2704 and Family Businesses

Remember the Obama Administration’s family-business valuation rules?  They were proposed back in August and resulted in such a backlash from the family business community that Treasury received nearly 29,000 comments during the 90-day comment period.  That’s a record as best as we can tell.

So where do the rules stand now?  Here’s the latest.

Two weeks ago, President Trump signed an Executive Order calling on Treasury to review all “significant tax regulations” issued last year and 1) identify those that are burdensome, complex or exceed Treasury’s authority, 2) issue a report within 60 days listing those identified rules, and 3) issue an action plan within 150 days on what Treasury plans to do about them.  Here’s what it says:

Addressing Tax Regulatory Burdens.  (a)  In furtherance of the policy described in section 1 of this order, the Secretary of the Treasury (Secretary) shall immediately review all significant tax regulations issued by the Department of the Treasury on or after January 1, 2016, and, in consultation with the Administrator of the Office of Information and Regulatory Affairs, Office of Management and Budget, identify in an interim report to the President all such regulations that:

(i)    impose an undue financial burden on United States taxpayers;

(ii)   add undue complexity to the Federal tax laws; or

(iii)  exceed the statutory authority of the Internal Revenue Service.

This interim report shall be completed no later than 60 days from the date of this order.  In conducting the review required by this subsection, earlier determinations of whether a regulation is significant pursuant to Executive Order 12866 of September 30, 1993, as amended (Regulatory Planning and Review), shall not be controlling.

(b)  No later than 150 days from the date of this order, the Secretary shall prepare and submit a report to the President that recommends specific actions to mitigate the burden imposed by regulations identified in the interim report required under subsection (a) of this section.

The 2704 valuation rules easily fit within the EO’s description of targeted rules.  They are obviously burdensome, confusingly complex, and the case can be made that they exceed Treasury’s authority under Section 2704.  A trifecta worthy of Churchill Downs.

Meanwhile, Team Trump continues to press for full repeal of the estate tax.  As Trump’s lead at the National Economic Council Gary Cohn stated the other day:

We are going to repeal the death tax. The threat of being hit by the death tax leads small business owners and farmers in this country to waste countless hours and resources on complicated estate planning to make sure their children aren’t hit with a huge tax when they die. No one wants their children to have to sell the family business to pay an unfair tax.

So we expect 2704 to be on the target list released by Treasury in the next couple months and the action plan released later in the year.  Since the rules are merely pending and not finalized, the obvious action is for Treasury to simply withdraw them.  No action by Congress or the President is required, which makes this an easy win for the Trump Treasury team and a significant relief to the family business community across the country.  More on this to come.

 

Tax Foundation and the Kansas Straw Man

Our friends at the Tax Foundation are generally rock solid on tax policy, but they missed the mark in a recent Politico piece.  Several of their economists took a look at the situation in Kansas, where the Governor several years ago cut the pass through tax rate to zero, and applied those lessons to the pending Trump Administration proposal to cut tax rates on corporations and pass through businesses alike down to 15 percent.  According to them:

Small-business advocates have suggested that these proposals will help create tax rate parity between pass-throughs and C-corporations by taxing them at the same rate. But these arguments ignore that corporate income is taxed twice, at both the business level and the shareholder level—for a combined tax of more than 50 percent. Lowering the corporate rate and continuing to tax pass-throughs at the individual income tax would move the U.S. tax code closer to treating all income equally. Enacting a lower tax rate specifically for pass-throughs would do the opposite.

Problem is, none of this is true.  Neither the S Corporation Association nor the Parity for Main Street Employers coalition has endorsed the Trump plan, partly because we still don’t understand it and partly because it’s hard to see how the math works.

We don’t ignore the double tax on C corporations, either.  Our tax reform principles letter, signed by 120 national Main Street trade groups, has just three key principles, one of which is to eliminate the double tax on C corporations. Far from ignoring the double tax, we made its elimination one of our goals in tax reform.

And finally, that corporate tax of “more than 50 percent” belongs in the fiction section.  Yes, if you add the 35 percent corporate rate with the 23.8 percent shareholder rate, you get a combined rate that high, but very little business income is ever subject to the classic double corporate tax.  As we pointed out back in January, the Tax Foundation’s own numbers show that less than 10 percent of all business income is even potentially subject to the double tax.

So the Tax Foundation is fighting straw men.  To be sure, the Tax Foundation is not alone in raising these points.  The Tax Policy Center has published several posts on the tax rate parity issue – here and here, for example.  These papers suffer similar challenges – they ignore the economic harm of the double corporate tax, they take it on faith that C corporations pay more than pass through businesses, and they ignore the gaming opportunities C corporations will have under the new, low rate structure.

The simple fact is that the business community has largely abandoned the classic model of business taxation.  Most C corporation shareholders don’t pay taxes, most C corporations don’t pay dividends, and most business income is earned under the pass through structure.  Any reform pushing companies back into the harmful double corporate tax is a step backward, not forward.

The correct way to tackle tax reform is to tax all income once, tax it when it is earned, tax it at similar reasonable top rates, and then leave it alone.  The business community is already there and it’s time for the tax code, and our think tank friends, to catch up.

 

Treasury Nominee Disappears

What ever happened to David Kautter?  Wasn’t he going to be named to be the next head of tax policy over at Treasury?  Politico and other outlets reported that over a month ago.  Since then, nothing.  No announcements, no nominating papers, nothing.

Which is too bad, because not only does Treasury need the help, but Kautter appears to understand the importance of Main Street businesses to jobs and economic growth.  In 2014, he testified as an expert to the Small Business Committee at a hearing on “The Biggest Tax Problems Facing Small Businesses.” You can read his entire written testimony here, but his section on the need for a single layer of taxation for business is worth highlighting:

“As part of the process of broadening the tax base and lowering the corporate tax rate, I believe the time has come for Congress to consider a single tax rate schedule for all business income no matter what legal form a business uses to conduct business. Given the importance of small businesses to our economy, it makes little sense that income earned by unincorporated businesses (which tend to be small businesses) is subject to tax at the higher individual rates while income earned by corporations is taxed at lower corporate rates.”

He concludes with this:

“In short, what is needed is “business tax reform” not simply corporate tax reform. A single business rate schedule would move us toward a more comprehensive system of business taxation – one that applies to all businesses equally across the board. If done right, it could ease the tax burden of small businesses while increasing simplicity and fairness. And ultimately, that could provide small businesses with some of the relief they need in order to compete and thrive.”

Couldn’t have said it better ourselves.  Now if we could just find him.

Trump To Weigh In On Taxes

So what do we know about the Administration’s tax announcement scheduled for tomorrow?  First, we expect the announcement will be limited to principles and a couple key proposals – not a full blown tax reform plan.

Second, the emphasis appears to be on cutting tax rates.  We expect something similar to the Trump campaign’s proposal setting the top rates at 33 percent for families and 15 percent for businesses.

Finally, there is likely to be a call for territorial tax treatment coupled with some commentary on the need for leveling the international tax playing field.  We could see the term “reciprocal taxes” used again but, as in the past, it’s unlikely to be fully spelled-out what that means – some sort of tariff or the border adjustment provision the House is pushing.

For S corporations and the pass through business community, the good news, as reported in the Wall Street Journal, is that S corporations should be eligible for the lower 15 percent rate:

President Donald Trump on Wednesday is planning to unveil a proposal to slash the top tax rate on so-called pass-through businesses, including many owner-operated companies, to 15% from 39.6%, said White House officials familiar with the planning.

We’ve been advocating “rate parity” for pass through businesses for seven years now, so assuming the Wall Street Journal is correct, it is gratifying to see the White House embrace our message.

Exactly how to enforce the new lower rate will be a hot topic.  As the Wall Street Journal notes:

Lawmakers will struggle to fit the 15% tax rate inside budgetary and procedural constraints and it will be hard for Congress to write rules that prevent people from converting higher-taxed wages into lower-taxed business profits.

Both are good points that will have to be addressed, but for now we will focus on the positive, as it appears all three of the players in tax reform – the House, Senate and White House – support the general concept of taxing all business income at the same top rate.  That’s a vast improvement compared to where we were just a couple years ago, and should be cause for optimism in the Main Street business community.

So what does it all mean for the prospects of tax reform?  It should increase the likelihood that any tax plan passed this year would be more narrowly crafted and focus on cutting tax rates as opposed to a full-blown reform.  It has been obvious since the election that President Trump prefers a straightforward rate cut approach over comprehensive reform, and we expect tomorrow’s announcement to reflect that preference.

And it signals that reform efforts may take longer than we thought earlier this year.  The case for quick action on tax policy was predicated on the White House, the House, and the Senate coming together on the broad outlines of a plan and then working that plan through the legislative process.  With the White House reverting to something resembling their campaign proposal, we are moving away from a general agreement, not towards it.

That said, both the Congress and the White House continue to work hard on tax reform, meeting on a regular basis and raising these issues consistently.  President Trump has talked about taxes more in the last few months than his predecessor did in eight years, so it’s obviously a priority.  With everything else going on, that may be tomorrow’s most important takeaway.  Where there’s a will….

Brady Plan and Pass Throughs

The Wall Street Journal featured S-Corp Board member Clarene Law last week in a story focused on the new tax rates for pass through businesses in the House tax reform plan.  As the story notes:

Clarene Law said a lower tax rate on pass-throughs would free up capital to add rooms to her hotels in Jackson, Wyo. or buy new air conditioners and washing machines.

“25% if it’s pure, not all cobbled up with a bunch of surtaxes, it would be a great benefit,” said Ms. Law, chief executive officer of Elk Country Motels Inc. Her businesses own more than 400 hotel rooms and generate revenue of more than $10 million a year, she said.

What does Clarene mean by a “pure” 25-percent rate?  The priority of the pass through community is making certain that the new, 25-percent rate is real and robust.  It should apply to all forms of active pass through business income just as the new 20-percent rate applies to all forms of active corporate income.

The concern here is twofold.  First, when Congress has considered special rates for closely-held businesses in the past, they typically have limited the application of the new rate or deduction based on industry and income.  For example, back in 2012, the House considered a special, 20-percent deduction for small business income, something you would expect the Main Street community would support.

However, the legislation included several carve-outs – various versions of it imposed limit on revenues, a cap on the number of employees, and excluded certain industries from the deduction.  In the end, most of the business community chose not to support the effort.

So for the new, 25-percent rate, how Congress defines the tax base is extremely important.  In our communications with Members of Congress, we have emphasized that the pass through tax rate base should:

  • Target active business income, rather than active shareholders.  Previous efforts to create a separate, pass through tax rate defined the tax base by looking at the shareholder, rather than the business.  That’s the wrong approach.  If a business makes income manufacturing steel, the income is the same regardless of whether the shareholder is active or passive.  The base needs to be broad, and focused on the income, not the shareholder.
  • Not be limited by industry or income.  Some early versions of a lower pass through rate would have excluded financial services companies from the lower rate.  This approach is also wrong – there is no valid policy reason to exclude pass through businesses operating in the financial services area. The tax base for the pass through rate should mimic the C corporation tax base, avoid excluding certain industries, and be as broad as possible.

The second challenge is how does Congress prevent cheating without undermining the value of the new 25-percent rate?  Under the Brady plan, the top tax rate on salaries and wages will be 33 percent, while the top rate for pass through businesses will be 25 percent.  For owners that also work at the business, there will be an incentive to allocate as much of their total income as possible as business profits rather than wages and salaries.

This is an old issue – it dates back to 1993 when Congress removed the salary cap on Medicare Payroll taxes – and we have addressed it many times in the past.  The larger rate differential in the House plan, however, raises the stakes, and lawmakers are eager to find a solution.

The challenge is how exactly do you distinguish between business income and wage income for active business owners?  Here’s the JCT on the existing rules:

A shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages, but generally is not subject to FICA tax on amounts that are not wages (such as distributions to shareholders). Nevertheless, an S corporation employee is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wages.

A significant body of case law has addressed the issue of whether amounts paid to shareholders-employees of S corporations constitute reasonable compensation and therefore are wages subject to the FICA tax, or rather are properly characterized as another type of income that is not subject to FICA tax.

In the past, S-Corp has maintained that any attempt to legislate in this area should pass a simple test – are the new rules clearer, more accurate at differentiating wages from profits, and more enforceable than the existing rules?  If not, then the new approach should be rejected.  To date, all the proposed solutions have failed this test.

So, as the Committee is working through these issues, the S Corporation Association and its allies are up on the Hill, educating members about the importance of addressing both these challenges fully and appropriately.  With lower rates, estate tax repeal, AMT repeal, expensing, and territorial on the table, the Brady bill has the potential to completely re-craft how pass through businesses pay tax, so it’s definitely worth the pass through business community’s time to help get this right.

Expect lots more on this in the coming weeks.

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