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.
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.
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.
Today, the S Corporation Association submitted its formal comments to the IRS on the pending Section 163(j) rules. Section 163(j) would impose the new, 30 percent cap on interest deductions as part of the Tax Cuts and Jobs Act (TCJA).
Under the TCJA, Congress intended to impose a higher cap to start, and then lower the cap in the future, giving affected companies time to prepare for the new policy. But the rules proposed by the IRS would inexplicably apply the lower, more onerous cap to manufacturers immediately! This is definitely not what Congress intended and will come as an unwelcome surprise to Main Street manufacturers across the country.
The basic message of S-Corp’s submission was that Treasury should apply the same rules to manufacturers as other industries. As the comments conclude:
Generally speaking, then, the new cap on interest deductibility is 30 percent of a taxpayer’s taxable income before interest, tax, depreciation and amortization (EBITDA) in tax years 2018 through 2021, and 30 percent of a taxpayer’s taxable income before interest and tax (EBIT) in tax years 2022 and beyond.
The proposed rules, however, do not follow this general approach in the case of manufacturers. This is because the rules effectively prevent taxpayers from adding back depreciation that is capitalized under Section 263A into inventory and recovered through cost of goods sold. Since manufacturers are required to capitalize to inventory their depreciation relating to investments in equipment and facilities, the rules block this depreciation from being added back to taxable income when determining ATI.
As a result, while other businesses will be subject to a cap on interest deductions equal to 30 percent of EBITDA through tax year 2021, manufacturers will be subject to a more onerous cap equal to 30 percent of EBIT beginning immediately.
Unchanged, this result is guaranteed to blindside many manufacturing businesses when they file their taxes this year. S-Corp has a number of members who are unaffected by a cap based on EBITDA but will pay significantly higher taxes under a cap based on EBIT. This is clearly not the result Congress intended when it adopted the TCJA.
In submitting these comments, S-Corp joined the U.S. Chamber of Commerce and other advocates in raising concerns about the rule’s impact on the manufacturing sector. As the Chamber notes:
Prop. Regs. §1.163(j)-1(b)(1)(iii) should be stricken as it adversely impacts certain business sectors, contrary to Congressional intent. The House and Senate bills differed on whether depreciation, amortization and depletion should be disregarded in computing ATI. The 2022 effective date to reduce ATI for such items was a compromise in conference committee. The impact of this regulation is to accelerate the negative impact selectively to manufacturers in 2018.
Four out of five manufacturing businesses are organized as pass-throughs. These businesses are counting on the new expensing and other friendly provisions included in the TCJA in crafting their business plans for 2018 and beyond. The proposed 163(j) rules would effectively eliminate the benefit of expensing for many of these businesses and subject them to effective marginal tax rates that far exceed anything else in the Tax Code. This issue is important to employers and communities throughout the country. S-Corp intends to follow up on its comments and meet with Treasury officials to push for these changes.
Treasury issued the final rules on 199A earlier this month. You can read the rules and accompanying guidance here:
You can also read a terrific “how does it all work” review published in Forbes the other day. As the writer notes:
I believe in giving credit where credit is due, and I’ll be damned if the IRS doesn’t deserve some serious credit. It was less than 13 months ago that Congress dumped 500 pages of sloppy statutory language on the Service in the form of the Tax Cuts and Jobs Act, and somehow, in that span the IRS has managed to provide final regulations on the most controversial, convoluted and complicated provision of the new law: Section 199A, better known as the “20% pass-through deduction.” It required a Herculean effort, particularly when you consider that, you know…most of the government has been on unpaid leave since December 22nd.
We agree. Treasury did a great job of getting a workable set of rules based on a very complicated law out the door quickly. They also embraced some very taxpayer-friendly ideas, like the ability to aggregate multiple businesses together when calculating the deduction in certain circumstances, as well as the option to calculate the deduction at the entity, rather than the taxpayer, level. These are welcome and will help make the 199A deduction workable for most businesses.
That said, there were many details that we hoped Treasury would improve in the final rules. The aggregation rules are still too restrictive, and the imposition of a two-tiered de minimis threshold is simply too low and could give rise to needlessly complexities.
Our biggest objection to the final rules, however, is the starting point. How so? When Congress created 199A, it needed guardrails to distinguish between business income that would qualify for the deduction and wage income that would not. It’s the old “John Edwards, Newt Gingrich” dilemma all over again, only more so since the 199A tax benefit is potentially bigger.
But instead of a targeted approach that distinguished business income from wages, Congress chose a wholesale exclusion of entire industries (so-called Specified Service Trades or Businesses or SSTB’s) from the deduction. The idea was that since a law firm’s income is largely due to services, let’s just say that all law firm income is ineligible for the deduction and not mess around with difficult distinctions of business income and an owner’s wages.
The statute accordingly describes an SSTB as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities, partnership interests, or commodities, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.
It is an extensive list and a classic case of picking winners and losers. Obviously, litigating which trades or businesses get the deduction will be an issue for years to come. There’s not much Treasury could have done about that.
Where Treasury went wrong, in our opinion, is in defining the term “involving” narrowly to encompass any level of activity in those listed professions. They explicitly rejected arguments that they should define “involving” more broadly where substantially all the corporation’s activities for a taxable year must involve the performance of services in the listed fields in order to trip the exception.
Treasury argues “… section 199A looks to the trade or business of performing services involving one or more of the listed fields, and not the performance of services themselves in determining whether a trade or business is an SSTB.”
Yet it can be argued that the final rule does exactly the opposite. If “involving” means any level of activity in the listed services, then any trade or business that has even a modicum of revenue from one of the listed services would be precluded from getting the deduction. For example, banks may earn revenue from many listed services and so would be disqualified under Treasury’s narrow interpretation, even though Congress explicitly chose not to list banking as an SSTB. The rule effectively puts the emphasis on the service, not the business.
So how does Treasury get out of this conundrum? They embrace two “outs.”
First, they established a two-tiered de minimis threshold for SSTB revenue in a business that would otherwise qualify for the deduction. The threshold is 10-percent for businesses with gross receipts of $25 million or less, and 5-percent for those businesses above $25 million. Allowing a minimum level of disqualified income is obviously inconsistent with the notion that “involving” is triggered by one penny of specified service revenue, but it’s necessary. Otherwise, all businesses would be at risk of being characterized as SSTBs, which obviously isn’t what Congress intended.
Second, Treasury relies on the fact that there can be multiple trades or businesses within a single business entity. Treasury argues that an S corporation bank that would otherwise be disqualified as an SSTB under their strict interpretation can still get the deduction for their qualified lending and banking operations by segregating other, disqualified services into a separate “trade or business.”
The final rules say “… a subchapter S bank could segregate specified service activities from an existing trade or business and operate such specified service activities as an SSTB separate from its remaining trade or business, either within the same legal entity or in a separate entity.”
This approach will work, albeit at a significant burden to the taxpayer. The approach also opens the door to gaming. As S-Corp argued in making the case for generous aggregation rules, gaming under 199A is more likely to come from disaggregation than aggregation. Treasury’s approach opens the door to disaggregation by law firms and other listed trades or businesses.
In our opinion, it would have been better to adopt a higher bar of activity in order to trip the SSTB definition. In practice, this higher bar would have established a single de minimis threshold that would have eased compliance and administration burdens, reduced the number of companies that are unintentionally tripped up, and limited the need for Treasury and the courts to continuously weigh in on what might and might not be an SSTB.
Of course, it would have been better still had Congress targeted wage income itself rather than whole trades or businesses for exclusion from the deduction, but that horse left the barn a long time ago.
One area where the Treasury did taxpayers a huge service was stomping on any expansive notions of the phrase “principal asset is the skill or reputation of one or more employees or owners.” This phrase is wholly unworkable (what exactly is a “principal asset” and how do you measure it?) and had the potential to open up a wide variety of trades or businesses to SSTB designation. Treasury correctly rejected that option and limited “the meaning of the reputation or skill clause to fact patterns in which an individual or RPE is engaged in the trade or business of receiving income from endorsements, the licensing of an individual’s likeness or features, and appearance fees.”
The bottom line is that S corporations and other pass-through businesses now have the rules in place to move forward. While the rules are not as broad as we had hoped, they are better than many possible alternatives and they now form the foundation from which we intend to build. Our agenda for 2019 is to continue to make the case for pass-through parity and working to make the 199A deduction broader and more permanent. Like so many S corporations, these final rules provide us with a starting point.