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.
The idea that corporate-only tax reform isn’t so bad because Main Street businesses can elect C corporation status has been argued for years. But should Congress reduce the corporate tax rate with the expectation that pass-through businesses will just switch to C status to access the lower rates? The answer is no. Here are the main points:
It’s the opposite of tax reform. The corporate-only approach to tax reform is effectively “anti-tax reform.” It will return us to the pre-1986 era, when corporate tax rates were significantly lower than individual rates and tax gaming and income sheltering were rampant.
It increases the negative effect of the double corporate tax. Everyone agrees the double corporate tax hurts investment and job creation. Forcing pass-through businesses (who employ the majority of private sector workers) into the double tax would make it worse.
It penalizes business owners when they sell their business. For many business owners, the sale of their business is their retirement plan. The tax code recognizes this by taxing any gain from the sale of a pass-through business at the capital gains rate of 24 percent. On the other hand, any gain from the sale of a closely-held C corporation is taxed twice at a combined rate of over 50 percent! This double tax punishes entrepreneurs who have spent a lifetime building their business.
1. Corporate-Only = Anti-Tax Reform
S-Corp Advisor Tom Nichols hit this point in his testimony before the Ways and Means Committee in 2013:
When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent. This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher.
This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations. Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.
Efforts to lower the corporate rates while holding steady individual and pass-through rates should be deemed “anti-tax reform.” They will return us to the world Tom describes above, effectively reversing the broad changes made by Congress in 1986 and creating a tremendous incentive for taxpayers to organize their income to take advantage of the lower corporate rates and then shelter that income from additional tax.
2. The Double Tax is the Problem
Any tax reform worth the name would seek to reduce or eliminate the double corporate tax by integrating the corporate tax code with the individual tax code.
Here’s what EY had to say about the double corporate tax in the study they did for us back in 2011:
In addition, the flow-through form helps mitigate the economically harmful effects of the double tax on corporate profits, in which the higher cost of capital from double taxation discourages investment and thus economic growth and job creation. Moreover, double taxation of the return to saving and investment embodied in the income tax system leads to a bias in firms’ financing decisions between the use of debt and equity and distorts the allocation of capital within the economy. As tax reform progresses, it is important to understand and consider all of these issues with an eye towards bringing about the tax reform that is most conducive to increased growth and job creation throughout the entire economy.
By forcing pass-through businesses into the corporate tax while increasing tax rates on shareholders, the tax reform envisioned by the Obama Administration moves in the opposite direction and will hurt job creation and investment. Under the Obama Administration’s plan:
The top marginal rate for pass-through businesses remains at 44 percent;
The corporate rate drops to 28 percent;
The tax on dividends increases to 28 percent; and
All these rates apply to a broader base of income.
Today, shareholders of an S corporation making $100 pay a top tax of $44 regardless of whether the income is distributed to shareholders or retained by the business. How would the Obama proposal affect that company?
Under the Obama plan, S corporation income would still pay a top marginal rate of 44 percent, only on a broader base of income. The taxes on pass-through businesses would go up.
Meanwhile, the Administration would cut the corporate tax rate to 28 percent while raising the dividend rate to 28 percent, so a C corporation would pay an initial tax of $28 plus another $20 for any dividends paid to taxable shareholders. These rates would apply to a broader base of income too, so it’s difficult to say whether any particular corporation would end up paying more or less tax under the Obama plan.
Under these rules, an S corporation could convert to C and reduce its initial tax bite from $44 to $28. It would then face a choice: Either retain its income at the firm and avoid the second layer of tax, or pay out a dividend and trigger another $20 in taxes (28 percent of $72) for a total tax hit of $48. Again, this combined rate would apply to a broader base of income.
In other words, the only way the S corporation lowers its tax burden by converting to C is if it then stops any dividend payments and keeps the income within the corporate structure. Tax reform should seek to reduce this type of distortionary incentive, not increase it. The double tax on corporations makes US businesses less attractive to investors and less competitive in the world marketplace. Forcing more businesses into the harmful double tax simply makes no sense.
3. Double Tax Applies to Business Sales
The “they can just convert” argument also ignores the penalty that closely-held C corporations face when they are sold. Closely-held C corporations currently face a combined federal tax rate of more than 50 percent when they are sold, versus just 24 percent for the sale of the business by an S corporation. Under the Obama approach of lower corporate rates but higher capital gains rates, the effective tax would be 48 percent.
This double tax makes switching to C corporation status a non-starter for entrepreneurs who might want to sell their business someday. Many business sales are tied to the retirement of the owner, where the proceeds are used to fund his or her retirement, so rates that high are a threat to their retirement security. It’s different for publicly held C corporations. Individual stockholders can sell their stock at any time, often at higher multiples as the stock of a public company enjoys a more liquid market.
So arguing that pass-through businesses can “just convert” simply is not credible. Some businesses might be in a position to switch to C status, but there are higher taxes waiting on the other side, along with unproductive tax complexity that does nothing to enhance business productivity. Given that pass-through businesses employ more than half the private sector workforce, how does any of this make sense? More broadly, how does forcing more companies into the inefficient and investment-stifling double tax model make America’s companies more competitive? Sounds like a plan to do the exact opposite.