We weren’t the only ones who noticed the President’s budget for 2017 is bad for Main Street Employers. Numerous outlets ran stories (CQ, Bloomberg, and Morningstar) focusing on the negative impact the President’s tax proposals would have on S corporations and other pass-through businesses. As our friends from NFIB noted about the Administration’s proposal to expand the Net Investment Income Tax (NIIT) to all pass-through business owners:
“It’s not closing any gap,” said Nick Karellas, tax counsel at the National Federation of Independent Business. “It’s just blatantly a revenue grab on small-business owners who are actively participating in their businesses.”
The Administration’s efforts to characterize this proposal as a loophole-closer are interesting, given that Congress intentionally excluded active business owners from the tax when it was enacted back in 2010 (See below).
But the proposals go well beyond expanding the NIIT. They include increasing payroll taxes on professional service businesses, raising the capital gains rate paid by S corporations and others to 28 percent, and establishing a 30 percent minimum “Buffett tax” on all forms of income. Each of these tax hikes would directly impact the profitability of pass-through employers.
Following the budget’s release, Treasury Secretary Jack Lew testified before the Ways and Means Committee and attempted to characterize their tax hikes as targeted at law firms and hedge funds, despite the fact that they would apply to all businesses – manufacturers, contractors, retailers, etc. S-Corp Champion Dave Reichert (R-WA) was having none of it:
“Let me just go through what I think tax reform should look like, and I don’t see it in the President’s budget, in fact I think it’s really offensive to small businesses. Tax reform should stimulate growth and efficiency by reforming America’s current complicated, burdensome system into a simpler, fairer, flatter tax code. Tax reform should promote U.S. jobs and higher wages through a more competitive international tax system. Tax reform should ensure that small businesses have a fair and competitive tax system, including the tax rate. As a result of the President’s budget, the top rate for small businesses will be 43.4 percent. They don’t get it, and I don’t get it either, Mr. Secretary. Tax reform should aggressively lower rates, and simplify the code. Even after enacting substantial increases in capital gains taxes in 2010 and again in 2013, President Obama continues to propose raising taxes on the investment American workers need to become more productive and earn higher wages…Mr. Secretary…I would like you to explain to me how raising taxes on small businesses helps the American economy grow, helps small business grow, helps create jobs? I don’t understand how you can raise taxes and create a growing economy and create jobs.”
Last year, one of our S-CORP Board Members testified on the effect of these tax hikes on his manufacturing business. McGregor Metalworking saw its effective tax rate – not marginal, effective — jump from 34 to 42 percent following the Obama-supported rate hike in 2013 that Congressman Reichert cites. Under the new Obama plan, McGregor’s effective rate would go even higher.
Confusion on the NIIT
There’s lots of confusion as to why the NIIT doesn’t apply to the business income of active business owners. Advocates eager to rewrite the history of the provision are driving this confusion, which is showing up in major publications. Take for example this excerpt from David Wessel in the Wall Street Journal:
Lobbyists for those who benefit from the NIIT loophole will be quick to accuse the administration of attacking small business. There are a lot of truly small businesses organized as pass-throughs, but the NIIT doesn’t affect them because they don’t earn $200,000 a year. The Treasury estimates that 67% of all S-corp income and 69% of all the partnership income goes to the top 1% of taxpayers, those with income greater than $375,000 a year.
Where to begin.
Let’s start with “loophole” and some of the facts surrounding the NIIT origins. The NIIT was enacted in 2010 as a pay-for to Obamacare. It was a late addition to the law that the Administration proposed in February of 2010, after both the House and the Senate had passed their respective health care reforms.
From the beginning, the proposal excluded the business income of active owners. Here’s how CongressDaily reported on the provision at the time:
President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed.
That was us. We led a broad coalition of business groups to oppose the provision when it was first floated, and we wrote extensively on the provision once it was released. You can read our analysis here, here, and here.
Congress made several key changes to the Administration’s proposal before enacting it – they removed its connection to Medicare and they increased the tax to 3.8 percent – but the exclusion on income of active business owners remained, as our Advisory Board Chair testified back in 2012:
This net investment income tax is generally imposed on interest, dividends, annuities, royalties, rents and gains, with one very important exception. Congress recognized that this new imposition should not apply to income derived by owners directly involved in active businesses. Therefore, Congress excluded from the tax base all income derived from a trade or business unless the income was reported by a person who did not “materially participate” under the passive activity rules or the trade or business consisted of trading in financial instruments or commodities.
So exempting the business income of active owners from the “investment” tax was part of the plan from the beginning and is no way a “loophole.”
And what about “benefit”? Why does Mr. Wessel suggest that business owners who were never subject to a tax, and not supposed to be subject to a tax, derive some benefit from not being subject to the tax? That label assumes that Congress intended to tax the business income of active shareholders. They didn’t, so it’s not appropriate to call it a benefit.
Finally, Mr. Wessel massively redefines “small business.” Any attempt to define “small” is by necessity going to be arbitrary and doomed to fail, but even the Small Business Administration (SBA) puts the threshold at 500 or fewer employees. With around 400 employees, McGregor Metalworking (the manufacturer whose effective tax rate has jumped under Obama’s policies) is considered to be a small business by the SBA. Mr. Wessel, on the other hand, would exclude any business that has just enough profits so that, when combined with all the other income earned by the owner’s household, it exceeds $200,000.
That’s the opposition in a nutshell. They support small business, as long as that small business creates few if any jobs and doesn’t make much money.
The Administration’s budget and its various anti-growth proposals are going nowhere this year, but as S-Corp readers understand, no bad idea ever dies in Washington. The false notion of a NIIT “Loophole” has been conceived and it will live long after the Obama Administration closes its doors.
Small Business Confidence Survey
You’ll remember back in June we profiled three small business surveys from NFIB, Wells Fargo/Gallup, and Thumbtack. Together, these surveys, with different sample populations and varying methods, provide the most complete picture of the small business landscape today. When we examined their findings during the summer, we saw words like “lukewarm”, “uninspiring”, and “more of the same” to describe the private business environment.
For the third quarter of 2015, it’s “more of the same” again. With minor variations, all three surveys show that business owners are no more confident today than they were during the summer. In particular, economic uncertainty is cited as a top concern:
- NFIB notes that over 20% of businesses that think it is a poor time to expand cite political uncertainty;
- 20% of Wells Fargo/Gallup respondents cite the economy or government as their top concern; and
- Economic conditions had the most business owners worried in Thumbtack’s survey, which had over 6,000 respondents.
So government action, and inaction in some cases, is hurting the small business sector and retarding investment and job creation. Maybe policymakers on the Hill and in the agencies should take note.
Where are the Democratic Tax Plans?
Most Republican presidential candidates have released a tax plan in one form or another to date. They range from Sen. Rubio’s detailed legislative proposal that he co-wrote with Sen. Lee (R-UT) to op-eds in the Wall Street Journal and elsewhere from candidates Chris Christy, Jeb Bush, Donald Trump, and others. The details vary, but a common theme in all the plans is the need to use the tax code to stimulate investment and job creation.
On the other hand, no candidate on the Democratic side has released a comprehensive plan. Secretary Clinton and Senator Sanders (D-VT) have released targeted proposals calling for profit sharing, as well as higher taxes on financial transactions and capital gains, but not only are these not comprehensive reforms, they would also, as Peter J. Reilly at Forbes writes, only serve to make the tax code more complicated. Tax policy was largely missing from the recent debate, too. Other than some vague references to higher taxes for the wealthy—particularly from Sanders — tax policy was a no-show.
Our friends at the Tax Foundation have been scoring and writing on all the Presidential plans. You can access their chart here. We expect that as the campaign matures, we’ll see more robust proposals from the Clinton campaign and others in the Democratic field. Tax policy is always a key part of any presidential run, and we expect 2016 to be no different.
Et Tu, CRS?
Last month, Treasury (or at least the bulk of their tax economist team), released a study on pass through businesses and the taxes they pay. We raised concerns with the Treasury approach here and here.
Now CRS also has a paper focused on pass through businesses and the challenge they present to reforming the corporate tax code. As BNA summarized, the basic message of the paper is this:
The 35 percent statutory corporate tax rate tends to be higher than the average marginal statutory rate for noncorporate business, estimated to average about 27 percent, according to data from the Internal Revenue Service. In addition, effective corporate tax rates are higher in most cases and for most assets than effective rates for passthroughs, and administrative and compliance costs would be lower if tax provisions such as depreciation and inventory accounts were harmonized across organizational forms.
As with the Treasury paper that preceded it, however, the lower effective (or average) rate for pass through businesses in the CRS paper is almost entirely due to the inclusion of lower-income sole props and other pass through businesses in their calculation. In other words, they’ve compared the effective tax rate of Wal-Mart to the handy man down the street and found, not surprisingly, that Wal-Mart pays a higher rate.
One interesting aside is the CRS estimate for shareholder level taxes. You’ll recall that Treasury estimated dividend and capital gains taxes on C corporation shareholders adds about 9 percentage points to the corporate effective rate. As we pointed out, Treasury made some very interesting assumptions to get there.
CRS appears to agree with us on that matter. Their estimate for shareholder level taxes is about one-fourth of Treasury’s, or just 2.3 percentage points. CRS lists the lower rates on capital gains and dividends, tax exempt shareholders, and capital gains that are passed on as part of an estate as the primary reasons for the lower estimate.
What’s missing from both the CRS and Treasury analyses is a comparison of likes – a large C corporation to a large S corporation in the same industry. That comparison would inform policymakers as to the respective tax burden of different business forms and help them make better policy decisions, but you are not going to find that sort of comparison in either the CRS or Treasury papers. Based on our previous work, we’re confident the S corporation in that analysis would pay the higher effective rate.
Family Business Valuation under Attack?
In a development that could harm valuations of S corporations and other family-owned businesses, the Treasury Department appears poised to issue guidance limiting discounts under section 2704. Such action has been hinted at for a while, but people began to pay real attention following comments from Catherine Hughes, head of Estate and Gift Tax Attorney-Advisor at Treasury, before the ABA’s Estate Planning breakfast back in April.
It’s not exactly clear what the Treasury has in mind, but Hughes referred the ABA audience to proposals the Administration included in their annual budget offerings prior to 2014. We took a hard look at those proposals back in 2013, and if you’re looking for an indicator of where Treasury is headed, that’s a good place to start. MPI, a business valuation and advisory firm, has a nice overview on their blog.
For months, we’ve been hearing that tax writers would like to couple some version of tax reform with a long-term highway bill. What the tax reform package would look like was unclear (international, patent box, extenders?) as was the funding source for the highway bill (deemed repatriation?).
Back-to-back hearings on highway funding next week should shed a little light on the latest thinking. Both the House Ways and Means and Senate Finance committees are holding hearings exploring the various options Congress could use to pay for highways. As Senator Hatch pointed out, “While many in Congress agree we should aim for a long-term highway bill, the problem is often agreeing on how to pay for it.” As usual, it’s all about the payfors.
The Ying-Yang of Tax Reform
McConnell focused on the challenges, particularly in bridging the policy gulf between President Obama and Republican Congress. “The President is not interested in revenue neutrality, and he’s not interested in treating all taxpayers the same, so I don’t think we’ll get there on comprehensive [tax reform].”
Ryan, meanwhile, continued to accentuate the positive. “The question is: Can we take a couple of steps in the right direction?” Ryan made clear he believes the answer is “yes”, particularly with international tax policy and extenders. So international, extenders, and highways? Something to watch.
Tax Foundation on Revenue Neutral Corporate Tax Reform
The Tax Foundation released another study on pass through businesses this week. You’ll recall they put out a really great paper on pass-through taxation in January that focused on the state of the pass through business community. Our summary – it’s large, dynamic, and employs a lot of people!
This new study dives right into the policy debate over corporate tax reform. Should Congress enact deficit neutral legislation that cuts the rates for C corporations only? According to the Tax Foundation, the answer is “no” unless you’re willing to raise taxes on pass through businesses in the process. They conclude “the impact of the elimination of business tax expenditures for pass-through businesses with no rate offset could reduce the size of the economy by 0.5 percent [or $84 billion in the long-run].”
Small Business Confidence
There’s a growing number of small business confidence surveys out there.
The Grand Daddy is NFIB’s Small Business Optimism Survey, which has been reporting quarterly since 1973 and monthly since 1986. NFIB uses a sample of nearly 4,000 small businesses, typically with a 15% response rate, and releases the information on the second Tuesday of each month.
This week’s survey gives a lukewarm assessment of the economy—“it’s moving ahead, but at an uninspiring pace” while the outlook for Q3 is “more of the same.” Two bright spots came in earnings and wages, which posted their best survey readings since October 2005 and January 2008, respectively.
A second survey, from Wells Fargo and Gallup, has been released on a quarterly basis since 2003. Their data is drawn from over 600 phone interviews with small business owners. While optimism among small businesses recorded a slight decline this Spring, overall “there’s more certainty in today’s economy than at this time last year, and we’re seeing more promising trends,” according to Lisa Stevens, head of Small Business at Wells Fargo.
Finally, there’s a brand new survey from Thumbtack, which focuses on hard-to-reach businesses such as seasonal employers and large swath of sole proprietors. Using their online community of professionals, Thumbtack is able to receive over 10,000 responses to their survey. The populations might be different, but Thumbtack’s results mirror those of NFIB—business owners are “somewhat positive” about the economy. Exploring the state-level results reveals some interesting data, particularly the discrepancies in ease of hiring and doing business in states with low regulatory burden compared to those with more red tape, typically in the Northeast and on the West Coast.
We’ll be keeping track of these surveys in future posts. Perhaps it’s time for a survey of the surveys?