Dear S-CORP Member:
The S Corporation Association recently surveyed voters and asked them how much private companies and other taxpayers should pay in taxes every year?
Almost without exception, the responses were consistent, reasonable and completely out of step with today’s rhetoric. Voters believed family businesses should pay no more than twenty cents for every dollar of income, or about half what most actually pay and less than one-third what they would pay under a wealth tax as proposed by Senators Warren and Sanders.
How to explain the disconnect? How can voters support reasonable tax rates on one hand and destructive wealth taxes on the other? In my experience, Americans are very moderate in their views, but they don’t always have the clearest picture of where things stand.
So when Senator Warren describes her plan as “just two cents,” voters don’t realize an annual tax equal to two percent or more of a company’s value can easily exceed its annual income, or that taxes that high threaten the future of family businesses nationwide.
That’s where the S Corporation Association comes in. Part of our mandate is to educate policymakers and voters alike on the importance of individually and family-owned businesses and to accurately describe how the policies considered in Washington would affect businesses residing on Main Street.
I was reminded of this mandate while watching Indiana’s new senator on CNBC the other day. Here’s what he said:
I’m a Main Street entreprenuer – I come from the small business world, and its never been better. C corps always take care of themselves. Lowering their nominal rate from 35 to 21 didn’t mean a lot because they had an 18 percent effective rate. Those of us in small business, we pay the full tax rates and when that changed, taking it down to 29.6 from 39.6, that was a big deal. That’s where jobs are created. That’s why we plowed through trade issues with China and so many other areas where recoveries at this stage of the game normally would flame out.
He’s right on both counts – while some sectors and regions could be doing better, its hard to think of another time in our history when so many were doing so well. It really has “never been better.” Meanwhile, the tax reform Congress enacted two years ago has helped Main Street keep the record expansion – now in its 127 month — going.
The S Corporation Association can take some credit for this success. When tax reform was debated, we worked closely with Senators Ron Johnson (R-WI) and Steve Daines (R-MT) on changes to improve the bill for Main Street. As Senator Daines explained at our recent Hill briefing:
Here’s why I think we need tax relief for pass-through businesses… Most of the jobs are created by pass-throughs more than C corps… so if tax reform is the means to an end, the means is lowering taxes and the end is economic growth and job creation. If we’re not addressing the pass-throughs, then we’ve not addressed the heart of what needs to happen to achieve that end.
Those changes included lowering the top individual rate, increasing the size of the Section 199A pass-through deduction, and expanding the deduction to include trusts and estates. The good news is that these efforts succeeded in balancing out the interests of Main Street businesses with those of large C corporations.
What is S-Corp’s plan to build on this success in 2020?
First, we are going to continue to make the case for individually and family-owned businesses. As a group, our companies are critically important to the economy. The stories of how they got started, the challenges they’ve overcome, and their collective contribution to the economy simply cannot be repeated too many times.
Second, we are going to focus on tax policies that help your bottom line now. The 199A deduction is complicated, limited, and temporary. S-Corp and our Main Street Employer coalition are working with allied groups to make the rules issued by Treasury as expansive as possible while building the foundation for making the deduction both permanent and more broadly applied. Getting the rules out of Treasury “right” is a short term effort that will pay immediate benefits to pass-through businesses.
We will continue to enact our SALT Parity reforms too. Limiting SALT deductions for S corporations while allowing them for C corporations is patently unfair. Instead of complaining, S-Corp and its Main Street Employers coalition identified a solution, drafted model legislation, and published the legal analysis demonstrating to states exactly how they can restore the SALT deduction for their pass-through businesses.
We then took the idea to state legislatures across the country. As our President testified before the Louisana legislature last spring:
This legislation would benefit thousands of family businesses operating in Louisiana by restoring their ability to fully deduct the State and local taxes (SALT) they pay on their business income. The bill is intended to be revenue neutral and its effect would be to make these businesses more competitive and Louisiana a more attractive place to do business.
Six states have adopted our approach to date – Connecticut, Wisconsin, Oklahoma, Louisiana, Rhode Island and New Jersey – with several others actively consdering it this year. Our goal is to reach a critical mass of legislatures taking action at the state level and force Congress to revisit the policy for everybody.
Finally, S-Corp is working to build the case for the next tax reform. Since its inception, S-Corp has supported the single-tax system for individually and family-owned companies — tax business income once, tax it when it is earned, tax it at a reasonable top rate, and then leave it alone. S corporations for everybody is our mantra.
Voters overwhelmingly agree. In our recent survey, an overwhelming 77 to 7 percent of respondents opposed the idea of taxing the same income twice. They also supported the ability of businesses to grow as much as possible and still retain its pass-through status. Ultimately, voters are looking for a tax system that is fair for all and encourages the establishment and growth of all types of businesses.
Armed with this support, when Congress next reviews the tax code, our goal is to be at the table, making the case for Main Street and the single tax system.
That’s our advocacy plan for 2020 and beyond. What can you do to help?
- Renew your membership for 2020: S-Corp is not flashy, and we don’t have a lot of bells and whistles. What we do have is great advocacy, and advocacy starts with our members. Renew today.
- Support the S-Corp PAC: The Main Street Community needs to support those members of Congress that support us. Political giving isn’t for everyone, but if you have the ability, support the PAC and help us support our champions.
- Spread the word: Our best ambassadors are our members. Let other private businesses in your community know about S-Corp and the important work that we do.
Again, I am deeply appreciative of your support and look forward to working with you in 2020 to defend the greatest vehicle for private enterprise ever invented – the S corporation.
Chairman, S Corporation Association
Former President & CEO, The McIlhenny Company
Video on Main Street Employers’ Briefing
In case you missed it, S-Corp has posted video of its October briefing on Main Street tax issues on its website. The briefing, which took place in the historic Senate Russell Caucus Room and was hosted by the Parity for Main Street Employers coalition, featured Senator Steve Daines (R-MT), Martin Sullivan (Tax Analysts), Bob Carroll (EY), David Winston (The Winston Group) and Chris Smith Parity for Main Street Employers).
It also featured new work from EY and the Winston Group focused on the challenges individually and family-owned businesses face in the post-tax reform world. You can watch the whole briefing on S-Corps YouTube channel and access the new reports by clicking on the links below:
Key takeaways from the briefing:
Section 199A the Key to Pass-Through Tax Parity: In terms of both effective and marginal tax rates, EY’s analysis shows that prior to TCJA, large S corporations and C corporations faced similar tax rates. Rough parity remained following enactment of the TJCA. However, the sector will face significantly higher tax rates in 2026 than C corporations with the expiration of key TCJA provisions, such as the 20% Section 199A deduction for qualified business income.
Pass-Through Businesses Employ Most Workers: Looking at the latest data available (2016), EY estimates that the pass-through sector (S corporations, partnerships, and sole proprietorships) employed 58 percent of the private sector workforce, up several percentage points from our last estimate. Large S corporations, defined as those with 100 or more workers, employed 13.1 million workers, or 10% of the 133 million private sector workers in 2016. States with the highest levels of pass-through employment include 1) Montana (69.7%), 2) South Dakota (67.4%), 3) Idaho (67.2%), 4) Wyoming (65.6%), and 5) Vermont (64.9%).
Pass-Through Businesses Pay the Most Taxes: EY found that in 2018, individual owners of pass-through businesses paid 51% of federal business income taxes ($326 billion), while C corporations and their individual shareholders paid 49% ($316 billion). The $131 billion in individual income taxes paid by owners of S corporations in 2018 comprised 20% of all business taxes and 40% of pass-through business taxes.
Voters Support Reasonable Top Rates: The Winston Group survey found voters support moderate rates of taxation, even for the wealthy and big business. When asked what the maximum acceptable rate should be for a list of taxpayers, voters responding with rates well below those that are being debated today. Moreover, for all the entities listed, the maximum acceptable rates for each entity was well below the top tax rate many already pay.
Voters Oppose Double Taxation: The Winston Group survey found voters overwhelmingly agree that it is unfair to tax the same business net income twice (77-7 percent agree-disagree). They also believe that a business should be allowed to grow as much as it can and still retain its pass-through status. Some 46 percent believe that once established, pass-through businesses should be able to grow without restriction and be taxed on their net income (46-20 percent believe-do not believe).
Voters Support Main Street: Voters have favorable views of the private sector (59-20 percent favorable-unfavorable), seeing it as more nimble than government and more responsive to consumer needs. Voters believe that small, private, and new business owners face serious competition from large corporations. Some 73 percent believed the statement, “Someone who wants to start their own business will have a hard time competing with large corporations” (73-15 percent believe-do not believe). Another 64 percent believed that “excessive taxes on businesses make it difficult for average Americans to start their own businesses” (64-20 percent believe-do not believe).
The bottom line for S-Corp is that tax reform succeeded in maintaining rough tax parity between large pass-through businesses and large C corporations, but only if the 199A is in effect and only if it’s made permanent. Meanwhile, voters support a tax system that is fair for all types of businesses and encourages the establishment and growth in all types of businesses, and believe that the pass-through structure helps achieve these goals.
Yesterday, the Main Street Employers coalition sent a letter to House tax writers raising concerns with their plan to provide temporary relief from the SALT deduction cap by raising the top tax rate applied to pass-through business income. As the letter states:
Individually and family owned businesses organized as S corporations, partnerships and sole proprietorships are the heart of the American economy. They employ the majority of workers, and they contribute the most to our national income. They also pay the majority of business taxes. A recent study by EY found that pass-through businesses pay 51 percent of all business income taxes.
The legislation introduced today would raise these taxes by 1) increasing the top rate pass-through businesses pay from the current 37 percent to 39.6 percent and 2) lowering the income threshold of the top rate from $622,050 to $496,600 (Joint) for the years 2020 through 2025, after which the 37 percent rate is scheduled to expire under current law.
The bill, titled the “Restoring Tax Fairness for States and Localities Act”, is scheduled to be considered by the House Ways & Means Committee today and voted on by the full House next week. According to the Joint Committee on Taxation, the bill provides the following relief from the SALT deduction cap:
- The proposal increases the dollar limitation on the deduction of certain State and local property, income, and sales taxes to $20,000 for married individuals filing a joint return and $10,000 for a married individual filing a separate return for taxable years beginning after December 31, 2018, and before January 1, 2020.
- The proposal removes the limitation on the deduction for certain State and local property, income, and sales taxes for taxable years beginning after December 31, 2019, and before January 1, 2022.
To pay for the SALT relief, the bill would repeal the new 37 percent tax bracket and return the restored 39.6 percent rate to its pre-tax reform income thresholds (from $622,050 to $496,600). Again, from the Joint Committee Taxation:
- The proposal increases the top individual income tax rate of 37 percent to 39.6 percent and reduces the dollar amounts at which the 39.6 percent bracket begins.
The relationship between the new SALT deduction cap and the pass-through business community is complicated. The SALT cap only applies in states with income taxes, and then only if the businesses taxes are paid at the shareholder level. So for S corporations residing in Texas (no income tax) or Wisconsin (where they adopted our SALT Parity legislation), SALT isn’t an issue and this legislation is just a tax hike. On the other hand, SALT is likely the reason so many California S corporations have converted to C corporation. The business community letter reflects this challenge, noting:
While this SALT relief will benefit some pass-through businesses, those savings will be reserved only for businesses residing in certain states, while the tax hike will apply to businesses in all fifty states.
One suspects the SALT issue is complicated for the bill’s proponents too. The SALT benefit is primarily enjoyed by the same upper-income taxpayers who will be subject to the higher top rate. As Richard Rubin at the Wall Street Journal tweeted yesterday:
“You can think of this as cutting taxes for some of the top 1% (and others below that) and paying for it by raising taxes on the top 1%. On balance, at first blush, it would be good for NJ/NY/CA rich/upper-middle-class people, not so much for TX/FL/WA rich people.”
Amid all this complexity, one point of clarity is that C corporations can continue to fully deduct their SALT while S corporations cannot. For that reason, S-Corp will continue to press for its SALT Parity legislation at the state level. Connecticut, Wisconsin, Oklahoma, Rhode Island, and Louisiana have already acted and restored the SALT deduction for their S corporations and partnerships, while several additional states are teed up to act early next year. The more quickly they act, the more quickly SALT ceases to be an issue for the pass-through community.
Whoever claimed there’s not a “dime’s worth of difference” between the political parties clearly was not referring to American politics in 2020. For tax policy alone, the difference is in the trillions.
On one hand, a Trump victory would likely mean continued divided government, possible consideration (although not adoption) of a middle-class tax cut, and a resumption of the status quo. If Trump has a fifty percent chance of winning next fall, then there’s a fifty percent chance your taxes don’t change substantially in the next few years.
On the other, a Democratic victory would likely result in Democrats controlling both the House and the Senate (it’s hard to see how they win the White House but Republicans hold the Senate), immediate repeal of the filibuster in the Senate, and the imposition of a new wealth tax along with several trillion in other new taxes, right?
Well, maybe not. If the Democrats do take control of the Senate, it won’t be by much. Their majority will be a slim one or two votes, so the moderates in both parties will represent the deciding votes and pull policy towards the middle.
Under those circumstances, it’s hard to see how something as extreme as the Warren/Sanders wealth tax passes. That’s not to say tax burdens won’t rise, and rise sharply, but rather that any increase would take place through more conventional means. Here is our thought process.
The wealth tax proposal put forward by Senators Warren and Sanders might be the most anti-free market tax ever put forward by serious presidential candidates. Even in Europe, where they have a more robust history of targeting wealth, it’s an outlier. As NPR recently noted, most of the EU countries that tried wealth taxes in recent decades subsequently repealed them:
In 1990, twelve countries in Europe had a wealth tax. Today, there are only three: Norway, Spain, and Switzerland. According to reports by the OECD and others, there were some clear themes with the policy: it was expensive to administer, it was hard on people with lots of assets but little cash, it distorted saving and investment decisions, it pushed the rich and their money out of the taxing countries—and, perhaps worst of all, it didn’t raise much revenue.
So for many EU countries, their experiment with wealth taxes failed on multiple fronts. Those three countries that retain wealth taxes, meanwhile, maintain them at levels much smaller than the Warren/Sanders proposal. Norway’s wealth tax, for example, tops out at 0.85 percent, or a rate seven times lower than Warren/Sanders.
Additional concerns not listed by NPR:
- Its pro-cyclical – it hits hardest when times are tough, exactly the opposite of what you want.
- It forces fire sales – one reason we have an income tax is to ensure that taxpayers have the money to pay the tax. The wealth tax is owed whether you make money or not.
- It might be unconstitutional — the Constitution prohibits “direct” taxation, while the 16th Amendment applies to income taxes only. Is the wealth tax a direct tax? The courts will have to decide.
Finally, this new tax would be layered on top of numerous other tax hikes, including mark-to-market taxation of unrealized capital gains and higher rates on corporations and individuals. This combo platter of higher marginal rates and layer upon layer of tax would take US tax policy into uncharted territory. According to Richard Rubin:
Potential tax rates over 100% could result from the combination of tax increases the Massachusetts senator proposes for the very top tier of investors. She wants to return the top income-tax rate to 39.6% from 37%, impose a new 14.8% tax for Social Security, add an annual tax of up to 6% on accumulated wealth and require rich investors to pay capital-gains taxes at the same rates as other income even if they don’t sell their assets.
The US has had high individual rates in the past, but they have always been paired with lower rates on capital gains and corporations, together with a generous menu of allowable deductions. Enacting a wealth tax while raising rates across the board and maintaining our current broad tax base would impose levels of taxation beyond anything we’ve tried in the past. That should be enough to scare more moderate legislators away from adopting a wealth tax.
If the wealth tax is a step too far, a less aggressive policy might be to impose M2M on capital gains by taxing them on an annual basis. Senator Ron Wyden, the Ranking Member on Senate Finance, released a plan last summer entitled “Treat Wealth Like Wages” that looks very serious. Key provisions include:
- Raising rates on capital gains to regular income tax rates;
- Imposing M2M taxation on taxpayers whose income and/or wealth exceeds certain thresholds;
- Dividing assets into three classes:
- Residences and retirement accounts up to certain levels are excluded from M2M;
- Publicly traded assets are subject to immediate M2M taxation; and
- Private asset gains are taxed upon their sale, but at a higher, formula-based tax rate.
How is M2M less aggressive than a wealth tax? First, it’s a tax on income, so the potential constitutional challenges of the wealth tax won’t apply here. Second, its counter cyclical (which is a good thing) – the effective tax rate increases when times are good and decreases (you get deductions, refunds and/or carryovers) when times are tough. And finally, as an income tax it should blend more smoothly with our existing tax code and there’s less danger of applying multiple layers of tax on the same income.
So M2M is not as draconian as a wealth tax, but there remain serious concerns. Taxing gains before they are realized, particularly with private companies, creates both valuation and liquidity issues — how do you determine the value of the asset and how do you ensure the taxpayer has the means to pay the tax?
The Wyden proposal attempts to address these concerns by treating publicly traded assets differently than private ones. Gains on public assets with liquid markets and transparent pricing would be taxed annually under the Wyden plan. Gains on private assets, on the other hand, would be taxed when there is a sale (or death), with a special formula used to calculate the tax. The goal of the formula is to balance out the treatment of public and private assets – the longer the private asset is held, the higher the tax. Exactly what it looks like remains to be seen.
It’s an interesting approach, but it doesn’t address all the issues raised by M2M:
- What happens when you have a loss in a particular year? Can you take those losses and, since everything is taxed at the same top rate, apply them against your wage and salary income? If not, can you carry them forward to offset future gains?
- What happens if you have an asset that suffers a large loss between the end of the year and April 15th? You owe tax on the higher valuation but will have to sell the stock at the lower price.
- How do you track basis? As long as the stock price moves in one direction, it’s not that hard, but what happens when the price fluctuates, so the taxpayer pays taxes in one year and accumulates losses in another?
- How do you prevent gaming between the three asset categories? Even with a formula-based tax, its likely investors will prefer private investments with deferred taxation over public ones with immediate taxation.
So M2M is an improvement over the wealth tax, but is it too complex to sell? We think so, and doubt that even a unified Democratic Congress would adopt it.
A More Likely Third Option
If the wealth tax is too draconian and the M2M too complex, what’s left? A third option for a new Democratic President is to simply increase taxes on the wealthy while leaving our basic approach to taxation in place. Such a package would:
- Increase individual rates;
- Increase corporate rates and eliminate 199A;
- Increase the capital gains tax rates and tax gains at death;
- Increase estate tax rates; and
- Increase the minimum tax on foreign income.
This approach has the advantage of including more traditional tax policies that policymakers are familiar with. It is not, however, modest in size or a “win” for the business community by any stretch. It would take us back to tax levels that precede Reagan, but without the safety net of lower alternative rates and lots of allowable deductions. It would be a tax hike of historic proportions.
Circling back to where we started, it’s clear the post-election outcomes for tax policy reflect the broader polarization of our politics – we could see little or no change, with the low rates adopted in 2017 continuing for the next few years, or we could see a sizable tax increase featuring uniformly higher taxes on businesses and upper income Americans.
What’s dangerous for the business community is if all this focus on wealth taxes and mark-to-market has inured them to the very real threat of sizable, albeit traditional, tax hike. By our analysis, it is time to start pricing in a fifty percent chance of the latter happening beginning in 2020.
Much of today’s tax policy debate is premised on the notion that income inequality is bad and getting worse. Economists Piketty and Saez have published numerous papers making this case (here, and here), and Saez recently wrote a book arguing for a wealth tax to address this inequality. But what if their premise is simply wrong? What if the whole income inequality narrative itself is built on a faulty foundation?
It’s been known for a long time that Piketty’s and Saez’s estimates fail to fully account for missing income sources, shrinking households, and the effects of tax policy on reported income. A new paper by Treasury economist Gerald Auten and Joint Committee on Taxation economist David Splinter takes a comprehensive look at all these issues and comes to the conclusion that income inequality since the 1960s is largely unchanged. Here’s the key illustration:
That black line shows that when you fully account for these missing items, the income share of the top 1 percent is essentially flat. As the authors write, “Our estimates for after-tax income suggest that the top one percent share increased 1.3 percentage point since 1979 and a quarter of a percentage point since 1962.”
One interesting aspect of Auten’s and Splinter’s paper is how much the growth of the pass-through sector affects the figures on income inequality. The sizable shift in business activity from C corporations to S corporations following the 1986 tax reform had the side effect of artificially inflating income for higher income shareholders. Income that previously appeared on C corporation returns was now showing up on 1040s. Auten and Splinter do a nice job of identifying and adjusting for that fact:
The most significant tax reform in the period studied was TRA86, which lowered individual tax rates and broadened the tax base. The base-broadening was targeted at high income taxpayers, including limiting deductions for losses on rental income and passive investments. The reform also motivated some corporations to switch from filing as C to S corporations and to start new businesses as passthrough entities (S corporations, partnerships, or sole proprietorships), causing more business income to be reported directly on individual tax returns. This is because all passthrough income is reported on individual tax returns while C corporation retained earnings are not. Before TRA86, the top individual tax rate was higher than the top corporate tax rate (50 percent vs. 46 percent), allowing certain sheltering of income in C corporations with retained earnings. This incentive was even larger when the top individual rate was 70 percent in the 1970s and 91 percent before 1964. TRA86 lowered the top individual tax rate below the top corporate tax rate (28 vs. 34 percent), reducing the incentive to retain earnings inside of C corporations and creating strong incentives to organize businesses as passthrough entities. Our analysis accounts directly for the limitations on deducting losses and indirectly for the shift into passthrough entities by including corporate retained earnings. This leads to important findings for in the 1960s and 1970s, when high individual income tax rates created strong incentives to shelter income inside corporations. Without these corrections, top income shares are understated before 1987. [Emphasis added.]
This is not a new observation – as we wrote back in 2016, “Pass through taxation doesn’t add to income inequality. C corporation tax treatment masks it.” To our knowledge, however, this is the first time somebody has attempted to fully quantify the income equality effect of the growth in the pass-through sector.
The bottom line is that the Auten-Splinter paper is worth a serious read. While its clear there is a high level of unrest in the country, their analysis suggests our challenges are much deeper than a superficial measure of relative incomes. For tax policy, meanwhile, it suggests there’s a whole lot of policy being driven by bad data these days.