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Talking Taxes in a Truck Episode 35: Tax Foundation’s Scott Hodge on the Outsized Role that Taxes Play in Our Daily Lives
Our latest guest is Scott Hodge, who is president emeritus at the Tax Foundation and author of the excellent new book Taxocracy: What You Don’t Know About Taxes and How They Rule Your Daily Life. Through the lens of history’s most ill-conceived taxes – like the “chicken tax” and 17th century “window tax” – Scott explains how tax policy shapes virtually every aspect of our lives and drives human behavior. He and Brian then discuss more recent policies, including the SALT cap and proposed wealth tax, the ongoing (and often misguided) debate over book versus tax accounting, and the pivotal role that S corporations play in all of it.
Scott’s book is available for pre-order and comes out on April 9.
This episode of Talking Taxes in a Truck was recorded on March 1, 2024, and runs 49 minutes long.
Court CTA Ruling a Huge Win for Main Street
Huge news to kick off the weekend — a federal judge just ruled that the Corporate Transparency Act is unconstitutional, marking the end of a 16-month legal battle led by the National Small Business Association and supported by S-Corp and the members of our Main Street Employers coalition.
By way of background, the CTA is a sprawling new data collection regime that would have required more than 32 million entities – including virtually every small business in America – to hand over their sensitive private data to the government. We’ve written about the statute extensively but the bottom line is that the CTA would have saddled law-abiding citizens with compliance headaches and criminal penalties, while doing virtually nothing to combat illicit activity.
Recognizing that the federal government went far beyond their enumerated powers in enacting and implementing the law, the National Small Business Association filed a legal challenge back in 2022, alleging that it violates a laundry list of constitutional protections. S-Corp and our Main Street Employer allies were strong supporters of the suit from the beginning.
As it turns out, presiding Federal District Court Judge Liles Burke agrees with our concerns. In a ruling issued just this evening, he wrote:
When Congress passed the 2021 National Defense Authorization Act, it included a bill called the Corporate Transparency Act (“CTA”). Although the CTA made up just over 21 pages of the NDAA’s nearly 1,500-page total, the law packs a significant regulatory punch, requiring most entities incorporated under State law to disclose personal stakeholder information to the Treasury Department’s criminal enforcement arm.
By requiring these disclosures, Congress aimed to prevent financial crimes like money laundering and tax evasion, which are often committed through shell corporations. Broadly defined, a shell corporation is a legal entity with no (or minimal) employees, customers, business, or assets. Although shell corporations serve many legitimate purposes, it’s also possible to disguise the identity of interested individuals and the flow of money by layering shell companies on top of each other, “such that each time an investigator obtains ownership records for a domestic or foreign entity, the newly identified entity is yet another corporate entity, necessitating a repeat of the same process[.]” Pub. L. 116-283 § 6402(4).
Yet corporate formation includes far more than for-profit enterprise. Each year, the States grant formal status to millions of entities that can and do serve “any lawful purpose,” including benefit corporations, non-profits, holding companies, political organizations, and everything in between.
With that in mind, this case presents a deceptively simple question: Does the Constitution give Congress the power to regulate those millions of entities and their stakeholders the moment they obtain a formal corporate status from a State? The Government thinks so. While it acknowledges that Congress “can exercise only the powers granted to it,” the Government says that the CTA is within Congress’ broad powers to regulate commerce, oversee foreign affairs and national security, and impose taxes and related regulations.
The Government’s arguments are not supported by precedent. Because the CTA exceeds the Constitution’s limits on the legislative branch and lacks a sufficient nexus to any enumerated power to be a necessary or proper means of achieving Congress’ policy goals, the Plaintiffs are entitled to judgment as a matter of law. As a result, the Court GRANTS the Plaintiffs’ motion for summary judgment and DENIES the Government’s motion to dismiss and alternative cross-motion for summary judgment.
So for now, millions of small business owners can stop navigating FinCEN’s website and go back to running their businesses.
The Department of Justice is almost certain to appeal the ruling, so the court challenge is far from over. But whichever way it goes, today’s ruling will help focus the attention of the public, the media, and lawmakers as to the threat the CTA and other laws like it pose to the privacy of law-abiding Americans, and it will help us in our efforts to ultimately fight these laws in Congress.
So with the caveat that S-Corp continues to review the ruling to assess its implications – the decision issued tonight is a big win for millions of law-abiding businesses nationwide. More to come.
The “Experts” Get 199A Wrong
When Congress finishes work on the tax package pending in the Senate, we expect the conversation to pivot rapidly to what we should do about all those expiring TCJA provisions at the end of 2025.
For S-Corp and its allies, our priority is to make the Section 199A deduction permanent and a big hurdle there is the lack of understanding of how pass-throughs are taxed and why the Section 199A small business deduction is critical to their success.
For example, of all the Republicans who served on Ways and Means during the TCJA debate, only five remain today. The staff turnover is even more dramatic. So educating members and staff through briefings, panels, op-eds and good old-fashioned shoe leather lobbying is very much in the plan for the coming months.
What we might have overlooked, but what is obviously critical and necessary, is the need to educate the so-called experts too — people like Reuven S. Avi-Yonah who writes for Tax Notes and is a professor at the U of M Law School. Reading his articles from the past week, it’s clear he has no idea how 199A works or why it’s necessary.
Here’s what he wrote in his most recent piece and why it’s wrong and completely missing the point about 199A.
Avi-Yonah: The passthrough provisions are totally unnecessary. As noted, the TCJA was driven by two key considerations: the desire for a low corporate tax rate, and the determination not to significantly reduce the top marginal rate on ordinary income.
Response: This characterization is simply wrong. The TCJA was certainly driven by the desire to cut the corporate rate, but Congress also wanted to cut individual rates (and they did – the House bill reduced the top individual rate to 35 percent). The challenge was the individual rate cuts were hugely expensive, and they didn’t have room for large cuts to both the individual and corporate rates. Section 199A was born as a bridge between the two competing rates to protect pass-through employers.
Avi-Yonah: Because owners of passthroughs pay tax at the ordinary income rate, this created the perception that the bill is unfair to passthrough owners.
But this perception is wrong for three reasons.
First, many passthrough owners (for example, hedge fund managers and investors) pay tax at a 23.8 percent rate on capital gains and dividends, not the ordinary income rate.
Response: Ah, here it is – the old “hedge funds and law firms” slander. There are 5 million S corporations, 4 million partnerships, 4 million LLCs, and about 20 million sole proprietors in this country. That’s 33 million businesses all being taxed under the pass-through model. Meanwhile, there are only about 4,000 hedge funds, and some of those are organized as C corps. So “many” pass-through business owners get carried interest treatment? Hardly.
Worse, hedge funds are considered “Specified Services Trade or Businesses” under 199A and therefore ineligible for the deduction.
Item #1 in Reuven’s case for eliminating Section 199A is a sector making up less than 0.012 percent of all pass-throughs, a sector that doesn’t even get the deduction. Brilliant.
Avi-Yonah: Second, taxable individual shareholders in C corporations are subject to a second level of tax on distributions and capital gains at 23.8 percent, so the after-tax return under the TCJA’s rate structure is (100 – 21 = 79 – (23.8 * 0.79) = 60.2), which is almost identical to the after-tax return on a passthrough investment, even if there was no rate reduction for passthrough income (100 – 37 = 63).
Response: We are well aware of the second layer of tax and have included it in all our calculations of what constitutes parity. We’ve written about it extensively here, here, and here. The nuance Avi-Yonah misses is that, these days, almost all C corporation income is earned by public companies where three out of four of their shareholders pay either zero taxes or greatly deferred (and therefore lower) taxes. As the Tax Policy Center writes:
More than 75 percent of corporate shareholders, however, are exempt from U.S. shareholder-level taxes because they are either tax exempt organizations like university endowments or retirement and pension funds, or are foreign shareholders, who generally are not liable for those taxes.8 For those shareholders, the only tax they face is the corporate-level tax.
So for the Harvard endowment, there is no second layer of tax. For a pension plan, the deferred nature of the tax means its effective rate is well below the statutory rate. This tax advantage gives the C corporations they invest in a huge advantage when it comes to their effective tax rates and cost of capital.
Understanding this nuance, we have spent years and lots of resources estimating exactly where parity lies. This table from EY takes into account all those factors, and estimates that the TCJA came close to rough justice for large private companies when compared to their public competitors, but only with 199A in place.
Avi-Yonah: Third, if owners of passthroughs do not like the 37 percent tax on passthrough income, they need only check the box and their passthrough magically becomes a C corporation taxed at 21 percent. If you hate the rate, incorporate.
Response: We love it when tax professors rhythm. We love it more when they do their homework. The same EY study showing general parity under 199A also shows why private companies, particularly S corporations, have a hard time competing with public companies under the corporate tax structure. While most public company shareholders are tax advantaged, all S corporation shareholders are, by definition, fully taxable individuals.
That means the double tax public companies largely avoid applies fully to converted private companies. We don’t have a clever rhythm, but it’s clear private companies get screwed whether they are an S or C corporation.
Add on top of that the fact that public companies don’t have to worry about the estate tax and have full access to the public equity and credit markets, and you can see why there’s been so much economic consolidation taking place in recent years. Public companies already have a lower cost of capital advantage – we don’t need the tax code making it worse.
This disparity has significant regional implications. A heatmap from our friends at EY shows the difference in public and private company employment. Public company employment is concentrated in the city centers and coast, while private company employment is spread more evenly across the country.
The education challenge confronting S-Corp in the coming tax fight is daunting. We need to arm all our friends and allies with good, accurate information as to why the 199A small business deduction is so important. We also need to address all the misinformation being spread by the so-called experts. This is a serious debate where the economic future of communities across the country is at stake. It deserves more than casual, poorly considered commentary.
FinCEN in the House
The head of the Financial Crimes Enforcement Network (FinCEN) will testify tomorrow before the House Financial Services Committee (HFSC). The hearing will focus on the Corporate Transparency Act’s implementation and is a good opportunity for Congress to learn more about this trainwreck of a law and why it should be repealed.
The Corporate Transparency Act claims to target so-called shell corporations engaged in illicit transactions like money laundering and terrorism finance, but the law defines a shell company as legal entities with $5 million or less in annual revenues or 20 or fewer employees – in other words, every small business in the United States. These businesses and other entities are required to report the personal information (BOI) of their “beneficial owners,” broadly defined to include not just owners, but every senior employee, board member, and other professionals exercising “substantial control” over the business.
So starting this year, millions of small businesses will need to report the personal information of their owners and significant others to FinCEN, and then keep this information updated on a timely basis, or face thousands in fines and years in jail. In case the law’s threat of fines and felony jail time wasn’t already clear, the description of the bill related to tomorrow’s hearing should dispel any confusion:
In addition, the bill charges the Director of FinCEN to establish a method to track delinquent businesses in its BOI reporting. Once a method is established, the Director must include that delinquency number in the quarterly report. Additionally, the Director will also be required to outline the measures taken to impose civil and criminal penalties on reporting companies that are delinquent in submitting a BOI Report.
Did we say the CTA applies to small businesses only? Not so. A serious challenge to CTA compliance and enforcement is the fact that the law’s employment and revenue thresholds are measured at the entity rather than the establishment level. This is a critical distinction and its significance appears to have eluded both the drafters of the CTA and FinCEN.
For example, you might believe the owner of a manufacturing business with $50 million in revenues and 400 employees would be too large to be a “shell” corporation and would be exempt from reporting under the CTA. You would be wrong. That is because most businesses are not organized as a single entity, but include numerous legal structures to house distinct locations and operations. We generated the illustration below to demonstrate the challenge of aggregation under Section 199A six years ago, but it applies to the CTA as well:
In our example, the business has three locations, each organized as a separate S corporation for legal and liability purposes. It also employs a fourth “administrative” S corporation that houses the payroll, contracts, bank accounts, insurance, and contracts for the business. Our reading of the CTA and FinCEN’s guidance is that the three location entities have no revenue and no employees and are required to report their BOI, as is the holding company in the tier above. This despite the fact that the enterprise as a whole has millions in contracts and hundreds of workers. It is not a “shell corporation” by any measure except under the CTA’s sloppy drafting.
It gets worse. FinCEN has been tasked with educating these businesses regarding their new reporting responsibilities, but the law’s structure makes it impossible for the agency to determine which businesses will need to report. Again, the CTA targets legal entities based on their employment, revenue, and organization. Neither FinCEN, the IRS, Secretaries of State, nor any other government agency has all this information. So how is FinCEN supposed to identify and alert – by its own estimates – 32 million entities that they need to report their BOI this year if they don’t know who to contact?
It gets even worse. The CTA creates a one-stop shopping market for cyber criminals eager to steal the critical personal information of the owners of millions of reporting businesses. Who is concerned about this danger? Here’s the warning message that’s currently emblazoned on FinCEN’s homepage:
We appreciate the warning, but the need to post it just illustrates the danger of putting all this personal information into a single federal database. It also complicates the fantasy expectations of the law’s sponsors to compel the compliance of millions of business owners who don’t know the law exists and who FinCEN can’t identify. It’s like they created the worst dating app in history, only with fines and felony convictions for failure to engage.
One last point. This whole exercise is a complete waste of time. Can somebody please ask tomorrow’s witnesses to explain how collecting the personal information of the owners and employees of 32 million small and large businesses will help identify those few engaged in illicit financial transactions? There is nothing in the collected data that would signal criminal activity to FinCEN, and the actual criminals are highly unlikely to accurately report their criminal operations. What’s a paperwork violation to somebody engaged in terrorism finance?
On the other hand, a paperwork violation that includes large fines and jail time is devastating to real business owners simply trying to make ends meet. Those owners are the real targets of the CTA, and the sooner Congress recognizes this, the sooner we can end this failed experiment.
Talking Taxes in a Truck Episode 34: Piper Sandler’s Don Schneider on the Tax Package’s Fate, Looming Debt and Deficit Crisis, and Monetary Policy Outlook
The House last week moved a large tax package. Will the Senate follow suit? To answer that and other burning questions, we spoke to Don Schneider, Deputy Head of U.S. Policy at Piper Sandler and the former Chief Economist at Ways & Means. Don explains why it might be too early to pop the champagne on the House-passed tax bill. Later he discusses the worsening spending crisis, what to expect from the Fed over the next several months, and the biggest myths he’s encountered on Twitter.
This episode of Talking Taxes in a Truck was recorded on February 1, 2024, and runs 29 minutes long.