For over 15 years, the IRS has discriminated against S Corporations when it comes to estate taxes and other matters where business valuation plays a role and, for 15 years, S Corp has been fighting them on it.
Our S-Corp advisor Nancy Fannon has written extensively on the subject. In 2007, we told you about her book, The Comprehensive Guide to S Corporation Valuation, which did a great job of laying out the entire issue.
Now, Nancy has followed up with Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle. You can purchase the book here and you can register here for a special May 20th webinar workshop Nancy is hosting.
For those new to the issue, the challenge is whether the courts take taxes into account when they value S corporations as part of an estate or other legal proceeding. In many cases, the courts ignore the taxes S corporations pay, resulting in them being subject to 60 percent or higher premium over similar C corporations. As you can imagine, premiums that large have been noticed by the S corporation community.
The discrimination stems from the Gross v. Commissioner case decided in 1999 where the court ruled against “tax affecting” the projected income of the S corporation – that is, adjusting the income down to reflect taxes paid – because S corporations are not subject to the corporate tax.
The tax community will recognize that the court was effectively asserting a distinction without a difference. The lack of an entity level tax on S corporations is one of form, not substance. S corporation shareholders are required to pay tax on their business income when it is earned (just like C corporations), regardless of whether the income is distributed (just like C corporations), and often at higher rates than C corporations are subject to. This reality is lost in the Gross decision.
The effect of that decision is that, in many cases, the IRS fails to adjust the fair market value of an S corporation to reflect the business’s overall tax liability, as they do when assessing the fair market value of a C corporation. Congress should be aware of this on-going discrimination on the part of the IRS against S corporations.
S corporations pay taxes – lots of them — through their shareholders. As our 2012 Quantria made clear, the average tax burden on S corporations is actually higher than the corresponding burden on C corporations, and this tax burden should be reflected in their fair market value when they are part of an estate.
If S corporation valuation is important to you, read Nancy’s book and watch her seminar. And know that with the ongoing debate over the estate tax, S-CORP will continue to fight the good fight and ensure family-owned businesses are valued fairly.
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.