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No One is Ready for the CTA
Just in time for Thanksgiving, Sunday’s Wall Street Journal’s editorial page highlighted our Main Street letter calling for a one-year delay of the Corporate Transparency Act’s reporting requirements. Appropriately titled The Coming Deluge for Small Business, the article reads:
The CTA assigns the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) with identifying shell companies used for illegal transactions and creating a registry of businesses with less than $5 million in annual sales and fewer than 20 employees.
That describes most small businesses in the country. In a Nov. 16 letter to Congressional leaders, 69 groups representing millions of small business owners say neither they nor FinCEN are ready for the law to go live in January 2024.
…The small business owners have asked that the statute be delayed for a year so they and their regulator can get their acts together. As it currently stands, the government isn’t ready to handle what they are requesting, and small business owners don’t know what they are supposed to provide. Short of cancelling the whole thing, a time-out is the least the feds can do to avoid a national bureaucratic meltdown.
As a reminder, federal regulators have yet to finalize two-thirds of the regs needed to implement the new statute – including the “Access Rule,” which specifies who can access the database and any updates to the “Customer Due Diligence Rule” which applies to financial institutions – yet they are plowing forward with plans to begin collecting data en masse starting January 1, 2024.
And while FinCEN regulators claim they are “working hard” to engage with affected small businesses, those efforts are showing little results. A recent NFIB survey found 90 percent of respondents are unaware the new reporting requirements even exist. Given the CTA’s steep civil and criminal penalties, that’s a big problem.
Meanwhile, the authors of this mess sit back and do nothing. Despite bipartisan, bicameral support for a pause, Congress has yet to take action. We expect that will change next year when millions of small business owners realize they face jail time for failing to notify the Feds that their driver’s license has expired, but by then it will be too late. The database will be up and running and its proponents will be on to step two – making the database public.
That means the best chance of stopping this reporting regime may be a lawsuit taking place in an Alabama federal court. The suit was filed by the National Small Business Association a year ago and alleges that the CTA violates fundamental constitutional principles, including protections against unreasonable search and seizure. Oral arguments in the case were held yesterday in what should be the final step before the judge issues a ruling. Again, the goal is to get a favorable ruling before the reporting begins next year. Now that would be something to be thankful for.
Congress Can Still Prevent a Regulatory Trainwreck
With just a month to go before the Corporate Transparency Act’s reporting requirements take effect, it’s abundantly clear – not to mention extremely worrying – that federal regulators simply do not have their act together when it comes to implementing the new law.
Recognizing this, the Main Street business community today called on lawmakers to delay the Corporate Transparency Act’s reporting requirements by one year, which would give the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) enough time to finish its work on the regulatory and education fronts.
The letter, which was signed by 70 trade associations including the National Federation of Independent Business, the Real Estate Roundtable, and the Associated General Contractors, points out two key items of unfinished business:
Of the three primary rules necessary to implement the new law, only one has been completed, the second is still at the “proposed” stage and needs to be finalized, while the third has yet to be released even as a proposed rule. FinCEN’s leadership has assured Congress they are ready to go starting next year but that is clearly not the case.
Meanwhile, FinCEN is woefully behind when it comes to educating stakeholders of their new obligations. A National Federation of Independent Business survey found that 90 percent of respondents were entirely unfamiliar with the reporting requirements. The CTA includes civil and criminal penalties of up to $10,000 and two years of jail time for failing to comply, so this lack of awareness is alarming and needs to be addressed before the law is implemented.
Starting next year nearly every small business in America will be required to report – and continuously update – a litany of personal information regarding their beneficial owners. The scope of the mandatory reporting is well beyond anything we’ve seen outside of the Tax Code, yet FinCEN doesn’t have all the rules in place to govern how this sensitive information will be used.
To add insult to injury, the AICPA recently pointed out that FinCEN has significantly underestimated the cost burdens associated with the new reporting regime, it has relied on vague and arbitrary standards in laying out the criminal and civil penalties under the statute, and it has implemented filing deadlines for newly-formed entities which, in some cases, are impossible to meet.
We’ve seen Treasury delay a major reporting regime before. Just last year, the IRS was unprepared to implement the lower 1099-K reporting thresholds and announced a one-year pause. FinCEN faces a nearly identical scenario with the CTA yet appears determined to plow forward regardless.
S-Corp’s preferred approach to the CTA is to repeal it altogether and we continue to support the NSBA’s constitutional challenge which would put this harmful law to rest. But with an effective date fast approaching, Congress and federal regulators need to accept that the CTA is just not ready for prime time.
Reality-Based Taxation
Actual tax policy remains on hold in Congress (listen to our recent “Talking Taxes in a Truck” for that discussion) but there’s been some activity in recent weeks that’s worth highlighting nonetheless. Specifically:
- Yesterday’s Finance hearing entitled, “Examining How the Tax Code Affects High-Income Individuals and Tax Planning Strategies”
- Wednesday’s Senate Budget hearing entitled, “Fairness and Fiscal Responsibility: Cracking Down on Wealthy Tax Cheats”
- A new Auten/Splinter paper examining income inequality and income shares
Here’s a quick summary of each and how it is all related to pass-through taxation. Kind of like six degrees of separation minus Kevin Bacon.
Senate Finance
Yesterday’s Senate Finance hearing was an obvious effort to rationalize why unrealized gains should be part of the tax base. As the Chairman argued:
Today, we’ll examine one strategy – among others – called “Buy Borrow Die.” Just three little words on the chart behind me, that have a huge impact. Here’s how it works: A corporate raider buys a business, and then borrows against its growing, untaxed value to fund their extravagant lifestyle. Everything from superyachts, to luxurious vacations, expensive art deals, you name it. It goes up and up in value all while not paying a dime in tax. And when they die, their assets are passed to their kids – often entirely tax-free – and the cycle continues.
Is any tax avoidance plan where the taxpayer has to die really that great? We prefer to stick around to enjoy our excessive after-tax income. Also, why does the Chairman sound like Robin Leach?
More to the point, how exactly does “Buy, Borrow and Die” work? First, a taxpayer (corporate raider) needs lots of appreciated stock. Second, the stock can’t be spinning off income, as the taxpayer would just use that to fund their (extravagant) lives. Think growth rather than value. Finally, the taxpayer borrows against the appreciated value of the stock.
Couple questions. Doesn’t the shareholder have to pay interest on the loan, and aren’t those interest payments taxable? While yesterday’s witnesses argued the stock’s appreciation always exceeds the interest so the benefit is permanent, the simple reality is that stock prices fall too, even for rich people. When they do, won’t the loan’s covenants demand repayment? When exactly does the loan get repaid, and how does the taxpayer pay it? Finally, doesn’t this trade lower capital gains taxes for higher taxes on interest? Is that a good deal?
Perhaps there are other, non-tax reasons the owner of a high-flying corporation might avoid selling their stock, such as SEC reports or the impact the sale might have on the stock’s price or the owner’s control of the company? Things like that.
And where is the corporate tax in all this? When Warren Buffett claimed he paid less taxes than his secretary, he left out the fact that his company paid billions in corporate tax. Yesterday’s witnesses with the exception of Doug Holtz-Eakin) did the same. Also, what about charitable donations of appreciated stock? Such donations are probably the dominant method wealthy taxpayers use to reduce their income taxes.
These issues didn’t come up because they don’t further the cause of taxing unrealized gains. Chairman Wyden has for years advocated for a mark-to-market approach (here). To get it enacted, however, he needs to 1) build political support for the idea and 2) overcome constitutional concerns regarding the definition of income under the 16th amendment.
This week’s hearing attempts to address challenge one, while the Moore v. United States decision by the 9th Circuit – and now before the Supreme Court — presumably is designed to address challenge two.
Senate Budget
While the Finance Committee focused on legal tax avoidance to promote mark-to-market taxes, the Senate Budget Committee targeted illegal tax evasion to promote more IRS funding. According to Chairman Whitehouse:
Most Americans follow the law and pay their taxes on time and in full. Many of the very wealthiest Americans, however, play by their own rules. Empowered by a tax code that is rigged in their favor, they rob the public weal of revenue and leave everyone else to foot the bill. Today, we will hear how the super-wealthy account for a large and disproportionate share of tax evasion, and cost the American people perhaps hundreds of billions every year….
Dr. Natasha Sarin, one of our witnesses today, estimates that the top 1 percent account for 30 percent of unpaid taxes. You heard that right: one percent of the population; thirty percent of the cheating.
Robbing the weal? That sounds bad, but don’t the top 1 percent pay more than 40 percent of all income taxes? Does that mean their compliance rate is better than average? Hard to say, as the truth in all this continues to be buried in a fog of iffy estimates and IRS budget battles.
What we do know is after decades of over-the-top rhetoric and unfulfilled promises, the tax gap remains just about where it has always been. This from CATO’s Chris Edwards’ testimony:
Auten/Splinter
An S-Corp mantra is you can’t make good tax policy without good data. Underlying this week’s hearings was the premise that the rich are getting richer and we need to use tax code to rein them in.
Missing was any examination of the premise, an omission which is particularly glaring given that its chief skeptics, economists Gerry Auten and David Splinter, just released an updated version of their Piketty/Saez/Zucman take-down. It is comprehensive and devastating. Here’s the abstract:
Concerns about income inequality emphasize the importance of accurate income measures. Estimates of top income shares based only on individual tax returns are biased by tax-base changes, social changes, and missing income sources. This paper addresses these shortcomings and presents new estimates of the distribution of national income since 1960. Our analysis of pre-tax income shows that top income shares are lower and have increased less since 1980 than other studies using tax data. In addition, increasing government transfers and tax progressivity have resulted in rising real incomes for all income groups and little change in after-tax top income shares.
For those uninterested in reading all 47 pages, this chart should suffice. Adjusting for changes in tax policy and other variables, the whole “the rich grabbed all the economic gains in recent decades” narrative simply falls apart.
The pass-through community is neck deep in this debate. Not only are we the target for higher taxes, but the growth of the pass-through sector post 86-TRA is a primary driver of P/S/Z’s errors in the first place. As Auten and Splinter write:
Our analysis addresses this issue by accounting for corporate retained earnings (i.e., profits after corporate tax not distributed as dividends), as well as base-broadening reforms that reduced taxshelter losses. Without these adjustments, top income shares are understated in the 1960s and 1970s, when high individual income tax rates created strong incentives to shelter income inside corporations.
So policies that improved tax transparency and enforcement back in the 1980s are being twisted to justify higher taxes on pass-throughs now. Their proposed solution, on the other hand, would simply return us to the pre-86 days of using corporations as tax shelters. Without all that income showing up on individual tax returns, its advocates could claim they made the world more equal, all while giving their corporate buddies the means to avoid the higher rates. Everybody wins, except for Main Street and the American economy.
Talking Taxes in a Truck Episode 31: Tax Grab Bag with Ryan Ellis – IRS Funding, SALTy Rumors, Year-End Tax Bill, and Mo(o)re
Congress is in overdrive tackling its legislative to-do list and things are starting to pile up on the tax policy front. To help us keep track of it all we’re joined by repeat podcast guest Ryan Ellis, Enrolled Agent and President of the Center for a Free Economy. Ryan kicks things off with a look at the latest developments on Capitol Hill, including the election of House Speaker Mike Johnson, rumors of a SALT cap deal, and ongoing negotiations over a year-end tax package. Ryan then draws on his experience as an IRS Enrolled Agent to talk IRS funding and the tax gap, and shares his thoughts on how the Supreme Court could shape the tax code through Moore v. U.S.
This episode of the Talking Taxes in a Truck podcast was recorded on November 3, 2023, and runs 50 minutes long.
Competing Tax Reforms (Part 1)
Massive deficits, the fiscal cliff, and Social Security’s pending insolvency are jump-starting a long overdue debate over real tax reform – specifically, how should we best reorganize the tax code to survive the fiscal hurdles we know are coming?
Three distinct voices have emerged recently to offer their views. Which offers the best hope for success? What impact would each have on small and family-owned businesses? Here’s a review of the competing plans, together with some thoughts on how to best tax business income from the Main Street perspective. (In a follow-up post, we will put forward our own plan for tax reform.)
The Estonian Example
The Tax Foundation is a big fan of the Estonian approach to taxation, and for good reason. Estonia combines a simple, flat income tax for individuals with a distributed profits tax for businesses, resulting in a single tax system where everything is taxed just once and at the same reasonable top rate.
According to the Tax Foundation, a similar approach applied in the United State would result in a larger economy, more jobs, and higher wages. Key features of the US plan include:
- A flat, 20-percent tax on individual incomes, including capital gains;
- A refundable, $2,000 Child Tax Credit, current EITC, and increased standard deduction and personal exemption;
- A 20-percent tax on distributed business profits coupled with an exemption for the subsequent dividends at the individual level; and
- The elimination of the estate tax and NIIT.
Economic benefits aside, the beauty of a single tax system is its simplicity. So much of the tax code’s compliance and enforcement costs stem from determining which rates apply to what income, so imposing a single top rate on all forms of income would eliminate all that complexity.
Another source of simplicity would be the plan’s elimination of multiple taxes. If a tax regime is a unique rate coupled with a unique base, then the US subjects taxpayers to at least seven – individual taxes, wage taxes, the corporate tax, the NIIT, estate taxes, capital gains taxes, and the AMT. The Estonian approach would eliminate four of these and should allow Congress to repeal more than half the income tax code.
One challenge with the Estonian plan is it would lose revenue. The write-up says: “At the end of the budget window, the plan loses about $100 billion in 2033 on a conventional basis.” They do argue economic feedback would result in higher revenues, but that depends on strong returns to the expensing and corporate tax relief, estimates that are iffy at best. Remember how much feedback the 21-percent corporate rate was supposed to generate?
Another problem is the distributed profits tax, where business income is taxed only when it is distributed to the owners. This type of levy might make sense in a small, capital starved country like Estonia, but in the US it’s an invitation for tax evasion. We already have a problem with hoarding at the 21-percent corporate rate. Imagine the tax avoidance that would accompany a zero-percent rate?
Finally, the plan would exempt foreign investment from the tax, “so long as it is subject to corporate tax in its foreign location.” Again, this might work in tiny Estonia. In the world’s most attractive investment destination, it’s a recipe to steal.
It’s Backkkkkk! The 15-Percent Corporate Rate
We could do real tax reform, or we could just cut the corporate rate again. That appears to be the message from Tax Foundation’s Garrett Watson, who published a piece promoting the Trump policy just last week. Garrett argues:
The current corporate tax rate leaves room for more progress to enhance U.S. competitiveness. Reducing it to 15 percent would bring the combined U.S. rate down to 20.1 percent, just above Estonia’s combined rate of 20 percent. In the OECD, only Hungary, Ireland, and Luxembourg would have a combined corporate tax rate significantly lower than the U.S. Enhanced international competitiveness will make the U.S. a more attractive location for business investment, raising economic opportunities for American households and reducing incentives for businesses to move operations overseas.
This obsession with the corporate rate is silly and flies in the face of the Estonian approach above. One plan imposes the same top rate on everybody, the other creates a huge, unsustainable imbalance between corporate tax treatment and everybody else. Garrett recognizes the inherent problem, writing:
A 15 percent corporate rate would improve U.S. competitiveness and grow the U.S. economy. However, policymakers and candidates should pair tax rate changes with tax base reforms to ensure the cost of tax cuts is paid for, investment is not penalized, and broader tax reform is not left off the table.
A nice sentiment, but as “Bert and I” once observed, you can’t get there from here. A 15-percent corporate rate reduces revenues by $750 billion or so. Offsetting those revenues with base broadening sounds great, but we just did that and, unlike the individual and pass-through provisions, those changes are permanent. To offset additional corporate cuts, Garrett would need to raise taxes on individuals and Main Street businesses. Again.
How would Main Street fare under a 15-percent corporate rate? For larger pass-through businesses, the response would be simple – they would convert. No more large S corporations, no more large partnerships.
That might make the JCT happy, but it’s not going to improve the economy. Why? Because public companies have a huge advantage over private companies when everybody is a C corp. They have access to the capital markets, their shareholders buy and sell their stock without transaction costs, and three-quarters of their shareholders pay no taxes or greatly reduced taxes, so the double tax doesn’t apply to them.
S corp shareholders are all taxable, on the other hand, so the double tax hits them hard. Plus, S corps have to pay dividends. How else do you reward owners of a private company? Over time, the public company advantage simply overwhelms the family business sector. It would be pre-1986 all over again.
Bottom Line: Giving companies that already pay the lowest rates another tax cut might provide a windfall to Apple and Amazon, but the cost would fall on individuals and pass-through businesses and further the economic consolidation that’s been taking place in recent decades. That might be good for Wall Street, but it’s bad for Main Street and the people who live there.
Deese & Kamin on Tax Reform
Finally, , former Biden NEC staffers Brian Deese and David Kamin penned a recent Tax Notes article arguing that the tax policy response to our fiscal challenges should conform to the following five principles:
- at a minimum, fully pay for tax reform relative to current law and strengthen the tax base to facilitate future increases in revenue;
- focus the existing limited fiscal space on helping lower-income families;
- reverse the erosion of the corporate income tax system while maintaining incentives to innovate and invest;
- eliminate tax cuts for the highest-income Americans and increase their contributions relative to the pre-2017 tax system; and
- improve tax administration and simplify tax filing.
First, these don’t look much like principles. They look like goals. The authors may think the rich should pay “more” but that’s hardly a governing principle, is it? More compared to what? When exactly do we reach “more”?
Anyway, Deese and Kamin are calling for tax reform that is deficit neutral, raises taxes on corporations and the rich, reduces taxes for lower-income families, increases funding for the IRS, and sets the stage for future tax hikes. In other words, the basic tax playbook of the Biden administration.
Couple problems. First, reducing taxes on lower-income families sounds good, but the combo platter of the EITC, Child Tax Credit, and larger standard deduction means that most low and modest income families don’t pay income taxes. Here’s the Tax Foundation on income tax distribution in 2020:
See how the bottom 50 percent of taxpayers only paid 2.3 percent of all income taxes? It’s actually less, as the percentages exclude the refundable portion of the family tax credits. As a result, calls for reducing their taxes really means sending bigger checks. You may support that, but it’s not tax reform.
Second, raising taxes on the wealthy may poll well, but only when the poll’s respondents fail to understand how much the rich already pay. As our surveys from the Winston Group demonstrate, wealthy taxpayers and private businesses already pay rates well above what most Americans think is fair.
Finally, the dirty little secret of the TCJA is that its tax relief went mostly to C corporations and lower-income families, not wealthy taxpayers. That might surprise Tax Notes readers, as Deese and Kamin include detailed tables showing who got what. The problem is they use Brookings estimates that ignore actual tax payments and focus instead on “post-tax income.”
Here are the actual revenue collections from the Congressional Budget Office. As you can see, collections on corporations dropped sharply post 2017, while individual collections went up.
Moreover, the individual collections reflect tax relief targeted at low-income families, including a larger standard deduction and a larger child tax credit. Those two TCJA provisions reduced individual income taxes by $1.3 trillion (yes, $1.3 trillion) over ten years. Add that back in and the remaining tax base of higher-income taxpayers and pass-through business owners paid $182 billion more in 2018 than they did in 2017, an 11-percent increase. Some tax cut.
How does the Brookings data show tax cuts for the wealthy when their payments went up? Their “Expanded Cash Income” data includes both corporate income and corporate tax relief. So while many pass-through business owners saw their taxes go up post-TCJA, Brookings has them going down by apportioning the large corporate tax cuts to them. Kind of like rubbing salt in the wound, no?
Exactly whose taxes went up post-TCJA? It’s a mixed bag. Do you reside in a high tax state? Do you get the 199A deduction? Did you lose the 199 manufacturing deduction? Do you have excess losses, high interest expenses, or large R&E costs? Generally, a pass-through business operating in high tax states but excluded from 199A got killed. A 199A-qualified business operating in no-income tax states did just fine.
Another problem. Deese/Kamin resurrect the old trope about the erosion of the corporate tax base. They write that “[o]ver the decades, federal corporate income tax receipts have fallen considerably as a share of the economy — even as that has not been true of corporate profits.” But the data they use to measure profits includes S corporations, while their data on tax payments does not. This paper from the BEA explains the issue. The corporate tax base didn’t erode — it migrated to the pass-through sector where, you may have noticed, they pay higher rates these days.
Finally, missing from Deese/Kamin is any discussion of jobs or economic growth. The only reference to jobs is in the title when they cite the Tax Cuts and Jobs Act, and the only reference to economic growth is when they discuss the challenge of higher interest rates paid on our national debt. This lapse continues a disturbing trend of tax policy experts simply ignoring the effect tax policy has on the economy, focusing solely instead on who pays what.
Bottom Line: Deese and Kamin may argue tax reform should make the wealthy pay more, but they can’t argue that this would be a change from recent policy. The TCJA already did that.
Conclusion
S-Corp put away its crystal ball following the 2016 elections, but you don’t need a clairvoyant to know Congress is going to debate a very large tax bill at the end of 2025 and everything will be on the table when Social Security goes broke in ten years. Here’s the Tax Foundation:
[D]ue to the TCJA, much of the individual income tax code is set to expire after the end of 2025, while several business tax increases have already begun to take effect, including the phasedown of bonus depreciation beginning this year, making now an opportune time to consider fundamental tax reform. The weakening economy, high interest rates and inflation, and severe fiscal challenges ahead also make fundamental and pro-growth tax reform more important than ever.
That last phrase is the key – how do you reform the tax code to raise the revenues the government needs while encouraging robust economic growth? It won’t be easy, but we have some ideas.
Next Up: A Tax Reform Plan for Main Street