It’s been a busy and productive week for team S-Corp! First, we had two S-Corp representatives testifying before congressional committees on Wednesday. Second, with the Finance Committee working group comments due on April 15th, we made three separate submissions to the Business, Individual, and International working groups. And finally, as part of the working group submissions, we released the 2015 version of our “Pass Through” tax reform principles letter with 118 trade groups signing on!
Here’s a quick summary of each of these efforts.
In an S-Corp first, we had two witnesses testifying at congressional hearings on Tax Day.
Board Member Dan McGregor testified before the House Small Business Committee Wednesday morning in a hearing entitled “Tax Reform: Ensuring that Main Street Isn’t Left Behind.” Dan is chairman of the McGregor Metal Working companies based in Springfield, Ohio. They engage in metal forming for the auto, agriculture, and locomotive industries and employ about 375 people.
Before the fiscal cliff (2012), McGregor’s effective tax rate was 34 percent. You should watch Dan’s testimony to get the full story on how important the S corporation structure is to family businesses like his, but if you don’t have time, here’s the headline:
After the cliff (2013), their rate rose to 42 percent.
Under corporate only, where Dan could likely lose LIFO, section 199, and the R&E tax credit, his effect rate would rise to 47 percent.
There may be a policy other than lower rates that would reduce Dan’s effective rate from 47 percent to something in line with what C corporations would pay under a 25 percent corporate rate, but we don’t know what it is and after years of trying, the policymakers pushing corporate only reform have failed to produce it. If you’re wondering what the pass through community’s angst over corporate only reform is, it’s illustrated above in three easy-to-understand numbers.
Next up for S-Corp was Brian Reardon, who testified before the Joint Economic Committee that afternoon in a hearing labeled “Small Business, Big Taxes: Are Taxes Holding Back Small Business Growth?”
You can watch Brian’s entire testimony here. His written testimony focused on the key advocacy messages we’ve been using over the past four years to ensure that S corporations are a full partner in any tax reform considered by Congress, including the “Pass Through Principles” endorsed by 118 business trade groups just last week (see below).
Finance Working Group Comments
Earlier this year, Finance Chairman Hatch announced he would form five working groups to explore the various aspects of tax reform, with a goal of these committees reporting back to the full committee by the end of May. Stakeholders were asked to provide their views by Tax Day – April 15th. In the end, we submitted comments to three different working groups.
Business: The business working group has been tasked with recommending reforms that would make US businesses more competitive. In our comments, we emphasize five key points
The history of the S corporation and how it has made the US economy stronger;
The fact that pass through businesses employ the majority of people and contribute the majority of income to our national economy;
The fact that tax rates on these businesses just went up sharply beginning in 2013;
The fact that S corporations pay the highest effective rate of any business structure; and
Tax reform needs to embrace the “Pass Through Principles” embraced by 118 members of the Main Street business community (see below).
International: The Hatch working groups, like the Camp and Baucus groups that preceded them, are an opportunity for S-Corp to educate policymakers on something that rarely gets significant attention – the presence and challenges of all those S corporations with significant overseas operations. The key message here is that, unlike C corporations, S corporations really don’t have the ability to defer paying US taxes on their foreign-sourced income. As with their domestic income, they pay the full tax when it is earned. For that reason, most S corp activity overseas is conducted under a branch structure, rather than as a controlled foreign corporation. It also means that any move towards territorial for C corporations needs to leave S corporations unharmed (i.e. not paying for the new territorial system since they won’t benefit).
Individual: Finally, we took the business submission and sent it into the Individual Working Group leadership too. Why did we need to send comments to both the Business and Individual Working Groups? Because while all other domestic business tax issues were included in the Business Working Group, the issue of the rates pass through businesses was delegated to the Individual Working Group. Not good if you’re concerned about reforms that reduce the corporation rate only, so we made sure to send our comments into the individual Working Group too.
118 Groups Support Pass Through Principles
Four years ago, we made policymakers aware that the pass through business community opposed “corporate only” tax reform. As our EY study made clear, corporate only meant a massive tax hike on Main Street businesses.
As part of our advocacy efforts, we went a step further and attempted to articulate what pass through businesses would support in tax reform – the three Pass Through Principles. Last week, in conjunction with our testimony and Working Group submissions, we released the 2015 update of the Pass Through Principles letter with 118 trade groups signed on, including the American Farm Bureau Federation, National Federation of Independent Business, American Council of Engineering Companies, National Beer Wholesalers Association, American Trucking Associations, Associated General Contractors, and the National Roofing Contractors Association.
This is the third iteration of these principles. In 2011, 45 groups signed on to them while in 2013 we had 72 signatories, so momentum is building for tax reform that treats Main Street Businesses as equal partners. As we’ve said many times, it’s all about the rates.
Edward Kleinbard, the former Director of the Congressional Budget Office, has a piece in Bloomberg on the prospects of corporate tax reform that makes some interesting points worth considering.
To start, he argues that Congress should pass corporate-only tax reform and pass through businesses can just convert to C corporation status and access the new lower rates. He’s made this case previously, and we address it here,
But why is corporate-only reform necessary? Well, it’s just impossible to reduce pass through rates these days:
Reducing top individual tax rates is a nonstarter. The Barack Obama administration would be adamantly opposed, and the revenue drain would be unacceptable. Many affluent individuals, after all, earn large salaries working for big companies. Lowering individual rates in the purported service of “small business” would bestow windfalls on these fortunate owners and employees.
It is true the President is unlikely to support lower rates. He has made clear he wants individuals and private businesses to pay more, not less. But supporting a tax hike is a non-starter for the Republican Congress, so that leaves us with a null set. The President won’t sign a law that doesn’t raise revenue, while Congress won’t pass a law that does.
Kleinbard’s next point is that shifting pass through businesses into the C corporation world will help stabilize the corporate code by giving multinationals more political clout:
The great fear of U.S. multinationals is that Congress will play them for fools: A few years after surrendering business tax subsidies in return for lower corporate tax rates, Congress will jack up the rates again. The best insurance against this is for the corporate-tax rolls to swell with tens of thousands of successful small- and medium-sized businesses, as found in every congressional district. They would serve as the enforcers of tax reform’s bargain.
It might be true that Main Street businesses could help defend the results of corporate-only tax reform, but those same businesses oppose being forced there in the first place. Without their support, corporate tax reform faces a really steep climb. How exactly does Congress pass a rate cut for large corporations without the support of Main Street businesses?
Finally, Kleinbard argues that reform should make the corporate rate structure more progressive by offering less profitable C corps lower rates. This sounds like a really good idea, but doesn’t the pass through structure offer that already? With pass through taxation, business income is taxed at different rates depending on the income of the business owner. High income owners pay more, and low income owners pay less.
On the other hand, C corporations are subject to an entity level tax, so there’s no certainty that progressive C corporation rates would reflect the shareholder’s income. A less profitable C corporation might pay low rates even if it’s owned by a wealthy shareholder. That’s not the result Kleinbard is seeking.
A better solution would be to preserve and grow the pass through structure. It imposes a single layer of tax on business income (good), the tax is applied when that income is earned (good), and the tax is at progressive rates that reflect the income of the shareholder or partner of the business (also good). It is simply superior to the corporate tax, and should be the starting point for any real business tax reform.
Rubio-Lee Plan Hits the Right Notes
To get an idea of what that might look like, Senators Marco Rubio (R-FL) and Mike Lee (R-UT) have proposed a tax reform plan that truly lives up to the concept of “reform.” You can read about the plan here, but the basic bits for businesses are:
Fully integrates the corporate code by eliminating taxes on capital gains and dividends;
Restores rate parity by reducing the top rate on corporate and pass through business income alike to 25 percent;
Allows for full expensing of business investment; and
Shifts the treatment of international business income from worldwide to territorial.
To get to rate parity for all businesses, the plan adopts something similar to the Grant Thornton “Business Equivalency Rate” where the top rate on pass through business income would be capped at the top corporate rate of 25 percent. Here’s how the sponsors describe the provision:
This plan eliminates double taxation for all business income. C corporations would pay a 25 percent corporate tax. Since the businesses’ income would be taxed at the entity level, dividends and capital gains on stock would not be subject to additional tax at the individual level. Shareholders would receive an annual informational statement indicating how much corporate tax had been paid on their behalf.
As under the current tax system, pass-through entities (partnerships, LLCs and S corporations) and sole proprietorships would not be subject to entity-level tax. Instead, this income would be reported as taxable income on the owners’ tax return. The maximum tax rate applicable to pass-through entity income would be 25 percent. This maximum tax rate would be statutorily linked to the tax rate on C corporations, and would be referred to as the business tax rate.
In order to prevent abusive misallocation of labor income as business income, this plan also creates strong rules that preserve current tax arrangements for partnerships and independent contractors while discouraging abusive reclassifications. We also require that reasonable compensation be paid by pass-through entities to owners that work for the business.
Why We Make These Changes:
The high tax rates faced by many pass-through entities and the double taxation of business investments are both barriers to investment. This bias against investment hurts long-term economic growth and prevents job creation. Double taxation also has other negative properties. Double taxation obscures the true burden of taxation, as rates reflect a lower tax burden than really exists. Double taxation is also inherently unfair, as individuals must pay taxes many times on the same income source. By eliminating double taxation and giving small firms access to the lower rate, we help balance the playing field between large and small firms.
It is important for the tax code to encourage investment in the United States. Our policy reforms will significantly reduce the tax incentives for businesses to participate in inversions, offshoring, profit shifting, and other activities that diminish economic activity within the borders of the United States.
By creating a single-layer of taxation while decreasing the business rate to 25%, and allowing for the full expensing of capital purchases, the United States will once again be a prime destination for business. Reforming the business tax code so that it is internationally competitive must be a top priority for policymakers.
According to our friends at the Tax Foundation, the move to lower rates, expensing, and territorial combine to help grow the economy significantly:
After modeling the plan, we find it to be indeed strongly pro-growth. As the table below shows, it would grow GDP by 15 percent by the end of the adjustment period, roughly 10 years. That means the economy would be 15 percent larger than CBO predicts under current law. As well, relative to a current law, we find the capital stock would grow by almost 50 percent, wages by almost 13 percent, hours worked by almost 3 percent, and jobs by 2.7 million.
For three years, the pass through community has argued that tax reform should be comprehensive, restore parity in the top tax rates, and seek to reduce the harmful double tax on corporate income. Over seventy business groups signed a letter making those points. The Rubio-Lee plan is one of the few efforts to hit on all three principles, and it’s a valuable addition to the discussion on the future of the tax code.
Last week was a good one for S corporations!On Friday, the House voted 272 to 142 to adopt long-time S corporation Association priorities – the built-in gains tax relief and the charitable contribution basis adjustment for S corporations as part of H.R. 636, the America’s Small Business Tax Relief Act of 2015.
These provisions were originally sponsored by Representatives Dave Reichert (R-WA) and Ron Kind (D-WI) in bills making permanent the five year built-in gains holding period (H.R. 629) and a basis adjustment to ensure S corporations are able to deduct the full value of the stock they donate to charity (H.R. 630). After being adopted by the Committee on Ways and Means, the reforms were combined with a provision to permanently increase the Section 179 expensing limitation as part of H.R. 636.
These important reforms received strong bipartisan support.All but one Republican voted for the measure, while 33 Democrats parted with their leadership and the Administration and voted yes. Ways and Means Committee Chairman Paul Ryan offered the following remarks about the passage of H.R. 636:
Small businesses need more certainty to grow, and this bill will help them plan for the future. We still have a long way to go, but I see this as a down payment on a simpler, flatter, fairer tax code. That’s what we need to build a healthy economy and create jobs. And so I want to thank my colleagues for supporting this commonsense idea.
Washington State Congressman and S-Corp ally Dave Reichert had this to say:
This bill, and the provisions I introduced with Congressman Kind, will significantly help small businesses access their capital and provide much-needed certainty, so that they can be successful and grow. S corporations are proven job creators and I am pleased that my House colleagues have recognized the need to make sure the tax code helps rather than hinders them as they support jobs and families all across this country.
Former small business owner and House Majority Leader Kevin McCarthy shared:
And the last thing a small business needs is uncertainty from their government, changes in the tax code, or even whether it’s going to go forward. So today is the day not to debate, but today is the day to invest in America’s small business. And as I’ve said a few times on this floor, these are things that should unite us, not divide us.
I think it’s time that people grow up, understand where jobs are created, understand what uncertainty does across America, not just in my district, but in every district that is represented here today.
It is unclear when the Senate may take up these provisions, particularly as Senate Finance Chairman Orrin Hatch (R-UT) is focused on comprehensive tax reform and the recently-announced tax reform working groups.So we still have a way to go before we see these important reforms signed into law.That doesn’t detract from the success of the day, however, and it certainly won’t prevent us from continuing to press these issues when we’re up on the Senate side –especially as part of any action on comprehensive tax reform!
Tax Foundation on Pass-Through Businesses
An enthusiastic group of 40-50 congressional staffers, business representatives, and tax experts braved the early morning cold last week to talk taxes – Main Street business taxes, that is.The organizers of the breakfast, held in the Rayburn House Office Building, were our friends over at the Tax Foundation.The briefing was designed to highlight their recent paper, “An Overview of Pass-through Businesses in the United States.”
Ways and Means member and Main Street Business champion Pat Tiberi (R-OH) kicked off the briefing with some important words on the importance of pass-through businesses and their contribution to jobs and investment.As the Congressman noted:
The data we are going to share today is extremely important.The facts of the matter are that we have in every single congressional district a Main Street and on every Main Street we have businesses, pass-through entities of every single type – from a hardware store, a doctor’s office, a small manufacturer – that pay tax, work hard and have a tax code that, quite frankly, isn’t fair to them… We need to continue to rally around the fact that we need a tax code that is simpler, fairer, more transparent, and that encourages investment and growth.As we do tax reform, they should not be left behind.
S-CORP Advisor Tom Nichols was on hand to provide a historical perspective to the challenge.As Tom made clear, reducing tax rates on C corporations while keeping them high on individuals and pass through businesses would be “anti-tax reform” — returning us to the pre-1986 days of sheltering and gaming. According to Tom, the 1986 tax reform helped get private companies “out of the business of tax planning and into the business of producing goods and services for their customers.”
Restoring rate parity by lowering rates on all business types while integrating the corporate with the individual tax code is the only and best way to simplify and improve business taxation.Anything else is reform in name only.
You can view the entire briefing here.For our purposes, this map showing pass-through employment levels by state is the key to our advocacy efforts moving forward.
Public policy debates on the economy always boil down to the question of jobs – where they come from and how to create more of them.The reality is that most jobs come from Main Street employers.Any policy that purports to be pro-growth and pro-job creation will need to recognize that most jobs from employers organized as S corporations, partnerships, and sole proprietorships.Those employers need to be treated as equal partners in any tax reform considered by Congress, including any rate relief.Anything else is simply not reform.