Big Picture on Pass-Through Taxation

Our expectation for 2013 is continued guerrilla warfare on specific tax hike proposals coupled with the looming threat of larger tax hikes when Congress next addresses the debt limit. Add in the determination of both tax-writing committee chairmen to pursue comprehensive reform, and you have a good understanding of how we’re going to spend our time over the next year:

  • Working with the tax committees to make their tax reform proposals as business friendly as possible;
  • Fighting the Administration’s efforts to turn tax reform into another opportunity to raise taxes on Main Street Employers; and
  • Fighting specific proposals to unfairly target S corporations and raise their taxes through discrete provisions like the payroll tax hike.

The President’s State of the Union address this week did little to change this outlook. In a world where 99 percent of policymakers agree that tax reform means lower marginal rates imposed on a broader base of income, the President’s view (illustrated by last year’s corporate reform proposal and his continued support of higher marginal rates) is just the opposite – higher marginal rates coupled with more special interest tax provisions. It’s the same anti-tax reform perspective offered by Senator Chuck Schumer late last year.

It’s this difference in perspectives that’s behind the pessimism over whether Congress will tackle tax reform this year. The gap appears just too large for Congress to find common ground and it would require a very, very large catalyst to bridge it.

Well, it’s possible that just such a catalyst is right on the horizon. The combination of sequestration cuts starting next month and the need for Congress to raise the debt limit before the August break is just the sort of ”rock and a hard place” scenario that could compel action.

Here’s why. The pain, political and otherwise, from the sequestration cuts will not be felt immediately but will instead grow over time. Each month will bring additional stories of how the cuts are adversely affecting Americans and US policy. Meanwhile, we know from experience that the House of Representatives will resist raising the debt limit without some sort of accompanying deficit reduction package.

So, starting this summer, Congress will be under tremendous pressure to revisit the sequestration cuts at the same time the tax-writers are talking tax reform and the House is insisting on additional deficit reduction. All while Congress is facing a deadline to extend the “must-pass” debt limit.

For these reasons, we’re taking tax reform seriously. The debt limit-tax reform scenario may play out differently, but the risk is simply too great to do otherwise.

We Are All for Comprehensive Reform Now

Two years ago, the S Corporation Association undertook the effort to combat “corporate-only” tax reform. We support cutting the corporate rate, but tackling the corporate tax code in isolation is bad policy and bad politics, and with the help of our E&Y study on the subject, we were able to quantify just how bad it would be for businesses organized as pass-through businesses…”$27-billion-a-year-in-higher-taxes” bad.

House Ways and Means Committee Chairman Dave Camp has always understood this challenge and has been a consistent advocate for comprehensive reform. Recent comments by Senate Finance Committee Chairman Max Baucus suggest he too understands the important role pass-through businesses play in jobs and investment – at 69 percent, his home state of Montana has the highest percentage of pass-through employment in the nation, after all.

With his comments in the State of the Union, it appears the President too has converted to the church of comprehensive tax reform. Here’s what he said:

Now is our best chance for bipartisan, comprehensive tax reform that encourages job creation and helps bring down the deficit. We can get this done.

Of course, he coupled that statement with a call for raising tax rates on high-income individuals, raising taxes on the overseas operations of multinational corporations, and for continued use of the tax code to target specific industries and taxpayers, so we’re not getting too excited here.

But the word “comprehensive” remains significant. Until somebody says otherwise, we’ll assume this means the President has backed away from his corporate-only proposal of last year. Let’s hope so.

Sequestration Highlights Threat to Pass-Through Businesses

Efforts to replace the sequestration spending cuts have highlighted the on-going threat S corporations and other pass-through businesses face this Congress.

For example, on Tuesday, Senators Whitehouse (D-RI) Levin (D-MI), Harkin (D-IA) and Sanders (I-VT) introduced two bills to offset the sequester with tax hikes. The first includes tax increases necessary to postpone the sequester until October 1, while the second would raise the taxes necessary to replace it entirely. As you can see, it’s the usual suspects list of LIFO and Carried Interest tax hikes, etc.

Another list posted by Politico reported the other day includes even more items:

POSSIBLE SENATE DEM SEQUESTER REPLACEMENTS - These ideas are making the rounds:

1) closing off a variety of “offshore tax shelters”;

2) ending preferential tax treatment for many private equity and hedge fund managers;

3) taxing the exercise of stock options more heavily

AMONG THE REVENUE ESTIMATES

1) Closing Carried Interest (14 billion);

2) Closing Corporate Jet (4 billion);

3) Closing Oil & Gas Credits (21 billion)

4) Farm Direct Subsidies (5 billion);

5) Closing S Corp pass Through (76 billion);

6) New Sen. White House Tax Proposals;

a) Set Min Rate for Millionaires;

b) higher rates for Oil & Gas;

c) SubPart F changes: Focus on Passive Income, Transfer Pricing & Loans to Parent Co.

Again, it’s the usual list, but what is this?

5) Closing S Corp pass Through (76 billion);

Closing S corporations? $76 billion? That’s a new one, and the description is just vague enough that it could be anything. That said, the only S corporation tax item out there with $76 billion attached to it that we know about originates with a Congressional Budget Office report from December entitled, Taxing Businesses Through the Individual Income Tax.

Here’s the key sentence:

The Congressional Budget Office (CBO) estimates that if the C-corporation tax rules had applied to S corporations and LLCs in 2007 and if there had been no behavioral responses to that difference in tax treatment, federal revenues in that year would have been about $76 billion higher.

In other words, if Congress repealed the current tax status of around 7 million private companies and subjected them instead to the double corporate tax, the CBO says you might raise some money. But $76 billion a year?B Not likely:

Behavioral responses-for example, owners of S corporations might have reduced those corporations’ taxable income by reporting larger amounts for their compensation (which would have raised payroll taxes and lowered corporate income taxes relative to CBO’s estimate)-would have changed the amount of additional tax revenue that would have been collected. Furthermore, the estimate does not account for interactions with other tax provisions, such as the alternative minimum tax.

Later in the paper, the CBO makes clear such a policy would result in less investment, lower wages, and more debt:

Nevertheless, the trend toward pass-through entities’ accounting for a larger share of business activity has some positive aspects. For example, it has probably reduced the overall effective tax rate on businesses’ investments, thus encouraging firms to invest. (The effective tax rate combines statutory rates with other features of the tax code into a single tax rate that applies to the total income generated over the life of an investment.) The shift in activity toward pass-through firms has also reduced at least two biases associated with the current corporate income tax that influence what businesses do with their earnings and how they pay for their investments:

  • The bias in favor of retaining earnings rather than distributing them, which results from taxing dividends immediately but deferring the taxation of capital gains; and
  • The bias in favor of debt financing, which results from allowing businesses, when they calculate their taxes, to deduct from their income the interest they pay to creditors but not the dividends they pay to shareholders.

It’s clear to us that whoever added this idea to the list likely had no clue what they were proposing, but it’s also in indication of just how desperate some in Congress are for revenue that they would even list something like this.

Forcing 7 million businesses into the double corporate tax is simply bad policy. It moves the tax code in exactly the wrong direction – we should be reducing the double tax, not increasing it. That’s the way to reduce the cost of capital and make American businesses more competitive.

Fiscal (Slope) Cliff Forecast

While everyone in Washington waits for Tuesday’s election results, this story in The Hill caught our eye: “Fiscal cliff already weighing on economy.” According to the story:

While the expiring tax cuts and automatic spending cuts that make up the cliff do not take effect until the beginning of 2013, Pawlenty said he is hearing from financial firms that businesses are already halting business activity because they are not sure what will happen.

For example, 61 percent of JPMorgan’s U.S. clients are altering their hiring plans because of the cliff, and 42 percent of fund managers for Bank of America identify it as their greatest investment risk.

That’s consistent with what our S-CORP members are telling us. Faced with higher tax rates, uncertain health insurance prospects, and lagging employment growth, the S corporations we hear from are choosing to forego hiring and investment decisions until they feel more confident about the future of public policy and the economy.

This suggests the so-called fiscal cliff is more of a downward slope, and we’re already on it. Employers are holding back, which is suppressing investment and hiring decisions right now, and that’s reflected in the less-than-stellar jobs and GDP numbers we’ve been seeing for the past six months.

That also means that any signal that Congress is prepared to address the cliff and block these tax hikes would help the economy immediately– not just after January 1st.

So, what’s at stake for S corporations? Here’s a short list:

Tax Rates: The best case is that current rates are extended for 2013. The worst case is total gridlock in Congress and rates rise to their pre-2001 levels and beyond. (Beyond because of the tax hikes included in health care reform). Here’s a table summarizing the options:

Top Rates

Worst Case

Best Case

Wage & Salary

44.7%

37.9%

Cap Gains

23.8%

15.0%

Dividends

44.7%

15.0%

Interest

44.7%

35.0%

S Corp Income

44.7%

35.0%

Keep in mind, the best case scenario includes both extending current rates and repealing the new 3.8 percent investment tax imposed under Obamacare. Not impossible if Romney wins and Republicans take the Senate, but not easy either.

AMT: One of the findings in our E&Y study released this summer was the significant number of pass-through owners who pay the AMT. According to E&Y, of the 2.1 million business owners who earn more the $200,000 annually, 900,000 pay the top two tax rates, while 1.2 million pay the AMT. This suggests that the expiration of the so-called AMT patch last year may have more impact on pass-through business owners than the expiration of the lower rates. Treasury estimates that 30 million additional taxpayers will be pulled into the AMT April 15th under the current rules (if the AMT patch remains expired). The findings of E&Y suggest many of those taxpayers are business owners. Business owners most at risk are those with dependent children and those living in high-tax states like New York and California.

Extenders: Congress has gotten into a [bad] habit of ignoring the expiration of all those tax provisions falling under the title of ’extenders’ — the R&E tax credit, the state and local tax deduction, the shorter built-in gains holding period, etc. The Senate Finance Committee has passed a package of extensions, but the House has yet to act. If and how these important issues are addressed during the lame duck are still to be determined, and unfortunately seem to have taken a backseat to dealing with the “must-do” broader 2001/2003 extenders that are set to expire at year’s end.

Those are the tax provisions directly impacting the S corporation community. Couple them with the spending cuts scheduled to begin January 1st, and the total makes up the $700-plus billion fiscal cliff.

What might happen?

Our friends at International Strategy & Investment in the past suggested that the choice before Congress is not “all or nothing” and we agree. Rather than be constrained by the idea that we will either fall off the cliff or step back entirely, our view is that Congress will take a half-step back, avoiding the most damaging pieces of the cliff while allowing others to take effect. Here’s a list with those cliff provisions most likely to be avoided starting at the top:

More Likely

  • AMT
  • Middle-Class Tax Relief
  • Sequestration
  • Doc Fix
  • Tax Extenders
  • Extended UI Benefits
  • Upper Income Tax Relief
  • Health Care Reform Tax Hikes
  • Discretionary Spending

Less Likely

We’ve highlighted the tax rates on upper income taxpayers, including S corporations, since their extension depends almost entirely on who wins the White House. The odds they get extended is close to zero under President Obama, and perhaps 50-50 under a new Romney Administration. Romney has made clear he will push for them, as has the House — it’s the Democrats in the Senate that are the wild card. As for the rest of the provisions, there may be some movement based on the elections, but not much.

In addition to the policies, there’s a question of timing. The general notion is that any deal on the fiscal cliff must occur before the end of 2012, but several of the provisions listed above could just as easily be dealt with in the first few weeks of 2013 with little additional harm to the economy, particularly if Congress and the incoming Administration effectively signaled what they had in mind. Moreover, with only a few weeks between the elections and the holidays, there may simply be insufficient time for the differing parties to come together.

But that doesn’t mean it’s okay to wait. Action immediately after the election to address the entire fiscal cliff — including the top tax rates — would help improve people’s lives now through increased hiring and increased business investment. Congress should act, and act quickly.

But will they? Not if their recent behavior, particularly in the Senate, is any indication. So our best pre-election guess is that Congress will act eventually, but only at the last minute, and that most of the fiscal cliff will be averted either prior to the end of the year or shortly thereafter.

New Ernst & Young Study on Top Rates

oday, the S Corporation Association released a new study by Ernst & Young focused on the rate debate in Congress and its impact on job creation and business investment.

According to the study, allowing the top rates on individual, business, and investment income to rise starting next year would, over time, result in fewer jobs, lower wages, and less investment. Key documents include:

Authored by Dr. Robert Carroll and Gerald Prante of Ernst & Young, the study examines the economic impact of the higher tax rates at the heart of the rate debate in Washington right now:

  • The top two rates on individual and flow-through income;
  • Tax rates on capital gains, dividend, and interest income earned by taxpayers making more than $250,000;
  • The reinstatement of the phase-out of itemized deductions (Pease); and
  • The addition of the new 3.8 percent tax on investment income.

The study points out that this policy would raise the top tax rate on S corporation and other flow-through income from 35 percent to nearly 45 percent. As a result, the marginal effective tax rate on new business investment would be more than 15 percent higher than it is today, discouraging businesses from investing in new plant and equipment and resulting, overtime, in fewer jobs and lower wages. As the study concludes:

Through lower after-tax rewards to work, the higher tax rates on wages reduce work effort and labor force participation. The higher tax rates on capital gains and dividend increase the cost of equity capital, which discourages savings and reduces investment. Capital investment falls, which reduces labor productivity and means lower output and living standards in the long-run.

  • Output in the long-run would fall by 1.3%, or $200 billion, in today‘s economy.
  • Employment in the long-run would fall by 0.5% or, roughly 710,000 fewer jobs, in today‘s economy.
  • Capital stock and investment in the long-run would fall by 1.4% and 2.4%, respectively.
  • Real after-tax wages would fall by 1.8%, reflecting a decline in workers‘ living standards relative to what would have occurred otherwise.

These results suggest real long-run economic consequences for allowing the top two ordinary tax rates and investment tax rates to rise in 2013. This policy path can be expected to reduce long-run output, investment and net worth.

For the past year, the S Corporation Association has partnered with NFI, the US Chamber, and other business groups to highlight the challenge the pending Fiscal Cliff poses for pass-through businesses and their employees. This study builds on the 2011 Ernst & Young study which found that pass-through businesses are the majority employer in the United States, providing 54 percent of private sector employment.

Larger pass-through businesses contributed significantly to this employment level, employing approximately one out of six private sector workers. Meanwhile, a recent CRS report found that the five industries most affected by raising taxes on large S corporations (those with more than $10 million in revenues) were manufacturing, wholesale and retail, mining, transportation, and construction. Those are the industries most at risk if rates rise starting next year.

Moving forward, the S Corporation Association plans to take this new study and related materials up to Congress to continue to educate policymakers on the important role pass- through businesses play in job creation and investment. The Congressional Budget Office predicts that failure to address the Fiscal Cliff will send the economy into recession in the short term. The new Ernst & Young study shows that failure to stop just the top rates from rising has the potential to cause long term harm as well. It’s an important contribution to the on-going debate, and we’re going to make sure it’s heard.

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