Remember the pass-through mantra for tax reform? All business income should be taxed once, it should be taxed at the same top rate, and then we should leave it alone! Well, that mantra was on display Tuesday when a panel of tax experts explored the benefits and costs of corporate integration. Here’s Dr. Michael Graetz:
“In the 1990s, principally because of its administrative advantages, the Treasury Department recommended taxing business income once—at the business level. This form of integration was advanced by President George W. Bush in 2003, but Congress instead simply lowered shareholders’ income tax rates on dividends. That approach is no longer apt today. Locating the income tax at the shareholder level would be more progressive and, given the mobility of business capital and operations, makes much more sense in today’s global economy.”
And Prof. Bret Wells:
“From a tax policy perspective, I think this committee needs to say ‘we need to preserve one level of efficient tax on active business income.’ Having that taxed at the shareholder level assures individual progressivity. That’s a wonderful goal. And if we take the distortions out of who the owner is, whether that’s a foreign-based multinational, or a pension, or others, that creates the tax symmetry that I think the system needs…Corporate integration absolutely is the vehicle to get us there. Whether it is the dividends-paid deduction regime, or other forms of integration. But I think it is absolutely a wonderful first step.”
Amen to that. But corporate integration is not just about reducing layers of tax – it’s also about restoring economic efficiency. The current corporate code distorts decision-making, hurts job creation, and limits investment. Again, here’s Prof. Wells:
“By having a corporate integration regime, the company would get a deduction currently and there would be an offsetting withholding tax, and that would ensure that the company makes the most efficient decision as to what to do with that income. There would not be a double-tax cost. The decision of what to distribute to shareholders or to invest in the business would be solely one based upon the right economics for that company.”
The hearing also did an excellent job of highlighting some of the political challenges of integration, including the loss of relative tax benefits for 401k’s, charities, and insurance products. Not that the tax on those entities goes up under integration – it remains unchanged. The tax on investments they compete with, however, will be reduced, so they could lose some of their comparative advantage. This is a key political challenge the Committee will have to overcome if they are going to move forward on integration. Here, Mr. Wells again did a great job of framing the argument:
“From my perspective, this is not a disadvantage to anyone. When you take a distortion away from a group of taxable shareholders, and you make them not suffer a double tax, then those that are benefited because the other person is suffering a double tax—an inefficient tax system—could say ‘that’s a relative disadvantage to me.’ But what I think this committee ought to understand, and what I think the corporate inversion phenomenon is getting us to understand, is if we allow one group the opportunity to erode the corporate tax base as a subsidy, whether that’s an inbound earnings stripping advantage, whether it’s that particular technique, then what’s going to be the result of that is that they will be the source of market inefficiency going forward.”
So there you have it – at a hearing on corporate integration, two of the key witnesses repeated the refrain the Main Street Business community has been singing for five years — tax business income once, tax it at reasonable rates, and then leave it alone! That’s the reason we cheer corporate integration efforts and look forward to reviewing the details of the Finance Committee plan when they are released.
Tax Policy Center: Only About One Quarter of C Corp Stock is Owned by Taxable Shareholders
Last fall, we reviewed two studies from Treasury and CRS on the effective tax rates of different business entities. The full reviews can be read here and here, but one of our key observations was how wildly different the estimates for how much the second layer of tax on corporate income adds to effective tax burdens.
You’ll recall that Treasury estimated dividend and capital gains taxes on C corporation shareholders adds about 9 percentage points to the corporate effective rate. As we pointed out, Treasury made some very interesting assumptions to get there.
CRS appears to agree with us on that matter. Their estimate for shareholder level taxes is about one-fourth of Treasury’s, or just 2.3 percentage points. CRS lists the lower rates on capital gains and dividends, tax exempt shareholders, and capital gains that are passed on as part of an estate as the primary reasons for the lower estimate.
Seems like a disagreement that large might be worth more study, no? Now the Tax Policy Center has released a paper that does just that. One of the keys to identifying the second layer of tax is estimating the percentage of corporate shareholders who are taxable. This week, writing in Tax Notes, Steven Rosenthal and Lydia Austin suggest that past estimations have vastly overstated that percentage:
After adjusting the data in several important respects, we estimated that taxable accounts held only 24.2 percent of C corporation equity in taxable accounts in 2015. Our exercise revealed that the share of U.S. stocks held by taxable accounts declined sharply over the last 50 years, by more than two-thirds.
As they explain, past estimates of the percentage of taxable C corp shareholders—including Treasury’s paper from last fall, which used a 2004 paper from James Poterba to determine the second layer of tax—used as much as twice this amount.
The Fed reported that in 2015, households directly owned 37.3 percent of corporate equity. Households owned another 13 percent indirectly through mutual funds (and more through ETFs and CEFs). In total, the Fed reported that households owned more than 50.3 percent of the value of outstanding U.S. stock.
The economics literature generally uses the Fed’s figures for household ownership, including both direct and indirect holdings, as a measure of equities held in taxable accounts. James M. Poterba added stock owned directly by the household sector with stock beneficially held through mutual funds — and estimated that the taxable household share of corporate equity was 57.2 percent in 2003. In so doing, Poterba counted stock owned by IRAs and nonprofits in his taxable sector.
If Treasury is doubling the amount of taxable shareholders in C corps, it stands to reason that they are also doubling the effective tax that second layer imposes on corporations. So their estimates would be off by at least a factor of two. That’s a huge discrepancy, and one that Treasury and others should thoroughly address when weighing in on business tax reform.
As our members know, S-Corp wears two hats when it comes to advocacy – one is defensive where we protect S corporations from bad tax policy. The other is proactive and seeks to improve the S corp rules.
Both hats were on display this week before the House Ways & Means Committee. First, Rep. Dave Reichert (R-WA) discussed his S Corporation Modernization Act which makes a number of improvements to the S corporation rules, including opening the door to foreign investment into S corporations. As Rep. Reichert told the Committee:
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“I’ve heard from a seventh-generation family-owned company and the struggles it has faced based on the nationalities of the spouses of the family members, including family members who have had to sell their stock in the company because of current restrictions. With the number of burdens our business owners face, does it make sense to maintain yet another hurdle simply based on who someone decides to marry?”
Allowing S corporations to attract foreign investment has been an S-Corp priority for years. The current restrictions simply make no sense, particularly if the fix is done through an ESBT structure in which the Treasury can be certain taxes will be paid. We’ve come close to getting this policy enacted in the past, and with Rep. Reichert’s leadership, we look forward to seeing it move through Congress soon.
Second, Rep. Vern Buchanan (R-FL) was able to educate the committee on the importance of tax rate parity. For a decade – between 2003 and 2012 – all forms of business paid the same top rate. Today, as a result of the Fiscal Cliff and Obamacare, C corporations continue to pay the same 35 percent top rate, but the rate on pass throughs is nearly 45 percent!
In response, Rep. Buchanan has introduced legislation – the Main Street Fairness Act – which would restore rate parity by capping taxes on pass-through businesses at the top C corporation rate:
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“Today, the average business in Florida, a pass through, [pays] 43 percent, big corporations are at 35 percent. In many places in the country, state and federal is over 50 percent. My bill simply says lower those tax rates to nothing higher than corporate rates going forward.”
What’s the prognosis for these efforts? Shortly after the hearing, Ways and Means Chairman Kevin Brady (R-TX) announced that he was committed to restoring regular order in the Committee, stating:
“Today’s hearing demonstrates that we are serious about considering tax legislation through an open and transparent process. We’re committed to introducing bills, considering them and moving them to the floor. The fact that over 30 Members are sharing their ideas today is a testament to our new process – and to our return after so many years to regular order.”
Does this mean a markup of member-driven proposals is in our future? That remains to be seen, but the fact that the Committee is giving members an opportunity to speak about their respective efforts is promising, and we will continue to work with our friends on the Committee both to protect S corps from bad policies and to fight for improved rules.
Business Community Unites Against 385 Regs
Speaking of bad policies, some of the largest business trade groups in the world have sent Treasury a letter calling on the agency to rethink the proposed section 385 regulations it released last April 4th. You can read the whole letter here, but the core of the letter’s message is contained in these two paragraphs:
Based on Treasury’s April 4 press release, the proposed 385 regulations are designed “to further reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping.” Nonetheless, even a cursory review of these regulations clearly indicates that they go far beyond cross-border mergers and apply to a wide range of ordinary business transactions by global and domestic companies both in and outside the United States.
Indeed, the proposed 385 regulations affect all aspects of both a company’s capital structure and the funding of its ordinary operations and fundamentally alter the U.S. tax rules on intercompany debt by overturning the well-established facts and circumstances analysis used by the courts and the Internal Revenue Service (IRS) to determine whether an instrument is debt or equity. Whether an instrument is debt or equity has significant, collateral consequences to business operations that go well beyond the interest deduction on the instrument and include the legal classification of an entity, eligibility for withholding tax exemptions under tax treaties and the ability to file a consolidated tax return. These issues present a severe impediment to the use of intercompany financing for even normal operations and will significantly increase the cost of capital and limit the amount of capital available to invest in the United States.
We noted in a previous post that these regulations pose a particularly acute threat to S corporations. All the concerns listed above apply to S and C corporations alike, but S corporations also face the possibility that they could lose their classification and be forced back into the C corporation world.
The comment period for these proposed regulations ends on July 7th. We intend to submit extensive comments and hope that others do as well. Our message is simple – these regulations were not well thought out and need to be pulled.
The business community is beginning to recognize that Treasury’s new Section 385 regulations published on April 4th have a much broader reach than anybody thought. S corporations in particular need to pay attention.
How broad are they? Here’s how Tax Notes described a meeting of the ABA Section of Taxation here in DC last week:
Practitioners who specialize in the taxation of S corporations said they’re concerned that many S corps may end up gratuitously losing their S corp status if the new related-party debt rules are applied as written without exception.
Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC said that as he reads the new rules— in particular the bifurcation rule of prop. reg. section 1.385-1(d), which enables the
government to divide a purported debt instrument into part debt and part stock — they could apply to debt issued by an S corp in a way that could automatically invalidate an S corp election.
Released April 4, the proposed section 385 regulations (REG-108060-15) generally treat
related-party debt as equity unless it facilitates new net investment in the borrower’s operations.
Although the regs were released along with a set of new anti-inversion rules, the section 385
regs can apply to transactions that have no connection at all to foreign acquisitions of U.S.
companies. Nichols said May 6 at the S Corporations session of the American Bar Association Section of Taxation meeting in Washington that the rules could turn debt into stock that could potentially violate the S corp single class of stock requirement or the eligible shareholder rule.
The disconnect appears to be that while the Treasury regulations were advertised as targeting corporate inversions, the actual policy would apply to the related party debt of all US companies, not just those moving overseas or seeking to shift income from one tax jurisdiction to another.
The bottom line is the proposed rules appear to give the IRS the ability to re-characterize the related party debt of a large percentage of S corporations. As S corporation owners know, the downside of having your debt remade into equity is not limited to the loss of an interest deduction. S corporations are only allowed to have a single class of stock. If they have more than one class of stock, they revert back to C corporation status.
Existing tax rules provide S corporations a safe harbor to ensure that different forms of debt are not misconstrued as equity and threaten their status. The proposed 385 regulations appear to override those existing rules.
A final point to make is that the effective date for the proposed regulations is April 4, 2016. So unless they are pulled entirely, or revised significantly, the proposed regulations already threaten the normal business practices of S corporations across the country.
The business community is gathering its forces to communicate its response to this massive regulatory proposal. It will be interesting to see if this Treasury Department listens.