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A Taxing Month for Lawmakers
Congress is back in session this week for what promises to be a busy April for tax policy. Here is a quick overview of what’s happening.
Smith-Wyden Bill in Senate
The big-ticket item is the $80 billion Tax Relief for American Families and Workers Act. This bill easily passed the House back in January but has remained stalled in the Senate since.
That’s largely due to Republican tax writers’ objections over the structure of the child tax credit, among other items. As Politico reported this morning:
Key Senate Republicans, including the ranking member of the Finance Committee, Sen. Mike Crapo of Idaho, and the two tax writers running to be next GOP leader in the chamber, Sens. John Cornyn of Texas and John Thune of South Dakota, all continue to have issues with the Wyden-Smith bill, complicating its chances of getting passed.
Republicans have asked Finance Chair Ron Wyden to hold a markup but he has resisted such calls to date. Leader Schumer, meanwhile, sent a note to his colleagues Friday outlining the Senate’s agenda and while he did mention the tax bill, it was only in the context of a longer list of issues that might be considered. Again from Politico:
There are also close to a dozen items listed in that “weeks and months ahead” bucket, and not all that much floor time left in 2024, in no small part because it’s a presidential election year — so it remains difficult to know just how much of a priority the tax bill will be for Schumer.
With time getting short – Tax Day is approaching and the business and Child Tax Credit provisions are retroactive to last year – it appears taking the bill directly to the Senate floor is the only viable option. Scheduling a markup at this late date is unlikely and Senate Republicans remain firm in their position despite the best efforts of the business community.
It’s not the normal path for a tax bill, but at this point in the calendar, it seems to be the only way forward.
Tax Policy Hearings
While the Smith-Wyden bill drama plays out in the Senate, several hearings are scheduled in the House that are worth flagging. The general sense is that the conversation is beginning to turn to next year and the expiration of the TCJA’s individual and pass-through provisions.
- House Small Business Committee on Tax Policy: Shifting the discussion to next year and the fiscal cliff, the House Small Business Committee convenes for a hearing Wednesday (April 10th) entitled, “Exploring the Adverse Effects of High Taxes and a Complex Tax Code.” The witness list includes several small businesses and a professor from Purdue. Should be interesting.
- Ways & Means on TCJA: The following day, the House Ways & Means Committee has a hearing to “highlight the benefits of GOP tax reform and discuss the path forward for tax policy ahead of 2025.” We’re looking forward to plenty of firsthand accounts about how the bill has helped Main Street employers and American families and will be watching closely.
- House Small Business on CTA: Not strictly tax-related, the House Small Business Committee convenes again on April 30 to discuss FinCEN’s implementation of the Corporate Transparency Act. Given that the vast majority of entities affected by the CTA – over 30 million – are small businesses, the panel is the ideal venue to bring concerns over the new data collection regime to light.
Main Street Tax Day Briefing
Finally, the S Corporation Association is teaming up with NFIB to host a Tax Day briefing on the looming tax threat faced by Main Street businesses. Attendees will get a crash course on the importance of Section 199A and other key provisions, the sizeable role played by private businesses in supporting virtually every community across the country (spoiler alert: it’s big), and survey results on how voters feel about these and other topics.
So a busy month for Americans rushing to beat the April 15th tax filing deadline and lawmakers on Capitol Hill as well. As always, we will be out there working to make sure Main Street gets a fair shake.
C Corps for Everybody?
S-Corp’s mantra for tax reform is “S corps for everybody!” Tax all businesses once, tax them when the money is earned, tax them at a reasonable rate, and then leave them alone. In other words, tax them like S corporations. Moving the Tax Code towards what we call a “single tax system” would level the playing field for all types of businesses while eliminating the complexity and distortions created by the double corporate tax.
This approach contrasts completely with the vision outlined in last week’s paper by Kyle Pomerleau and Don Schnieder (P-S). There are lots of moving parts here, but the short version is they would use next year’s fiscal cliff as an excuse to cut taxes for public C corporations while raising them on Main Street businesses. If you’ve been wondering how the corporate sector was going to respond to next year’s looming tax hikes on pass-throughs and individuals, look no further.
Tax Cuts for Me, Tax Hikes for Thee
Public corporations have three advantages over private companies regardless of how those private companies are organized:
- They have access to cheaper capital through the public equity and debt markets;
- Their shareholders often pay little or no shareholder level taxes; and
- They aren’t affected by the estate tax.
By contrast, access to capital is a huge challenge for private companies. With few exceptions their shareholders are always individuals or trusts who are fully taxable, and every private company of any size spends a considerable amount of time and resources trying to manage around the estate tax.
This is a tax discussion so we’ll set aside the first point for now, but challenges two and three are products of a poorly designed tax code. Any tax reform plan worth considering would seek to address those issues.
To their credit, P-S would eliminate the estate tax. That helps, particularly in the context of businesses hoping to continue a legacy of family ownership. They then step all over that decision by either (Option 1) raising taxes on pass-through businesses while lowering them for C corporations or (Option 2) forcing all larger private companies into the double corporate tax.
What would the corporate rate be under their plan? 21 percent. What is the double tax under their plan? 23.8 percent. They start by assuming the TCJA’s corporate relief remains in place and then proceed to offer America’s largest public companies even more benefits by extending full expensing, curbing the impact of the interest deduction cap, eliminating the corporate AMT, and other changes.
Pass-through businesses don’t fare quite as well. P-S would either repeal the 199A deduction outright – they mention this several times lest it escape our notice – or replace it with a “return on capital formula” that’s so narrow and laughably complex as to be beneath discussion.
They also would raise taxes on pass-throughs by allowing the current top rates to revert to their pre-TCJA levels while reducing their income thresholds to new, lower levels. The result would subject pass-through businesses to higher rates imposed on a broader base of income. Just to be clear, those are higher rates and a broader base compared to their pre-TCJA levels, not current law.
This treatment is apparently justified by their observation that pass-throughs are making out like bandits under the TCJA:
Although lawmakers were correct to be concerned about how differences in the taxation of pass-through businesses and C corporations affect behavior, Section 199A reduced the statutory tax rate on business income far below the tax rate on labor compensation, increasing the incentive to reclassify income from labor compensation to capital income. It also increased the competitive advantage of pass-through businesses over traditional C corporations, discouraging companies from incorporating.
So many mistakes in one paragraph. Section 199A doesn’t discourage “incorporation” (S corps are corporations too); 199A reduced the effective rate, not the statutory rate (it’s a deduction); and P-S offer no evidence for their reclassification claim because it doesn’t exist. We are aware of no post-TCJA study finding unusual levels of workers shifting to independent contractor status.
More to the point, “worker versus pass-through” is not the critical comparison here. S corps don’t compete with workers, they hire them. S corps compete with public C corps, and here is where P-S’s own calculations belie the notion that pass-throughs have a rate advantage. Here’s the key portions of Table 8:
And here’s Table 9:
Neither table reveals a demonstrative advantage for pass-throughs. If anything, they reveal rough rate parity. Moreover, the tables skip over several important details, such as the fact that the pass-through tax burden includes smaller companies paying the lower rates, whereas the corporate tax is imposed on large public companies almost exclusively. They also ignore that the 39.8 percent rate for corporations only applies to private companies whose shareholders are fully taxable, as most public company shareholders don’t pay the full tax so their actual effective rate is much lower than what’s reported here.
Tax Policy Center on Shareholders, Again
That last point is very, very important. One of the head scratching aspects of P-S is their total neglect of the damage the double corporate tax does to the economy. They simply don’t mention it, let alone reflect on its implications. Preserving the current corporate treatment, regardless of how distortionary, was apparently their starting point.
And distortionary it is. Just this week, the Tax Policy Center released a more fulsome version of its 2016 analysis of how the profile of corporate shareholders corporations has shifted in recent decades. The profile has migrated from mostly taxable individuals to being dominated by tax exempt foreign investors, retirement accounts, and other tax-exempt entities.
If you separate the business community into public and private companies, then the blue, yellow and pink shareholders are almost universally reserved for public companies. You don’t get a lot of sovereign wealth funds investing in smaller, private companies.
So while the percentage of taxable shareholders of public companies has dropped, the profile of private company shareholders has remained the same – fully taxable. As authors Rosenthal and Mucciolo write:
First publicly reported in 2016, the pronounced shift from taxable to tax-exempt shareholders complicates tax policy. Policymakers who seek to increase shareholder taxes, for instance, must grapple with a relatively small group of taxable accounts. Policymakers pursuing corporate tax cuts could send a large share of the benefit to foreign investors, at least in the short run. And policymakers seeking to stem corporate stock buybacks must address the tax advantages of buybacks over dividends to foreign shareholders — and to a lesser extent to domestic shareholders.
P-S would preserve this disparity as is, with public corporate shareholders paying little to no second layer of tax while the shareholders of private companies pay the full boat. They then compound this inequity by arguing that all larger pass-through businesses should be forced into the corporate double tax.
What’s interesting is that P-S acknowledge the importance of reducing distortions generated by the Tax Code, and then promptly ignore the role the double corporate tax plays here. They observe:
Timing of Realization. The current tax system relies, in part, on a “realization” principle. For administrative convenience, taxpayers are often taxed only when they realize income. For example, capital gains and losses are counted only when a taxpayer disposes of an asset. As a result, taxpayers have an incentive to hold off on selling appreciated assets and accelerate the sale of an asset to realize a loss. Ideally, taxation would not distort transactions like this.
This failure has geographic implications. As our work with EY has shown, public company employment tends to be concentrated in city centers and the coasts, whereas private company employment, including pass-throughs, is spread more evenly across the country. By further distorting the Tax Code in favor of public companies, P-S would harm large parts of the country.
The irony is that this is why S corporations were created in the first place. Congress back in 1958 recognized that closely-held businesses were disadvantaged under the double corporate tax and made the single tax system more widely available in response. Today’s rates are different but the essential challenge is the same.
Pass-Through Tax Hikes
Finally, let’s revisit the justifications P-S identify for why Section 199A was created in the first place. Parity and economic growth were definitely in the mix, but the primary reason the Main Street community argued for rate relief was our desire to avoid a tax hike.
Starting with the Obama budget and extending through all those Camp drafts, Paul Ryan’s efforts when he chaired Ways and Means, and finally the Brady draft, Main Street correctly argued that the base broadening included in the corporate reforms would result in a tax hike on the pass-through sector. It’s our tax base too, after all. TCJA base broadeners that raise taxes on pass-throughs included:
- SALT Cap
- Section 163(j) Interest Deduction Cap
- Section 461(l) Loss Limitation Rules
- Section 212 Deduction Limitations
- Section 199 Manufacturing Deduction Repeal
- Section 174 R&E Amortization
Those tax hikes are preserved in the P-S plan without the Section 199A deduction to help offset them. The P-S plan would make the pass-through tax base broader and their rates higher than pre-TCJA.
Full Circle
We are in danger of coming full circle here. Pre-1986 tax reform, the C corporation was the tax shelter of choice; every rich person had one. They would earn their income in the C corporation and then load up the company with as many personal expenses as possible – apartments, cars, trips, whatever they could get away with. The goal was to apply the lower corporate rate to a smaller base of income.
This gaming ended post-86 when rates on individuals, pass-throughs and C corporations were consolidated into the same neighborhood (for a while, the top rates were even the same). The result was the abandonment of the C corporation shelter and a massive shift of business activity into the superior pass-through form.
Now P-S and their colleagues would return us to the bad old days of tax cheating C corporations. It’s not an improvement, and it’s going to hurt most of the country. Congress should reject this approach.
Time to Pause the CTA
The Main Street business community came out in force today calling on Congress to enact the Protect Small Business and Prevent Illicit Financial Activity Act (S. 3625). The legislation, championed by Senator Tim Scott (R-NC), would delay by one year the onerous Corporate Transparency Act (CTA) filing requirements and accompanying jail time and penalties. A similar bill sponsored by Representatives Zach Nunn (R-IA) and Joyce Beatty (D-OH) passed the House late last year 420-1.
The letter, signed by more than 120 trade associations, points out that such a delay would allow the ongoing legal battle to play out, be consistent with lawmakers’ original intent to give covered businesses two years to file their CTA reports, and give regulators more time to continue their outreach and education of affected entities.
To the first point, two weeks ago a Federal District Court deemed the CTA unconstitutional. The decision was welcome but confusing. Even though the entire law was found to be unconstitutional, the ruling applied to the plaintiffs only – members of the National Small Business Association (NSBA). As the letter reads:
Following the ruling, FinCEN indicated it would continue to enforce the CTA against all small businesses and other entities not named in the lawsuit. This decision effectively creates two classes of small businesses: those that were members of the NSBA as of March 1st will enjoy the protections of the Constitution while the remaining 32 million small businesses targeted by the CTA will not.
Meanwhile, many small business owners will hear about the ruling and conclude that they are no longer obligated to comply, unaware that they are making themselves vulnerable to the CTA’s stiff fines and criminal penalties. FinCEN, meanwhile, has no practical means of distinguishing between NSBA members and other small businesses. The NSBA’s membership is not public, and the courts have previously ruled that the government cannot compel trade associations like the NSBA to turn over their membership lists.
Second, a two-year deadline was the plan along:
The CTA statute, adopted as part of the National Defense Authorization Act for Fiscal Year 2021, called for a reporting deadline of “not later than 2 years after the effective date of the regulations” for existing entities. This timeframe was designed to give affected entities sufficient time to learn of, understand and comply with the new reporting regime. The two-year initiation period is in keeping with the legislation’s preamble which instructs FinCEN to “seek to minimize burdens on reporting companies associated with the collection of beneficial ownership information.”
In its rulemaking, however, FinCEN shortened this deadline and gave existing entities just one year to comply. That decision is problematic both in its disregard of congressional intent and its practical implications for CTA compliance rates. The CTA covers tens of millions of legal entities plus all those millions of individuals defined as their so-called “beneficial owners,” yet the vast majority of the law’s targets remain wholly unfamiliar with their new compliance obligations. They simply need time to learn about the new law.
Finally, affected businesses remain largely unaware of their new reporting obligations, and regulators are far behind in their efforts to engage the business community:
Filing under the CTA began more than two months ago, yet fewer than 2 percent of covered entities have submitted their required information to FinCEN. At this rate, it will take more than ten years for filings to reach FinCEN’s estimates of 32 million submissions.
One reason for this low compliance rate is that most business owners are ignorant of the new law. A recent survey conducted by the National Federation for Independent Business found that four out of five small business owners are “not at all familiar” with the new reporting requirements. Meanwhile, as a Tax Notes article highlighted, while the accounting community is best positioned to educate their small business clients regarding their filing obligations under the CTA, they are precluded from doing so it could constitute practicing law without a license.
The CTA is the largest data grab in history outside the Tax Code. Covered businesses and other legal entities need time to learn about their new obligations, particularly as a failure to comply could result in two years in jail and thousands in fines.
The one-year delay called for in the Scott legislation is exactly what the business community needs right now. It would give them time to learn about the CTA, time for the courts to work their will, and time for FinCEN to finish the job educating the public about the new law.
More than a Dime’s Worth of Difference
Two events took place this week which demonstrate just how remarkably divergent the potential paths of tax policy are next year.
First, the Senate Finance Committee held a rare hearing Tuesday on the challenges faced by American manufacturers. Senator Steve Daines (R-MT) took the opportunity to highlight the importance of 199A to his manufacturers in Montana and how Congress needs to act to make it permanent.
As Daines noted:
The foundation of businesses in Montana are passthrough businesses. They make up 95 percent of all businesses and employ a majority of workers in our country. In Montana, 75 percent of private sector workers are employed by passthroughs. Back in 2017 we placed these businesses on more equal footing with their C corp counterparts, by providing them a 20 percent tax deduction on their qualified business income.
These businesses are absolutely critical to our communities. You look at data in terms of when you come out of a recession, it’s the passthroughs that take the lead in hiring and growing and so forth faster than the C corps. And that’s why I’m proud to be leading the bill that would make this deduction permanent.
The Main Street Tax Certainty Act protects tens of millions of small businesses, allowing them to make more profits, add new jobs, strengthen the economy. Think about the core word in “capitalism,” which is “capital.” This allows these businesses to have more capital to invest. It allows businesses to decide, and the free markets to decide, where to make these capital investments, versus the federal government taking more of those dollars and allocating them here in this city called Washington, DC.
Later, Senator Ron Johnson (R-WI) made a strong case for comprehensive tax reform. As he pointed out:
Why aren’t we talking about simplifying and rationalizing our tax code? What’s a simple way of taxing American businesses? I would suggest, a really simple way, would be to consider cash income taxable income. Then you wouldn’t have all these issues like R&D tax credit and accelerated depreciation, and by the way it would just be a timing difference…Let’s tax cash income and get rid of all this crap.
So to recap, let’s ensure we don’t raise taxes on millions of small and family owned businesses next year, while simultaneously working to enact comprehensive reforms that put all businesses on a level playing field. Amen to that. S Corporations for everyone, is what we say.
Meanwhile, the President released his budget this week, which not only assumes the 199A deduction sunsets at the end of 2025 but calls for an additional $5 trillion in tax hikes over the next decade, many of which are targeted directly at Main Street.
As we wrote about these same policies last year:
…the President’s budget would raise the top rates paid by pass-through businesses and corporations alike, increase the Net Investment Income Tax and expand it to cover the active business income of pass-through business owners, make permanent the harmful loss limitation rules, make it harder for family-owned businesses to survive from one generation to the next by gutting the existing grantor trust rules, nearly double the tax rate on capital gains, and impose a new minimum tax on larger family businesses that appears to redefine how income is measured. The combination of these policies would raise top tax rates on these businesses to close to 50 percent, both on their operating profits and on any gain when they sell the company.
Meanwhile, the changes on the corporate side are gathering lots of ink, but the provisions targeted at the pass-through business community are actually bigger. And that comparison excludes the expiration of Section 199A, the grandaddy of all tax hikes, which is assumed in the baseline of the President’s budget.
Fortunately for our members, the Biden budget is dead on arrival. The House is run by Republicans and that, coupled with a tight Democratic majority in the Senate, means nothing along these lines has a chance this year. That is a huge change from last Congress, when similar policies came within one thin vote (thank you Senator Sinema) of passing both the House and the Senate. The current impasse is welcome relief, albeit transitory.
If we needed a reminder of just how quickly things can change, a recent announcement that Representative Ken Buck will retire next week(!) means the Republican’s House majority is down to just one out of 435 members. That’s as tenuous as you can get.
The elections may go well this November, but they may not, which means the business community needs to be prepared. We need to arm our allies like Daines and Johnson with the best data and the best arguments, so we increase the odds we end up with a positive result.
The alternative is remarkably unattractive. As the Biden budget demonstrates, there are lots of really bad ideas out there and they are hanging right out there on the horizon, just one or two votes away from being enacted.
Talking Taxes in a Truck Episode 36: The CTA Compliance Wrinkle No One’s Talking About
The Corporate Transparency Act is now in effect, imposing complex reporting requirements on every small business in the country, and many large ones too. But what if the person best equipped to assist those businesses with compliance – your local CPA –wasn’t allowed to do so?
To explore this dynamic, we talked to Jim Hamill, Director of Tax Practice at the Albuquerque-based accounting firm Reynolds, Hix, and Company and an Associate Professor of Accounting at Texas A&M Commerce. Jim explains how the CTA puts tax professionals in a bind and forces them to choose between helping their clients and possibly engaging in unauthorized practices. He also explores how difficult the CTA’s “beneficial owner” definition is to pin down, why compliance will cost small businesses far more than FinCEN estimates, and how it is all unlikely to deter money laundering.
This episode of Talking Taxes in a Truck was recorded on March 6, 2024, and runs 47 minutes long.