199A Trigger Warnings
Tax writers need to put a trigger warning on future 199A discussions, particularly for DC tax experts. It appears they are highly sensitive to the topic.
For example, in response to Ways and Means Chairman Jason Smith’s recent support for increasing the 199A deduction to 25 percent, AEI’s Kyle Pomerleau posted some thoughts that, on the surface, appear to make sense:
Pass-through businesses are already tax advantaged. Although C corporations face a 21 percent corporate tax rate, their profits are also subject to the individual income tax when distributed to shareholders. After considering various tax provisions that reduce the tax burden on C corporation shareholders, the Congressional Budget Office (CBO) finds that pass-through business investment faces a lower tax burden than C corporate investment.
Just one problem – the CBO analysis Kyle cites clearly shows pass-throughs pay higher effective rates than C corporations:
Whoops. Moreover, the CBO is not alone. A 2021 Treasury analysis found pass-throughs pay consistently higher rates, even on new investment.
This despite the fact that almost all C corporation income is earned by large public companies, whereas a large portion of pass-through income is earned by smaller businesses paying lower marginal rates. If the comparison were “Big vs. Big,” the advantage for C corporations would be larger.
So that’s an issue. Kyle also appears to confuse a benefit enjoyed by public corporations as one available to all C corporations. He writes:
An enhanced deduction would primarily make it even less attractive to use the C corporate form. This has economic implications because C corporations have better access to outside capital.
C corporations only have better access to outside capital if they are publicly owned. That’s the chief advantage of jumping through the hoops necessary to become a public company — you get access to the public equity and debt markets generally not available to private companies. An S corporation that converts to C with the same ownership does not magically see its cost of capital go down. That’s not how it works.
Kyle also argues that the expensing reduces the effective tax on new pass-through investments to zero, so what’s the problem?
Expanding the deduction would do little to enhance the competitive advantage of pass-through businesses. In fact, they would maintain a tax advantage even if 199A were repealed. This is because expensing already reduces the tax on new pass-through investment to roughly zero, while it only shields C corporations only against the 21 percent corporate rate. The shareholder-level tax on the return is untouched.
Notice the sleight of hand? This analysis only applies to new investment and it only applies to what economists refer to as “normal profits” – the minimum profit necessary to keep a business afloat. Older investments that don’t qualify for expensing and those investments that return greater than normal profits (in other words, just about every business investment worth making) bear the brunt of the statutory tax rate.
Moreover, Kyle’s line about the “shareholder-level tax on the return” ignores reality. As we have noted repeatedly, most C corporation income is never subject to a shareholder level tax. The Tax Policy Center has been writing about this for years, and it’s the principle challenge we face in trying to balance the tax treatment of public and private companies. Here’s the TPC:
Most Shareholders are Not Subject to a Second Layer of Tax
Often, however, there is not a second level of tax. Many shareholders of corporate stock, such as retirement accounts, educational institutions, and religious organizations, are exempt from income tax…. By some recent estimates, the share of U.S. corporate stock held in taxable accounts has fallen from over 80 percent in 1965 to about 25 percent today (Rosenthal and Austin 2016).
There’s more, but that’s enough for now. Every authority we are aware of in this space (here, here, here, here, here) has found that pass-throughs pay higher effective tax rates than C corporations, even with the 199A deduction in place. Jason Smith is right that the 199A deduction should be expanded, even if saying so throws the 199A sceptics into a tizzy.
The Reasonable American, Continued
A recent Real Clear Politics-Emerson poll shows Pennsylvania residents oppose capping the wealth of individuals but appear to support raising taxes on billionaires and corporations. As RCP reports:
We began by asking Pennsylvanians whether the law should cap how much wealth any one person may hold. The answer was a “no”: 62% oppose such a maximum, compared with 21% who support it, and 17% who aren’t sure. That might make Pennsylvania look comfortable with concentrated wealth, but the rest of the survey suggests otherwise. We also find that 64% of respondents support raising taxes on billionaires, wealthy corporations, and Big Tech to help pay for healthcare, food access, transit, and education.
So folks in Pennsylvania don’t like targeting wealth. That’s good news if you live in a market-based economy where capital accumulation raises living standards for everybody (which we do, by the way). But they also appear comfortable raising top rates on wealthy individuals and businesses, right?
Wrong.
Pennsylvanians and Americans more generally support raising tax rates on the wealthy and corporations only because they underestimate how much those groups pay. Our work with the Winston Group over the years has made this clear – when asked how much the wealthy pay, respondents generally cited rates well below their current tax rates. Moreover, when asked what’s the most those same taxpayers should pay, the responses were well within the range of what they already pay:
As our write-up from the 2022 poll summarized:
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A majority of voters do believe that corporations and wealthy individuals are not paying their fair share of taxes (61-26 believe-do not believe). Independents believe this 60-23, and Republicans believe it more than not, at 46-39.
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However, voters underestimate what the wealthy and individually/family-owned businesses actually pay. People believe that wealthy individuals pay an average 21% rate and that individually/family-owned businesses pay a 24% rate (they also estimated a 24% rate for small businesses). They correctly estimated that corporations pay a 21% rate.
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As for the maximum rate at which these entities should be taxed, voters believed that wealthy individuals should pay more (33%), but that perception still underestimates what they are currently paying. Voters thought small businesses (17.8%) and individually/family-owned businesses (17.5%) should pay less compared to what they thought these businesses actually pay.
It gets better. When voters learn that much of the proposed rate hike on the wealthy will fall on pass-through businesses, support for the policy collapses, even before they learn about who pays what.
As you can see, support for raising the top rate falls nearly in half – 53 to 29 percent – when voters learn that the new rate would apply to small and family-owned businesses.
So what did we learn here? Regarding wealth taxes, voters simply don’t support targeting wealth, despite a multi-year campaign to villainize it. On the income tax front, meanwhile, some policymakers want to tax billionaires at rates up to 60 or 70 percent but voters only support rates about half that level. As we’ve noted before, Americans are very reasonable about what they expect even the wealthiest individuals or corporations to pay. And finally, regarding private businesses, voters think they are overtaxed now and don’t support raising their rates further.
It’s not all good news. You can see the maximum rate voters support has risen slightly over the past seven years, suggesting the omnipresent campaign to paint the wealthy as tax cheats is having some effect. We need a counter campaign to educate voters and policymakers alike on how the tax system works, how it has become more progressive over the past forty years, and how taxpayers respond strongly and negatively to excessively high tax rates. We either begin educating folks on the realty of our tax code, or we’re going to end up with some really harmful policies getting enacted.
S Corp Mod Introduced in Congress
Good news for the S corporation community! Ways and Means Member Mike Carey (R-OH) has teamed up with Senator Tim Sheehy (R-MT) to introduce the House version of the S Corporation Modernization Act of 2026 (H.R. 9840). “S Corp Mod” has a long history of simplifying the rules for Main Street businesses, making it easier for them to remain viable in an increasingly difficult business environment.
S corporations were created 70 years ago to help small and family-owned businesses better compete with public companies. At the time, Republicans and Democrats alike were alarmed that too much economic activity was being consolidated into a small number of large, multinational corporations. Today, S corporations are America’s most common form of business organization with more than 6 million located in every community and in every industry, employing more than one-in-four private sector workers.
Despite their popularity, the rules governing S corporations remain among the most restrictive of any business form. To address this, the S Corporation Association and its congressional champions began to identify helpful provisions under the umbrella of S Corp Modernization starting in the 1990s, with a number of these provisions being enacted into law over the past three decades. This year’s bill will build on that success and make it easier for S corporations to compete and grow by:
- Increasing their access to capital;
- Expanding the number and types of shareholders eligible to own S corporation stock; and
- Easing limitations that penalize S corporations compared to other business forms.
In his statement introducing the bill, Representative Carey made clear the importance of these reforms:
“S corporations are the backbone of our economy, supporting tens of millions of jobs and driving economic growth in communities across the country,” said Rep. Carey. “Unfortunately, many of the rules governing S corporations haven’t kept pace with today’s economy and create unnecessary hurdles for S corporations, both large and small. The S Corporation Modernization Act updates these outdated policies, reduces complexity, and gives job creators the flexibility they need to invest, grow, and keep more Americans employed.”
As a long-time business owner and champion for Main Street businesses, Senator Sheehy joined Representative Carey in marking the House introduction:
“Across Montana, S corporations are the backbone of our economy – from family ranches and Main Street businesses to local manufacturers that keep our rural communities strong. This legislation makes long-overdue updates to modernize the tax code, helping these businesses access capital, grow, and pass opportunities on to the next generation. By cutting unnecessary barriers and modernizing the rules, we’re ensuring Montana’s small businesses can create jobs and continue to invest in the communities they call home.” – Senator Tim Sheehy
The provisions included in the new version of S Corporation Modernization will help thousands of businesses operating in dozens of industries, including engineering companies:
“The American Council of Engineering Companies (ACEC) supports the S Corp Modernization Act and thanks Congressman Mike Carey and Senator Tim Sheehy for introducing the legislation. Employee ownership is central to many engineering firms across the country. ACEC particularly appreciates the provision that would treat all employee-owners as one shareholder. This reasonable modification of the S corp shareholder cap aligns the treatment of employee-owners with that of ESOPs and of family-owned businesses. It will allow engineering firms to offer ownership to additional employees without having to bear the costs and administrative burdens of changing their business structure. ACEC urges enactment of the S Corp Modernization Act.”
Independent community banks also strongly support S Corporation Modernization and its provisions to allow IRAs to own S corporation stock:
“ICBA thanks Senator Sheehy and Representative Carey for introducing the S Corporation Modernization Act. Many community banks have chosen the S Corporation model to help them remain independent in a competitive marketplace and better serve their communities. However, shareholder restrictions have not been modernized for over 20 years. The S Corporation Modernization Act would provide that all employees of a bank count as a single shareholder for the purposes of the shareholder cap and allow individual retirement accounts, or IRAs, to invest in S corporations. These provisions will allow the community banks that have chosen this model to raise more capital to provide more credit in their local economies and meet regulatory requirements.”
Finally, S-Corp President Brian Reardon made the following statement in support of the bill’s introduction:
“The S corporation is America’s most popular form of business organization and it deserves rules adapted to the economy we live in today. The S Corporation Modernization Act would ensure the continued success of these businesses by increasing their access to capital while easing many of the rules that limit their growth.”
S Corporation Modernization has a long history of support from the business community and its introduction in the House today is another step forward for Main Street. S-Corp is prepared to work with our champions to see these important provisions enacted into law soon.
Wealth Taxes (Still) An Existential Threat
Even before California voters have a chance to weigh in this November, the state’s proposed billionaire tax has already helped drive billions (if not trillions) of dollars in wealth and investment elsewhere. Rather than reconsider the approach, Governor Gavin Newsom is now calling for a national wealth tax, arguing the same policy should be exported nationwide.
Meanwhile, the Washington Post reports that progressives increasingly see a genuine opening for a federal wealth tax, believing the political environment has shifted in their favor. At the state level, proposals continue to proliferate, building on Senator Elizabeth Warren’s revived “Ultra-Millionaire Tax” legislation and similar efforts.
We’ve been down this road before. As the wealth tax debate gains new momentum, it’s worth revisiting one of our earlier posts examining why these proposals pose a unique threat to successful private businesses. Here’s what we wrote back in 2019:
Wealth Taxes Pose Existential Threat to Private Businesses
October 22, 2019
The Peterson Institute held a “Combating Inequality” event last week that included a vigorous debate over wealth taxes. The heavyweight match between Emmanuel Saez – the leading advocate for wealth taxes these days – and Larry Summers in particular is worth watching.
One aspect missing from the debate, however, was how wealth taxes would handcuff successful private businesses. Summers briefly touches on the challenge his family’s hardware store would have paying the tax, but there is so much more to it. Wealth taxes:
- Are far larger than their headline numbers suggest;
- Paid on top of all existing taxes;
- Hit hardest when the economy is bad; and
- Target illiquid, private companies the most.
Add it all up, and it’s hard to see how successful family businesses can survive an aggressive wealth tax.
Wealth Tax — Bigger than it Looks
Senator Elizabeth Warren likes to describe her plan as just “two cents” but it’s so much more than that. The tax would be two percent on the cumulative wealth of families worth more than $50 million, and three percent on those worth more than $1 billion.
So a family business worth $100 million would pay $2 million, per year, every year. Two million dollars a year is obviously a lot of money, but to understand the scale of the tax, you need to compare it to an income tax. As AEI scholar Alan Viard wrote for the Aspen Institute:
A useful way to interpret wealth tax rates is to translate them into equivalent income tax rates. For a taxpayer who holds a long-term bond with a fixed interest rate of 3% per year, a 3% per year wealth tax is equivalent to a 100% income tax because the tax captures 100% of the taxpayer’s interest income. Similarly, an 8% per year wealth tax is equivalent to a 267% income tax.
The tax-rate translation is more complicated for risky investments. Suppose that, alongside her holdings of the 3% bond, the taxpayer holds a stock with an annual return that could fall anywhere between 2–10%, with an expected value of 6%. The 3% per year wealth tax could end up being anywhere from 30–150% of the stock’s return. It is not immediately clear what income tax rate the taxpayer would perceive as equivalent to the wealth tax in advance, when the stock return is uncertain.
As Alan notes, returns on capital vary, but if the average return on capital in the US is 6 percent, then the Warren tax is the equivalent of a 33 percent income tax rate, not 2 percent.
Pro-Cyclical
While investments might earn 6 percent on average, they can lose money too. The wealth tax doesn’t account for losses – the tax is owed whether an investment earns positive returns or not. This “pro-cyclical” aspect of the wealth tax is particularly dangerous, as it can force investors to divest their capital interests at times when the economy is doing poorly, encouraging a vicious downward cycle.
To counter this issue, the Warren tax allows tax payments to be deferred for five years, with interest. This provision mitigates the worst cyclical aspects of the wealth tax, but it doesn’t eliminate them. The tax is still owed, after all. For the family business worth $100 million, they could defer payment of one year’s tax for five years, but then they would owe $4 million in year five, plus interest on the deferred payment of $2 million. It’s effectively a loan that lenders will take into account when assessing the credit worthiness of the business. For credit constrained companies, there’s a limit to how much they can borrow.
What if the business loses value over the five years the tax is deferred? Income taxes account for losses. A business that loses money in year two can get a refund for the taxes paid in year one. The idea is to accurately measure and tax the income of the business over time. This approach has the benefit of being counter cyclical, meaning the income tax provides refunds when the economy is soft and business lose money, and taxes them when they earn money. Even with deferral, a wealth tax doesn’t have this valuable feature.
Layer upon Layer of Tax
The Warren wealth tax is layered on top of other taxes, so a 2 percent bond would be subject to both the wealth tax and the income tax. For a $100 bond that pays 2 percent, the income tax is 82 cents (the 37 percent income tax plus the 3.8 percent NIIT), while the wealth tax is $2 dollars. The bondholder is losing 82 cents for every $100 in bonds they hold, every year. If it’s a 10 year bond, then the bondholder will be left with just $91.80 of the original $100 they invested. Instead of earning money on the investment, they lose it.
For private businesses, the layering effect will be similarly harmful. A 2 percent wealth tax is equal to a 33 percent income tax on a business earning 6 percent, which would be paid on top of the existing income taxes. In last year’s report, EY estimated the top marginal tax rates on S and C corporations were effectively equal at around 33 percent. For a successful S corporation earning 6 percent profits, then, the effective tax on its earnings, on average, would be 66 percent.
Those businesses will also be subject to the estate tax. Every generation, they will be required to buy back a portion of their business from the federal government. At a 40 percent estate tax rate and a $12 million exemption, the tax on the $100 million business could be more than $30 million. Estate planning can help to reduce this tax and spread the costs out over time, it’s still a cost private companies will have to shoulder. If the total tax ends up being $20 million and the company passes from one generation to the next every 30 years, the annual tax would be an additional $666,000 a year, on top of the $2 million in income taxes and the $2 million in wealth taxes. The company’s effective rate is now 78 percent.
Bullseye on Private Businesses
This chart from the Visual Capitalist illustrates how the wealth tax targets private businesses. Most multi-millionaires or billionaires are not liquid and most of their wealth comes from private business interests. See all that dark blue area in the bottom two income categories? Those are private businesses that will need to pay the Warren wealth tax of 2 or 3 percent per year. They will owe the tax whether the business is profitable or not.
Private vs Public Businesses
So private companies are in the bullseye of the wealth tax. Public companies, on the other hand, are largely immune to it. Public companies have access to capital from many sources – charities, pension funds, retirement accounts, and foreign investors – not easily accessible to private companies, and nearly all of these investors are not subject to the wealth tax.
To be clear, some corporate shareholders might be subject to the wealth tax, but it’s unlikely it will have any impact on their planning. At most, the corporation’s cost of capital might rise slightly as its billionaire shareholders sell off stock to pay the tax, but the effect will only be slight as the public stock markets are extremely liquid and open to so many alternative sources of capital.
In contrast, a single shareholder S corporation worth $100 million is, by definition, subject to the wealth tax on its entire valuation and it’s generally the person who runs the company who pays the tax. There’s no “arms length” separation between the taxpayer and the company.
Just how would they pay the tax? Private companies tend to be illiquid and the market for partial stakes in a private company stock is all but non-existent. Selling off a “few shares” to pay the tax is not really an option. Few investors are interested in buying a non-controlling interest in an illiquid asset, and as a result minority stakes of these businesses often sell at steep discounts compared to controlling stakes.
Falling Valuations
The wealth tax will require private companies to get valuations every year even as the tax drives down those valuations.
Think about it this way – for a certain level of risk, an investor needs to earn 4 percent after-tax on their investment. A business that fits that risk level and makes $6 million pretax would be worth $100 million to the investor. It would return 6 percent pretax, and 4 percent post tax. With the Warren wealth tax, however, the business only returns 2 percent – 6 percent minus the 33 percent income tax and the 2 percent wealth tax. For that rate of return, the investor is only willing to pay $50 million.
Not all private businesses will lose half their value, of course. The challenge to estimating declines in asset values under a wealth tax is that it doesn’t apply to all taxpayers, just those whose wealth exceeds a certain threshold. To a buyer not subject to the wealth tax, the business still is worth $100 million. The dilemma is that a single buyer won’t be able to buy the business at that price, since they would be subject to the wealth tax. Meanwhile, a group of buyers could buy the business with each of their stakes below the wealth tax threshold, but they would insist on steep discounts for lack of control, as they each would be purchasing a minority stake in the business.
Who could buy the business at something approaching its previous valuation and still avoid the tax? Private equity and public corporations come to mind. Private equity because they can raise capital from diverse sources but can still enjoy a controlling stake in the business, and public corporations because, as discussed above, they are largely immune to the tax. Individuals and families, on the other hand, would be locked out.
Economic Consolidation
This combo platter of excessive tax rates, counter-cyclical applications, broad exposure, and uneven application will result in a wholesale migration of business activity into the public corporate sector.
Family-owned businesses over a certain size would begin to disappear – they either would be sold to public corporations or private equity firms with large, diverse investor bases, or they would continue on at a competitive disadvantage, paying effective tax rates more than twice what a public company pays. In the end, the wealth tax would cause increased concentration of business activity and decision making.
The irony is that S corporations were created 60 years ago to counter this consolidation. As it says on the history page of our website:
At the same time, Republicans and Democrats were increasingly alarmed that too much economic power was being consolidated into the hands of a few wealthy, multinational corporations. This economic centralization was characterized by economists like John Kenneth Galbraith, who saw America’s economic future as a grand balance of power between Big Labor, Big Business, and Big Government. Private enterprise was viewed as a thing of the past.
In response to these concerns, Eisenhower embraced the Treasury proposal and recommended the creation of the small business corporation to Congress. In 1958, led by Democratic Finance Chairman Harry Byrd, Congress acted on Eisenhower’s recommendation, creating subchapter S of the tax code as part of a larger package of miscellaneous tax items.
Be sure to watch the Peterson Institute event and the debate between Saez and Summers. It’s very compelling, even if it does underemphasize one of the key challenges of implementing the wealth tax – the existential threat it poses to successful, private companies.
Webinar Recap: Voters, Taxes, and the Midterms
As we head into the midterms, longtime S-CORP allies David Winston and Myra Miller of The Winston Group joined us to walk through their latest polling on tax policy, spending, and where the voters stand heading into the next big tax fight.
With concerns over debt, deficits, and Social Security’s pending insolvency mounting, the Winston Group’s research suggests Main Street enters the debate from a position of strength, but only if we build a foundation of understanding upon a number of key economic realities.
As we’ve covered before, when voters are asked what is the maximum the biggest corporation or wealthiest taxpayer should pay in taxes, they consistently cite a “maximum acceptable rate” that’s well below what’s actually being paid. We don’t face a pollical challenge, we face an education challenge.
Another misperception is the narrative that the tax cuts in 2017 and 2025 are depriving the government of needed revenue. The latest budget numbers tell a completely different story. Here’s David:
During that time frame, revenues increased 58 percent. And everybody was talking about how much the bill was going to cost, and in fact, revenues increased by a significant margin. Individual tax revenue increased 67 percent, and corporate tax revenue increased 52 percent. So what was the problem here in terms of the deficit? Well, actual federal spending — government spending — increased 76 percent.
We face a spending challenge, not a revenue challenge.
And even where voters seem open to raising rates, that support is fragile. On the idea of taking the top rate to 40 percent, Myra noted that support flips fast once small businesses enter the picture:
Introducing the fact that raising that top rate would apply to small and family-owned businesses overwhelmingly flips voters, Republicans, and independents to opposing that. So this is an ongoing education challenge — just making sure people know when we talk about raising that top rate, who you’re actually going to be hitting, which is small family-owned businesses.
So the voters and the numbers are on our side. We just need to let people know it — making sure Congress, staff, and voters alike have the facts before the next big tax bill lands.