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Tax Teams and Section 199A
A couple of quick updates on the Ways & Means “Tax Team” front. First, the Main Street Employers Coalition today submitted comments making the case for a permanent Section 199A pass-through deduction.
The letter is addressed to the Main Street Tax Team, one of ten teams organized by Ways & Means Chairman Jason Smith to identify solutions to the 2025 fiscal cliff, and it covers the various key aspects of the 199A debate – why the provision is important, how Congress should define parity, why can’t family businesses just convert, etc. As the letter notes:
The Main Street Employers Coalition (MSEC) is comprised of dozens of trade associations representing businesses operating in virtually every industry and community across the country. The vast majority of these businesses are structured as pass-throughs – S corporations, partnerships, and sole proprietorships – and they rely on the Section 199A pass-through deduction to help them grow, create jobs, and remain competitive.
You can read the entire letter here.
Second, just yesterday S-Corp champion Michelle Gallagher, whose Michigan-based accounting firm was one of our best allies in the battle to defeat the horrible Section 2704 rules, briefed the Rural America and Main Street Tax Teams on the estate tax, valuation issues, and Section 199A. It was a perfect opportunity for lawmakers to hear firsthand what farms and businesses are going through and how the 2025 fiscal cliff threatens their survival.
So things are moving on the fiscal cliff front. The Tax Teams are up and running and the Main Street community is engaging with lawmakers on how to best address this looming threat. The coalition is grateful for the opportunity to share these perspectives and, alongside our allies and Representative Smucker, look forward to seeing his Main Street Tax Certainty Act enacted into law next year.
More to come…
Elusive Tax Cheats
More evidence the campaign to target high-income taxpayers with more audits isn’t going too well. A new report by the Inspector General for Tax Administration at the Treasury Department (TIGTA) suggests the expanded audits are failing to raise the promised revenue. Here’s the WSJ’s take:
Unlike bank robbers, IRS auditors tend to look where the money isn’t. That’s what happened after the agency started scrutinizing more tax returns from the wealthiest Americans. A new report says increased targeting of these taxpayers was hugely ineffective.
The policy, launched in 2020 by former Treasury Secretary Steven Mnuchin, required the IRS to audit 8% of taxpayers each year who earned more than $10 million. To hit that quota, the agency started examining returns with fewer irregularities. The efficiency drop was steep, according to the Treasury Inspector General for Tax Administration, or Tigta, which recently reviewed the results.
The average dollars assessed per return above $10 million “was nearly six times more productive prior to the 2020 Treasury Directive,” meaning the average examination recovered six times as much in unpaid taxes. Or to put it in terms of IRS productivity, after the policy change the money that auditors assessed per hour from this income group dropped 93%.
Reading the report provides a more nuanced picture. For example, this table appears to show that the audits are providing a positive return for the IRS:
The problem with these numbers is they ignore any audits that resulted in taxpayer refunds, plus they measure preliminary assessments only, not ultimate collections. These are not small considerations. For example, last year’s GAO report on the IRS’s new audit regime for large partnerships found the refunds actually exceeded the assessments:
The Internal Revenue Service (IRS) audits few large partnerships—54 in tax year 2019—and the audit rate has declined since 2007. More than 80 percent of the audits resulted in no change to the return on average from tax years 2010 to 2018, double the rate of large corporate audits. For those that did change, the average adjustment was negative $264,000. IRS officials attributed the declining audit rate to resource constraints. The Inflation Reduction Act of 2022 (IRA) provided IRS with $45.6 billion for enforcement activities through the end of fiscal year 2031, and in response IRS identified large partnerships as an enforcement priority. (emphasis added)
Meanwhile, the bulk of the TIGTA report suggests a less than successful effort. For example:
As shown in Figure 7, the average dollars assessed per hour on returns with TPI of $10 million or more were nearly 14 times more productive prior to the 2020 Treasury Directive. Overall, we found that the no change rate was lower and average dollars assessed per return and the average dollars assessed per hour were higher in TYs 2016 and 2017 prior to the 2020 Treasury Directive.
What to do? The good news is Treasury has abandoned Mnuchin’s “8 percent” audit rule. The bad news is the current IRS leadership appears determined to arbitrarily target large pass-throughs and other high-income returns anyway.
Meanwhile, the chorus to target rich tax cheats continues unabated in Congress. People do cheat on their taxes, but the cheating is relatively rare (we have one of the highest compliance rates in the world) and it isn’t limited to any one taxpayer class. The IRS needs to get back to dispassionately reviewing all returns and looking for specific indicators of tax evasion. If they did that, perhaps they’d have more support on the Hill.
Defending 199A in Tax Notes
Tax Notes ran a letter to the editor this week penned by S-Corp President Brian Reardon. It responds to a recent critique of the Section 199A deduction and serves as a useful “cheat sheet” in rebutting the various claims we’ve seen over the years.
The first is that extending 199A will add to the deficit. As the piece points out:
The deduction was packaged with numerous tax hikes — the state and local tax cap, the excess loss limitation, the interest deduction cap, and others — that target upper-income business owners. Many of these pay-fors stay in the tax code even as section 199A expires, which would result in a significant tax hike on passthrough businesses.
The use of the word “significant” here isn’t just hyperbole. Because many of those revenue raisers are permanent, the loss of Section 199A would lead to a large tax hike on Main Street businesses, not relative to current law but rather to the pre-Tax Cuts and Jobs Act code.
The second critique centers on the notion that upper-income taxpayers disproportionately benefit from 199A. Here’s the response:
Large passthroughs do get the section 199A deduction, but only if they employ lots of people or make significant investments. That’s because section 199A imposes so-called guardrails on large passthrough businesses, so, for example, they only get the deduction up to 50 percent of the W-2 wages they pay. A 2019 Treasury study shows how these guardrails exclude about 40 percent of their income from the section 199A benefit, while a recent Congressional Research Service report observes that the section 199A deduction is neutral with regard to progressivity.
What’s portrayed as some sort of smoking gun is the natural consequence of a tax structure where business income shows up on a taxpayer’s individual return. Per Treasury’s own estimates, four out of five taxpayers with incomes exceeding $1 million were business owners. Furthermore, as a recent CRS report notes, “The Section 199A deduction appears to have little effect on vertical equity, as it does not appear to diminish the progressivity of the federal income tax.”
The same cannot be said for the corporate rate cuts. According to the Urban-Brookings Tax Policy Center, the corporate rate cuts primarily benefited upper-income taxpayers and detracted from the code’s progressivity. Anyone looking for “tax cuts for the rich” should start on the corporate side of the tax code.
The third argument claims pass-through businesses are competitive without Section 199A. Based on countless conversations we’ve had with our members and others in the Main Street business community, that’s patently false. But don’t just take our word for it:
…effective rate estimates by Treasury, the Congressional Budget Office, EY, Robert Barro and Jason Furman, and Jason DeBacker and Roy Kasher…show that the Tax Cuts and Jobs Act resulted in rough parity between business forms.
If there is an imbalance, it goes the other way. The folks at Penn Wharton predicted that one sixth of all passthrough activity would shift to C corporations following adoption of the TCJA: “Prior to the TCJA, pass-through businesses were growing remarkably over time. We project that the TCJA will reverse this trend…” Keep in mind, this migration was supposed to occur with the section 199A deduction.
That claim also ignores perhaps the most salient feature of the ongoing tax debate – that most publicly traded corporation shareholders don’t pay tax. Why is that important? Because tax burden comparisons must estimate the burden of shareholder-level taxes. If 75 percent of corporate profits go to shareholders who pay little or no tax, then the overall C corporation rate is significantly lower than the advertised rate.
The good news is that the facts are on our side and we have a year to educate policymakers on why pass-throughs are critical to the US economy, and why Section 199A is important to these businesses. More to come…
Talking Taxes in a Truck Episode 38: Helping Students Read Better
Our latest podcast guest is Marc Matsoff, President of Read Naturally, a Minnesota-based company that helps developing readers of all ages.
Marc discusses the company’s fascinating history and how the S corporation structure has helped it stay in the family for three generations, as well as the various tax challenges they currently face – from the looming expiration of Section 199A to their inability to deduct their R&E tax regime.
This episode of Talking Taxes in a Truck was recorded on June 20, 2024, and runs 29 minutes long.
Congressman Steube Hosts Main Street Employers Roundtable
More than 20 business owners and members of the Main Street Employers Coalition convened in Sarasota, Florida yesterday for a roundtable discussion with Congressman Greg Steube. The key topic – the Section 199A deduction – was one that’s near and dear to the hearts of tens of millions of Main Street businesses nationwide, yet is scheduled to sunset at the end of next year.
The businesses at the event were a microcosm of the broader Main Street community nationwide and represented a wide array of sizes and industries. On hand were contractors, beverage distributors, manufacturers, roofers, shopping center operators, and others. It confirms what we’ve said many times before: private companies are the heart of local economies nationwide.
The data backs this up as well. In Congressman Steube’s 17th congressional district, small and family-owned businesses employ three out of four workers. Those figures hold true when you broaden the lens. Nationwide, private companies supply 77 percent of the jobs.
Despite the outsized positive impact Section 199A has on these job creators, the deduction is scheduled to expire at the end of next year.
Yesterday’s roundtable was organized to highlight this challenge and provide real-world examples of what the deduction means for these businesses, how it’s helped them invest in their communities, and other tangible benfits. It also comes on the heels of the formation of several “tax teams,” including the Main Street panel Congressman Steube co-chairs, which tasked with identifying legislative solutions to avert the 2025 fiscal cliff.
The 199A pass-through deduction is the only tax provision protecting thousands of local communities from fewer jobs and more boarded up buildings. It reduces the tax burden on local businesses to make them more competitive while helping to level the effective rates paid by private and public companies. Congress needs to commit to preserving these communities and these jobs by making the Section 199A deduction permanent.
As an original cosponsor of the House 199A permanence bill, it’s safe to say the Congressman “gets it” and we’re grateful for his participation in yesterday’s event, and for his broader leadership in the fight for Main Street businesses. We’re looking forward to hosting many more of these events going forward. With so much at stake, we can’t afford not to.