxing that income as a return on labor is simply not correct.  Not every S corporation has lots of capital – some have little, while others have tons.  Applying a one-size-fits-all 70/30 rule to all S corporations does not accurately capture this diversity, and it certainly doesn’t justify a massive increase in the application of payroll taxes to business income.

As readers know, we’ve been fighting this issue for a decade now, ever since Vice President Dick Cheney chastised Senator John Edwards for using the S corporation structure to avoid payroll taxes on the income from his law practice.  Over the decade that followed, S-Corp has developed the following position on the issue:

  1. We don’t support using the S corporation structure to avoid payroll taxes.  We represent businesses that comply with the law, not sneak around it.
  2. It’s not a loophole, its cheating.  This issue is often described as a loophole, but that’s not accurate.  Underpaying yourself in order to avoid payroll taxes is already against the rules.
  3. The IRS has a long history of successfully going after taxpayers who abuse the S corporation structure.  The current S corporation rules on this have been in place since 1958.
  4. Any “fix” needs to improve on the current rules.  That means they need to be easier to enforce and they need to target wage and salary income only.  Employment taxes should apply to employment.

Measured against those rules, the two proposals put forward here fall short.  They ignore the distinction between employment and investment, and they unfairly raise taxes on business owners who are fully complying with the law.  They might successfully raise revenues, but they don’t appear to contribute to fairness or simplicity.

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.

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