You have to feel for the House tax writers. They spent months putting together a plan to reform the tax code and now all anybody wants to talk about is Brexit and Section 385. That’s too bad, because the plan outline released last week is pretty good.
You can read the whole outline here, plus there’s been lots of discussion among the tax experts on how it would help to simplify tax collections while encouraging more business investment and job creation:
- Tax Foundation: “Details of the House GOP Tax Plan”
- Tax Policy Center: “Ryan Proposes Big Tax Cuts for Business and Investors, Moves Towards a Cash Flow Tax”
- Deloitte: “House GOP tax reform blueprint proposes across-the-board rate cuts, move to territorial tax system”
- Forbes: “House GOP Tax Plan Combines Pro-Growth and Pro-Family Elements in Common Sense Package”
From the S-Corp perspective, the headline is the plan would make progress on all three of the key “pass-through principles” we’ve been championing since 2011 – that is, it takes a comprehensive approach to reform, it reduces both the corporate and pass-through rates to more reasonable and similar levels, and it makes progress on reducing the harmful double tax imposed on corporations. It also gets rid of the dreaded estate tax, which hits private companies much more acutely than publicly-owned ones.
And while some folks are concerned about the fact that the initial tax on C corporation income is 20 percent while the pass-through tax rate is 25, the simple fact is that the tax imposed on successful S corporations and partnerships will be almost 20 points lower under this plan than it is under current law. That’s a huge rate cut and one that would be welcomed by S corporations across the country. As Tax Notes reported yesterday:
At the briefing, House Republican taxwriters insisted that their plan offers parity for the various types of businesses, with a 25 percent rate for small business and passthrough income and a 20 percent rate for C corporation income.
Double taxation on corporations’ paid dividends accounts for their lower rate under the plan, Nunes said.
“It’s not based on small or large. It’s based on how you’re legally set up. I could be a one-man C-corp and get a 20 percent rate,” Nunes said. “Because of the double taxation on C-corp is why it’s necessary to have a little lower rate than the individual. But any company can create an LLC or C-corp no matter what size you are.” The blueprint labels the two rates as applying to “small businesses” and “large businesses,” respectively.
Brady emphasized that the GOP plan’s rate for small businesses is a dramatic drop from the current tax structure.
“Don’t let that myth continue. You know right now that our passthroughs are paying the top rate of 44.6 percent as individuals, not just 39.6 percent. That’s the dramatic cut to 25 percent,” Brady said.
Regarding next steps, the Committee views this white paper as a discussion draft and is soliciting comments from stakeholders. We like the broad parameters outlined last week, but there are lots of details that go unexplored. For example, the 25 percent rate on pass-through businesses is structured as a rate cap rather than a separate tax rate schedule. That approach may work similar to a top rate in principle, but in practice it seems to be susceptible to being limited either by size or by industry (see our comments on the Buchanan bill). The authors of this plan need to resist the temptation to limit the pass-through rate in any way, and treat it just the same as the top rate on corporations.
We intend to comment further on this and other key aspects of the blueprint. There’s lots here to like, and much more that needs to be clarified. Our goal will be to ensure that the plan continues to be something Main Street can support as it moves through the process.
House R’s and D’s Weigh In on 385
Speaking of Section 385, in separate letters to Treasury Democrats and Republicans on the Ways and Means Committee have communicated their respective concerns about the pending regulations.
First, eleven Ways and Means Democrats sent a letter to Secretary Lew last week that applauded his agency’s efforts to crack down on inversions and base erosion practices, but also raised concerns that the proposed regulations implementing Section 385 go too far:
However, there may be a number of unforeseen circumstances in which the regulations could adversely affect ordinary course business transactions between related parties in the absence of tax avoidance motives. It has been raised that certain business sectors, including financial services, insurance, and utilities, may encounter industry-specific challenges to implementing these regulations due to various regulatory requirements unique to those industries. We also have been informed that there are broader concerns related to various internal cash management practices, such as cash pooling, and appreciate that Treasury is continuing to examine the effect of the proposed regulations on those practices. For these and other limited circumstances, we ask that you give careful consideration to whether exceptions or special rules, including transition rules, are appropriate.
Next, all the Republicans on the Committee signed a letter to Secretary Lew today that takes a much more aggressive and critical tone regarding the rule. As the letter notes:
We believe any finalization of the proposed regulations in present form will have a profound and detrimental impact on business operations nationwide. If not significantly altered, they will undoubtedly reduce overall investment and economic activity to the detriment of the United States and its business community. Since the release of these proposed 385 regulations, strong concerns have been raised with our offices by constituent companies and business groups representing every economic sector and industry in the United States. …
Furthermore, the proposed regulations represent a dramatic departure from current policy and practice, overturning more than a half century of well-established jurisprudence based upon analysis of an instrument’s actual substance … the proposed regulations are broadly applicable to a wide array of ordinary business transactions, creating unacceptably high levels of uncertainty and adverse collateral consequences for non-tax motivated business activity.
So, in addition to the broad concerns raised by the business community to date (here and here), we now have bipartisan concerns raised by Republicans and Democrats alike regarding the 385 rule. Let’s hope Treasury is in listening mode.
Remember the pass-through mantra for tax reform? All business income should be taxed once, it should be taxed at the same top rate, and then we should leave it alone! Well, that mantra was on display Tuesday when a panel of tax experts explored the benefits and costs of corporate integration. Here’s Dr. Michael Graetz:
“In the 1990s, principally because of its administrative advantages, the Treasury Department recommended taxing business income once—at the business level. This form of integration was advanced by President George W. Bush in 2003, but Congress instead simply lowered shareholders’ income tax rates on dividends. That approach is no longer apt today. Locating the income tax at the shareholder level would be more progressive and, given the mobility of business capital and operations, makes much more sense in today’s global economy.”
And Prof. Bret Wells:
“From a tax policy perspective, I think this committee needs to say ‘we need to preserve one level of efficient tax on active business income.’ Having that taxed at the shareholder level assures individual progressivity. That’s a wonderful goal. And if we take the distortions out of who the owner is, whether that’s a foreign-based multinational, or a pension, or others, that creates the tax symmetry that I think the system needs…Corporate integration absolutely is the vehicle to get us there. Whether it is the dividends-paid deduction regime, or other forms of integration. But I think it is absolutely a wonderful first step.”
Amen to that. But corporate integration is not just about reducing layers of tax – it’s also about restoring economic efficiency. The current corporate code distorts decision-making, hurts job creation, and limits investment. Again, here’s Prof. Wells:
“By having a corporate integration regime, the company would get a deduction currently and there would be an offsetting withholding tax, and that would ensure that the company makes the most efficient decision as to what to do with that income. There would not be a double-tax cost. The decision of what to distribute to shareholders or to invest in the business would be solely one based upon the right economics for that company.”
The hearing also did an excellent job of highlighting some of the political challenges of integration, including the loss of relative tax benefits for 401k’s, charities, and insurance products. Not that the tax on those entities goes up under integration – it remains unchanged. The tax on investments they compete with, however, will be reduced, so they could lose some of their comparative advantage. This is a key political challenge the Committee will have to overcome if they are going to move forward on integration. Here, Mr. Wells again did a great job of framing the argument:
“From my perspective, this is not a disadvantage to anyone. When you take a distortion away from a group of taxable shareholders, and you make them not suffer a double tax, then those that are benefited because the other person is suffering a double tax—an inefficient tax system—could say ‘that’s a relative disadvantage to me.’ But what I think this committee ought to understand, and what I think the corporate inversion phenomenon is getting us to understand, is if we allow one group the opportunity to erode the corporate tax base as a subsidy, whether that’s an inbound earnings stripping advantage, whether it’s that particular technique, then what’s going to be the result of that is that they will be the source of market inefficiency going forward.”
So there you have it – at a hearing on corporate integration, two of the key witnesses repeated the refrain the Main Street Business community has been singing for five years — tax business income once, tax it at reasonable rates, and then leave it alone! That’s the reason we cheer corporate integration efforts and look forward to reviewing the details of the Finance Committee plan when they are released.
Tax Policy Center: Only About One Quarter of C Corp Stock is Owned by Taxable Shareholders
Last fall, we reviewed two studies from Treasury and CRS on the effective tax rates of different business entities. The full reviews can be read here and here, but one of our key observations was how wildly different the estimates for how much the second layer of tax on corporate income adds to effective tax burdens.
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.
Seems like a disagreement that large might be worth more study, no? Now the Tax Policy Center has released a paper that does just that. One of the keys to identifying the second layer of tax is estimating the percentage of corporate shareholders who are taxable. This week, writing in Tax Notes, Steven Rosenthal and Lydia Austin suggest that past estimations have vastly overstated that percentage:
After adjusting the data in several important respects, we estimated that taxable accounts held only 24.2 percent of C corporation equity in taxable accounts in 2015. Our exercise revealed that the share of U.S. stocks held by taxable accounts declined sharply over the last 50 years, by more than two-thirds.
As they explain, past estimates of the percentage of taxable C corp shareholders—including Treasury’s paper from last fall, which used a 2004 paper from James Poterba to determine the second layer of tax—used as much as twice this amount.
The Fed reported that in 2015, households directly owned 37.3 percent of corporate equity. Households owned another 13 percent indirectly through mutual funds (and more through ETFs and CEFs). In total, the Fed reported that households owned more than 50.3 percent of the value of outstanding U.S. stock.
The economics literature generally uses the Fed’s figures for household ownership, including both direct and indirect holdings, as a measure of equities held in taxable accounts. James M. Poterba added stock owned directly by the household sector with stock beneficially held through mutual funds — and estimated that the taxable household share of corporate equity was 57.2 percent in 2003. In so doing, Poterba counted stock owned by IRAs and nonprofits in his taxable sector.
If Treasury is doubling the amount of taxable shareholders in C corps, it stands to reason that they are also doubling the effective tax that second layer imposes on corporations. So their estimates would be off by at least a factor of two. That’s a huge discrepancy, and one that Treasury and others should thoroughly address when weighing in on business tax reform.
For five years, the S Corporation Association and its allies have asked tax writers to pursue business tax reform that taxes all business income just once and at the same, reasonable top rates. That’s the correct way to tax business income and more than 100 trade groups, including the largest trade groups in the country representing millions of employers, have signed on to this premise.
And for five years, we’ve watched as the tax code moved in exactly the opposite direction.
Instead of preserving rate parity, the combination of the Fiscal Cliff and the implementation of the Affordable Care Act resulted in pass through businesses paying at a top rate nearly 10 percentage points higher than C corporations. Instead of reducing the double corporate tax, President Obama signed into law new polices that raised shareholder taxes dramatically. The result is that the effective marginal tax on business investment today is significantly higher than it was just a few years ago.
No wonder companies and capital are fleeing the United States.
In recent months, however, we have seen signs of hope. First, Finance Chair Orrin Hatch (R-UT) announced he was working on a plan to eliminate the double corporate tax. His plan isn’t due out until June so we haven’t seen the details, but the fact that the Chairman and his staff are spending time and resources pursing policies to create a single layer business tax is promising. A properly constructed integration plan has the potential to address many of the ills the business community faces.
And just this week, Congressman Vern Buchanan (R-FL) introduced legislation on the issue of rate parity. Entitled the Main Street Fairness Act, the bill would cap the top pass through business tax rate at the top corporate rate. Under the Buchanan bill, the same 35 percent top rate that applies to corporate income would also apply to successful pass through businesses. If Congress reduces the corporate rate next year, pass through businesses would get the new lower rate too.
Groups weighing in on the Buchanan bill include the National Association of Manufacturers, the National Retail Federation, and the Associated Builders and Contractors. You can read more about the Buchanan bill here. You can read the S Corporation Association letter on the bill here.
We would like to see the Buchanan bill expanded to apply to all active pass through income, and Congress still needs to repeal the 3.8 percent Affordable Care Act tax that applies to some S corporations and other businesses. We don’t want those concerns, however, to detract from the fact that of the three core Main Street Business principles we outlined five years ago – tax reform should be comprehensive, restore rate parity, and end the double tax — two of those principles are being actively pursued by senior members of the tax writing committees.
That’s a positive sign, and something we plan to build upon in the coming months.