It’s Easter recess here in D.C. and we’ve had a chance to catch up on our reading. Topping the stack was Marty Sullivan’s Tax Notes piece from March 26th. It’s a rebuttal to our tax reform principles letter signed by 45 business groups here in town, so we thought a rebuttal to the rebuttal was in order.

As a reminder, our letter calls on Congress to reform the tax code by adhering to three broad principles: make reform comprehensive, keep the rates low and the same, and continue to reduce the incidence of double taxing corporate income. Marty appears to quarrel with all three, but this piece is focused primarily on the second principle — keeping rates the same.

He begins with the premise that we need to cut corporate tax rate. Here’s his rationale:

A lower corporate rate is chicken soup for the code. It helps cure many ills with few adverse side effects. It would increase capital formation and add to growth. It would increase compliance. It would reduce the tax bias for issuing debt over equity, for retained earnings over distributions, and for booking profits offshore instead of in the United States.

We all like chicken soup and we agree lower marginal rates would be good. But why just for corporations? What about the other half of business income earned by pass-throughs? Fifty-four percent of employment takes place at S corporations, partnerships, and sole proprietorships — wouldn’t those workers benefit if their employers enjoyed lower rates, too? And what about the tax rates paid by the shareholders of corporations? Doesn’t the marginal tax they pay on corporate income ultimately determine the cost of corporate equity investment here in the U.S.? These questions are left unaddressed.

Instead, Marty focuses on how to pay for the corporate rate cut. Marty argues that higher rates on capital gains and dividends could offset the cost of the lower corporate rates, plus they would help ensure that C corporations don’t become tax shelters for folks trying to avoid the higher rates applied to individual income.

We’re less confident that would work. First, sharply higher rates on capital gains and dividends are already current law, so the potential for raising revenue is limited. Second, any time you have wide differentials in tax rates, taxpayers have a powerful incentive to move their income into the lower tax bucket.

Here’s where the Ways and Means testimony from S-Corp Advisor Tom Nichols comes in handy. As Tom explains, in the pre-1986 tax world, using C corporations to hide income was exactly what they did:

When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent. This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher.

This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations.

Since the taxes at stake could be substantial, the tax opportunities and pitfalls inherent in this system provided tax advisors with a significant source of business. For example, Section 1.537-1(b)(1) of the Treasury Regulations provides that “the corporation must have specific, definite, and feasible plans for the use of such accumulation” in order for such plans to be taken into account for purposes of justifying such accumulation and avoiding the accumulated earnings tax. This led many closely-held business owners to hire attorneys to hold meetings and/or draft corporate minutes when they would otherwise not have incurred the time and expense of documenting such plans so formally.

Cutting today’s corporate rate down to the mid-twenties while allowing rates on individuals and pass-through businesses to rise to the mid-forties would effectively return us to the pre-1986 days of tax shelters and gaming. Marty recognizes this danger, and spends a remarkable amount of time listing all the enforcement tools needed to minimize the games: accumulated earnings tests, personal holding company rules, eliminating step-up in basis at death, limiting charitable donations of stock, taxing passive investment earned by C corporations at individual rates, and limiting C corporation profits to some standard return on investment test. See, it’s easy.

Or, you could just keep rates similar and all these rules would be unnecessary - hence, our reform principle.

Second, Marty may ignore the economic harm caused by high marginal rates on pass- through business and investment income, but it’s there nonetheless. Why is it good to cut the corporate rate? Because it makes U.S.-based businesses more competitive, it reduces distortions in the tax code that hurt growth, and it makes the U.S. a more attractive place to invest. Why doesn’t this same argument apply to tax rates on income earned by pass-through businesses and the shareholders of C corporations? Dead silence.

Marty’s ultimate proposition is to draw a bright line between publicly-held businesses and those in private hands. If you’re public, you get to be a C corporation and pay the new lower rate. If you’re privately held, you get pass-through treatment and pay the new, higher rates. Again, this might make sense as a reform in a world where top tax rates are similar, but here Marty is using it as a tool to ensure that taxpayers don’t game the system in his low-corporate-tax, high-taxes-on-everybody-else world.

It’s possible the Ways and Means Committee chooses to do this, albeit without the huge delta between corporate and non-corporate tax rates. It’s something Jeffrey Kwall has written about on several occasions and he testified about it before the Ways and Means hearing, too. Something to keep an eye on.

CRS on Taxing Large Pass-Throughs as Corporations

More reading. The CRS weighed in recently on the issue of forcing large pass-through businesses to pay taxes as C corporations. The March 30th report entitled “Taxing Large Pass-Throughs As Corporations: How Many Firms Would Be Affected” discusses an idea pushed by the Obama Administration primarily, although key members of Congress have hinted at it as well.

You know our position on this — why does it make sense to cut tax rates for really large C corporations and pay for it by raising taxes on smaller pass-through businesses? It doesn’t. The fact that the CRS paper is almost written in a “How to Raise Taxes on Pass-Throughs in Three Easy Steps!” style, however, doesn’t help much, but it does include one or two nuggets that will be useful in coming debate.

Nugget one is the report makes clear that the businesses affected are anything but the “hedge funds and law firms” targeted by the advocates.Table 5 on page 10 breaks the affected firms down by industry. The top five affected industries for S corporations? Manufacturing, Wholesale/Retail, Mining, Transportation, and Construction.

Nugget two, it makes clear that if your goal is to reduce the disparity in taxation between C corporations and pass-through businesses, further integration of the corporate tax could get you there:

At the same time, an alternative policy prescription that is generally more appealing to economists’ integration of the corporate and individual tax systems’ could also achieve these objectives.

And third, the report raises an issue we haven’t spent a whole lot of time talking about but we probably should — the lack of an economic case for treating all businesses the same. Here’s what CRS says:

Taxing large pass-throughs as corporations would also allow for lower tax rates as it would broaden the corporate tax base. Lower tax rates combined with a reduction in the tax disparity between the corporate and non-corporate sectors could improve business tax equity and the allocation of resources relative to current policy.

Applied to economic activity, this sort of analysis is well established. Tax breaks for homeownership encourage increased investment in residential real estate and less investment elsewhere. The result is an over-investment in houses and a less efficient economy.

But business structure isn’t business activity. Different rules for S and C corporations don’t push business investment into housing or any other sector of the economy. Contrary to the above example, the growth of pass-through businesses doesn’t necessarily encourage residential real estate at the expense of manufacturing or other sectors. You can be either an S or C corporation and still be active in both.

On the other hand, there are offsetting benefits to giving entrepreneurs a choice in selecting a business structure. They can pick the structure that best fits their capital, management, and transition needs.

Forcing some pass-through businesses to pay the corporate tax should be viewed as a pay-for and nothing more. It’s not tax reform, and it’s not going to lead to a more efficient economy or tax code. It’s certainly not going to reduce the cost of business investment in the United States — it will do the opposite under the Administration’s proposals.

Bloomberg on S Corps and Payroll Taxes

Bloomberg’s GOV put out a nice summery of the recent appeals court decision Watson v. U.S. This is the Iowa case where an accountant set up an S corporation to block paying Medicare taxes. The lower court ruled for the IRS and its use of the “Reasonable Compensation” test to require him to pay the correct amount in taxes. The appeals court agreed. Here’s the GOV summary:

The U.S. District Court for the Southern District of Iowa ruled in favor of the IRS in David E. Watson, P.C. v. U.S. The corporation appealed the decision to the U.S. Court of Appeals for the Eighth Circuit, which affirmed the lower court’s conclusion that Watson’s salary for services rendered should have been $91,044 per year. This represents 40 percent of the S corporation’s total distributions to Watson for 2002 and 46 percent for 2003.

In arriving at the $91,044 figure, the Appeals Court agreed with the lower court’s findings: Watson “was an exceedingly qualified accountant” with 20 years of experience; the 35 to 45 hours per week Watson worked made him “one of the primary earners in a reputable firm” that had earnings of about $2 million in 2002 and $3 million in 2003; and Watson’s $24,000 annual salary was “unreasonably low compared to other similarly situated accountants.”

We don’t support taxpayers who use the S corporation to block payroll taxes they would otherwise legally owe. That’s not the purpose of the S corporation. And we’re glad the IRS is successfully using the tools it already has to go after these taxpayers. A few more high profile cases like this, and you might see the problem shrink.