S Corporation Association advisor and Board member Tom Nichols of Meissner Tierney Fisher and Nichols has published a solid defense of 199A in TaxNotes this week.

As we’ve noted previously, the House tax package would knee-cap private companies with rates nearly twice those paid by public C corporations – 46.4 percent versus 26.5 percent.  No business structure can survive such an imbalance, so the net effect would be to encourage further consolidation into the few thousand companies traded on the public exchanges.  That’s bad for millions of Main Street businesses and bad for the workers and communities that depend on them.

Capping the Section 199A deduction is a core part of these rate hikes.  It comes after four years of continuous criticism from both the left and right, including representatives of public corporations, for whom hundreds of billions in tax cuts, shutting down Main Street in response to COVID, and floods of cheap money courtesy of central bankers are just not enough.

The piece is entitled “SOS: Save Our Section 199A” and it’s a response to all the previous criticisms of the deduction and its origins.  As Tom notes:

Section 199A was enacted to provide rough parity between passthrough businesses (which are typically closely held by a small number of owners and often constitute new or multigenerational family businesses) on one hand, and C corporations (for which most taxable income is earned by publicly held entities) on the other hand. Substantially limiting its scope — especially when tethered to the other drastic tax increases for estates, trusts, and high-income individuals described above — will unavoidably suppress the economic activity of the targeted businesses. More important, destroying the current rough parity between closely held passthrough businesses and publicly held C corporations will force even more closely held businesses into the distortive double tax C corporation regime.

While the authors of the tax hike like to argue that only the wealthy will pay the higher rates, Tom makes clear these new taxes will fall on workers too:

No reputable economists take the position that increased taxes on businesses, especially an increase of this magnitude, will be borne exclusively by the owners. Some of that cost will be passed on to customers in the form of increased prices and to employees in the forms of reduced wages and lost jobs. Yes, only entrepreneurs with income over the threshold actually cut the checks, but that doesn’t mean the rest of us don’t pay a good deal of the cost. It is unrealistic to think that a 50 to 60 percent increase in marginal tax rates for these businesses won’t have any negative effects on their current and prospective employees’ income and employment.  Someone should really tell employees who consequently lose or don’t even get a job that it’s OK because there was no tax rate increase for their now-nonexistent income. Moreover, since for most businesses targeted by the Neal tax increases, the cap on the section 199A deduction is equal to 50 percent of W-2 compensation paid to employees, an upper-income entrepreneur has paid out at least $400 in wages for every $74 of tax benefit that entrepreneur derived under current law.

And what about that double corporate tax?  That only exists for private companies, these days.  Public companies with access to foreign and tax-exempt pools of investment rarely if ever pay the second layer.  As Tom observes:

The large majority of publicly held C corporation stock is held by wealthy people, foreigners, qualified plans, tax-exempt entities, and others who either never pay the second tax or do so on a greatly deferred or reduced basis. It is estimated that the wealthiest 10 percent of Americans own over 70 percent of the value of individually owned stocks. They don’t typically need to cash in their marketable securities to buy a car. In fact, the wealthiest of the wealthiest can donate their stock to charity and take a tax deduction for its value. Foreigners own 26 percent of publicly held U.S. stock and generally pay only a 15 percent withholding tax on dividends from these C corporation investments (and nothing on the sales of their stocks at a profit in their home countries). 

Another 35 percent is owned by qualified plans that don’t pay any immediate tax on dividends and stock sales, and qualified plan beneficiaries generally pay tax on distributions and gains only after retirement. Another 4.9 percent is owned by tax-exempt entities that typically never pay that second tax. Thus, the EY study cited earlier found that the net effective rate on publicly held C corporation income was substantially below that hypothetical maximum tax rate.

The 199A deduction was designed to help family businesses compete with public C corporations on a level playing field.  The current rules are barely sufficient to accomplish that task.  Under the Neal draft, any sense of balance is gone and many large family businesses would simply cease to exist – they would be sold to the public competitors or simply fade away as the cost of capital advantage enjoyed by public companies wears them down over time.  Maybe that’s the goal.