Both the Camp discussion draft and the President’s budget include provisions to expand the application of payroll taxes to S corporation income.
The White House proposal is an expanded version of efforts that failed in the Senate in 2010 and 2012, where 100 percent of income from a professional services businesses – law, accounting, consulting, etc. – organized as an S corporation, general or limited partnership, or an LLC taxed as a partnership, would be subject to SECA taxes.
The Camp provision, on the other hand, is a whole new approach that is dramatically broader than anything considered to date. It would reach beyond professional services businesses and would impact all S corporations, including manufacturers and other producers. The draft would:
- Bring S corporation business income under self-employment taxes (SECA);
- Create a new 70-30 rule, whereby 70 percent of an active shareholder’s wage and business income derived from the S corporation would be subject to payroll taxes;
- Credit the active shareholder with any FICA taxes paid on the S corporation wages;
- Apply to all S corporations, not just professional services businesses; and
- Apply the same 70-30 rule to partnerships.
Another area of difference between the two plans is their revenue estimates. The Obama provision is narrower – it applies to professional services businesses only – yet Treasury estimates it will raise $38 billion over ten years! The Camp provision is significantly broader – it applies to all S corporations – but the JCT says it will only raise $15 billion. What gives?
We’re not sure, but since the new 70/30 rule applies to both S corporations and partnership income, it appears the Camp proposal would both raise and lose revenue, with the net effect resulting in a $15 billion tax hike. Under current rules, a significant portion of partnership income is fully subject to payroll taxes – particularly among large law and accounting firms – which means the new 30 percent exclusion would have the effect of lowering collections on those businesses. That’s good for partnerships, but bad for S corporations, because it means the tax hike on them is significantly larger than $15 billion.
The Committee claims their approach is simpler than current rules, but we don’t see it. Consider the case of an owner of a large manufacturing plant with dozens of employees and millions in capital investments. This is not a rare example – drive around any sizable town and you’ll see dozens of them. He pays himself a market-based salary of $250,000 and the business makes $750,000 in profit. Under the current rules, his salary is subject to FICA while the business income is not. Since he’s paying himself a market wage, the business income is, by definition, a return on the capital invested in the business and should not be subject to payroll taxes.
The Camp proposal, however, would do just that. Under the provision, the owner would need to aggregate his salary and business income ($250,000 + $750,000 = $1 million) and then multiply the result by 70 percent. That’s the amount of his total income that would be subject to payroll taxes ($700,000). The owner would then subtract out the salary income that has already been subject to FICA ($700,000 – $250,000 = $450,000). That’s the amount of the owner’s business income that would be subject to SECA taxes. It’s not simple, and it’s certainly not fair.
Moreover, the Camp approach appears to severely limit the benefit of excluding domestic manufacturing income from the new 10-percent surtax. As advertised, the Camp plan would tax S corporation “producers” at a top rate of 25 percent. But the draft also appears to apply the same 70/30 rule to production income as it does to payroll taxes. That means, in the example above, the owner would pay a 25 percent rate on $300,000 of his business income, but 35 percent on the rest. Suffice it to say that the C corporation down the street doesn’t face this byzantine approach to marginal tax rates. The combination of the 10 percent surtax and the 70/30 applied to active shareholders presents a strong incentive for the owner of this business to retire, convert to C corporation status, or sell the business entirely.
Finally, it’s important to address the origins of the 70/30 rule. According to the Committee’s section-by-section:
The provision’s distinction between net earnings from self-employment and other income not subject to SECA reflects the fact that over the last several decades, the portion of Gross Domestic Product (GDP) attributable to labor has remained remarkably constant at approximately 70 percent, while the portion of GDP attributable to capital has held steady at roughly 30 percent. The 30-percent deduction recognizes that a portion of the distributive share of a partnership, LLC or S corporation represents earnings on invested capital.
In other words, since the nation’s income is divided 70/30 between labor and capital, that ratio should also apply to the business income from an S corporation or partnership. We’re not so sure. Take the example above. The GDP definition of “income” is not limited to the combined $1 million in business and salary income attributed to the owner. It also includes all those wages paid to the other workers. Those wages are included in the GDP calculations, but the Committee ignores them in applying the 70/30 rule to S corporations.
As we pointed out, since the owner in our example pays himself a market wage, any business earnings beyond that amount are a return on capital. So taxing that income as a return on labor is simply not correct. Not every S corporation has lots of capital – some have little, while others have tons. Applying a one-size-fits-all 70/30 rule to all S corporations does not accurately capture this diversity, and it certainly doesn’t justify a massive increase in the application of payroll taxes to business income.
As readers know, we’ve been fighting this issue for a decade now, ever since Vice President Dick Cheney chastised Senator John Edwards for using the S corporation structure to avoid payroll taxes on the income from his law practice. Over the decade that followed, S-Corp has developed the following position on the issue:
- We don’t support using the S corporation structure to avoid payroll taxes. We represent businesses that comply with the law, not sneak around it.
- It’s not a loophole, its cheating. This issue is often described as a loophole, but that’s not accurate. Underpaying yourself in order to avoid payroll taxes is already against the rules.
- The IRS has a long history of successfully going after taxpayers who abuse the S corporation structure. The current S corporation rules on this have been in place since 1958.
- Any “fix” needs to improve on the current rules. That means they need to be easier to enforce and they need to target wage and salary income only. Employment taxes should apply to employment.
Measured against those rules, the two proposals put forward here fall short. They ignore the distinction between employment and investment, and they unfairly raise taxes on business owners who are fully complying with the law. They might successfully raise revenues, but they don’t appear to contribute to fairness or simplicity.
February 28, 2014 by admin ·
The House Judiciary Committee held a hearing Wednesday on the Business Activity Tax Simplification Act of 2013 (H.R. 2992), a bill that seeks to rationalize the current maze of state and local practices when it comes to taxing businesses residing outside their borders.
Testifying in support of the legislation was S-CORP Chairman Tony Simmons, President and CEO of the McIlhenny Company. In his testimony, Tony got right to the heart of the matter and described the burden faced by his and similar companies doing conducting business across state lines:
Monitoring, interpreting, and compliance with, in many cases, unclear and constantly changing individual state and local nexus regulations places an undue burden on our limited resources, and brings uncertainty to our business planning and execution.
This is not a sales tax issue, but rather a fight over how far states and localities can go to impose income and other business activity taxes on companies with no apparent presence in their jurisdictions. Confronted with tight budgets and a weak economy, these taxing authorities are becoming increasingly aggressive in attempting to reach beyond their borders to tax non-resident businesses.
I am here today to speak in support of HR 2992, the “Business Activity Tax Simplification Act” because we are seeing an increase in the number of cases where states are expanding their definition of substantial nexus to increase the number of nonresident companies subject to state income tax. They are doing this by applying a concept called “economic nexus,” which argues that a state should be permitted to tax a non-resident company with not physical presence in the jurisdiction simply because that company has customers in the state.
Tony was joined on the witness panel by Joseph Henchman from the Tax Foundation, who made the need for congressional action clear:
Only Congress can bring sanity to this patchwork of overly aggressive rules that is currently doing harm to our national economy. Clarifying that substantial nexus for business activity taxes must be linked to the physical presence of solicitation activity in the state is in line with international taxation concepts and with the “benefit principle” idea of paying taxes in the jurisdiction where you get the benefits of government services. The revenue impact to states will be minimal, and generally states are adopting “single sales factor” rules that reduce their reliance on corporate income tax by in-state taxpayers anyway.
Tony’s testimony and the hearing in its entirety can be viewed by clicking below:
More on Camp Draft
The Tax Policy Center has a number of posts up today on the Camp draft, including a nice analysis by Len Burman that adds detail to the chart we quickly put together on the draft’s marginal rate impact. As Burman notes:
House Ways and Means Committee Chair Dave Camp (R-MI) has produced an impressive tax reform plan that eliminates most loopholes, deductions, and credits. But the plan also introduces a number of hidden taxes that push marginal rates—mostly for higher-income taxpayers—well above the advertised levels.
Burman goes on to itemize the hidden taxes in some detail. We’ve attempted to add those to our marginal rate chart to demonstrate just how complex the resulting marginal rates are for S corporations, depending on what industry they’re in, whether the shareholder works at the business, and how many children they have. You can access the chart with notes here.
We’ve gotten feedback that the chart doesn’t include the second layer of taxes for C corporations and so doesn’t fully reflect the tax burden on those businesses. It’s a fair point, and we’ve long advocated for integrating the corporate tax in order to eliminate the double tax on C corporations.
But the point of this chart still stands. Not only does the Camp draft present S corporations, and to a large degree all pass-through businesses, a remarkable matrix of arbitrary marginal rates as they move up the income scale, but for the initial layer of tax – the tax all businesses pay when they earn income – the rates on S corporations will put them at a distinct disadvantage compared to the C corporation down the street.
February 27, 2014 by admin ·
Ways and Means Chairman Dave Camp (R-MI) released his long-awaited tax plan yesterday. The Chairman has worked hard to put out a plan that addresses the biggest challenges faced by the tax code, and he should be applauded for keeping this effort alive.
From day one, Camp has been our lead in promoting comprehensive reform that addresses both the individual and the corporate tax codes. Such an approach was needed if pass-through businesses like S corporations and LLCs were going to be treated in an even handed manner. This priority of leveling the playing field was embraced by our Main Street letter, signed by more than 70 business associations representing millions of employers, that called for equalizing the top rates on active income paid by all tax payers—individuals, pass through businesses, and corporations alike.
Somehow, however, that fairness message got lost in the drafting of the draft. So did simplicity.
Consider the new rate structure. The Committee says they reduced the rates from seven to just two – 10 and 25 percent. But they also included a 10 percent (10 percentage points, that is) surtax on incomes above $450,000. A surtax is really just another bracket by a different name. Everybody knows that. In fact, that’s how we got the current 39.6 percent bracket. It started as a Clinton-era 10 percent “surtax” on the old top rate of 36 percent, and just evolved into what it really is – a new, higher tax bracket.
So really there are three tax brackets – 10, 25, and 35 percent.
Then there is all that other stuff. The Obamacare 3.8 percent investment surtax is still there. For some reason, tax reform couldn’t address that atrocity. A new tax applied to a new definition of income, it taxes most forms of investment income above $250,000, including the S corporation income of passive shareholders.
There’s also a new, broader application of payroll taxes to S corporation income, including income from capital intensive businesses like manufacturers. Years ago, Congressman Charlie Rangel (D-NY) proposed to apply payroll taxes to income earned by S corporations in the personal services industries. Senator Max Baucus (D-MT) proposed a similar plan several years later. The rationale was to crack down on tax cheats, but the proposals went much further than that and would have raised taxes on businesses that were fully complying with both the spirit and the letter of the law. The Camp proposal would take the Rangel-Baucus idea even further by applying payroll taxes (in this case, SECA) to 70 percent of S corporation income earned by all active S corporation shareholders, regardless of what industry they are in. That appears to add 11.6 percentage points to the tax rate of S corporations below the FICA cap and another 2.7 points to income above that.
Then there’s the disparate application of the new 35 percent bracket depending on which industry your business is in. President Obama proposed several years ago to cut corporate tax rates to 28 percent for all C corporations, but if you were in manufacturing, you got a special lower rate of 25 percent. The Camp draft takes this “winners and losers” approach a step further, offering pass-through businesses with production income a 25 percent top rate while other forms of income (retail, engineering, services, etc.) pay a top rate ten percentage points higher.
Finally, there are the recaptures and cliffs. A cornerstone of “reform” has always been to eliminate thresholds and phase-outs as much as possible. A key part of the Bush tax reforms in 2001 and 2003 was to eliminate the notorious phase-outs known as PEP and Pease. Nothing makes the code more complicated than loading it up with one income phase-out after another. Low-income families today face a potent combination of phase-outs from the EITC, the child tax credit, and the new health care reform subsidies. The marginal rate cliff resulting from these phase-outs is the reason the CBO estimated the health care reform subsidies would encourage 2 million workers to stay home. The Camp draft invents several new ones that will impact pass-through business income. There’s the recapture of the 10 percent bracket, standard deduction, and child credit. That starts at $300,000. Then there’s the application of the new 10 percent surtax to previously untaxed employer-provided health benefits. That starts at $450,000.
The net result is a bewildering array of rates and thresholds for pass-through businesses, with at least 11— not two—different marginal rates. This chart is based on our first look at a very complex plan, so it might have some of the details wrong, but gives you a general idea of what we’re up against.
See the rate schedule on the right side for C corporations? That’s what tax reform looks like. Rational and even-handed. The rate schedule for individuals looks pretty good too, especially if you ignore the effect on marginal rates of payroll taxes and low-income credits, as this table does (we simply didn’t have the time to figure it all out).
The rate schedule for S corporations, on the other hand, is a mess. Why should it matter what industry you are in, or how involved you are in the business? Business income should be business income.
This is not to say that there aren’t good items in the plan. There are lots of them, including the lower marginal rates on labor and business income, the repeal of the individual AMT, the repeal of a zillion miscellaneous special-interest tax credits, the handful of provisions to improve S corporation governance, and more.
But each of these victories for fairness and simplicity is offset by a provision that moves in the opposite direction, like raising the tax burden on capital expenditures, increasing taxes on retirement savings, and increasing the top tax rate on capital gains and dividends.
The net effect of all this is that, even with the sharp reduction in corporate tax rates, the Camp draft increases the cost of investing in the United States! That’s not our assessment. That’s the assessment of the economic analysis circulated by the Committee to promote the plan.
So how did we get to this result? The main culprit has got to be the remarkable number of constraints the Committee placed on its efforts before they began crafting the plan, including:
- Budget neutrality;
- Neutrality with respect to income classes;
- Establishing a top rate of 25 percent for individuals, corporations and pass through businesses;
- No cross-subsidization between individuals, pass-through businesses and corporations; and
- Excluding health care from the plan, including health care taxes.
Einstein couldn’t have drafted a reasonable reform plan under these constraints; neither could the capable staff at the Ways and Means Committee. The result is that they neither stayed within their constraints – 3, 4, and 5 were all sacrificed to one degree or another – nor did they achieve the level playing field or simplicity at the heart of any real tax reform.
This is a discussion draft, so we’ll be working with the Committee to identify our concerns and work on changes. Our message to the Committee will be focused on what’s in this post. We will encourage them to return to first principles and remember why they started down the path of tax reform in the first place. The outlook for reform moving through the Congress may be bleak, particularly the Senate, but the ideas put forward by plans like this live on forever. It’s important to get them right.