Anti-Tax Reform in the President’s Budget

The President’s budget is out, and for the second year in a row it seeks to redefine tax reform to fit its own purposes.

The vast majority of policymakers view tax reform as embracing two fundamental goals:

  • Increased simplicity for both taxpayers and the IRS; and
  • Lower marginal tax rates imposed on a broader base of income.

The President’s budget , however, would take us in exactly the opposite direction. Rather than simplify the tax code, it would make it more complicated, and rather than move towards lower rates and a broader base of income, it would selectively lower and/or raise rates based on priorities that have little to do with simplicity or overall economic growth.

Corporate-Only Tax Reform: The business community is united behind the premise that tax reform should be comprehensive and address the tax treatment of individuals, pass-through businesses and corporations. Nonetheless, the Obama Administration continues to push Congress to consider budget-neutral, corporate only tax reform instead.

Under this approach, Congress would eliminate business tax expenditures and use the new revenue to offset lower rates on C corporations. A 2011 Ernst & Young study made clear the challenge corporate-only tax reform presents to pass-through businesses. According to E&Y, a broad policy of eliminating business tax expenditures while cutting only corporate rates would raise the tax burden on pass-through businesses by approximately $27 billion per year- and that doesn’t include the additional hit to pass throughs from their increased marginal tax rates beginning as of January 2013. The most affected industries include agriculture and mining, followed by construction, retail trade, and manufacturing.

This shift in the tax burden happens because pass-through businesses use the same business deductions as their C corporation counterparts. So, if a simple reform package eliminated the Section 199 manufacturing deduction in order to offset a reduction in corporate tax rates, a manufacturer organized as a C corporation would lose the use of that deduction, but they would get a lower corporate rate in return. It is a mixed bag.

For the S corporation manufacturer down the street, however, there is nothing but downside. They too would lose the use of Section 199, but unlike their C corporation competitor, the resulting higher tax base is not offset by lower tax rates. Instead, tax rates on the pass-through manufacturer just went up. Corporate-only tax reform represents a double whammy on pass-through businesses’ higher tax rates imposed on a broader base of income.

To address this challenge, some advocates have suggested allowing pass-through businesses a deduction on their income, or even separating pass-through business income from individual income and taxing it at different rates. While these options might mitigate the adverse impact of corporate-only tax reform on pass-through businesses, it also inflicts serious damage to the tax reform effort in general.

Prior to the 1986 Tax Reform Act, the tax rates on individuals and pass-through businesses were significantly higher than the tax rate imposed on C corporation income. Here is how tax attorney Tom Nichols described the situation during his testimony before the Ways and Means Committee last year:

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. These provisions included Internal Revenue Code (the “Code”) Sections 302 (treating certain redemptions of corporate stock as dividends) and 304 (treating the purchase of stock in related corporations as dividends), as well as Code Sections 531 (imposing a tax on earnings retained inside the corporation other than for the reasonable needs of the business) and 541 (imposing a tax on the undistributed income of personal holdings companies deriving most of their gross income from investments).

In other words, business owners began making decisions based on the tax code and not on the needs of their business. The 1986 Tax Reform Act ended this dynamic. Corporate-only tax reform would restore it. It is literally ”anti-tax reform.”

Buffett Tax: The Buffett Tax is again included in the President’s budget submission as a means of raising revenue while ensuring that the tax code is more progressive and fair. Despite the frequency with which the President and others talk about the need for the Buffett Tax, the arguments in favor of the tax are uniformly weak.

Congressional Budget Office (CBO) analysis makes clear that the federal tax code is already strongly progressive. According to the CBO, the top 1 percent of taxpayers in 2009 paid an effective tax rate of 29 percent, or nearly three times the effective tax rate paid by moderate income taxpayers (11 percent).

Moreover, we already have three tax codes for individual income, not counting the payroll tax system used to finance Social Security and Medicare. That is, we already impose three distinct tax rate structures on three distinct definitions of income earned by individuals and pass-through business owners:

  1. The Individual Income tax
  2. The Alternative Minimum Tax (AMT)
  3. The Affordable Care Act Investment Tax

By any reasonable standard, tax reform should seek to reduce rather than to increase the number of tax codes we impose on families. Yet proponents of the Buffett Tax would impose yet a fourth tax code, this time on families and pass-through businesses earning in excess of $1 million dollars.

Under the Buffett Tax, families and business owners earning that much in income would need to calculate their taxes four different ways! First, they would calculate their taxes under the Individual Income tax, then under the new Investment Surtax, then under the AMT, and then, after adding all those taxes together, they would need to calculate their overall Buffett Tax liability and see if it is higher.

On this basis alone, Congress should reject the Buffett Tax concept.

For S corporations and other pass-through businesses, however, there are other reasons for rejecting the Buffett Tax. As discussed above, S corporations must make quarterly distributions sufficient for their shareholders to pay taxes on the business income. The Buffett Rule would exacerbate this challenge by forcing an S corporation to calculate and distribute additional earnings, even if only one of its shareholders has (or might have) income subject to the Buffett Tax. The result would be to drain additional capital and resources from S corporations seeking to build up their equity and working capital.

Finally, perhaps the most dramatic and unfair consequence of the Buffett Tax for closely-held business owners would occur in the context of a sale of the business. The current federal tax rate for sale transactions is 20 percent (before taking into account the 3.8 percent additional tax on net investment income). The Buffett Tax would increase this tax rate for taxpayers making more than $1 million, even if that higher income was triggered by a once in a lifetime transaction involving the sale of a business built up over decades, effectively punishing entrepreneurs for starting and building a successful business.

By definition, both corporate-only tax reform and the Buffett Tax would make the tax code more, not less, complex. They are anti-tax reform and should be rejected by Congress.

Treasury Targets S Corporations, Flow-Throughs

A Bloomberg article from Friday morning has been flying around tax policy circles here in D.C. and elsewhere. From the article:

The Obama administration is seeking to widen the scope of its proposal to overhaul the corporate tax code, urging Congress to also change rules that allow some businesses to take advantage of tax laws governing individuals.

The article cites testimony by Secretary of the Treasury Tim Geithner earlier this year in which he advocated “revisiting” long-standing rules allowing businesses to choose to be taxed as S corporations or partnerships. According to Geithner:

“Congress has to revisit this basic question about whether it makes sense for us as a country to allow certain businesses to choose whether they’re treated as corporations for tax purposes or not.”

Combined with statements by Michael Mundaca (head of tax policy at Treasury) to business groups in recent days, the idea appears to be to force some partnerships and S corporations to pay taxes as C corporations, and use the additional revenue to help offset reforms (i.e. lower tax rates) for C corporations.

Bottom Line: The Obama Treasury Department is actively pursuing policies to impose corporate tax treatment on certain flow-through businesses as part of their corporate tax reform initiative.

Private and family businesses, be warned.

The President’s Budget and Corporate Reform Preview

As expected, the President’s budget didn’t offer any details on how he would reform the corporate tax code, but his budget did renew the call for corporate reform. According to the budget:

In an increasingly competitive global economy, we need to ensure that our country remains the most attractive place for entrepreneurship and business growth. As a first step toward reform, the President calls on the Congress to immediately begin work on reform that will close loopholes, lower the overall rate, and not add a dime to the deficit.

So budget-neutral corporate reform it is. But exactly how would that work?

Let’s start with the basics. Tax reform usually entails two components: broaden the base by eliminating specific tax deductions and credits, and use the additional revenue to reduce the overall tax rate.

Sounds great, but what about all of those non-corporate employers that use the same deductions and credits? Their tax rates (the individual tax rate schedule) are scheduled to go up in coming years, not down.

Further, not every business sector relies on the same credits or deductions, or to the same degree, so a budget-neutral reform means some sectors will win and some will lose.

Last month, former Treasury official Bob Carroll (now at Ernst & Young) and two colleagues penned a very interesting look into budget neutral tax reform and its impact on various business sectors. Here’s what they found:

“The biggest winners from using repeal of business tax expenditures to lower business tax rates to approximately 28 percent would be the retail and wholesale trade, information, transportation, finance and insurance,9 and services industries. Rate reduction would more than offset the loss of benefits from their tax expenditures.”

And:

“Eliminating all business tax expenditures would disproportionately hit the manufacturing industry, especially those manufacturers with multinational operations. The tax rate would need to be lowered to roughly 26 percent to offset the tax increase from repealing the various tax expenditures that benefit the manufacturing industry.”

A key point: the above analysis assumes rates on flow-throughs are reduced right alongside C corporation rates. It also found that a revenue-neutral reform that reduced rates for all forms of business would bring the top rate down to 28 percent, not the 26 percent rate needed by manufacturers. (Hence the Administration’s push to disallow flow-through status for certain S corporations and others. They need the money.)

To determine the impact on S corporations, partnerships, and other flow- throughs, the S-Corp Association has asked Dr. Carroll to take another look at “corporate-only” reform, but this time assuming that only corporate rates are reduced, a la Chairman Rangel’s “”Mother” bill from 2007.

Dr. Carroll will have a chance to educate Congress on this issue Thursday when he testifies before the Ways and Means Subcommittee on Select Revenue. His testimony will be the beginning of a broad-based education campaign on the part of S-Corp and its allies.

Our message is simple: if you’re going to tackle tax reform, do it right and include both the corporate and individual tax codes. To do otherwise would mean picking winners and losers, and we know who the losers will be: manufacturers and the majority of employers in the country.

Tax reform should seek to make the entire U.S. economy more competitive, not just a subset of large corporations.

Tax Relief Bill Negotiations Proceed

Today’s Congress Daily includes a number of points about the conference between House and Senate negotiators:

  • “One source said April 25 it appears House negotiators will be willing to accept at least some of the offsets that were included in the Senate’s bill.”
  • “It also appears that negotiators are simultaneously working out the details of a second bill of tax break extenders that will be dropped from the reconciliation bill, the source said.”
  • “Pressure from the leadership and administration remains on conferees, Senate Finance Committee Chairman Charles Grassley (R-Iowa) said April 24, but he added that it was unclear whether a deal could be reached by week’s end.”

Full Article: http://nationaljournal.com/pubs/congressdaily/

Continued Focus on the Tax Gap

Yesterday, Senator Max Baucus (D-MT) - the ranking member of the Finance Committee - issued a press release calling on the IRS to be more accurate in its assessment of the tax gap - the difference between what taxpayers owe and what they pay on a timely basis. The release was done in conjunction with a new report from the Inspector General for Tax Administration at Treasury, which concluded that the IRS current estimates of the tax gap are incomplete and may underestimate the problem.

“The IRS will have a hard time closing the tax gap as long as they don’t know what the tax gap really is,” said Baucus. “Since this report indicates that the annual gap between taxes owed and taxes collected may be even more than $345 billion, there’s really no more time for the IRS to waste.”

In the past, Senator Baucus has called on the IRS to establish a goal of 90 percent voluntary compliance rate by 2010. Currently, the IRS estimates the compliance rate at about 85 percent. Both Baucus and the TIGTA estimate that a 90 percent compliance rate would increase annual collections by more than $100 billion.

S-CORP remains concerned that efforts to close the tax gap will result in destructive tax policies that  - like the Joint Committee on Taxation proposal to increase payroll tax collections on S Corps - raise taxes on S Corps and other taxpayers who are already in full compliance with the tax code, paying what they owe, and playing an important role in the health of their communities.

 

TIGTA Report: http://www.treas.gov/tigta/oa_auditreports_fy06.shtml.

JCT Report:http://www.house.gov/jct/s-2-05.pdf

 

Tax Expenditures Estimated

Finally, the Joint Committee released its annual “Tax Expenditures” report yesterday. The report defines tax expenditures as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” The concept of tax expenditure has been criticized from its inception, since it presumes there is a “normal” or regular amount of tax the Federal government should be collecting and that anything less than that amount is a give-away by the Federal government. It’s been compared to that old joke about the two-line tax form:

Line 1: How much did you make last year?

Line 2: Send it in.

Nonetheless, there are some interesting tidbits of information about how taxes are being collected, or not, as the case would be. Top tax expenditures include the exclusion of employer pension contributions ($577 billion over five years), employer-provided health benefits ($534 billion), lower rates on dividends and capital gains ($438 billion), and the home mortgage deduction ($402 billion).

You can see the full JCT Report at: http://www.house.gov/jct/s-2-06.pdf

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