Text of the letter we sent to Speaker Boehner earlier today:

Dear Speaker:

The S Corporation Association would like to thank you for all your work over the past two years to protect closely-held businesses and ensure that as Congress considers changes to the tax code, privately-owned businesses are not harmed or singled out.

With that in mind, the S Corporation Association supports H.J. Res. 66, the “Permanent Tax Relief for Families and Small Businesses Act of 2012.” While H.J. Res. 66 would allow tax rates to rise for S corporation owners with incomes above $1 million — something we oppose — it is the best of all the options before Congress and it sets the stage for comprehensive, pro-growth tax reform in 2013.

By making permanent relief from higher rates (up to the $1 million threshold), the estate tax, the Alternative Minimum Tax, and the limitations on deductions, H.J. Res 66 helps privately-held businesses immediately by giving them the certainty they crave. The recent sharp decline in the National Federation of Independent Businesses’ survey of small business owners should serve as a grave warning to all policymakers — Congress needs to act now to provide private employers with certainty or risk seeing the small business sector, and the economy as a whole, pull back and contract. H.J. Res 66 provides some of that certainty.

Moreover, H.J. Res 66 improves the odds that Congress will be able to enact meaningful, comprehensive tax reform in 2013.By making the permanent a large part of the tax code, the legislation ensures that the debate over tax reform will be focused on moving the tax code forward through rate reductions and base broadening, rather than endlessly debating the continuation of existing provisions that are due to sunset sometime in the future.

The S Corporation Association has been a leading voice in the business community in opposing raising marginal tax rates on employers while supporting comprehensive tax reform that lowers rates on all forms of business income. The legislation before the House of Representatives is not perfect, but it is our view that it is the best of all options being considered, and it does the best job of setting the stage for the enactment of positive tax policies moving forward.

Thank you for your efforts and for continuing to defend private enterprise.

The vote on Plan B is scheduled for tonight.

Can Main Street Businesses Elect C Corp Status? Should They?

The idea that corporate-only tax reform isn’t so bad because Main Street businesses can elect C corporation status and access the lower rates has been floating around DC for months, but we’ve never had the idea sourced until last week’s Politico Pro report:

“A lower corporate tax rate that will keep American businesses more competitive in an increasingly global economy is critically important, but it cannot come on the backs of the small business community, which is why corporate reform must be linked with individual reform,”  Caldeira said Tuesday afternoon in his statement to POLITICO.

Groups like the RATE Coalition - which represents larger corporations such as AT&T, Boeing, Ford, Lockheed Martin – dispute this logic.

Elaine Kamarck, the coalition’s co-chair, said last week that the two overhauls should be separate and that small businesses could just switch to the corporate code.

“There’s also an argument that some of those [small] businesses and pass-throughs might become corporate,” she said. “There is nothing that keeps them from switching. Because of the high corporate tax rate they don’t file [under the corporate code]. So I think that is less of a problem than some people would guess it to be.”

A later version of the story included this new quote:

A spokesman for the group, which represents big names such as AT&T, Boeing, Ford and Lockheed Martin, said Tuesday evening, however, that Kamarck’s views were her own and the coalition supports comprehensive tax reform.

We’re glad the RATE Coalition clarified that they support comprehensive reform, but what about the other issue raised here. If the corporate rate is reduced, should pass-through businesses just switch to C status to access the lower rates? The answer is no. Here are the main points:

It’s the opposite of tax reform. Taken as a whole, the corporate-only approach is effectively “anti-tax reform” in that it will return us to the pre-1986 era, when corporate tax rates were significantly lower than the top individual rate and tax shelters and gaming dominated taxpayer behavior.

  • It’s a tax hike either way. S corporations that retain their S status would pay a top rate of 45 percent on their earnings. Meanwhile, those that switch to C corporation status would pay the new lower corporate tax of 25 percent, but also be subject to the second layer dividend tax. The dividend rate is scheduled to rise from 15 to 45 percent next year, so the total effective tax on the new C corporation would be as much as 59 percent! With the lower dividend rate envisioned in the Senate-passed bill, the combined rate still would exceed 40 percent.
  • The double tax applies to the sale of a closely-held C corporation too. When an S corporation owner sells their business, they pay the capital gains rate on any gain. The same treatment applies to the shareholder of a publicly traded corporation — they pay a single tax at the capital gains rate. But gains from the sale of a closely-held C corporation are taxed twice, first at the corporate rate and again at the capital gains rate. Even with the lower corporate rate of 25 percent, that still means a total effective tax of over 40 percent.

Let’s take these points one at a time:

  1. Corporate-Only is Anti-Tax Reform

S-Corp Advisor Tom Nichols hit this point in his testimony before Ways and Means earlier this year:

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. Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.

Efforts to lower the corporate rates while raising individual and pass-through rates should be deemed “anti-tax reform.”  They will return us to the world Tom describes above, effectively reversing the broad changes made by Congress in 1986 and creating a tremendous incentive for taxpayers to organize their income to take advantage of the lower corporate rates and then shelter that same income from the higher rates.

  1. Either Way, It’s a Tax Hike

Consider the scenario embraced by the Administration, where the top marginal rate for individuals rises to 45 percent, the corporate rate drops to 25 percent, but the tax on dividends increases to 45 percent:

      • Under the current rules, if our S corporation made $100 dollars this quarter, its shareholders would pay $35 in federal taxes (same as a C corporation) regardless of whether the income is distributed or retained by the business.
      • Next year, under the Obama scenario where the top rate rises to 39.6 percent, plus the new 3.8 percent investment tax, plus the reinstatement of the Pease limitation on deductions, our S corporation’s shareholders could pay as much as $45.
      • Finally, if we were able to convert to C, we would pay $25 initially but then face a choice — either retain the income at the firm and avoid the second layer of tax, or pay out a dividend and pay another $34 in taxes (the 45 percent dividend tax times $75), for a total tax hit of $59. If the dividend rate is 23.8 percent next year (as proposed by the Senate), then the combined tax would be 43 percent.

You’ll notice that the converted C corporation has a very strong incentive to keep its post-tax income within the firm and not pay that second layer of tax. If our business has a single, active shareholder, it might be an option. He can just retain the earnings and adjust his salary and bonus to meet his income needs and shelter the rest (see argument 1).

But what if we have multiple shareholders, many of whom don’t work at the business and rely on the business’ income to finance their lives?  Avoiding the second layer of tax isn’t really an option there, so converting to C would be less attractive, particularly with the possibility of a 45 percent tax rate on dividends.

Meanwhile, for S corporations that retain their earnings, lowering only the headline C corporation rate means that their publicly held competitors would pay a lower tax on earnings retained in the business, in addition to having access to the public markets and all of the other advantages of being a much larger business. Does this make sense when most job creation comes from pass-through businesses?

  1. Double Tax Applies to Business Sales

The “they can just convert” argument also ignores the penalty closely-held C corporations face when they are sold. The 1986 Tax Reform Act applied the double layer of tax onto sales of closely-held C corporations, which means a C corporation sold this year is subject to a combined federal tax rate of nearly 45 percent versus just 15 percent for the sale of an S corporation. Under the Obama approach of lower corporate rates but higher capital gains rates, the effective tax would be 43 percent.

This double tax makes switching to C corporation status a non-starter for any entrepreneur who might sell their business someday. Many business sales are tied to the retirement of the owner, where the proceeds are used to fund their retirement, so rates that high are a threat to their retirement security.

It’s different for publicly held C corporations. Individual stockholders can sell at any time, often at higher multiples, and business to business acquisitions can be done with stock, often on a tax-free basis, once again giving public C corporations a tax advantage over private ones.

So arguing that pass-through businesses can just “convert” simply is not credible. Some businesses might be in a position to switch to C status, but there are higher taxes waiting on the other side. Given that pass-through businesses employ more than half the private sector workforce, how does any of this make sense? More broadly, how does forcing more companies into the inefficient and investment-stifling double tax model make America’s companies more competitive? Sounds like a plan to do the exact opposite.