We weren’t the only ones who noticed the President’s budget for 2017 is bad for Main Street Employers. Numerous outlets ran stories (CQ, Bloomberg, and Morningstar) focusing on the negative impact the President’s tax proposals would have on S corporations and other pass-through businesses. As our friends from NFIB noted about the Administration’s proposal to expand the Net Investment Income Tax (NIIT) to all pass-through business owners:
“It’s not closing any gap,” said Nick Karellas, tax counsel at the National Federation of Independent Business. “It’s just blatantly a revenue grab on small-business owners who are actively participating in their businesses.”
The Administration’s efforts to characterize this proposal as a loophole-closer are interesting, given that Congress intentionally excluded active business owners from the tax when it was enacted back in 2010 (See below).
But the proposals go well beyond expanding the NIIT. They include increasing payroll taxes on professional service businesses, raising the capital gains rate paid by S corporations and others to 28 percent, and establishing a 30 percent minimum “Buffett tax” on all forms of income. Each of these tax hikes would directly impact the profitability of pass-through employers.
Following the budget’s release, Treasury Secretary Jack Lew testified before the Ways and Means Committee and attempted to characterize their tax hikes as targeted at law firms and hedge funds, despite the fact that they would apply to all businesses – manufacturers, contractors, retailers, etc. S-Corp Champion Dave Reichert (R-WA) was having none of it:
“Let me just go through what I think tax reform should look like, and I don’t see it in the President’s budget, in fact I think it’s really offensive to small businesses. Tax reform should stimulate growth and efficiency by reforming America’s current complicated, burdensome system into a simpler, fairer, flatter tax code. Tax reform should promote U.S. jobs and higher wages through a more competitive international tax system. Tax reform should ensure that small businesses have a fair and competitive tax system, including the tax rate. As a result of the President’s budget, the top rate for small businesses will be 43.4 percent. They don’t get it, and I don’t get it either, Mr. Secretary. Tax reform should aggressively lower rates, and simplify the code. Even after enacting substantial increases in capital gains taxes in 2010 and again in 2013, President Obama continues to propose raising taxes on the investment American workers need to become more productive and earn higher wages…Mr. Secretary…I would like you to explain to me how raising taxes on small businesses helps the American economy grow, helps small business grow, helps create jobs? I don’t understand how you can raise taxes and create a growing economy and create jobs.”
Last year, one of our S-CORP Board Members testified on the effect of these tax hikes on his manufacturing business. McGregor Metalworking saw its effective tax rate – not marginal, effective — jump from 34 to 42 percent following the Obama-supported rate hike in 2013 that Congressman Reichert cites. Under the new Obama plan, McGregor’s effective rate would go even higher.
Confusion on the NIIT
There’s lots of confusion as to why the NIIT doesn’t apply to the business income of active business owners. Advocates eager to rewrite the history of the provision are driving this confusion, which is showing up in major publications. Take for example this excerpt from David Wessel in the Wall Street Journal:
Lobbyists for those who benefit from the NIIT loophole will be quick to accuse the administration of attacking small business. There are a lot of truly small businesses organized as pass-throughs, but the NIIT doesn’t affect them because they don’t earn $200,000 a year. The Treasury estimates that 67% of all S-corp income and 69% of all the partnership income goes to the top 1% of taxpayers, those with income greater than $375,000 a year.
Where to begin.
Let’s start with “loophole” and some of the facts surrounding the NIIT origins. The NIIT was enacted in 2010 as a pay-for to Obamacare. It was a late addition to the law that the Administration proposed in February of 2010, after both the House and the Senate had passed their respective health care reforms.
From the beginning, the proposal excluded the business income of active owners. Here’s how CongressDaily reported on the provision at the time:
President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed.
That was us. We led a broad coalition of business groups to oppose the provision when it was first floated, and we wrote extensively on the provision once it was released. You can read our analysis here, here, and here.
Congress made several key changes to the Administration’s proposal before enacting it – they removed its connection to Medicare and they increased the tax to 3.8 percent – but the exclusion on income of active business owners remained, as our Advisory Board Chair testified back in 2012:
This net investment income tax is generally imposed on interest, dividends, annuities, royalties, rents and gains, with one very important exception. Congress recognized that this new imposition should not apply to income derived by owners directly involved in active businesses. Therefore, Congress excluded from the tax base all income derived from a trade or business unless the income was reported by a person who did not “materially participate” under the passive activity rules or the trade or business consisted of trading in financial instruments or commodities.
So exempting the business income of active owners from the “investment” tax was part of the plan from the beginning and is no way a “loophole.”
And what about “benefit”? Why does Mr. Wessel suggest that business owners who were never subject to a tax, and not supposed to be subject to a tax, derive some benefit from not being subject to the tax? That label assumes that Congress intended to tax the business income of active shareholders. They didn’t, so it’s not appropriate to call it a benefit.
Finally, Mr. Wessel massively redefines “small business.” Any attempt to define “small” is by necessity going to be arbitrary and doomed to fail, but even the Small Business Administration (SBA) puts the threshold at 500 or fewer employees. With around 400 employees, McGregor Metalworking (the manufacturer whose effective tax rate has jumped under Obama’s policies) is considered to be a small business by the SBA. Mr. Wessel, on the other hand, would exclude any business that has just enough profits so that, when combined with all the other income earned by the owner’s household, it exceeds $200,000.
That’s the opposition in a nutshell. They support small business, as long as that small business creates few if any jobs and doesn’t make much money.
The Administration’s budget and its various anti-growth proposals are going nowhere this year, but as S-Corp readers understand, no bad idea ever dies in Washington. The false notion of a NIIT “Loophole” has been conceived and it will live long after the Obama Administration closes its doors.