Defense of the “Framework’s” Pass Through Tax Rate

October 10, 2017 by · Leave a Comment 

The class warfare debate over the tax reform “Framework” has shifted its focus to the pass through business provisions.  John Harwood has a typically one-sided piece on the CNBC website, which includes this paragraph:

“There is no strong policy justification for the special pass-through rate in the GOP’s plan,” said Kyle Pomerleau, an analyst at the conservative Tax Foundation.  Since pass-through earnings represent around one-third of all income for the top one percent of taxpayers, Pomerleau added, the provision tilts the plan’s benefits toward the wealthy while favoring one kind of business over others.

Kyle is wrong of course.  There is s very strong policy rational for cutting rates on pass through businesses.

First, consider what would happen if Kyle got his way and the Framework established top rates of 35 percent for S corporations and 20 percent for C corporations.  With the base broadening envisioned in the Framework, the effective tax on S corporations would go up, while the effective tax on C corporations would go down.

That’s correct, a modest reduction in the pass through rate coupled with the extensive base broadening provisions envisioned in the Framework would raise taxes on family businesses across the country even as it cut taxes on larger C corporations.  That’s bad policy and bad politics.  We’ve addressed this issue back in 2011.

The only justification for such a policy is if those S corporations currently paid less than C corporations, with the framework seeking to level the playing field.  But our 2013 study on effective rates by business structure found the opposite is true – S corporations pay a higher effective tax than C corporations, even when you ignore the size disparity:

  • Sole Props:          15%
  • C Corporations:    27%
  • Partnerships:        29%
  • S Corporations:    32%

How is it possible that giant C corporations pay less tax than smaller, closely-held S corporations?  The answer is multifold, including the following:

  • Lower Rates: C corporations are taxed at lower top rates than S corporations – 35 percent verses more than 40 percent.
  • Tax Exempt Shareholders: Unlike S corporations, C corporations can have tax exempt shareholders and many do.  The Tax Policy Center reports that 75 percent of C corporation shareholders are tax exempt or tax advantaged.
  • Deferral of Tax on Overseas Income: C corporations can indefinitely defer repatriating income from their overseas operations to avoid the US tax.  S corporations have to sacrifice their foreign tax credits if they defer, so it isn’t an effective strategy for them.
  • Base Erosion Practices: C corporations can shift income overseas to avoid high US tax rates.  For S corporations, no deferral means no income shifting.
  • Less Aggressive AMT: There is a Corporate Alternative Minimum tax, but it is not as aggressive as the Individual AMT that applies to S corporations.  The fact is most successful S corporation shareholders pay the AMT, not the regular tax code.

All these factors result in S corporations paying more.  But what about the double corporate tax?  Doesn’t that increase the effective tax paid by C corporations?  The answer is that most C corporation income is never subject to the double tax.  Keep in mind that 75 percent of C corporation shareholders either don’t pay tax at all (charities, private foundations, etc.) or they are tax advantaged and pay really low rates (foreign shareholders, qualified retirement plans, etc.).  Meanwhile, SOI data shows that less than five percent of C corporations pay any dividends at all.  Warren Buffett’s shares of Berkshire Hathaway have never been subject to the second layer of tax, and they never will.

The result is that while the double tax distorts behavior and hurts investment and job creation, it doesn’t add that much to the federal treasury.  This is why 120 national trade groups endorsed restoring rate parity and eliminating the double tax as part of tax reform.

S corporations pay more now, and under a tax reform where their tax rates hold steady, they would pay more still.  Not good.

Why don’t they just convert?  This is a question we get quite often.  While most C corporations don’t pay dividends, and don’t pay the double tax, converted family owned S corporations would have no choice.  With few exceptions, S corporation shareholders are taxable U.S. residents.  It is one of the requirements for being an S corporation.

Moreover, the basic nature of closely held businesses requires dividend payments.  How else do you reward shareholders?  There’s no public market to sell your shares, and there’s no listing to track its value.  You can’t borrow against it easily, either.  So if the business doesn’t pay out dividends, why bother owning it?  And unlike a C corporation, all those dividends are being paid to taxable shareholders.

Under a Framework where pass through rates stay high, S corporations would pay more if they retain their S corporation status, and even more if they convert to C.  Talk about being stuck between a rock and a hard place.

The Framework recognizes this challenge by giving S corporations and other pass throughs a lower tax rate to match the rate reduction offered to C corporations and offset the base broadening in the plan.  It’s no giant giveaway, mind you.  Even with the lower 25 percent rate, the base broadening coupled with the 3.8 percent NIIT and the need for enforcement measures means the actual tax reduction for S corporations is likely to be modest.

But he alternative is to tell all those pass through businesses – the ones who employ most private sector workers and earn the majority of business profits – that it’s time to sell, because they won’t survive in an environment where they pay effective tax rates in the 30s, while their C corporation competition pay effective rates in the low 20s or teens.  That’s simply not sustainable, which is why it’s not in the Framework.

Treasury Pulls Harmful 2704 Rules

October 4, 2017 by · Leave a Comment 

It’s official – the Treasury Department today released a new report announcing they will withdraw the family business valuation rules that had threatened the family business community for more than a year!  Today’s announcement is a big win that will be celebrated by family businesses nationwide.

The report released today was in response to an earlier Executive Order instructing Treasury to identify and address regulations issued by the Department in 2016 that were harmful and/or exceeded Treasury’s authority.  In other words, the 2704 rules.  You can read the whole report here.  The portion addressing the valuation rules reads like this:

After reviewing these comments, Treasury and the IRS now believe that the proposed regulations’ approach to the problem of artificial valuation discounts is unworkable. In particular, Treasury and the IRS currently agree with commenters that taxpayers, their advisors, the IRS, and the courts would not, as a practical matter, be able to determine the value of an entity interest based on the fanciful assumption of a world where no legal authority exists. Given that uncertainty, it is unclear whether the valuation rules of the proposed regulations would have even succeeded in curtailing artificial valuation discounts. Moreover, merely to reach the conclusion that an entity interest should be valued as if restrictions did not exist, the proposed regulations would have compelled taxpayers to master lengthy and difficult rules on family control and the rights of interest holders. The burden of compliance with the proposed regulations would have been excessive, given the uncertainty of any policy gains. Finally, the proposed regulations could have affected valuation discounts even where discount factors, such as lack of control or lack of a market, were not created artificially as a value-depressing device.

In light of these concerns, Treasury and the IRS currently believe that these proposed regulations should be withdrawn in their entirety. Treasury and the IRS plan to publish a withdrawal of the proposed regulations shortly in the Federal Register.

Today’s report marks the successful culmination of more than a year of advocacy on the part of the S Corporation Association and its allies in the business community.  To fight these rules, we have drafted official comments, testified, organized coalitions, educated policymakers, and sponsored reports.

While all this analysis may be moot now, the successful outcome it engendered represents a fundamental reality that the family business community is an effective and powerful voice when it comes to tax and economic policy.  Something to keep in mind as Congress debates tax reform.  The corporate sector may be grabbing all the headlines, but it will be the support of families and Main Street businesses that gets tax reform over the finish line.

Framework Hits Key Notes

September 27, 2017 by · Leave a Comment 

The Big Six released their “framework” today and it’s pretty good.  You can read all eight pages here, but key provisions for Main Street businesses include:

  • A new, lower pass through tax rate of 25 percent;
  • Full repeal of the estate tax; and
  • Full repeal of the Alternative Minimum Tax.

Those three provisions represent long-time priorities of the Association and we applaud the Big Six for including them.  As S-Corp President Brian Reardon commented:

“Today’s release is good news for Main Street businesses and the families that work for them.  The Framework announced this morning would help Main Street employers by lowering tax rates, eliminating the Alternative Minimum Tax, and repealing the estate tax.  Implemented correctly, those provisions mean more investment and more jobs in communities across this country. 

You can read our full statement here.

So, the framework is a solid beginning, but we aren’t doing our NFL-approved touchdown celebration just yet.  As S-Corp readers know, it’s the details that accompany the framework, details that are necessarily missing from today’s document, that are the difference between a plan that benefits Main Street and one that hurts it.

For example, our comments to the Finance Committee last summer, found here showed how the combination of a 25 percent pass through rate, extensive base broadening as envisioned in the framework, and an enforcement provision like 70/30 would literally raise taxes on many S corporations.  That’s the opposite of what is supposed to happen, so the tax writers need to get the enforcement provisions right.

Something else missing from the framework is repeal of the 3.8 percent ACA surtax, or Net Investment Income Tax (NIIT).  This tax was created to help offset the cost of the Affordable Care Act, so the congressional leadership planned to repeal it as part of their health care reform.  But with health care stalled, repeal of the surtax is stuck in limbo – it’s not moving in health care reform, and it’s not part of the tax reform framework.  Back in July, an S-Corp led letter calling for the repeal of the NIIT was signed by 42 national trade groups.  As Congress grapples with the goal of establishing parity between pass through businesses and C corporations, the NIIT is sure to be part of the discussions.

In terms of timing, first Congress will need to pass a budget that allows for expedited consideration of the tax reform plan, and then turn to crafting the plan.  Getting a budget done will not be easy, but it is essential if Congress is going to move on tax reform this year.  No budget, no tax reform.  Once the budget is in place, the Ways and Means and Finance Committees will begin their work filling in all the missing details.  Congressional leadership is aiming to get this all done by Christmas, which is a very aggressive timetable indeed.  On the other hand, as the late Senator Domenici used to say, you can do anything you want as long as you have the votes.

For S-Corp, our focus will be on ensuring that the new 25 percent rate is real and applies to a broad definition of active business income.  As the example above shows, it’s a serious challenge and getting it right could be the difference between tax reform success and failure.  There’s lots of work to do, but at least we are starting in a good place.

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