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The Importance of 199A
Today’s House Budget Committee hearing on “Incentivizing Economic Excellence Through Tax Policy” is a good chance for members to learn about the importance of the Section 199A deduction for individually and family-owned businesses.
This deduction was enacted as part of the Tax Cuts and Jobs Act and serves two primary purposes – 1) to encourage job creation and economic growth by reducing the tax burden on pass-through businesses and 2) to ensure tax parity between pass-throughs and C corporations with their lower, 21-percent rate.
Did it work? A new study by Robert Carroll at EY suggests that a rough parity between business types does exist, but only roughly and only as long as 199A remains in place. As you can see in the table below, public C corporations pay somewhere between 25 and 31 percent effective tax rates, depending on the assumptions you make as to their shareholder makeup. All pass-throughs, on the other hand, pay around 27 percent, while large pass-throughs pay 34 percent.
The deduction is set to sunset beginning 2026, however, at which point family-owned businesses will be forced into a Hobson’s choice – remain in their pass-through form and pay rates 16 percentage points higher than the competition or convert to C status and be forced into the double tax. Either way, Bob’s table shows private companies pay more than their public company competition.
The new EY study follows in a long line of studies emphasizing the importance of 199A to Main Street competitiveness and parity, including:
As former Joint Committee on Taxation Director Ken Kies concluded, “Current law section 199A should be retained in its entirety. Doing so will still leave passthroughs more heavily taxed than C corporations, but removing any of the benefits of section 199A will only make the disparity worse.”
For members of the Budget Committee, here are a few questions to ponder during their hearing:
What About the Double Tax?
A key difference between pass-through taxation and the classic corporate form is the double tax that applies to C corporations. The corporation pays an initial tax (21 percent) when the money is earned, and then a second tax may be applied when the company pays a dividend or its shareholders sell the stock. This contrasts with pass-throughs, who pay a higher rate initially (37 percent), but there’s no second layer of tax. The problem with the double tax on corporations is multifold. It raises the effective rate on those businesses, and it results in a remarkable amount of distortion as businesses and their shareholders change their behavior to avoid the second layer.
In recent years, however, the percentage of C corporation shareholders who are tax advantaged – they either pay no taxes at all (charities, endowments) or pay greatly reduced rates (qualified retirement accounts, foreign shareholders) — has increased dramatically. In the sixties, four out of five shareholders paid the full tax. Today, the Tax Policy Center estimates that three out of four pay no tax or greatly reduced rates. Bob’s study addresses this variable by providing alternate results depending on competing profiles of shareholders. So a C corporation with fully taxable shareholders (say an S corporation that converted to C) would pay an effective rate of 32 percent, while a public company with 75 percent tax-advantaged shareholders would pay only 25 percent. That’s a huge difference and it suggests the old corporate double tax is of decreasing importance when measuring the tax burdens of public companies.
What about the Size of Companies?
Another key consideration raised by Bob’s work is the importance of taking business size into account. Too often, economists will compare the overall tax paid by C corporations to the overall tax paid by pass-throughs, only to find that the pass-through rate is less. But pass-through businesses tend to be much smaller and less profitable, while nearly all reported C corporation income comes from the few thousand companies listed on the public exchanges. In other words, failing to adjust for size does little more than point out that very large public companies tend to pay higher rates than very small private ones. Duh. (The irony here, of course, is that nobody is suggesting raising rates on smaller pass-through businesses, even as some use those low reported rates as an excuse to hike taxes on large pass-throughs.)
To adjust for this, Bob separated out large S corporations (those subject to the individual top rate) so that a large v. large comparison can be made. As the table shows, large pass-through businesses paid higher rates before the TCJA, they pay higher rates now, and they will pay really high rates if the 199A deduction is allowed to expire.
Why Can’t They Just Convert?
Which brings us to the usual response from critics – why can’t large S corporation just convert? Again, Bob’s table shows that private companies that convert will still pay higher rates than public companies. That is because, by definition, all S corporation shareholders are taxable, and therefore the converting company would face the full brunt of the double corporate tax. In the table, compare today’s rate on large S corporations (34 percent) with the fully-taxable rate (32 percent) they would pay if they converted, versus the rate (25 percent) the public company pays. Either way, the private company pays more.
This brings up an important point – the way to divide the business community is not between large and small. Such comparisons are artificial and immediately devolve into debates over what qualifies as “small.” Instead, a better demarcation is between public and private companies. A large private company has more in common with a smaller pass-through than it does with a similar-sized public company. Their governance and management challenges are completely different. Most importantly, the public company has access to relatively inexpensive money in the public equity and debt markets whereas the private company’s options are usually limited to the family’s assets and bank loans.
Where are the Jobs?
This final question is the key to the whole debate. Private companies organized as pass-through businesses employ 58 percent of all private sector workers. When the Budget Committee debates the importance of economic growth and job creation, they need to start with the pass-through sector, since that’s where the jobs are.
This question has geographical implications too. An earlier EY study showed that while most public company jobs are located on the coasts and in city centers, private company employment is both larger (80 percent of all jobs) and more evenly spread around the country.
Entire communities (and even states) depend on private company employment for their economic base. Congress needs to ensure that the Tax Code doesn’t hurt the ability of these companies to survive. That won’t be easy, as the trend in recent decades has been going in the other direction — towards market consolidation within the public company space.
As this graph from the St. Louis Fed shows, the market cap for companies traded on US public exchanges (public C corporations) has increased from less than 100 percent of GDP in the 1990s to around 160 percent of GDP today. Economic decision-making is being concentrated into fewer and fewer boardrooms and away from the communities who will be affected by the decisions. There are many factors causing this concentration – the Tax Code shouldn’t be one of them.
Conclusion
The 199A pass-through deduction is the only tax provision protecting thousands of local communities from fewer jobs and more boarded up buildings. It reduces the tax burden on local businesses to make them more competitive while helping to level the effective rates paid by private and public companies. Congress needs to commit to preserving these communities and these jobs by making the Section 199A deduction permanent.
Congress Focused on CTA Flaws
With just six months to go before the Corporate Transparency Act’s (CTA) reporting requirements take effect, federal lawmakers are sounding the alarm over just how far reaching – and poorly constructed – the rules are.
A quick primer for those new to the issue: the CTA requires smaller businesses and other entities to annually report the personal information of their “beneficial owners” to the Treasury Department’s Financial Crimes Enforcement Network (FinCEN). According to FinCEN, “beneficial owner” includes individuals with at least a 25-percent stake in the business, as well as those who serve on the entity’s board, helped organize the entity, play a significant consulting role, or meet the vaguely-worded standard of exercising “substantial control” over the company (i.e. senior staff, officers, and minority owners).
Covered entities are businesses, charities, and other legal structures with under $5 million in gross revenue or fewer than 20 employees, meaning the new requirements directly target the small business community. By FinCEN’s own estimates, more than 30 million such entities will be affected, a number that will grow significantly as new ones are formed each year.
The stated goal of the reporting regime is to crack down on money laundering, tax fraud, and other illicit activity. But as we’ve written previously, it’s hard to imagine a scenario in which bad actors will volunteer accurate, detailed information of their criminal enterprises to the federal government. Instead, the CTA will create a massive database that’s too large to effectively manage or monitor for law enforcement purposes, and house it all at an agency with a spotty track record of safeguarding sensitive personal information. What could go wrong?
So starting next year, millions of businesses and individuals will get a letter in the mail from an agency they’ve never heard of, telling them they need to comply with a new anti-terrorism law. The plumber who just incorporated his business, or the privacy-conscious homeowner who registered their dwelling under an LLC, will probably throw the notice away. Little do they know that doing so could yield hefty fines at best (up to $500 per day), two years of jail time, or both.
With the clock ticking on the CTA’s January 2024 effective date, members of Congress are coming to grips with the pending disaster and they have some questions. Last week, House Financial Services Committee Chairman Patrick McHenry (R-NC) sent a letter to Treasury Secretary Janet Yellen that raises concerns over the scheduled rollout. It begins:
As you know, the impending Beneficial Ownership Information collection rule will go into effect January 1, 2024. It is concerning that with six months until its effective date, FinCEN has yet to lay out a clear plan for engagement. It is highly unlikely that the 32 million small business owners know what FinCEN is let alone know to look for a press release on FinCEN’s website. As a result, there is a real possibility that these small businesses could be held civilly or criminally liable for noncompliance.
The Chairman also introduced legislation this week which would delay the reporting regime’s January 1, 2024 effective date until FinCEN finalizes two other CTA-related regulations. The agency is still working on the “Access Rule,” which specifies who can access the database and for what purposes, as well as an updated “Customer Due Diligence Rule” which applies to financial institutions. The notion that FinCEN plans to start collecting information en masse in just a few months without any clear rules in place is absurd, and this legislation would ensure that doesn’t happen.
But while these are important fixes, they fail to address the underlying issue: that the Corporate Transparency Act will do little to combat money laundering and illicit activity even as it targets millions of law-abiding Americans with expensive reporting requirements, fines, and jail time.
That’s why S-Corp and its allies strongly support the National Small Business Association’s lawsuit challenging the constitutionality of the CTA. The CTA is clearly a law enforcement exercise, yet neither the bill’s sponsors nor FinCEN have made any attempt to establish why they have the right to the personal information of millions of law-abiding business owners, their consultants, or their employees. A favorable ruling would stop the reporting requirements from taking effect and put this harmful statute to rest. The case has been proceeding quickly, and with all the necessary filings from both sides now submitted, we anticipate a ruling sometime this summer.
In the meantime, S-Corp is hearing rumblings of a possible House Financial Services Committee hearing on the CTA next month. That would present an ideal opportunity to raise both concerns about CTA implementation and begin a real conversation about repealing the law should the lawsuit fail. We will keep S-Corp readers apprised as the issue develops.
Does the House Tax Bill Have Legs?
The Ways and Means Committee began marking-up its long-discussed economic package earlier this morning. The package includes a number of provisions important to the pass-through community, including restoring R&E deductions and offering relief from the tighter interest expense caps. Here’s a quick review of the package and what we expect.
Details
The Ways and Means Committee is currently marking up a three tax bills under the banner of the “American Families and Jobs Act.” The goal is for House Republicans to report them out of committee, combine them with work products from other committees, and then bring that broader package to the full House next week. The three tax bills were made public over the weekend and include:
- H.R. 3936 – Tax Cuts for Working Families Act
- H.R. 3937 – Small Business Jobs Act
- H.R. 3938 – Build it in America Act
The package also would repeal a number of recently enacted tax credits for clean vehicles and clean electricity production. An analysis conducted by the Joint Committee on Taxation estimates this combination of tax cuts and revenue raisers nets out to a roughly $21 billion loss over the 10-year scoring window, so it is not completely “paid for” but it’s close.
For S corporations, key provisions would:
- Increase the Standard Deduction by $4,000;
- Restore the higher, $20,000 reporting threshold for electronic payments;
- Increase the 1099 subcontractor reporting threshold from $600 to $5,000;
- Expand the Section 1202 benefit to include S corporations;
- Increase the Section 179 expensing cap to $2.5 million; and
- Restore the broader EBITDA base for the Section 163(j) interest expense deduction cap.
S-Corp Advisor Lynn Mucenski-Keck was able to testify on the importance of several of these provisions before the House Small Business Committee. As she noted, R&E expensing may be viewed as something that only affects larger businesses, but the reality is that many smaller companies are heavily invested in research as well and need this deduction restored.
Meanwhile, rising interest rates mean the tighter interest deductibility caps are going to hit businesses hard. As she testified, the combination of tighter caps and higher rates means a business that maintains a consistent debt load can still lose valuable deductions. Add the possibility of a recession and lower taxable income into the mix, and many, many companies – even those with low debt loads – could be subject to the cap this year and next.
Finally, the Section 1202 expansion was introduced as a stand-alone bill by Rep. David Kustoff (R-TN) earlier this year. Section 1202 provides tax benefits to small business start-ups that eventually are sold. Those benefits have always been limited to stock issued by C corporations only. This provision would expand the benefit to S corporation stock as well.
What About 199A?
As S-Corp readers know, making 199A permanent is our top priority – we are working to build support for the Daines bill in the Senate and are eagerly anticipating the introduction of its House companion in the coming weeks. The 199A deduction doesn’t sunset until 2026, however, so making it permanent wasn’t included in this package, which is focused on shorter-term challenges.
But while it may not belong in this package, it does belong in the conversation. The tax relief provisions being marked up today are all scheduled to sunset at the end of 2025, adding to the long list of provisions with that expiration date. The net effect would be to create an even larger “fiscal cliff” of expiring tax provisions, creating both a challenge for the pass-through community and, frankly, an opportunity.
The obvious challenge is that pass-through taxes are scheduled to rise dramatically starting 2026. S-Corp is actively working to prevent that. The opportunity, on the other hand, is the cliff gives Congress yet another chance to reset the conversation and consider the best means of taxing business income overall – pass-through businesses and C corporations alike. As you can imagine, we have lots of ideas on that front and will be putting them forward in the coming months.
Prospects
So does the House bill have legs? As noted, the full House plans to take up the package next week, but after that the path is less clear. The Democrat-led Senate is unlikely to consider anything similar anytime soon, so once the House is done, we could be looking at a delay until this fall or winter before tax policy rises to the surface again.
On the other hand, successful action by the House would significantly increase the odds that we see tax policies enacted by Congress this year. Just as the House-passed debt limit bill resulted in the eventual adoption of a compromise debt bill, a tax package passed by the House might have a similar effect. It would give the Senate a tax vehicle to play with (tax bills need to originate in the House), it would allow the press and business community to focus their attention on one legislative body rather than two, and it should stimulate more aggressive conversations between House and Senate tax writers.
Conclusion
So lots of positive here. The House is focused on issues that directly concern employers both large and small, which should be applauded, and successful action in the House could help catalyze a tax deal between the House and Senate before the end of the year. More to come.
Debt Limit Deal
The BIG news over Memorial Day was the debt limit deal reached by President Joe Biden and Speaker Kevin McCarthy. While the package is an obvious compromise, the result is a big positive signal for the long-term budget picture that should not be overlooked. It’s also a signal that, with tensions high and a hostile press, the government can still operate as it is supposed to.
The deal centers on a suspension of the debt ceiling through calendar year 2024. We did a deep dive last week on what a default would look like, but the takeaway was that those are uncharted waters no one wants to explore. Hence the urgency on both sides to get something done.
In exchange for extending the limit, Republicans received a number of spending cuts and other reforms, including caps on nondefense discretionary spending, rescissions of unspent Covid relief funds, and a $1 billion reduction in IRS funding. (Both sides agreed in principle to repurpose another $20 billion in IRS funding over the next two fiscal years, but the CBO did not include this deal in its scoring.) The legislation also ends the pause on student loan payments starting August 1, implements new work requirements for welfare recipients, and reforms the permitting process for certain energy projects.
The CBO estimates total savings at around $1.5 trillion over the next decade. That’s far less than Republicans’ original proposal, which cut nearly $5 trillion, but notable given that Democrats were calling for a “clean” debt limit bill until just a few weeks back.
Prospects
Will the package pass both the House and the Senate? Sure appears like it. While members of the conservative House Freedom Caucus have spoken out against the plan, as have some progressive Democrats, it appears there are sufficient numbers of members in the middle to produce a majority in the House.
On the Senate side, the bill’s prospects are also somewhat murky, with opposition on both sides and the chance certain members seek to extend consideration through procedural roadblocks and multiple amendments. But the deal is backed by Leaders Schumer and McConnell and it’s hard to see a scenario where the two can’t cobble together at least 60 votes, so overall the prospects look good.
Timing
In terms of timing, the House Rules Committee adopted the package last evening and the House is set to take up the bill later today. If it succeeds, the Senate would begin consideration either later tonight or early tomorrow and start the process of closing out debate through at least one or, more likely, a series of cloture motions beginning tomorrow or Friday.
Several Senators have made clear they intend to run the clock on the process in order to get votes on their favored amendments and/or voice their opposition, but those efforts often fizzle once the Senate demonstrates it has 60-plus votes necessary to move forward.
So expect the House to complete its work tonight and the Senate to work into the weekend, with final passage coming sometime Saturday or Sunday. Or just prior to the current June 5th “drop dead date” announced by Treasury Secretary Yellen.
Take-Aways
Assuming it all works out, what should the S-Corp community take away from this process?
- Size: The budget savings may be smaller than what some wanted, and tiny compared to the long-term problem, but they should not be discounted. As the saying goes, even the longest journey starts with a first step. This a good first step.
- IRS Funding: If IRS funding is indeed reduced by $20 billion, that’s both significant and, well, maybe not that important. On the surface, a $20 billion reduction of the total $80 billion provided in the Inflation Reduction Act is a 25-percent cut — nothing to sneeze at. As others have noted, however, the IRS’s early spending and hiring plans already are limited by a shortage of qualified workers and other obstacles, so we are unlikely to see much difference over the next couple years either way.
- Focus on Spending: One reason these savings are a “good first step” is they move in the right direction by focusing on the real problem – spending. Federal spending has grown dramatically in recent years, easily outpacing revenues and resulting in trillion-plus deficits “as far as the eye can see.”
- Spending Caps: Most of the budget savings comes from new caps on discretionary spending, which have a mixed history of success. Critics argue that Congress has a bad habit of repealing the caps every time they start to bite. There is some truth to this, but it’s also true that spending caps are better than nothing, which is what we have right now.
For Main Street businesses who already pay combined federal and state rates of around 50 percent, the prospect of future tax hikes is daunting. This package may not be as big as some wished, but it moves federal budgeting in the right direction. It’s a welcome development which should be applauded by the business community.
Talking Taxes in a Truck Episode 27: “We’re Not Sure, But It’s Probably Not Good”
For today’s Debt Ceiling-themed episode, we’re joined by repeat guest Joe Lieber, Director of Research at Washington Analysis, an institutional research firm that closely tracks the goings-on in Congress. Joe offers his thoughts on the debt limit negotiations and the odds of a deal being reached, the surprising dynamics within the House Republican caucus, and which provisions are likely to emerge from a potential deal. Later he breaks down how Wall Street and Main Street are reacting to the impasse, what a default on US debt would look like, and the broader implications of growing debt and deficits to S corporations and other taxpayers.
This episode of the Talking Taxes in a Truck podcast was recorded on May 24, 2023, and runs 35 minutes long.