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Our SALT Parity Campaign Back in the News
Richard Rubin is out with a new piece in the Wall Street Journal that highlights just how successful our SALT Parity efforts have been. The article centers on an upcoming Tax Policy Center analysis which finds these reforms save businesses $15-20 billion each year, double what the Journal estimated last year.
As longtime readers know, the 2017 Tax Cuts and Jobs Act (TCJA) imposed a $10,000 cap on the amount of state and local tax (SALT) deductions taxpayers can claim on their federal return. While C corporations were exempted from the cap, most pass-through businesses owners were subjected to it, putting them at a significant disadvantage.
To address this imbalance, S-CORP and the Main Street Employers Coalition have successfully pushed for state-level reforms that restore the full deduction for pass-through entities. Under our SALT Parity approach, pass-throughs can elect to pay their SALT at the entity level (PTET), thus restoring the deduction at the federal level while maintaining revenue neutrality for the state. It’s a win-win for the businesses and the states, which is why 36 of 41 eligible states now have SALT Parity legislation on the books.
Rubin’s piece appeared in the WSJ print edition under the title, “Cap on Tax Deductions Has a Business Loophole.” The WSJ should run a correction. Our SALT Parity efforts are not taking advantage of a loophole, but rather the law as it was intended.
During the tax reform debate, it became clear that the Senate version of the TCJA applied to taxes paid by individuals but not taxes paid by businesses. C corporations were not subject to the cap. Nor were taxes paid by pass-through entities, including property taxes and income taxes paid directly by the entity (as they are here in the District of Columbia). Those taxes would continue to be deductible as a business expense, as they always had been.
This reality is why our SALT Parity laws have been explicitly blessed by the Treasury Department – they are consistent with the TCJA’s intent and the underlying tax code. The fact that federal receipts are lower than initial estimates is neither relevant nor that unusual – the Joint Committee on Taxation revises its estimates all the time. Consider the Inflation Reduction Act’s green energy provisions, whose costs are expected to come in up to four times what was originally estimated.
Nonetheless, the WSJ piece makes clear not everyone is excited about reducing business taxes or leveling out the treatment of C corporations and pass-throughs:
As a result, the cap—part of the 2017 tax overhaul—is generating 80% to 85% of its intended revenue, according to the Tax Policy Center, which is a joint venture of the Urban Institute and Brookings Institution. That means the cap doesn’t offset other tax cuts as much as expected, complicating lawmakers’ plans to extend the bulk of the law beyond its scheduled expiration at the end of 2025.
We prefer to think of the effort as reducing taxes on the business sector hardest hit by COVID and the resulting shutdowns, but to each their own. Meanwhile, the SALT Parity bashing continues – here’s Len Burman of the Tax Policy Center:
If you have a SALT cap, it doesn’t make any sense to say that the richest workers are basically exempt from it, but everybody else is subject to it.
That’s a lot to unpack. For starters, the SALT Parity bills don’t apply to workers, they apply to business owners. And the richest “owners” own C corporations, whose income is exempt from the SALT cap, hence the parity in our SALT Parity work. We missed the part where the Tax Policy Center scored how much revenue the federal government is losing by failing to cap the deductibility of SALT payments by C corporations.
The class warfare aspect to these comments is pure nonsense too. The cap itself is structured so lower income individuals can continue to deduct their taxes up to $10,000. In a state with a flat 5 percent rate, that translates into $100,000 of taxable income, which means that any effort to ease the cap would only benefit business owners making more than that amount.
Meanwhile, pass-through business owners who take the standard deduction also can make the election and get both the standard deduction and the SALT deduction. As a result, the SALT Parity bills are a big benefit to lower- and middle-income business owners.
Finally, here’s Daniel Hemel, a New York University professor, with a recycled line about who stands to benefit from the reforms:
President Biden promised to enforce the tax laws as they apply to high-income individuals, yet his administration has allowed hedge-fund managers, law-firm partners and other predominantly high-income pass-through owners to skirt the $10,000 SALT cap.
Again, no mention of the corresponding C corporation treatment, whose owners not only get the full SALT deduction but also pay a much lower, 21-percent tax rate. As long as they keep the money in the company, they can keep their taxes low indefinitely and then use charitable donations and other devices to avoid paying additional taxes, a la Warren Buffett.
SALT Parity, Section 199A, and other provisions help ensure that otherwise similar companies are not treated differently under the tax code simply because of how they are structured. Without them, we would see a return of the pre-1986 days, where everyone used the C corporation structure to shelter income. We’d also see a continuation of economic consolidation within public corporations, as family businesses would face a Hobson’s choice of either selling the business or converting to the C structure that favors public companies. Is that what the TPC wants?
The S Corporation Association is proud of the work it has done to advance these reforms. Critics may not like it, but the bottom line is that SALT Parity helps level the playing field, and puts money back in the hands of businesses, their workers, and their communities.
Section 199A Reality Check
Chuck Marr, who heads up tax policy at the Center on Budget and Policy Priorities, took to Twitter recently to slam the Section 199A deduction. It’s a perfect example of the empty rhetoric deployed by critics of the provision:
There’s a lot to unpack here so we’ll start from the top. First, Marr is correct that pass-through businesses do not pay the corporate tax – they pay tax at individual rates.
These days, that’s a critical distinction, as the 37-percent top individual rate is well above the 21-percent corporate rate. So are the 35- and 32- and 24- and 22-percent individual rate brackets. In fact, the vast majority of pass-through income is taxed at rates well above the corporate rate that applies to trillion-dollar businesses like Apple and Amazon.
Are all these business owners rich? Well, no. The 22-percent bracket starts at $41,775 for single and $83,550 for married taxpayers. Here’s a table showing the relative rates:
Second, what a weird grouping of industries Marr highlights. What does he have against car dealers and beer distributors? Why does he single them out, as opposed to manufacturers and retailers and home builders and all the other industries with partnerships, LLCs and S corporations among their ranks? There are about 9 million of these businesses – nine million! – so it is safe to say that just about every industry is well represented here.
Third, Marr is focused on rich business owners, but he ignores the rules that limit the 199A deduction for those taxpayers. In simple terms, successful auto dealers, beer distributors, and others don’t get the deduction if they don’t create jobs or invest in their communities. That’s because there are guardrails that limit the 199A deduction tied to the wages a business pays and/or the capital it has invested. (No such guardrails apply to the corporate rate, by the way. That low rate applies to all corporate profits regardless of how few jobs the business creates.)
Fourth, Marr doesn’t mention it, but many readers ask about the so-called double corporate tax. The corporate rate of 21-percent applies to business income, but the shareholders of those business might also be subject to tax when they sell stock or receive a dividend.
The challenge with calculating this second layer of tax is 1) according to the Tax Policy Center, three-fourths of public company shareholders pay no taxes or enjoy significantly reduced rates, and 2) the minority of shareholders who do pay tax have the ability to defer that tax for years or decades. Just ask Warren Buffett. By contrast, the tax imposed on pass-throughs is immediate and full, regardless of whether the business distributes any earnings.
To cut through all this complexity, we asked EY to estimate the effective rates paid by the typical pass-through verses the burden imposed on the typical C corporation. As you can see from the table, pass-throughs and C corporations pay similar levels of tax, but only if the pass-through deduction is available and only if lots of the C corporation’s shareholders actually pay tax.
Absent the Section 199A deduction, that gap widens to as much as 16 percentage points. There’s simply no way for pass-through businesses to compete in that environment, which is why Congress enacted 199A.
Marr’s conclusion that Section 199A is a “trickle-down failure” is where things really fall off the rails. The statement is based on a CBPP paper which finds Section 199A accrues largely to higher-income taxpayers, with 64 percent of the tax benefit going to those households with over $400,000 in annual income. But what’s portrayed as some sort of smoking gun is the natural consequence of a tax structure where business income shows up on a taxpayer’s individual return. As an earlier Treasury study estimated, four out of five taxpayers with incomes exceeding $1 million were business owners.
If Marr gets his way and Section 199A is allowed to expire come 2026, he won’t have to worry about how much tax is paid by “rich” business owners. Faced with a massive rate differential, many of these businesses will be forced to sell, close up shop, or convert to C corporations and use the lower corporate rate to shelter their income. That’s good news for Wall Street and tax accountants, but it’s bad news for the communities and workers who rely on private and family-owned companies.
Luckily, lawmakers on Capitol Hill see things differently. Legislation to make Section 199A permanent now has bicameral and bipartisan support, and is backed by more than 160 national trade associations. With the fate of Main Street on the line, it’s time to stop the false rhetoric and instead focus on helping American employers.
Support for 199A Reaches New Heights
The effort to make permanent the Section 199A Main Street business deduction just hit a significant milestone.
In just two weeks the Main Street Tax Certainty Act (H.R. 4721), introduced by Congressman Lloyd Smucker, has garnered the support of more than 100 House cosponsors. Among those backing the legislation are Democratic Representatives Henry Cuellar (TX) and Josh Gottheimer (NJ), and all 25 Republican members of the Ways & Means Committee.
Section 199A was enacted in 2017 to encourage job creation and new investment by private businesses. It also helps private companies compete with large, publicly-traded corporations. Without the deduction, pass-throughs would face rates up to 16 percentage points higher than their publicly-traded competitors. Despite this important role, Section 199A is set to expire at the start of 2026.
Of the more than 5,000 House bills introduced this year, the Main Street Tax Certainty Act is just one of 80 to hit the 100-cosponsor mark. Over the past decade, only about 2 percent of bills have reached that threshold. In other words, the broad support for Section 199A permanence shows lawmakers fully grasp the severity of the situation, and are committed to preventing a massive tax hike on millions of Main Street businesses come 2026.
There’s good news on the other side of the Capitol as well. Back in May, Senator Steve Daines (MT) – a longtime ally of the Main Street business community – introduced his 199A permanence bill (S. 1706). To date, one of every five Senators is a cosponsor.
Section 199A is more than just a tax provision. It protects thousands of local communities from fewer jobs and more boarded up buildings, reduces the tax burden on local businesses to make them more competitive, and allows multi-generation businesses to stay family-owned.
Ensuring Section 199A is a permanent fixture of the Tax Code is the number one priority for the S Corporation Association. As it turns out, we are not alone. More than 160 trade associations – representing millions of Main Street employers from every corner of the country – recently signed onto our letter thanking Senator Daines and Congressman Smucker for their leadership and are actively backing the effort.
There’s still much work to be done, but the broad support for the Main Street Tax Certainty Act shows it is time for Congress to pass this commonsense legislation and let affected businesses go back to doing what they do best: hiring workers, growing the economy, and supporting their communities.
More on Moore
We promised more on Moore v. United States, and here it is. The pending court case is garnering lots of attention, including the WSJ, the Tax Policy Center, Tax Notes, former tax staffer George Callas, even former Senator John Breaux. What’s got them all worked up?
9th Circuit Goes Big
At issue is whether Charles and Kathleen Moore realized income even though the business they partially owned never distributed earnings. Before you start yawning, be advised this case could have implications for all sorts of tax policy, including mark-to-market proposals, wealth taxes, even pass-through tax treatment.
According to the brief, the Moores invested in a company that provides modern equipment to rural farmers in India. From the start, its business plan included reinvesting any profits rather than distributing them. The Moore’s described their investment as an act of goodwill.
But their goodwill turned into a tax burden when Congress enacted Section 965. That Section deemed the company’s retained earnings to have been distributed and imposed a tax on the deemed income. It required the Moores to pay tax on an ownership stake where they received no income.
The Moores are understandably unhappy with this result. They could try to sell their shares, but who wants to buy a stake in a business where all you get is tax bills? So they sued and here we are.
From S-Corp’s perspective, this case would be a nothing burger save for the remarkably broad ruling from the 9th Circuit. How broad? Here’s the dissent penned by Judge Bumatay:
We become the first court in the country to state that an “income tax” doesn’t require that a “taxpayer has realized income” under the Sixteenth Amendment. Instead, we conclude that the Sixteenth Amendment authorizes an unapportioned tax on unrealized gains because the “realization of income is not a constitutional requirement.” We thus endorse the constitutionality of a federal tax on the share of undistributed earnings of a foreign corporation owned by a U.S. taxpayer—despite (in this case) the U.S. taxpayer being a minority shareholder of the foreign corporation. In other words, we allow a direct tax on the ownership interest of a taxpayer—even when the taxpayer has yet to receive any economic gain from the interest and has no ability to direct distribution of gain from the interest.
This all seems pretty cut and dry. The 9th Circuit has a history of overreaching and this appears like another opportunity for the Supreme Court to reassert the law.
But Wait, There’s “Moore”
The Tax Policy Center is apparently on board with this overreach. To start, they quote Justice Oliver Wendell Holmes in a dissent to the case Eisner v. Macomber (1920):
I think that the word “incomes” in the Sixteenth Amendment should be read in “a sense most obvious to the common understanding at the time of its adoption.” For it was for public adoption that it was proposed. The known purpose of this Amendment was to get rid of nice questions as to what might be direct taxes, and I cannot doubt that most people not lawyers would suppose when they voted for it that they put a question like the present to rest. I am of opinion that the Amendment justifies the tax.
On the face of it, the Holmes dissent is obviously wrong. If the 16th Amendment were drafted to eliminate “nice questions as to what might be direct taxes,” it would have addressed the Constitution’s required apportionment of direct taxes. Instead, it allowed for the direct taxation of income without apportionment, which means we are now discussing nice questions as to what might be income.
More importantly, the Holmes quote is the dissent. What did the actual ruling say? You know, the law of the land? Here’s the court:
What is or is not “income” within the meaning of the Amendment must be determined in each case according to truth and substance, without regard to form….
Income may be defined as the gain derived from capital, from labor, or from both combined, including profit gained through sale or conversion of capital assets….
Mere growth or increment of value in a capital investment is not income; income is essentially a gain or profit, in itself, of exchangeable value, proceeding from capital, severed from it, and derived or received by the taxpayer for his separate use, benefit, and disposal. [emphasis added]
To be clear, the case cited by the TPC in their support of the 9th Circuit decision actually refutes it – “mere growth or increment of value in a capital investment is not income.” The TPC then moves on to Helvering v. Horst:
Twenty years later, the Court described the requirement that money or property be received as a rule of “administrative convenience,” not of constitutional import. Now, for more than one hundred years, the Court has respected Congress’s use of “income” for tax purposes.
But the facts in Helvering weren’t about a taxpayer who received no income. They were about a taxpayer who had his son receive the income that would have otherwise accrued to him, all in an apparent attempt to avoid tax. The Court was having none of it:
The tax laid by the 1934 Revenue Act upon income “derived from . . . wages or compensation for personal service, of whatever kind and in whatever form paid . . . ; also from interest . . . ” cannot fairly be interpreted as not applying to income derived from interest or compensation when he who is entitled to receive it makes use of his power to dispose of it in procuring satisfactions which he would otherwise procure only by the use of the money when received.
The court ruled the taxpayer received income and then disposed of it. Not the same thing as not receiving the income in the first place.
What About S Corporations?
It may seem odd to hear the S Corporation Association argue for a “realized income” standard of taxation when S corporations (and partnerships) do not follow that model. As the Tax Policy Center notes:
If the Court rules for the Moores, it… could force Congress to rewrite major parts of our international, pass-through, and financial tax regimes. The courts have permitted, for many decades, Congress to tax a corporation’s undistributed investment income to the controlling stock holders of personal foreign investment companies and CFCs (and Congress continues to tax these undistributed earnings). These rules prevent wealthy Americans and US multinationals from using foreign corporations like uncapped traditional Individual Retirement Accounts.
S-Corp friend George Callas made a similar argument in response to former Senator John Breaux’s recent piece critiquing the 9th Circuit:
Excellent points. The 9th Circuit decision does highlight our mixed history on the question of taxing income. In addition to S corporations, the TPC identifies a number of taxes that apply before any income is realized, including our new quasi-territorial international tax system, PFICs, zero-coupon bonds, and the treatment of some derivatives.
But just because Congress and the courts have a history of being inexact does not mean the 9th Circuit is right to dispose of the realization doctrine altogether. As Judge Bumatay noted in his dissent:
Neither the text and history of the Sixteenth Amendment nor precedent support levying a direct tax on unrealized gains. Ratification-era sources confirm that the prevailing understanding of “income” entailed some form of realization. And a hundred years of precedent establishes that only realized gains are taxable as “income” under the Sixteenth Amendment. While the Supreme Court has allowed flexibility in identifying “incomes,” it has never abandoned the core requirement that income must be realized to be taxable without apportionment under the Sixteenth Amendment. Simply put, as a matter of ordinary meaning, history, and precedent, an income tax must be a tax on realized income. And our court is wrong to violate such a common-sense tautology.
Conclusion
The Moore case involved a one-time tax and a small amount of money. As Tax Notes quoted the TPC’s Steven Rosenthal:
Rosenthal further observed that the Court isn’t addressing a split in the lower courts, that the amount of money at stake for the petitioners — just under $15,000 — is a relative pittance, and that the repatriation tax is a temporary transition rule, not a long-term, ongoing problem that would need to be rectified.
“So the case itself is rather modest, other than, does it breathe fresh life into the realization doctrine?” Rosenthal said.
If that’s the case, the consequences could be enormous, not just for future progressive policymaking, but for many areas of existing tax law.
While Rosenthal’s comments are directed at the Supreme Court’s actions, it’s the 9th Circuit that could have issued a narrow ruling and left the status quo intact. Instead, it appears to have used the case as a stalking horse to open the door for the broader list of tax proposals mentioned above, setting the stage for a show-down with the Supreme Court.
Can that court preserve the tax treatment of S corporations, partnerships and CFCs while also preserving the realization doctrine (or what’s left of it)? Let’s hope so. But if the SCOTUS does respond in kind to the breadth of the lower court decision, there’s nobody to blame but the 9th.
NY Needs R&E Expensing!
Lynn Mucenski-Keck, an S-Corp Advisor and Principal at the accounting firm Withum, is out with new Forbes piece highlighting how punitive the new research and experimentation (R&E) tax regime is to businesses in New York and across the country.
With New York already fighting to retain businesses, the capitalization of federal R&E expenditures may result in more companies moving out of New York to balance their federal and New York State tax bills. One of the attractions for New York businesses is our highly educated and talented workforce. New York is consistently rated as one of the top ten most highly educated states in the United States. However, if out-of-the-box thinking, innovation, and growth is impeded by forced R&E capitalization, New York could cease to be a place to innovate and grow.
Since its inception, Section 174 allowed businesses to deduct their R&E expenses in the same year they were incurred. Congress enacted the provision to spur innovation while allowing domestic companies to better compete on the international stage.
Beginning in 2022, however, business must amortize their domestic R&E costs over a five-year period. (For 2022, taxpayers could only begin at the midpoint of the taxable year, resulting in a still lower 10-percent deduction.) On its face, the change may seem like a simple matter of timing. A deduction claimed over multiple years versus a full deduction claimed in year one. In practice the policy saddles innovative companies with massive, unexpected tax bills.
This example from Lynn’s earlier testimony before the House Small Business Committee shows how. A company receiving research grants that spends the full amount on R&E within the year (a common requirement) would see its taxable income increase from zero to $4.5 million:
But the new regime doesn’t just target high-tech and large companies. Because the definition of R&E expenses is broad and includes labor costs, a surprising number of small- and mid-sized businesses are affected as well. As Lynn explains, the incentive has been transformed into a deterrent, stripping much-needed cash away from companies just because they made certain investments:
…The cash impact on these New York companies is extreme. For example, the clothing designer reported a financial statement loss of $ 2 million, but primarily due to the R&E capitalization requirement of the eCommerce platform drove their taxable income up by $1.7 million, resulting in additional tax due of over $350,000. The software development company reported a financial statement loss of approximately $1 million, but due to the required R&E capitalization increased their federal taxable income by $2.2 million resulting in an additional $462,000 of federal income taxes. For two companies that would have paid little to no federal income tax due to their investment in their businesses, and actual cash outlay for research expenditures, they are now struggling with where to find the cash for their federal income tax payment.
R&E expensing may be viewed as a big business problem, but the reality is that many smaller companies are heavily invested in research and innovation too.
The House Ways & Means Committee recently advanced the American Families & Jobs Act which includes a return to the old R&E expensing regime. While some view the bill as a messaging vehicle, we think there’s more to it. Just as the House-passed debt limit bill led to a compromise package enacted into law, a tax package passed by the House might have a similar effect. For Main Street businesses in New York and elsewhere, the sooner those negotiations take place the better.