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Talking Taxes in a Truck Episode 32: The State of State Taxes

December 9, 2023|

Congress may have skipped tax policy this year, but the states have been busy. To get an idea of where things stand both good and bad, we talked to Jared Walczak, Vice President of State Projects at the Tax Foundation and one of the more active players in this space. Our conversation starts with the wealth taxes several states have proposed in recent months, the important but ignored Antio case moving through the Washington State courts (look out investors!), and a quick review of the record number of states implementing rate cuts reforms this year (go states!). We close by discussing some of the more bizarre state-level taxes that are still on the books.

This episode of Talking Taxes in a Truck was recorded on December 8, 2023, and runs 46 minutes long.

Join Us: Fines, Jail Time, and Headaches – CTA Compliance Challenges for Main Street Businesses

December 8, 2023|

The Corporate Transparency Act is the most far-reaching data collection mandate you’ve never heard of. Starting January, the new law will require more than 32 million businesses and other legal entities to report the personal information of their owners, key employees, and other individuals to the federal government. 32 million!

The CTA is as complex as it is expansive, yet with less than a month to go, most Main Street businesses remain in the dark about the law’s existence or what they need to do to comply.

Is your landlord a beneficial owner? If a shareholder changes their address and doesn’t tell anybody, who is responsible for updating their information? Exactly what are the practical implications of this new compliance regime?

On our upcoming webinar, longtime S Corporation Association ally and CTA expert Tim Terry — General Counsel at Hartz Capital — will provide the information you need as we approach the CTA’s effective date.

Whether you’re a business owner, tax practitioner, attorney, or policymaker, you won’t want to miss this. Registration is free but limited to the first 500 attendees, so be sure to sign up soon using the link below:

Date: Tuesday, December 12th

Time: 4:00pm ET

Click Here to Register

Save the Tax Code, Save the Country

December 7, 2023|

Save the Tax Code, Save the Country 

This week’s Ways and Means hearing adds to the growing conversation focused on “what comes next” for the tax code. Like the residents of a dying planet, the DC tax crowd appears to instinctively understand that something big needs to change if we’re going to survive the decade.

Rumor has it that the hearing was a promise then-Speaker McCarthy made to the Freedom Caucus in exchange for their support of a past effort.  The challenge is consumption taxes – the focus of Wednesday’s hearing – are problematic for everybody. On the left, their center of gravity has moved so far that older ideas like the Cardin sales tax or European VAT taxes now fall into the category of unmentionables.  Meanwhile, conservatives distrust consumption taxes because they raise lots of money and would be additive, not replicative, of the income tax.

That said, as our fiscal outlook continues to deteriorate, we expect to see more talk of tax reform, and frankly we endorse the trend fully. The federal budget will not survive the coming fiscal cliff and pending Social Security bankruptcy without a complete overhaul, and the sooner we get started the sooner the healing can begin. What does reform look like? Maybe not consumption taxes, but there are lots of good ideas out there.  In a previous post, we analyzed some of those ideas.  This week, we put forward some thoughts of our own.

Simplification

You hear lots about simplification in tax reform conversations, but much of the talk is directed at the wrong targets.  For example, tax writers like to brag about the number of tax brackets they’d eliminate, but are tax brackets really that complex?  Does anybody really sweat the fact that we have six brackets as opposed to two or three?  Not really.

But what about tax codes?  We have lots of those and eliminating some of them would offer meaningful simplification.  Exactly how many tax codes do we have, how many do we need, and how many can we eliminate?  If you define a tax code as a distinct set of rates applied to a distinct tax base, then we have at least seven tax codes at the federal level:

  • Income
  • Dividends
  • Capital Gains
  • Payroll
  • NIIT
  • Estate
  • AMT

Seven!  That’s too many.  And unlike brackets, taxing the same income multiple times really does contribute to complexity.  The more layers, the more taxpayers change their behavior to avoid them.  And like drug interactions, there’s no way to ensure the net result is not hurting the very thing you’re trying to help.

For example, prior to the TCJA, the income tax allowed businesses to expense research costs.  But the Alternative Minimum Tax disallowed the R&E expensing, so business owners who finance research would often learn, after the fact, that they don’t qualify for the deduction. That was just stupid and it undermined the whole point. To its credit, the TCJA greatly reduced the AMT, but it also eliminated full expensing for R&E. Whoops.

The estate tax is another needless complication.  Advocates argue the estate tax raises needed revenue while reducing income inequality, but it does neither. On the other hand, as a direct tax on capital, it does hurt investment. It also hurts family businesses, who are subject to the estate tax, relative to public companies who are not. And it’s simply bad policy. Taxpayers don’t know when the tax will be due nor do they know how much will be owed. Finally, it’s just mean (let’s tax the crap out of somebody when their relative dies).

Under the best of circumstances, the estate tax drains capital and time from family businesses.  At worst, it results in wasted tax planning that gets discarded as the facts change on the ground.  A simple swap would be to tax the capital gains when the assets are sold.  Such an approach would be more humane and it would eliminate the uncertainty and planning expenses of the estate tax. It might also increase revenue.

The bottom line is real reform would eliminate the number of tax codes we have, eliminate all this waste and uncertainty, and focus instead on collecting the revenues we need as efficiently as possible.

Tax Code Integration

Reducing the layers of tax should be another priority. Income should be taxed once and only once, not two or three times like it is now.  The worst example is how we tax C corporations.  Corporate income is taxed at the business level, and then again when it is distributed to the shareholders. Economic literature is rife with examples of how this double tax reduces hiring and investment by altering taxpayer behavior.  Corporate executives rely on stock buybacks rather than dividends to avoid the double tax while shareholders forgo or delay selling shares for the same reason.  People behave differently and, as a result, the economy suffers.

The recent focus on cutting the corporate rate has increased, not reduced, this distortion. When the corporate tax was 35 percent and the dividends tax was just 15 percent, the relative penalty for paying taxable dividends and capital gains was low.  Today, the corporate rate is 21 percent but the dividend/capital gains rate is 23.8 percent. The penalty for paying out profits now exceeds the initial corporate tax. The result is more taxpayers are using the corporate structure to shelter their income.

Real tax reform would eliminate the double tax on corporate profits and tax all business income once, when it is earned.

A Single, Reasonable Top Rate    

Another complexity is the practice of taxing different forms of income at different rates. In the 1950s, individuals were taxed at rates up to 91 percent while C corporations were taxed at about half that much. In response, wealthy taxpayers paid themselves lower salaries and kept the bulk of their income imbedded in the corporation.

They would push personal costs into the corporation too.  Back then, the IRS was kept busy disallowing “business” expenses such as cars, boats, vacations and apartments.

After the Tax Reform Act of 1986 reduced and largely equalized the top income tax rates, the gaming stopped and taxpayers shifted their focus to making business decisions, not tax decisions.

Real reform would restore this parity so that income would be taxed only once and at a reasonable top rate that applied to all forms of income.

Progressivity

Another challenge is progressivity.  Most people agree wealthy Americans should pay more than lower-income Americans.  But the concept of progressivity fails to define exactly how much.

For example, by most measures, our current tax code is highly progressive, with wealthy Americans paying many times more than their middle-income neighbors, and infinitely more than the poor (you can’t divide by zero).  Despite this, most plans call for making the tax code even more progressive.  How much more?  They don’t say. Just more.

This emphasis on taxing the rich has less to do with raising revenue and more about leveling incomes, so that the wealthiest earn no more than a specified amount more than the poor. But if these policies are successful, who will we tax to pay for government?

More to the point, these policies are never successful. Our tax history is ripe with failed efforts to “tax the rich.”  The 1991 Bush tax hikes imposed a 10-percent “luxury” tax on expensive cars, boats and jewelry.  The tax was quickly repealed after it became apparent the rich had stopped buying expensive cars, boats, and jewelry. Meanwhile, tens of thousands of workers lost their jobs as entire industries disappeared. The New York Times quoted one displaced boat builder as saying, “You had to be an ignoramus to believe the luxury tax was only going to soak the rich.  The only people it hurt was working people like myself.”

Soaking the rich is a policy dead end – inevitably it’s the middle class that ends up getting soaked – and progressivity offers little guidance on exactly how much the wealthy should pay.  Always more is not an operational metric.

We need a different measuring stick. What about proportionality?  Under proportionality, a taxpayer earning ten times more than another would owe ten times the tax.  That seems reasonable, but it will never fly.  The current code already applies a degree of progressivity that goes well beyond proportionality. What about two times proportionality or three times?  We don’t have a specific number in mind but something concrete, measurable, and achievable is needed to ensure the wealthy pay a fair amount of tax while at the same time acting as constraint on the insatiable desire of some for more revenue.

Economic Growth

Finally, a goal for tax reform should be economic growth. To some, that means cutting marginal rates as low as possible and encouraging investment and/or by reducing taxes on workers to increase their after-tax income.

Low rates are great, but focusing on marginal tax rates to the exclusion of effective tax rates is a mistake.  What’s the difference?  Marginal rates measure the tax imposed on the last dollar a taxpayer earns, whereas effective rates measure the total tax they pay on all their income, divided by their income.

So it’s possible to have a tax code with really high marginal rates but really low effective tax rates. That’s literally what we had in the 1950s and 1960s. Those policies hurt economic growth by dramatically altering taxpayer behavior – nobody purposefully earned income above the 91-percent threshold — so little tax was collected at that rate.  The net result was really high marginal rates, but really low effective ones.

The opposite example would be where rates stay low, but the tax code imposes so many layers that the result is a high effective tax that applies unevenly throughout the economy. That’s the code we have now, where lots of income goes untaxed while its neighbor is taxed two or three times.

The best balance is where marginal and effective rates converge, so that the delta between the tax on the last dollar earned and the average tax is as close as possible. We don’t have that now, but we should. Properly constructed, tax reform would impose similar marginal and effective rates on the economy across all industries.

Summary

The tax reform conversation is heating up, but so far it’s been missing the elements necessary to ensure success. This post highlights the elements we think should be included in the next big tax reform bill. In our next post, S-Corp will put forward our own ideas on how Congress can reform the code, raise the necessary revenue, and save the country.

In the past, our mantra was “S Corps for Everybody!” Our new mantra is “Save the Tax Code, Save the Country.”  It’s time for Congress to be a hero. Tee shirts to follow.

 

Crapo on Tax Gap

November 30, 2023|

Senator Mike Crapo, Ranking Member of the Finance Committee, is out with a piece in Tax Notes that highlights the various flaws in recent tax gap estimates. It’s a useful reminder that while these figures are great at generating headlines, they’re a lousy framework on which to base tax policy.

As longtime readers know, we’ve been skeptical of these figures for years. While S-Corp strongly supports policing illegal tax evasion, our message to policymakers has been that it’s wrong and counterproductive to characterize the entire gap as willful evasion.

Senator Crapo shares that skepticism. On the newly-released tax gap figures, he writes:

It is crucial here to understand what the IRS’s $688 billion projection is and is not. It is simply a projection of what the 2021 tax gap would be, assuming that the tax law and compliance rates from the 2014-2016 estimate are held constant and applied to the 2021 economy.

In other words, it is a projection of an estimate, which is Washington-speak for a guess (projection) of a guess (estimate). Like any double guess, it is wise to approach such a claim with healthy skepticism.

Setting aside the fact that these estimates are based on shaky assumptions, when taken at face value the IRS data does show a $138 billion increase in the tax gap over the past few years. Does that necessarily mean the tax gap has risen dramatically? Not so, explains Senator Crapo:

When viewed in proportion to the economy’s size over the last 20 years, the tax gap is actually flat and historically average. The Cato Institute examined the tax gap as a percentage of GDP and found that for 2021, the tax-gap-to-GDP ratio was 2.9 percent, squarely in line with the last 20 years of estimates.

Further, an equally valid way of expressing the tax gap is in the share of taxes the IRS believes are voluntarily paid — the so-called voluntary compliance rate. The new projection pegs this rate at 84.9 percent, while the 2014-2016 estimate had it as 85 percent. In stark contrast to overblown characterizations of tax cheating run amok, the tax compliance rate is in fact high and stable.

We made these exact points last year while highlighting that the U.S.’s voluntary compliance rate is among the best in the world. What should be cause for celebration and something to build on instead has been distorted into a talking point used to increase the budget of the IRS.

What are the problems with the tax gap’s methodology? Senator Crapo identifies several:

First, in 2021 the economy experienced its most rapid expansion in three decades, inflation saw its sharpest increase in 40 years, and the federal government was in the midst of disbursing $4.6 trillion in pandemic-related aid. These factors inflate the tax gap, as people and businesses spend and earn more, without increasing the amount of tax evasion.

Second, the recycled estimate was based on compliance behavior with old tax laws, which profoundly changed in 2017 with Republican-led tax reform. With improvements like increasing the standard deduction, decreasing the alternative minimum tax’s impact, and lowering marginal rates, Republican tax reform made paying and filing taxes easier for Americans, which simplified compliance. Shortcuts like presuming identical compliance — despite major changes in tax law — lead to errors.

When issuing its new tax gap guess, the IRS reflexively identified “high-income and high-wealth individuals, partnerships and corporations” as areas of concern, but cited no evidence. Historically, these groups have high levels of compliance, according to IRS data. These data also show the most sizable parts of the tax gap are principally attributable to taxpayers of modest means — particularly, small businesses trying to navigate an overly complex tax code.

Bad data drives bad policy, and we’re seeing that play out in real time. The $80 billion IRS funding boost included in last year’s Inflation Reduction Act was sold as necessary in plugging the growing tax gap and bringing in revenue that would otherwise go uncollected. In reality, a large percentage of the tax gap is from low- and middle-income taxpayers and those who are simply unable to pay what they owe. No amount of additional enforcement and sensational press releases will solve that problem. As Senator Crapo concludes:

With its new tax gap projection, the IRS conveniently created a justification for its supersize supplemental enforcement budget. Yet the IRS’s bold proclamations are stale and misleading. Measuring the tax gap requires a better approach using relevant, reliable data and sound methodology.

We could not have said it better.

No One is Ready for the CTA

November 21, 2023|

Just in time for Thanksgiving, Sunday’s Wall Street Journal’s editorial page highlighted our Main Street letter calling for a one-year delay of the Corporate Transparency Act’s reporting requirements. Appropriately titled The Coming Deluge for Small Business, the article reads:

The CTA assigns the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) with identifying shell companies used for illegal transactions and creating a registry of businesses with less than $5 million in annual sales and fewer than 20 employees.

That describes most small businesses in the country. In a Nov. 16 letter to Congressional leaders, 69 groups representing millions of small business owners say neither they nor FinCEN are ready for the law to go live in January 2024.

…The small business owners have asked that the statute be delayed for a year so they and their regulator can get their acts together. As it currently stands, the government isn’t ready to handle what they are requesting, and small business owners don’t know what they are supposed to provide. Short of cancelling the whole thing, a time-out is the least the feds can do to avoid a national bureaucratic meltdown.

As a reminder, federal regulators have yet to finalize two-thirds of the regs needed to implement the new statute – including the “Access Rule,” which specifies who can access the database and any updates to the “Customer Due Diligence Rule” which applies to financial institutions – yet they are plowing forward with plans to begin collecting data en masse starting January 1, 2024.

And while FinCEN regulators claim they are “working hard” to engage with affected small businesses, those efforts are showing little results. A recent NFIB survey found 90 percent of respondents are unaware the new reporting requirements even exist. Given the CTA’s steep civil and criminal penalties, that’s a big problem.

Meanwhile, the authors of this mess sit back and do nothing. Despite bipartisan, bicameral support for a pause, Congress has yet to take action. We expect that will change next year when millions of small business owners realize they face jail time for failing to notify the Feds that their driver’s license has expired, but by then it will be too late.  The database will be up and running and its proponents will be on to step two – making the database public.

That means the best chance of stopping this reporting regime may be a lawsuit taking place in an Alabama federal court. The suit was filed by the National Small Business Association a year ago and alleges that the CTA violates fundamental constitutional principles, including protections against unreasonable search and seizure. Oral arguments in the case were held yesterday in what should be the final step before the judge issues a ruling. Again, the goal is to get a favorable ruling before the reporting begins next year. Now that would be something to be thankful for.

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