March 24, 2017 by admin ·
Good news! The 2017 version of the “S Corporation Modernization Act” has been introduced the House and the Senate. Led by Senators Thune (R-SD) and Cardin (D-MD) and Representatives Reichert (R-WA) and Kind (D-WI), the bill calls for needed updates to the rules governing S corporations, some of which date back over 50 years!
- You can see the entire bill here
- You can see the section-by-section analysis here
- You can see the S-Corp press release here
- You can see the Thune/Cardin release here
Today’s introduction comes at a critical juncture in the legislative calendar. The House of Representatives is pulling all the stops to vote on their health care reform package this week, with a showdown vote planned for this afternoon. Whether it passes or not, we expect the House to shift its attention to taxes and the House Blueprint tax reform package.
Which is where our S Corporation Modernization bill comes in. As S-Corp readers know, key provisions from past S Corporation Modernization Acts have moved through Congress and been signed into law, most recently the shorter 5-year recognition period for built-in gains, which was made permanent just over a year ago. Our hope is that large tax bill like that contemplated in the House would have enough room to accommodate all the provisions of this year’s S Corp Mod bill. Key changes in this version relative to past efforts include:
- Moving the Nonresident Alien provision up to the top slot – it is time for direct foreign investment to be available to S corporations; and
- Including the new internal basis adjustment provision to ensure that S corporation assets receive similar treatment as partnerships.
As in the past, Senators Thune and Cardin and Representatives Reichert and Kind are championing the cause. All four members do a great job representing Main Street on the Finance and Ways and Means committees, so America’s 4.7 million S corporations couldn’t have a stronger team of advocates. We really appreciate the hard work the members and their staffs put in to get the provisions just right.
The legislative outlook remains hopeful and we’ll be working closely with our legislative champions to ensure that if a big tax bill moves this year, these provisions will be part of it.
March 17, 2017 by admin ·
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.
January 26, 2017 by admin ·
The Tax Foundation published its annual piece on pass through businesses this week, and as usual, there’s lots of great material in there. To begin, the Foundation updates its numbers on pass through employment and marginal tax rates. As in past years, pass through businesses employ the majority of private sector workers even though they face marginal tax rates that often exceed 50 percent! Talk about shooting yourself in the foot, economically speaking.
Robert Samuelson at the Washington Post noticed. In an op-ed last week, he highlighted some of the key metrics found in the Foundation’s report:
“Here are some of the key findings in the report:
- More than 90 percent of businesses in America are pass-through enterprises. In 2014, that was 28.3 million out of 30.8 million business establishments.
- Pass-through firms account for more than half of U.S. private-sector employment. In 2014, the number of workers at these firms totaled 73 million, compared with 54 million at C corporations.
- The total profits of pass-through firms have surpassed the profits of C corporations. In 2012, the net income was $1.6 trillion for pass-through firms and $1.1 trillion for C corporations.”
The employment figure in particular is worth emphasizing. Back in 2011, EY estimated that pass through businesses employed 54 percent of the private sector workforce. According to the Tax Foundation, that number rose to 57 percent by 2014. That’s a big jump in just three years.
The Tax Foundation report makes clear that far from being second-class citizens, pass through businesses are the dominant business structure and they are clearly the way all businesses should be taxed in the future. Here’s a nice paragraph on how pass through tax treatment should be the model for tax policy moving forward.
Proponents of [forcing large S corporations into the C corporation tax] argue that some pass-through businesses are just as large and economically significant as C corporations, and that there is little justification for creating two separate tax regimes for similar types of businesses. There is merit to this line of argument, but instead of forcing pass-throughs into the problematic double tax regime faced by C corporations, lawmakers should work to improve the C corporate tax regime, to move it closer to a single layer of tax at the same rates that apply to wages and salaries. In short, the tax code should treat C corporations more like pass-through businesses, not the other way around.
Tax it once, tax it when it’s earned, tax it at the same reasonable, low rate, and then leave it alone! We’re glad the Tax Foundation agrees.
One concern is how the Foundation continues to miss headline material right in front of them. Years ago, they did a piece on the “erosion of the corporate tax base” since 1986 that wholly ignored the fact that their numbers showed the “business tax base” (pass throughs and C corporations combined) had actually grown over that time. That statistic has become one of our principle talking points for tax reform, and we source the Tax Foundation when we use it, even though they never spelled it out.
This year’s report offers a similar opportunity for acknowledging that the glass is half-full. Consider this chart on business income.
You can see how pass through businesses have consistently earned more than C corporations in recent years. This chart fits with the Foundation’s past focus on the corporate tax base and its decline.
But think about a different chart – a better, more informative chart using the same data. One that compares business income subject to a single layer of tax versus business income subject to two layers of tax. As we know, pass throughs pay a single layer of tax on their income when they earn it, so the income represented in the blue line falls into that category.
But we also know that most – 75 percent! – of C corporation shareholders are tax-exempt or tax-deferred. They are pension funds, charities, foreign shareholders and retirement accounts. So upwards of 3/4s of the green line is actually taxed once, too. In order to measure how much business income avoids the double corporate tax, you should take three-quarters of the green line and add it to the blue line. Here are the new numbers:
So there you have it. The business community has voted with its feet for single-layer taxation, and it wasn’t close. It was a landslide of historic proportions – 9 to one!
You can quibble that not all tax-deferred shareholder income escapes the second layer of tax, but that misses the point. Single-layer taxation is the new norm for US companies. Any analysis of business taxation should begin with that premise. The double corporate tax is still harmful to jobs and investment, but only because companies and investors take such great pains to avoid it. The “classic” corporate tax structure is no longer the base case, which means we need to transition to a new way of examining business taxation that reflects the underlying reality of how businesses are taxed today.