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The “Experts” Get 199A Wrong, Part 2
We like Marty Sullivan. He always has something interesting to say. His latest piece criticizing Section 199A is a bit of a disappointment, however.
Where to start? Marty says the pass-through community was “seething” following the resolution of the 2012 fiscal cliff – we weren’t. He says family businesses can just elect to be C corps if they don’t like paying higher rates – except they pay more either way (we’ve covered that one many, many times). And he says we should reject 199A because it excludes certain industries – wasn’t our idea.
But those are quibbles. The big issues are listed below, together with our response.
Sullivan: “[An] inconvenient fact for the passthrough lobby is that the bulk of section 199A tax benefits goes to high-income taxpayers. In 2021, as shown in Table 1, individual tax returns with adjusted gross income between $500,000 and $10 million got more than one-third of the total deductions claimed.”
Large pass-throughs do get the 199A deduction, but only if they employ lots of people or make significant investments. That’s because 199A imposes so-called guardrails on large pass-through businesses so, for example, they only get the deduction up to 50 percent of the W-2 wages they pay, or a similar cap tied to capital investments. This Treasury study shows how these guardrails exclude about 40 percent of pass-through income from the 199A benefit.
Meanwhile, a recent CRS report observes that the 199A deduction is neutral regarding progressivity. As the report notes: “The Section 199A deduction appears to have little effect on vertical equity, as it does not appear to diminish the progressivity of the federal income tax.”
The same cannot be said for the corporate rate cuts. Critics argue the TCJA primarily benefited wealthy taxpayers but that is mostly due to the corporate rate cuts. This table from the Tax Policy Center shows that as income rises, so does the benefit from the corporate rate cuts.
This reality doesn’t help pass-through business owners, and it doesn’t stop critics from blaming 199A anyway. You can see this slight-of-hand play out in real time at a recent Tax Foundation panel where Bill Gale argues against 199A because the TCJA reduced taxes on the rich, admits that this is mostly due to the corporate rate cuts, then concludes that we should keep the corporate rate cuts anyway.
Finally, we’d be remiss by not pointing out that Sullivan made his name highlighting how little tax large multi-national corporations paid. Nobody ever said the same regarding large family-owned businesses. As our studies have made clear, these businesses pay the highest rates regardless of how they are organized.
Sullivan: Extending the deduction will add significantly to our ever-growing, record-level federal debt. The staff of the Joint Committee on Taxation estimates the 10-year cost at $684 billion.
The 199A deduction does reduce revenues but it wasn’t adopted in a vacuum. It was packaged with numerous offsetting provisions that raise lots of money – more than 199A costs – and they primarily target upper-income business owners:
- SALT Cap
- Section 461(l) Excess Loss Limitation Rules
- Section 174 R&E Amortization
- Section 199 Manufacturing Deduction Repeal
- Section 163(j) Interest Deduction Cap
- Section 212 Deduction Limitations
Moreover, these provisions (save the SALT cap) will stay in the tax code even as 199A expires, resulting in a significant tax hike on pass-through businesses – not relative to the TCJA, but rather the tax code that preceded it. Avoiding a tax hike is how the Main Street Employers coalition got started in the first place. You can read about it here, here, here, here, and here.
Sullivan: [P]omerleau’s calculations tell us that without a section 199A deduction, passthroughs on average would have a slightly higher effective statutory rate than corporations — 44.5 percent for passthroughs versus 42.3 percent for C corporations. However, section 199A reduces that 2.2 percentage point average disadvantage for passthroughs to a 5.2 percentage point advantage.
Exactly where rate parity lies is at the heart of this debate, yet Sullivan relies on a single source with a long history of 199A hate. Kyle Pomerleau’s preferred tax code would eliminate all pass-throughs and tax everybody as C corporations.
Focusing on a single source ignores effective rate estimates by Treasury, CBO, EY, and others which show the TCJA resulted in rough parity between business forms. Here’s Barro-Furman and DeBacker-Kasher:
Meanwhile, the folks at Penn-Wharton predicted that one-sixth of all pass-through activity would shift to C corporations following adoption of the TCJA:
Prior to the TCJA, pass-through businesses were growing remarkably over time. We project that the TCJA will reverse this trend. In particular, we project that 235,780 individual business owners—especially higher income business owners or service providers—will switch from owners of pass-through entities to C-corporations, representing about 17.5 percent of Ordinary Business Income from pass-throughs.
Keep in mind, this migration was supposed to occur with the 199A deduction.
The reason Kyle’s estimates are outliers is he ignores perhaps the most salient feature of this debate – that most public C corporation shareholders don’t pay taxes. Here’s the Tax Policy Center’s latest on that front:
Why is this important? Tax burden comparisons must estimate the portion of corporate earnings that are subject to shareholder-level taxes. If three-quarters of C corporation profits are earned by shareholders who pay little or no tax, then the overall effective rate paid by C corporations is significantly lower. Kyle, meanwhile, just assumes the applicable corporate rate is 40 percent for everybody. As the TPC graph makes clear, that’s no longer a tenable position.
Sullivan: “Even though in tax circles it is widely known that many passthrough businesses are large, proponents of section 199A won’t be able to resist implying that tax cuts for passthroughs flow exclusively to small businesses.”
Nobody claims 199A goes “exclusively” to small businesses. All of our materials highlight the importance of 199A to businesses both large and small. And while many advocates do refer to 199A as the small business deduction, that’s because pass-throughs are small. It’s a relative thing. A 2018 Congressional Research Service report found that 99% of pass-throughs had fewer than 100 employees and were, in just about every measure, smaller than their C corporation counterparts:
So Sullivan supports the “worthy cause” of enacting large tax cuts for massive public corporations, but opposes efforts to ensure pass-through businesses aren’t disadvantaged in the process? Doesn’t seem reasonable. The good news is we have the facts on our side and we have time to educate policymakers on why pass-throughs are an important part of the economy, and why 199A is important to pass-throughs. In the meantime, we will continue to read Marty’s work. He’s always interesting, even when we disagree.
S-Corp Modernization Introduced in the House
Good news for the S corporation community! Ways and Means Member Brad Wenstrup (R-OH) has introduced the S Corporation Modernization Act of 2024 (H.R. 8614). S-Corp Mod has a long history of simplifying the rules for Main Street businesses and helping the Main Street businesses be more competitive as they remain in the family.
The introduction of this year’s bill will help S-Corp move forward on a list of technical tax provisions important to the country’s 5 million S corporations, including:
- Increasing their access to capital;
- Expanding the list of eligible shareholders to include more employees, non-resident aliens, and retirement accounts; and
- Eliminating rules that penalize S corporations compared to partnerships and other business forms.
The S corporation was created by Congress in 1958 and has grown in popularity over the years, particularly among small- and family-owned businesses, because of its simplicity and flexibility. Today, S corporations are the most common form of business structure in America with more than 5 million. Despite their popularity, the rules governing S corporations can have the effect of restricting their ability to invest and create jobs, which is why the Wenstrup bill is so important.
As S-Corp readers know, Representative Wenstrup has been a long-time champion of our issues. In his statement introducing the bill, he made clear the importance of these reforms:
“S Corporations are the backbone of American business, located in every city and town across America, especially in rural areas like Southern Ohio. As Congress works to build upon the success of the Tax Cuts and Jobs Act, it’s critical that S Corps aren’t forgotten. The S Corporation Modernization Act contains important changes to the tax code that will make it easier for S Corps to operate and access capital so that they can grow, employ more Americans, and continue to invest in the communities in which they operate.”
S-Corp Board Member Dan McGregor, Chairman of Ohio-based McGregor Metal, praised Representative Wenstrup and his legislation:
“While our business has grown over the years, many of the rules governing S corporations have remained the same. This legislation makes important and timely improvements to those rules, making it easier for businesses like ours to raise capital, create jobs, and make succession plans. Representative Wenstrup is to be congratulated for his long-term commitment to helping S corporations succeed.”
S-Corp President Brian Reardon made the following statement in support of the bill’s introduction:
“Well into the 21st century, America’s most popular form of small-business corporation deserves rules adapted to the economy we live in today. The S Corporation Modernization Act would ensure the continued success of these businesses by modernizing the rules that apply to firms that have selected S corporation status.”
S Corporation Modernization has a long history of support from the business community, and its introduction today means we now have a sponsor sitting on the critical House Ways and Means Committee with six months of legislative session to go. S-Corp is gearing up to ensure that the priorities of the S corporation community are represented in any tax bill considered later this year.
Wait, What???
Under the category of “Care to elaborate?” this month’s CBO analysis of the fiscal cliff costs includes estimates of the Section 461(l) excess loss provision that are, shall we say, significantly revised. The new numbers are much more believable, but they do beg the question of what took the JCT so long to rework their original estimates.
To review, the TCJA capped the ability of pass-through business owners to deduct their active business losses. Under the old rules, those losses could immediately offset other forms of owner income (wages, capital gains, investment income, other business income, etc.). This approach was consistent with the concept of an income tax, where taxpayers should be taxed on their net income. It also reflected good tax policy, as it produced counter-cyclical results – taxes on business income went up during the good times and declined during the bad ones.
Then somebody decided to cap these deductions to address…well, we have no idea what the point was. The result was Section 461(l) where any active business losses exceeding $500,000 would have to be carried forward and treated as a net operating loss in the following year. The effect was to delay, by perhaps a year or two, the ability of business owners to deduct some of their losses.
It also meant that the counter-cyclical treatment of losses was turned on its ear. Now when the economy goes south and businesses start losing money, their taxes go up, not down. That’s what is known as bad tax policy.
Fueling the provision were JCT revenue estimates so outrageous that almost nobody bothered to ask how a simple timing change could produce so much revenue. The initial JCT score back in 2017 was $176 billion over eight years! That was later revised down to $137 billion, but it went up again in the final conference report to $150 billion, or about $18 billion per year.
These eye-popping scores set the stage for the soap opera that occurred during the COVID pandemic.
The CARES Act was designed to help families and businesses during the COVID shutdowns. One of its provisions relaxed the net operating loss rules (including the excess loss rule) to allow businesses to get refunds from prior years. As the Obama administration described similar provisions during the financial crisis, it all was pretty standard stuff:
The Economic Recovery Act included a provision that allowed small businesses to count their losses this year against the taxes they paid in previous years. Today, the President extended that benefit for an additional year and expanded it to medium and large businesses as well….This provision is a fiscally responsible economic kick-start, putting $33 billion of tax cuts in the hands of businesses this year when they need it most, while enabling Treasury to recoup the majority of that funding in the coming years as these businesses regain their strength and resume paying taxes.
Pretty standard, except for the score. According to the JCT, a one-year suspension of the excess loss cap would reduce revenues by $158 billion! So a provision that was supposed to raise $150 billion over eight years now was going to cost more than that if it was suspended for a year? If this was true, then somebody was making out like a bandit, and it sure looked like rich people. Cue the critics. Here’s NPR:
[T]he only people that are going to benefit from this tax change are people that make at least half a million dollars in income outside of their businesses. And just to put that in context, that is literally the top 1% of U.S. taxpayers. So in other words, the government, in the CARES act, is going to give out $135 billion in tax relief only to people that make at least half a million dollars, only to the top 1% of taxpayers in this country.
And the Tax Policy Center:
Congress justified massive CARES Act tax relief for losses to infuse cash quickly to businesses, including “small” businesses. But providing cash to the wealthy via tax refunds is little more than a windfall. Congress should target relief to those truly small businesses that desperately need help.
Keep in mind the “massive” there is a reference to the JCT’s errant score, but the “windfall” critique is also in error. Say you run a large family business in a state where the governor has just mandated a pandemic shutdown. Your previously profitable business is now bleeding cash. Your doors may be closed but you still have to pay your employees and suppliers, cover rent, stay current on loans, etc. One option would be to fire everybody and ride out the crisis.
Another would be to sell other assets to stay liquid and keep people employed. If you chose the latter, as many businesses opted to do, the old rules allowed you to deduct your business losses against any capital gains you incurred from the asset fire sale. The new rules, on the other hand, would have forced you to pay taxes on income you don’t have now and postpone the deduction of your losses until after the pandemic. Brilliant.
Fortunately for all those employees, the TPC and its allies failed to cancel the CARES Act relief.
The effect of the errant scoring wasn’t limited to press releases and shallow analysis. It moved policy too. During Senate debate over the Inflation Reduction Act, a successful amendment to shield private equity from the Corporate Alternative Minimum Tax (CMAT) used a two-year extension of the excess loss limitation as its pay-for. The CAMT relief reportedly cost $35 billion, while the JCT scored the extension at $53 billion.
Fast forward to this month’s CBO report and suddenly, absent any explanation, the scores on the excess loss provision have been revised down by a factor of nearly 10.
So a policy that the JCT scored as reducing revenues by $28 billion in 2029 now magically costs the government only $2.9 billion? If only somebody had flagged this previously…
How can a one-year suspension of a “timing” policy cost the federal government this much revenue? The answer is we have no idea, but the next step in this debate should be a full accounting of the committee’s revenue estimate.
We still would like an explanation. We would also like a redo on the Inflation Reduction Act amendment. According to today’s revised estimates, that result was a fraud.
In the private sector, economic modelers who want to get published are required to be transparent and provide both their data and their methodology. Perhaps it’s time to apply these same rules to the CBO and JCT?
The Bull Case for a Bipartisan Fiscal Cliff Deal
For years we’ve been sounding the alarm over the 2025 “fiscal cliff,” a watershed moment that will force lawmakers to address a litany of expiring tax provisions or risk a massive tax hike on families and Main Street businesses. Below is a look at what’s at stake for Main Street businesses and our bull case for Congress taking action next year.
Sunsets and Families
One TCJA myth is that it benefited big corporates and billionaires only. That’s simply not true. Much of the tax relief targeted at corporations and wealthy individuals was paired with significant revenue raisers, while the tax relief targeting low- or modest-income families was largely free of offsetting provisions. The result was a clean tax cut for families of modest means but a mixed bag for wealthier taxpayers.
Low-income families benefitted from lower tax rates, a higher standard deduction, and a larger child tax credit. The recent CBO analysis put the cumulative benefit of those provisions at over $4 trillion. Subtract out the rate relief going to higher-income taxpayers and still you’re left with a multi-trillion-dollar tax cut for taxpayers of modest means, largely devoid of any offsetting raisers.
The benefits accruing to upper income taxpayers, on the other hand, are more complicated. The lower rates and individual AMT relief they got were substantially offset by the new SALT cap, the loss of Section 212 deductions, a cap on the mortgage interest deduction, and other provisions. For those taxpayers, how they fared depended on many factors, including where they live, how many children they have, and how they make their money. Some did well, but others saw their taxes go up.
This means allowing the TCJA provisions to expire as scheduled would result in tax cuts for many high-income taxpayers but significant tax hikes for families of more modest means. This reality is the first reason we are confident that Congress will act next year to prevent us from going over the cliff.
The Main Street Time Bomb
We all know the Section 199A small business deduction and lower pass-through rates are scheduled to sunset at the end of 2025. If they do, any semblance of parity between pass-throughs and public C corporations will be eliminated, inflicting large tax increases on millions of Main Street businesses located in every single community in America.
As with the individual relief, however, the pass-through discussion is more nuanced than the headlines would suggest. That is because, as with the individual tax provisions, the lower rates and 199A deduction were largely offset – this time by the SALT deduction cap, the elimination of the old 199 manufacturing deduction, the new excess loss limitation, the new 163(j) cap on interest deductions, R&E amortization, etc.
This chart using the JCT’s 2017 estimates is a rough effort to illustrate how the benefits and costs were distributed.
These are back-of-the-envelope estimates, but you get the picture. Smaller enterprises got a clean tax cut while the results for larger enterprises depended on a multiplicity of factors, including where they operate. (It was this result that motivated S-Corp to engage in our successful SALT Parity campaign.)
Moreover, the revenue raisers in red stay in place post 2025. We’ve written about this dynamic for over a decade now (here, here, here, here, here) but it continues to be neglected in the general tax conversation. The Main Street Employers Coalition got its start not to advocate for tax cuts, but rather to avoid the very tax hikes we now face post-2025.
The bottom line is if we go over the cliff, businesses of all sizes will see their tax burden go up – not just relative to today, but relative to the pre-TCJA Tax Code. That’s the second reason we are confident Congress will act next year.
Not Just Business Relief
Finally, there’s more at stake next year than expiring tax relief, including the pending sunset of expanded Obamacare tax credits. Here’s Forbes on the expiration of these credits:
In early 2021, Congress significantly increased subsidies for people who purchase coverage through the exchanges. In the Inflation Reduction Act, Congress maintained these higher subsidies through 2025. These higher subsidies present several major problems, but they have led to about 3 to 4 million additional exchange enrollees. Since nearly 2 million people who lose Medicaid from the redeterminations are projected to enroll in subsidized exchange coverage, CBO projects that overall Obamacare exchange enrollment will rise to 17.9 million people in 2025 (up from 15.2 million this year). CBO projects that the loss of the enhanced subsidies will cut exchange enrollment to 12.8 million in 2027.
Five million people losing their health coverage is bound to get somebody’s attention.
So is the expiration of WOTC and other worker, community, and renewable energy deductions and credits. The recent CBO report on next year’s cliff highlighted $199 billion of these, including credits for advanced manufacturing, clean fuel production, clean vehicles, energy efficient home improvements, among others. These expiring provisions enjoy bipartisan support and are the third reason we are optimistic Congress will act next year.
Bipartisan Reasons for Action
The point of all this is that there are strong reasons why members of both parties will act to avoid next year’s fiscal cliff. A failure to act would result in tax hikes on millions of low-income families, tax hikes on millions of Main Street businesses, and the loss of health insurance for millions more. It’s a pretty compelling set of incentives for action.
Talking Taxes in a Truck Episode 37: Carol Roth Explains Why It’s Time to Repeal the CTA
Our latest podcast guest is Carol Roth, a New York Times bestselling author, small business advocate and most recently, a staunch ally in the fight to repeal the burdensome and ill-conceived Corporate Transparency Act.
Carol starts by talking about how her time in the investment banking world exposed her to the uneven playing field between small businesses and larger corporations, and how that experience led her to become a Main Street advocate. Later she dives deep into the CTA and its onerous reporting requirements, her recent testimony on Capitol Hill that focused on the new statute, and the many compliance horror stories she’s heard from small business owners nationwide.
Be sure to connect with Carol via CarolRoth.com/news or on X (@CarolJSRoth)
This episode of Talking Taxes in a Truck was recorded on May 6, 2024, and runs 41 minutes long.