S-Corp Comments on Section 4960 Excise Tax
The S Corporation Association sent comments to the Department of Treasury today raising concerns that recent guidance it published has the potential to impose the new, Section 4960 excise tax onto private operating companies.
The tax is supposed to be targeted at big non-profits and universities that pay their executives and coaches salaries in excess of $1 million per year, but due to expansive definitions of “employee” and “related organization” included in the department’s guidance (Notice 2019-09), the tax could be paid by many family businesses with related foundations and other charities instead.
Worse, the new law is written in such a way that, for many of these families, the only way to avoid the tax would be to shut down the tax exempt organization, or roll all its resources into a Donor Advised Fund.
As the letter explains:
How does a tax targeted at tax-exempt organizations hit private operating companies instead? A typical case is where a successful family business or family stakeholders establish a private foundation (“Foundation”), where the family business and/or family stakeholders or non-family employees of the business contribute financial support to the Foundation and personal time administering the Foundation’s affairs as unpaid directors, officers or staff. The compensation paid by private operating companies is not impacted by personal services provided by these employees to the Foundation. Under the broad definition of “employee” included in Notice 2019-09, officers of the Foundation could be considered employees of the Foundation even though they receive no compensation from the Foundation, are full-time employees of the business and provide limited services to the Foundation or otherwise serve the Foundation in a nominal capacity.
The Notice may also be applied in a manner that a “related person or government entity” could include private operating companies merely because the Foundation is financially dependent on contributions from the company and has overlapping directors, officers and staff. The result could be that highly-compensated employees of the company could be included in the Foundation’s “top five” compensated individuals for purposes of the $1 million threshold.
The excise tax is pro-rated to the entity paying the compensation, so in the case posited above where the Foundation pays no compensation, the business could owe an excise tax of 21 percent on compensation exceeding $1 million, even though the relevant business “employees” donated limited personal services to the Foundation.
Finally, private operating companies subject to this unintended excise tax cannot terminate ongoing liability by having the relevant family stakeholders or other business employees end their relationship with the Foundation, as Section 4960 makes clear that once an individual is listed as a “covered employee” of an Applicable Tax Exempt Organization (ATEO), they are always to be listed, even if the individual is no longer associated with the ATEO. These relevant family stakeholders or other employees of the business could stop volunteering at the Foundation, but their compensation in excess of $1 million from the company would continue to be subject to the 21-percent tax. The only practical means to end the tax may be for the Foundation to transfer its assets to a Donor Advised Fund.
The good news in all this is that while Treasury has published guidance on Section 4960, it has yet to release proposed or final rules, so there’s time to work with them and the Hill to prevent this unintended tax from hitting numerous private operating companies. More to come.
Tax Foundation Needs to Fix Their Map
The Tax Foundation has updated some of their data on pass-through businesses last week, including this nice map with state-by-state data on the percentage of jobs from pass-throughs, which is helpful. As before, it shows that pass-through businesses employ the majority of private sector workers in every state of the country, including seven out of ten workers in Montana!
On the other hand, this map purporting to show the marginal rates paid by pass-through businesses by state appears to illustrate only a small subset of pass-through businesses, and those towards the bottom end of the possible marginal rate range to boot.
Backing out the numbers, it appears that the Tax Foundation based their rates on a general partnership or sole proprietorship that enjoys the full 199A deduction and is able to deduct a portion of the wage taxes they pay on the business’ profits. Using Wisconsin as the test case, here is the math:
What are our concerns with this approach? For starters, it is clear that these rates only apply to businesses that qualify for the full 199A pass-through deduction. As tax folks know, many pass-through businesses qualify for only a partial deduction, while others get no deduction at all:
- Pass-through businesses operating in the wrong industries – health, law, accounting, consulting, etc. – are labelled “Specified Services Trades or Businesses” (SSTBs) and precluded from any deduction.
- Other pass-through businesses are subject to “guardrails” that limit the size of their deduction to 50 percent of the wages they pay or a combination of wages and return on qualified capital.
- Finally, pass-through businesses with international income have that income excluded from the pass-through deduction.
For those businesses, their marginal rates are significantly higher than those represented on the map. Using Wisconsin as the sample state, the top marginal rate for a partnership SSTB is:
This is important because, unlike FICA and self-employment taxes, no portion of the NIIT is deductible. So an active shareholder of an S corporation operating in Wisconsin pays 3.1 percent less than the rate paid by an active partner would, while a passive investor shareholder in that same S corporation would pay 0.7 percent more, 48.45 percent versus 47.75 percent.
Other details are lost on the Tax Foundation map. For example, S corporations do not pay wage taxes on their business profits, but they may be subject to the 3.8 percent Net Investment Income Tax (NIIT) implemented to help pay for Obamacare. That tax applies to S corporation owners who do not actively work in the business.
These wide variations in outcomes are one of the challenges we face in explaining the impact of tax reform on S corporations, and why we use the line graph below to illustrate the range of possible rates for both pass-through businesses and corporations. (Top rates on C corporations vary depending on their dividend policies and the tax profile of their shareholders.)
Our line graph reflects only federal taxes. As the Tax Foundation map shows, state taxes make a big difference as well but, again, their map misses some key nuances. For example, while C corporations may continue to deduct their state income taxes in full, most state income taxes (ranging up to 13.3% in California) are effectively nondeductible for pass-through business owners. The loss of the deduction shows up in the pass-through businesses’ tax base, however, not the rate.
So for businesses in low tax states that get the full 199A deduction, they might see the lower overall tax rate reflected on the map and achieve something that approaches rough parity with the typical C corporation. Specified services businesses operating in high tax states, on the other hand, are not even close to parity and likely saw their overall tax burden go up.
So the Tax Foundation needs to correct their map, or at the very least make clear that the illustrated rates reflect only one, and close to the best, possible outcome for pass-through businesses. Many pass-throughs will pay rates significantly higher than what is on the map. The highest marginal rate paid by a California S corporation that is an SSTB and has passive shareholders is not 46.1 percent, its 54.1 percent.
Business Community Rallies around 199A Permanence Bill
More than 100 business groups came out in support today of new legislation to make permanent the 20-percent pass-through deduction. Introduced by Senator Steve Daines (MT), the “Main Street Certainty Act of 2019” — S. 1149 — is the companion bill to H.R. 216, bipartisan legislation introduced by Representatives Jason Smith (MO) and Henry Cuellar (TX) in the House of Representatives.
The new, 20-percent deduction was a key part of the big tax reform bill enacted back in 2017. The deduction was designed to balance out the tax treatment of pass-through businesses with the lower, 21-percent tax rate paid by C corporations. As our EY study from last year made clear, the deduction works to level the playing field, but only for those business that get the full deduction.
The challenge is that the deduction is scheduled to expire in 2026, at which time taxes on pass-through businesses would go up. This tax hike is due to the fact that while most of the individual provisions in tax reform, including the Section 199A deduction, expire beginning 2026, many of the revenue raising provisions applied to the business community remain in place, including the new cap on interest deductibility and the repeal of the old manufacturing deduction.
The Daines-Smith-Cuellar bill would prevent this tax hike on Main Street businesses.
The letter, led by our Parity for Main Street Employers coalition, makes the case for permanence and was signed by one hundred and three national trade associations, including the U.S. Chamber, the National Federation of Independent Businesses, and the American Farm Bureau:
Despite the economic importance of the pass-through sector, the Section 199A deduction is scheduled to sunset at the end of 2025. Repealing this sunset will benefit millions of pass-through businesses, leading to higher economic growth and more employment. Economists Robert Barro and Jason Furman found that making the pass-through deduction permanent would result in a significant increase in economic growth. The American Action Forum found similar results.
You can read the entire letter here.
Also released today is a “whiteboard” video designed by the Main Street Employer coalition to illustrate the challenge faced by pass-through businesses. The whiteboard makes clear that while tax reform is complicated, the challenge for pass-through businesses is simple — make the 199A deduction permanent!
The legislation, the letter, and the whiteboard are all part of a broader, long-term advocacy campaign by the Main Street business community to make the 199A deduction permanent. As the number of letter signatories attests, there is broad-based support among the business community to make this provision permanent, and it’s going to be the number one priority of the S Corporation Association moving forward.
Section 199A Deduction Needed to Provide Pass-Throughs Tax Parity with C Corporations
A new presentation on the Section 199A deduction from the Joint Committee on Taxation has gotten people’s attention, particularly this slide:
The slide prompted Senator Ron Wyden, the Ranking Member on the Senate Finance Committee, to observe, “These are not the struggling small business owners we were told this provision would benefit.”
The Ranking Member’s response is misdirected, however. The 199A deduction was not an effort to reduce taxes on small businesses, but rather an attempt to maintain tax parity for pass-through businesses of all sizes. Without 199A, Main Street businesses would face sharply higher tax rates than the C corporations they compete with.
This is well-trod ground, but with the renewed focus on 199A it deserves to be reviewed. Pass-through businesses come in all shapes and sizes, and while on average they are significantly smaller than the typical C corporation, there are some very large pass-through businesses. (Tax Foundation Chart)
Pass-through businesses of all sizes employ the majority of private sector workers – 66 million workers or 55 percent of the total private sector workforce according to a 2015 report from the Tax Foundation. Large pass-through businesses (those with 100 or more workers) employ 18 million of those workers. (Tax Foundation Chart)
These businesses pay a high level of tax, often more than their C corporation competition. You wouldn’t know this from most reporting on pass-throughs. Critics of the sector like to remind us that businesses organized as S corporations, partnerships, and sole proprietorships “avoid” the corporate tax.
This is true, but it is just as accurate that C corporations “avoid” the individual tax. Now that the top individual rate is nearly twice the corporate rate, that is the more cogent point. Why is paying 21 percent tax “fair” but paying 37 percent (29.6 percent with the 199A deduction) is “tax avoidance?”
Faced with this new reality, pass-through critics immediately cry, “Double tax, double tax!” C corporation income is subject to two layers of tax, the corporate layer and then a second layer imposed on dividends and capital gains. A dollar of C corporation income paid out immediately to taxable shareholders faces an effective rate equal to 39.8 percent, not 21 percent. (S-Corp has long supported eliminating this double tax. “S corps for everyone” is our mantra.)
But most C corporations don’t pay dividends, and most dividends (and capital gains) avoid tax. On the other hand, one-third of pass-through businesses don’t qualify for the 199A deduction, while the rest see their tax burden increased depending on their size, location, industry, and ownership. The result is a remarkably broad range of marginal tax rates that apply both to C corporations and pass-through businesses, all specific to the facts and circumstances of each business.
So where does that leave us on parity? Last summer, we asked EY to calculate the effective marginal tax rate of the typical public C corporation under tax reform and compare that rate to the top rates S corporations pay under various circumstances.
As you can see, the typical S corporation with the full 199A deduction achieves an effective rate that is close to the C corporation rate when considering the double corporate tax. On the other hand, those S corporations excluded from the deduction, or only receiving a partial deduction, pay effective rates significantly higher.
An important finding from EY is that conversion isn’t really an option. Companies that convert from S to C would still face higher marginal rates. This is because unlike C corporations, S corporation shareholders are subject to the full second layer of tax. Meanwhile, as closely-held businesses, newly minted C corporations will have to distribute a larger share of their earnings to shareholders to compensate them for their ownership. There is no public exchange for closely-held business stock.
EY’s findings are consistent with the findings of other economists. While the assumptions and numbers vary, the overall message is clear – pass-through businesses that get the 199A deduction pay top tax rates in the same range as their C corporation competition. Those that don’t get the deduction pay rates significantly higher.
The bottom line is that the Tax Cuts and Jobs Act achieved rough parity of top tax rates for C corporations and pass-through businesses, but only for those businesses that get the full 199A deduction. If Congress were to repeal Section 199A, or limit it to smaller businesses, that would sharply raise taxes on large pass-through businesses, putting them at a disadvantage and endangering the jobs of 18 million Americans.
The Legal Case for Pass-Through SALT Parity
Last week, Bloomberg published a report that got our attention. Entitled, “IRS May Knock down New York, Connecticut SALT Workarounds,” the article says the IRS is “likely” to issue regulations that invalidate SALT workarounds.
The reference to New York didn’t surprise us. It’s no secret the IRS is targeting the charitable workaround adopted by New York and other states – they already issued guidance last fall throwing sand in the gears of that one. But the pass-through SALT parity bills passed by Connecticut and Wisconsin are entirely different, both legally and politically.
Why can C corporations deduct all their SALT while individual pass-through business owners are subject to a $10,000 cap on their SALT deductions? It’s patently unfair and the reason the S Corporation Association and our Main Street Employers coalition has spent the last year pressing states to adopt a pass-through SALT parity bill to level the playing field.
So exactly what does the IRS have in mind for Connecticut and other states looking at adopting pass-through parity? Bloomberg doesn’t say, but here’s what we do know:
- The current treatment of SALT deductibility for pass-through businesses is unpopular and a source of uncertainty for businesses and states alike.
- Treasury added “Guidance on applying the state and local deduction cap under §164(b)(6) to pass-through entities” to their priority list last November, suggesting that something is in the works.
- Treasury and the IRS would have to issue guidance on this topic regardless of state activity. The uncertainty surrounding the application of the SALT cap to pass-through business would require clarifying guidance either way.
- Whether this guidance might attempt to block companies from deducting their entity-level state taxes is entirely unclear, as is the legal basis for doing so.
As to the last point, S-Corp has long maintained that the new SALT policy for pass-through businesses can be summarized as:
- SALT imposed and paid at the individual level is subject to the new cap; but
- SALT imposed and paid at the entity level is deductible at the entity level and reduces the distributive share passed on to the owners.
A new memo released this week expands upon these points and details the legal foundation underpinning state efforts to restore SALT parity for their S corporations and partnerships. As it summarizes:
State income taxes paid by S corporations and partnerships, limited liability companies and other entities treated as partnerships (collectively, “pass-through entities”) under 2017 Wisconsin Act 368 (“Wisconsin Act 368”) should not be subject to the new $10,000 state tax deduction limitation under section 164(b)(6) of the Internal Revenue Code of 1986, as amended (the “Code”). The Internal Revenue Service (the “Service”) has consistently held that income and other taxes imposed upon and paid by pass-through entities are simply subtracted in calculating nonseparately computed income at the entity level, and are not separately passed through or incorporated into the various provisions and calculations applicable to itemized deductions at the individual level, such as the standard deduction, alternative minimum tax and the Pease reduction. In discussing the final provisions of the Tax Cuts and Jobs Act, the Conference Committee Report explicitly reiterated and relied upon this principle in describing the scope of new section 164(b)(6) of the Code.
While the memo focuses on the new Wisconsin law, its analysis is relevant to Connecticut and other states as they move forward to restore SALT parity. Bills modeled after the Wisconsin effort have been introduced in Arkansas and Oklahoma, with other states not far behind.
These initiatives make states a more attractive place to invest and create jobs, all without reducing state revenue. It’s a win-win for the states and their employers. This new legal analysis explains the authority behind these initiatives, and it’s designed to help more states move forward and begin the process of restoring parity for Main Street Employers.