Flaws in the Tax Foundation’s Review

November 20, 2017 by · Leave a Comment 

The Tax Foundation is out with a new write-up called, “Are Pass-Through Businesses Treated Fairly Under the Senate Version of the Tax Cuts and Jobs Act?” that has a chart showing the top rate applying to S corporations in the Senate bill is 34.94 percent while the C corporation rate is 39.04 percent.  Is that correct?  No.  Not even close.

Here are the concerns we have with the Tax Foundation Write-Up:

Deferral:  The Tax Foundation analysis assumes that the full second layer of corporate tax is paid, and paid immediately.  This is simply not true.  First, there are some taxpayers who will never pay that second tax, such as tax-exempt organizations and estate beneficiaries entitled to stepped-up basis.  Second, foreign shareholders are often subject to much more favorable treaty rates.  Third, shares held by qualified plans can put off any tax liability for years, if not indefinitely.  Finally, earnings retained inside the C corporation might not be subject to tax for years.  The time value of money makes a big difference when only one category of taxpayers gets the benefit of it.

The result of these exceptions is that the second layer of tax has a very low effective rate.  A recent (badly flawed, in our view) study authored by several Treasury economists estimated the second layer added 8.9-percentage points to the corporate effective tax rate, but that appears high.  You can read our concerns with this study here and here.  A more recent CRS analysis determined that the actual effective rate for the second layer of tax was just 2.3-percentage points.  Split the difference, and you’re around six-percentage points.  Or about ten points less than the pass-through penalty in the Senate bill.

The 17.4 Percent Deduction:  The Tax Foundation acknowledges that the 17.4 percent deduction is limited to 50 percent of payroll and would not be available to all S corporations, but it makes no attempt to quantify the impact that limitation would have on marginal rates.  The reality is that many businesses with significant levels of capital and payroll will get a deduction well below 17.4 percent, which means their top rate will be higher.  Professional service S corporations above the $500,000 income threshold get no deduction at all.  Add in the effects from the loss of SALT and their top tax rate is around 47 percent in the Senate bill, not 34.94.

State and Local Income Tax Deduction:  The Tax Foundation ignores the effects of repealing the SALT income tax deduction for S corporations while preserving it for C corporations.  Preventing businesses from deducting this business expense could raise marginal rates on S corporations significantly, depending on which state they reside in.  Those in Wyoming, for example, would see no effect, while those doing business in California would see their marginal rates increased by five-percentage points.  On average, SALT repeal raises effective marginal rates by between two- and three-percentage points.

To give you an idea of just how far off the Tax Foundation is in asserting money a single top pass-through rate of 34.94 percent, here is our chart with a more comprehensive and accurate range of possible rates for non-personal services corporations who qualify for the full deduction.  Corporations who do not qualify for the full deduction would obviously pay even higher rates:

For personal services corporations, the range of possible outcomes is even higher:

Finally, there has been a renewed chorus out there of “they can just convert!”  This response ignores the reality of pass-through taxation as well as the history of the S corporation and why Congress embraced the pass-through model in the first place.

Think about it this way:  Two identical companies compete; the only difference between them is their ownership structure – one is a family-owned and closely-held S corporation, while the other is a public C corporation; otherwise, they make the same product, the employ the same people, and earn the same before-tax profits.

C Corporation under the Senate Bill:  The C corporation under the Senate bill pays just 20 cents of tax on every dollar it makes.  It could pay out the remaining 80 cents in dividends, but like many C corporations, it chooses not to, retaining the earnings within the corporate structure instead.

This has the effect of driving up its share prices and shareholders who need money can sell their shares on the public markets.  This is a very efficient way to reward shareholders.  It drains no capital from the company, the additional tax is shouldered by the shareholder, and the shareholder, not the company, chooses when to sell the stock.  Meanwhile, the company has the ability to retain the full 80 cents of after-tax profits.

S Corporation under the Senate Bill:  As an S corporation, the family business will pay a much higher initial layer of tax under the Senate bill.  Assuming this business 1) gets the full 17.4 percent deduction, 2) has a mix of active and inactive owners, and 3) is in a median tax state, it will need to pay out tax distributions of around 38 cents for every dollar it earns, nearly twice the tax applied to the C corporation.  These distributions would cover the federal tax owed by the shareholders, and they need to be paid every quarter, just like C corporation taxes.  Depending on the applicable base broadening, the tax owed by this S corporation may be larger than the tax owed under current law.  (Many S-Corp members report a tax hike under the Senate bill.)

So, the S corporation is only able to retain about 62 cents of every dollar it makes, compared to the 80 cents retained by the C corporation.  Over time, the disparity will allow the C corporation to accrue substantially more capital than the S corporation, giving it an advantage when competing over projects, strategic purchases, etc.

And what about rewarding shareholders?  There are no public markets for S corporation stock, so selling a minority stake in the business is not really an option.  Instead, the S corporation would need to make additional distributions.  These would drain additional revenue from the company, further increasing the advantage of the C corporation.

Converted S Corporation:  Finally, the S corporation could convert to access the lower 20 percent rate.  Since its ownership structure is closely-held, however, it would need to continue to pay out dividends to reward its shareholders, as there is no ready market for minority stakes in a family business even when organized as a C corporation.

Moreover, the company was recently an S corporation, so all its shareholders are likely taxable, meaning the full double tax would still apply to them.  The result is largely the same as if the business elected to remain an S corporation.  The effective tax is in the high thirties, and the only way to reward shareholders is to pay out dividends, draining additional resources from the company.

The challenge presented to S corporations by the Senate bill is exactly the reason why Congress created the S corporation back in 1958.  Public C corporations have many advantages over private companies, and those advantages will be exacerbated by the Senate bill.  Unless it is amended, the Senate bill will force many S corporations to make the difficult, and by no means costless, transition to C corporation status.  But they won’t be better off, and they will have to change how they operate.  None of this is good for investment or job creation, which was supposed to be the point of tax reform in the first place.

 

 

S-Corp Concerns with Senate Tax Reform Bill

November 11, 2017 by · Leave a Comment 

Top Line

The Framework and rhetoric leading up to its release indicated that Senate Leadership and the Finance Committee were committed to treating the millions of companies organized as pass-through businesses fairly in relation to C corporations.  The Framework explicitly called for a rate differential of five percentage points, while previous Finance Committee work focused on leveling the playing field between C corporations and pass-through businesses by eliminating the double corporate tax and moving the entire business community towards a single, reasonable level of tax on all businesses.

Unlike much of the business community, S-Corp fully supported both efforts and expressed that support publicly.

The tax bill released Thursday night falls well short of these promises and policies.  It abandons any notion of equity for pass-through businesses.  Under the plan, no successful pass-through business will receive the promised 25 percent rate or anything close to it, while the new, larger tax rate gap between pass-through businesses and C corporations will result in a migration of business activity out of the correct, single layer tax approach and into the harmful, double corporate tax.  The economy will suffer as a result – there will be fewer jobs and less investment than if pass-through businesses could continue as a viable alternative for family businesses.

The new disparity of rates between individuals and C corporations will turn the C corporation into the tax avoidance vehicle of choice for wealthy taxpayers, returning the Tax Code to the pre-1986 Tax Reform Act days when C corporation rates were sharply lower than individual rates and tax gaming within the corporate structure was rampant.

Below are specific concerns and questions we have regarding the Senate bill.  It was released late Thursday evening, so this is not a comprehensive list or review.  S-Corp will continue to work with the Committee and members of the Senate to seek improvements and restore some semblance of parity between the tax treatment of C corporations and S corporations.

Specific Concerns

Rate Differential:  The bill reduces the top rate on C corporations to 20 percent.  The bill reduces the top rate on S corporations to 38.5 percent, 18.5 points higher and 13.5 points above the promised rate in the Framework.  The bill does include a deduction for pass-through businesses, if they have sufficient employees and payroll costs, of up to 17.4 percent, bringing the effective rate on qualifying pass-through businesses down to 32 percent, or 12 points above the C corporation rate.  That is not the rate most S corporations will pay, however:

  • SALT: The bill repeals the State and Local Tax Deduction for individuals and pass-through businesses.  C corporations will continue to deduct SALT.  Depending on which state(s) an S corporation resides in, the repeal of this business expense will increase the marginal rate of S corporations by as much as 5 percentage points.  S corporations operating in California, therefore, will pay a marginal rate of 37 percent.  The average S corporation will pay a marginal rate of around 34 percent, or 14 points above the C corporation rate.
  • NIIT: Republican leadership promised to repeal the Net Investment Income Tax (NIIT) following the election of President Trump.  This tax applies to income from S corporations earned by inactive shareholders.  The failure of health care reform, coupled with the decision by leadership to not repeal the NIIT in tax reform, means marginal rates on S corporation income for inactive shareholders will be even 3.8 percentage points higher, resulting in a top marginal rate for S corporations of 40 percent or more.
  • Revenues: The reason the pass-through rate is so much higher than the C corporation rate is the Committee chose to devote relatively more revenues to reducing the corporate rate.  The JCT reports that the 20 percent corporate rate reduces revenues by $1,326 billion, whereas the pass-through deduction reduces revenues by just $460 billion, or 26 percent of the total revenue pool devoted to business rate relief.  By way of comparison, pass-through businesses employ the majority of workers and earn the majority of business income.  They represent approximately one-third of the American economy, not one-fourth.
  • Fix: The Committee should devote a proportional amount of revenue to reducing the pass-through rate as it does to reducing the C corporation rate.  At the very least, it should set as a goal maintaining the current maximum rate differential of approximately 9 percentage points between the two entity types.

Base Broadening:  The Senate bill includes extensive base broadening, much of it affecting both C corporations and S corporations.  But many of these base broadening provisions apply to pass-through businesses only, while all the base broadening will hurt S corporations more, since their marginal rate is so much higher than the C corporation rate.  The loss of a $1 deduction will cost C corporations just 20 cents, whereas it will cost an S corporation up to 40 cents or more.  Here are some of the significant base broadening provisions that will affect S corporations:

  • Loss Limitation Rules: The Senate bill includes a wholly new limitation on “excess business losses of a taxpayer other than a C corporation…”  There is little explanation as to why this provision is needed, necessary or even good policy.  It would apply to active pass-through business income (not passive income) and it raises $176 billion over ten years.  By way of background, the JCT references an existing limitation on losses by farmers who receive federal crop subsidies, yet this provision appears to have nothing to do with farms or subsidies.  When you net this extra tax against the cost of the 17.4 percent deduction, the rate relief targeted at pass-through businesses drops to $284 billion, or just one-fifth the cost of the 20 percent corporate rate.
  • SALT: The bill would repeal the State and Local Tax (SALT) deduction for individuals and pass-through businesses but not for C corporations.  As noted above, this has the effect of raising marginal rates of pass-through businesses by up to 5 percentage points, exacerbating the rate differential between S and C corporations.
  • Section 199: The bill would repeal the Section 199 deduction for production income, utilized by manufacturers and other producers.  Four out of five manufacturers are organized as pass-through businesses.  The deduction is up to 9 percent of production income, so it has the potential to reduce effective marginal tax rates by more than 3 percentage points.  While the 199 repeal applies to both C corporations and pass-through businesses, the rate disparity between C corporations and pass-through businesses means it will hit S corporations up to twice as hard.
  • Repeal of Miscellaneous Deductions: These are a series of deductions that are only limited for individuals and pass-through businesses, including indirect and miscellaneous deductions from a pass-through business and deductible investment expenses from a pass-through entity.  Preventing a partnership from deducting investment expenses can result in the partners paying taxes exceeding the returns on the investment.  Needless to say, C corporations may continue to deduct their investment expenses.
  • AMT: The Senate bill would repeal the individual Alternative Minimum Tax (AMT).  This is a large benefit to pass-through businesses, since much of their income is taxed under the AMT rather than the regular code.  The effect is muted if not fully offset, however, by the fact that the bill repeals many of the deductions restored by the AMT repeal.  For example, pass-through businesses lose the SALT when their shareholders pay the AMT.  Repealing the AMT restores their ability to deduct the SALT.  The bill then repeals the SALT, but only for individuals and pass-through businesses, not C corporations.  Combined, the base broadening in the Senate bill has the effect of turning the regular Tax Code into a new AMT, only at higher marginal rates.
  • Fix: Strike the new limitation on active pass-through business income and allow pass-through businesses to deduct SALT.

International:  The bill moves the tax code from a world-wide system to a modified territorial system (subject to the new GILTI regime).  This new territorial system is reserved for C corporations only.  S corporations and other pass-through entities are not included.  This exclusion puts S corporations with overseas operations at a distinct disadvantage.

  • Example: Under the bill, a C corporation with a CFC operating in the UK would pay the 20 percent UK corporate tax.  Assuming no further inclusions under the GILTI regime, it would be able to pay the remainder back to the US with no additional tax.  When the C corporation pays that income as a dividend to its shareholders, they would be taxed at 23.8 percent, but only those shareholders who pay taxes.  Seventy-five percent of C corporation shareholders are tax advantaged – charities, endowments, qualified plans, foreigners, etc.
  • S Corporations with branch operations in the UK would pay the 20 percent tax to the UK and then the US tax of 32-41 percent immediately (see section above) at the new pass-through tax rates. They would be allowed a Foreign Tax Credit for the taxes paid in the UK against their personal income, but this would be subject to limitations.  There would be no opportunity to defer paying the US tax.
  • Alternatively, an S corporation with a CFC would pay the 20 percent UK tax and its shareholders would be taxed at 23.8 percent on 100 percent of the dividend income when that is repatriated, regardless of whether the dividend was distributed to the shareholders. In other words, an S corporation with a CFC is treated worse than a C corporation CFC under the new territorial system.
  • IC-DISC: The bill repeals the IC-DISC.  This repeal has little effect on C corporations, as income qualifying for the new territorial system is taxed almost exactly as the IC-DISC system does now.  The foreign earnings would be subject to foreign tax, and then a single additional layer of tax at the dividend rate when dividends are paid to the shareholder.  The only difference would be that the dividends can be paid directly to the shareholder, rather than through the DISC.  Since S corporations are excluded from the new territorial system, they will be harmed by this repeal.  They lose the benefit of the DISC, but also are precluded from the benefits of territorial.
  • Fix: The Senate bill should allow S corporations with CFCs to participate in territorial.  The result would be IC-DISC-like treatment for all types of business operating overseas, with all of them having equal treatment.   An alternative fix would be to preserve the IC-DISC for pass-through businesses.

Bottom Line

If enacted as introduced, the Senate bill would result in a large migration of business activity from the pass-through tax and into the double corporate tax.  This migration would not result in better economic performance – the transition costs, the double tax imposed on a broader base of business income, and the change in behavior it would require on the part of converted family businesses will hurt economic growth, not help it.

Pass-through businesses employ the majority of workers, they earn the majority of business income, and they pay higher effective tax rates than C corporations, yet they are literally being treated as an after-thought in this legislation.

The fix is for the Senate (and the House) to pursue tax reform that balances the importance of the pass-through community with the legitimate need to reduce the C corporation rate.  S-Corp and its allies are willing and eager to work with the Committee and the full Senate to affect these changes.

House Tax Reform and S Corps, Part II

November 9, 2017 by · Leave a Comment 

The Ways and Means Committee is likely to wrap its tax reform markup today.  The bill presents many challenges to pass-through businesses that are unlikely to be fixed today.  Here are some quick hits on what we’re seeing.

Reality v. Rhetoric

We continue to hear from S corporations who believe they will get a 25 percent tax rate under this bill.  As we reported earlier this week, most businesses won’t see anything even close to the 25 percent rate.  Part of the confusion is the rhetoric coming out of Congress.  For example, here’s one description from the House:

That’s not all.  In order to ensure that small businesses continue to expand and raise wages, the Tax Cuts and Jobs Act includes a small business provision: a 25 percent cap on how much small businesses can be taxed.

That means, a small pass-through business bringing in one million dollars will not be taxed at 39.6 percent, but rather will be able to take advantage of the new small business income tax of 25 percent.

This is simply not accurate for the majority of S corporations and other pass-through businesses.  You can read the full explanation here, but the bottom line is only small minority of pass-through businesses will get the 25 percent rate.  The simple metric is:

  • Millions of professional services pass-through businesses – doctors, lawyers, accountants and other professionals – are precluded from the lower rate and would, in many cases, see a tax hike under this legislation.
  • Other pass-through business owners who are active in operating their businesses would see their profits subjected to an arbitrary 70/30 separation of wages and profits, resulting in a melded marginal rate above 35 percent, or more than 15 points above the C corporation rate. Coupled with the base broadening in the bill (including the SALT deduction repeal), some of these owners could see modest tax hikes under the mark.
  • Manufacturers and other capital-intensive industries could elect the return on capital option in the bill, applying a set rate of return (around eight percent in the current draft) to a defined measure of capital and see if they do better than the 70/30 rule. Some of our members who have run the calculation did better under this option, but none got close to the promised 25 percent rate.

So don’t be confused about the 25 percent rate – it only applies to a small minority of pass-through businesses.

S Corps & SALT

One major area of confusion was whether the repeal of the SALT deduction applies to pass-through profits.  Richard Rubin in the Wall Street Journal has an excellent piece in the WSJ on it:

There’s a bit of a mystery hanging over the House Republicans’ tax bill.

Here’s the question:  Can pass-through businesses deduct state and local taxes from their federal income?  And to what extent?

It’s clear under the House bill that individuals can’t deduct state and local income taxes and only up to $10,000 in property taxes.

It’s also clear that corporations can deduct state and local taxes as ordinary business expenses, just as they do now.

But it’s fuzzier when it comes to pass-throughs, the partnerships and S corporations that pay taxes through their owners’ individual returns and are getting a new tax regime with a 25% rate.

The reason was a mystery is that while the Committee’s descriptive language of the bill says that pass-through businesses would be able to deduct SALT on their profits, the legislative text appears to say no.

We alerted the Committee to this concern earlier this week, but apparently they rejected our fix and decided to apply the SALT deduction repeal to pass through businesses.  Here’s the letter the Chairman released today:

We have discussed the italicized language with the JCT staff, and they have confirmed that this language was in error.  We intend to correct this mistake in the Committee Report…. State and local income taxes paid by an individual owner of such business would not be deductible on the individual’s tax return.

Needless to say, C corporations will continue to be allowed to deduct SALT under the bill.

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