More on the Administration’s Budget

February 19, 2016 by · Leave a Comment 

We weren’t the only ones who noticed the President’s budget for 2017 is bad for Main Street Employers.  Numerous outlets ran stories (CQ, Bloomberg, and Morningstar) focusing on the negative impact the President’s tax proposals would have on S corporations and other pass-through businesses.  As our friends from NFIB noted about the Administration’s proposal to expand the Net Investment Income Tax (NIIT) to all pass-through business owners:

“It’s not closing any gap,” said Nick Karellas, tax counsel at the National Federation of Independent Business. “It’s just blatantly a revenue grab on small-business owners who are actively participating in their businesses.”

The Administration’s efforts to characterize this proposal as a loophole-closer are interesting, given that Congress intentionally excluded active business owners from the tax when it was enacted back in 2010 (See below).

But the proposals go well beyond expanding the NIIT.  They include increasing payroll taxes on professional service businesses, raising the capital gains rate paid by S corporations and others to 28 percent, and establishing a 30 percent minimum “Buffett tax” on all forms of income.  Each of these tax hikes would directly impact the profitability of pass-through employers.

Following the budget’s release, Treasury Secretary Jack Lew testified before the Ways and Means Committee and attempted to characterize their tax hikes as targeted at law firms and hedge funds, despite the fact that they would apply to all businesses – manufacturers, contractors, retailers, etc.  S-Corp Champion Dave Reichert (R-WA) was having none of it:

 

“Let me just go through what I think tax reform should look like, and I don’t see it in the President’s budget, in fact I think it’s really offensive to small businesses. Tax reform should stimulate growth and efficiency by reforming America’s current complicated, burdensome system into a simpler, fairer, flatter tax code. Tax reform should promote U.S. jobs and higher wages through a more competitive international tax system. Tax reform should ensure that small businesses have a fair and competitive tax system, including the tax rate. As a result of the President’s budget, the top rate for small businesses will be 43.4 percent. They don’t get it, and I don’t get it either, Mr. Secretary. Tax reform should aggressively lower rates, and simplify the code. Even after enacting substantial increases in capital gains taxes in 2010 and again in 2013, President Obama continues to propose raising taxes on the investment American workers need to become more productive and earn higher wages…Mr. Secretary…I would like you to explain to me how raising taxes on small businesses helps the American economy grow, helps small business grow, helps create jobs? I don’t understand how you can raise taxes and create a growing economy and create jobs.”

Last year, one of our S-CORP Board Members testified on the effect of these tax hikes on his manufacturing business. McGregor Metalworking saw its effective tax rate – not marginal, effective — jump from 34 to 42 percent following the Obama-supported rate hike in 2013 that Congressman Reichert cites.  Under the new Obama plan, McGregor’s effective rate would go even higher.

 

Confusion on the NIIT

There’s lots of confusion as to why the NIIT doesn’t apply to the business income of active business owners.  Advocates eager to rewrite the history of the provision are driving this confusion, which is showing up in major publications.  Take for example this excerpt from David Wessel in the Wall Street Journal:

Lobbyists for those who benefit from the NIIT loophole will be quick to accuse the administration of attacking small business. There are a lot of truly small businesses organized as pass-throughs, but the NIIT doesn’t affect them because they don’t earn $200,000 a year. The Treasury estimates that 67% of all S-corp income and 69% of all the partnership income goes to the top 1% of taxpayers, those with income greater than $375,000 a year.

Where to begin.

Let’s start with “loophole” and some of the facts surrounding the NIIT origins.  The NIIT was enacted in 2010 as a pay-for to Obamacare.  It was a late addition to the law that the Administration proposed in February of 2010, after both the House and the Senate had passed their respective health care reforms.

From the beginning, the proposal excluded the business income of active owners.  Here’s how CongressDaily reported on the provision at the time:

President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments.  The carve-out is a concession to a range of business groups and advocates for the self-employed.

That was us.  We led a broad coalition of business groups to oppose the provision when it was first floated, and we wrote extensively on the provision once it was released. You can read our analysis here, here, and here.

Congress made several key changes to the Administration’s proposal before enacting it – they removed its connection to Medicare and they increased the tax to 3.8 percent – but the exclusion on income of active business owners remained, as our Advisory Board Chair testified back in 2012:

This net investment income tax is generally imposed on interest, dividends, annuities, royalties, rents and gains, with one very important exception. Congress recognized that this new imposition should not apply to income derived by owners directly involved in active businesses. Therefore, Congress excluded from the tax base all income derived from a trade or business unless the income was reported by a person who did not “materially participate” under the passive activity rules or the trade or business consisted of trading in financial instruments or commodities.

So exempting the business income of active owners from the “investment” tax was part of the plan from the beginning and is no way a “loophole.”

And what about “benefit”?  Why does Mr. Wessel suggest that business owners who were never subject to a tax, and not supposed to be subject to a tax, derive some benefit from not being subject to the tax?  That label assumes that Congress intended to tax the business income of active shareholders.  They didn’t, so it’s not appropriate to call it a benefit.

Finally, Mr. Wessel massively redefines “small business.”  Any attempt to define “small” is by necessity going to be arbitrary and doomed to fail, but even the Small Business Administration (SBA) puts the threshold at 500 or fewer employees.  With around 400 employees, McGregor Metalworking (the manufacturer whose effective tax rate has jumped under Obama’s policies) is considered to be a small business by the SBA.  Mr. Wessel, on the other hand, would exclude any business that has just enough profits so that, when combined with all the other income earned by the owner’s household, it exceeds $200,000.

That’s the opposition in a nutshell.  They support small business, as long as that small business creates few if any jobs and doesn’t make much money.

The Administration’s budget and its various anti-growth proposals are going nowhere this year, but as S-Corp readers understand, no bad idea ever dies in Washington.  The false notion of a NIIT “Loophole” has been conceived and it will live long after the Obama Administration closes its doors.

Administration Budget

February 9, 2016 by · Leave a Comment 

The President’s budget is out and, as usual, it includes a number of retread proposals to hike taxes on pass-through businesses, including the Buffett Tax and a big hike in the capital gains tax.  We’ve dealt with these in the past.

There is, however, a new tax hike directly targeted at the Main Street Employer next door – an expansion of the Net Investment Income Tax (NIIT) to include all S corporation shareholders and other pass-through business owners.

The NIIT was enacted to help pay for the Affordable Care Act and is designed to tax the investment income of taxpayers making more than $250,000.  The 3.8 percent tax applies to dividends, capital gains, and other forms of investment income.  It also applies to the active business income of S corporation shareholders, partners, and LLC members, but only if they are NOT active in the operation of the business.  If they work at the business, then the 3.8 percent tax does not apply.

Under the heading of “Rationalize Net Investment Income and Self-Employment Contributions,” the Administration’s proposal would have the NIIT apply to all pass-through income, regardless of whether the taxpayer is active in the business.

  • The result of this policy would be to increase the top rate on all pass-through business income to 44.6 percent, further lengthening the gap between the top tax rates on pass-through employers and the 35 percent top rate paid by the C corporations with whom they compete.
  • It also flies in the face of the Administration’s continued support for cutting the corporate rate to 28 percent or less.  Why is it good policy to cut the marginal rates of one business, while hiking the tax rates on another?

This idea is going nowhere fast, but they do make clear the level of hostility this Administration has for Main Street Employers.

Our Chairman’s New Year Message

January 22, 2016 by · Leave a Comment 

2015 was a terrific year for the S Corporation Association.  We saw the shorter, five-year built-in gains recognition period made permanent, we organized the Main Street business community into a coherent advocacy force, and we successfully blocked misguided efforts to enact President Obama’s corporate-only tax reform plan.

For 2016, our goal is to build on these successes to ensure more legislative wins this year and beyond.

  • That means educating policymakers on how taxes on S corps already went up sharply in 2013 and working to enact legislation to repeal that tax hike.
  • It means building out our pass-through business coalition to ensure that S corps and other Main Street businesses are at the center efforts to rewrite the Tax Code, not just an afterthought.
  • And it means tackling new obstacles to S corp capital accumulation and growth like the prohibition against non-resident alien shareholders and other restrictions unique to S corporations that limit your access to capital.

That’s it in a nutshell.  For a more detailed account of our efforts in 2015 and what we have planned in 2016, click here to read our Chairman’s annual letter to the S Corporation Association membership.

Oh, and Happy New Year!

 

Brady Identifies the Challenge

Will Congress reform our international tax rules this year?  Ways and Means Chairman Kevin Brady’s (R-TX) recent interview with Politico’s Ben White gives us some insight.  You can watch the entire interview here.  Our takeaway was that Brady did a good job of identifying both the opportunities and challenges confronting tax reform advocates this year.

On the opportunity side, Brady announced that he intends to have the Ways and Means Committee mark up an international plan later this year.  American companies continue to invert, the BEPS implementation process is moving forward, and a vocal contingent of congressional reform advocates continue to refine their plans, so there are lots of catalysts for action.  The Chairman is “optimistic” they can act on international reforms this year, and it’s likely the new Speaker will support him.

But how does action on international fit with the broader tax reform vision Brady laid out in the interview?  Brady called for a “tax code built for growth” that is “fair, flatter, and simpler” and where “small businesses aren’t paying more than large businesses.”  The Chairman has been a longtime advocate for Main Street businesses – he spoke at the release of our first EY study on pass-through businesses – and he understands the important role these businesses play in job creation and investment.

Those two visions – the desire to move international this year and the recognition that tax reform must address the higher rates imposed on pass-through businesses — highlight the challenge facing the new Chairman.  How he resolves it is unclear, but we know Brady understands the position of Main Street employers and we look forward to working with him to craft a solution.

 

Hatch on the Double Tax

In a positive development, Senator Orrin Hatch (R-UT) and the Finance Committee staff are planning to release a proposal to eliminate the double corporate tax.  According to Politico:

Hatch’s plan takes aim at the double taxation of corporate profits, one of critics’ chief complaints about the current business tax system. Details are sketchy, but the Utah Republican is seriously considering giving companies a deduction for the money paid out to shareholders in dividends. That would have the effect of canceling out corporate income taxes.

“The corporation will not have the double taxation anymore,” said Hatch. “It would go a long way towards topping some of these inversions.”

He hopes to release his plan, which is still being written, “in about a couple weeks.”

Tax Notes added:

One tax lobbyist familiar with discussions around corporate integration said Hatch “is looking at this as more of an incremental approach, basically the art of the doable.” He added that Hatch has not given up on “big comprehensive reform, but if it proves to be not much easier even in a new administration, then this could become a fallback to address competitiveness.”

Specifics will have to wait until the plan’s release, but our understanding of the package is that it would:

  • Eliminate the double tax through the use of a “dividends paid” deduction;
  • Be revenue-neutral without the usual base broadening associated with tax reform; and
  • Be a stand-alone proposal that is not accompanied by rate cuts, innovation boxes, or other provisions not directly related to the double tax.

On the surface, this looks like a really worthwhile effort.  The benefits of eliminating the double corporate tax are numerous and would accrue to shareholders and workers alike.  Our EY study on pass-through businesses made clear that the double tax reduces investment, jobs, and wages.  That’s the reason we made its elimination one of the three key principles in our tax reform letter signed by 120 trade groups.

Eliminating the double tax also helps curb inversions by reducing the tax paid by corporations on their overseas income.  Right now, if a corporation wants to repatriate income in order to pay a dividend to its shareholders, it would have to pay the US tax on the income, and then its shareholders would have to pay the dividend tax.  With corporate integration, only one level of tax would apply.

Finally, integration helps to level the tax imposed on debt versus equity.  If a corporation raises capital to pay for a new investment today, the tax code imposes a really high tax on it.  But if a corporation borrows the money, the tax is significantly lower, and could be negative (i.e. the taxpayer is subsidizing the investment).  The current code encourages businesses to borrow, resulting in higher debt levels and a less secure employment base.  Integration reduces this bias.

All in all, this is reform that’s worthy of the name.  The details are important – how do they pay for this? — and we’re going to review the proposal closely when it’s released, but it’s encouraging to know the Finance Committee is focused on the underlying disease of how we tax businesses.  It’s a good place to start!

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