Washington Wire

The “Experts” Get 199A Wrong (Part 3)

admin2024-07-23T19:46:27+00:00July 23, 2024|

A recent Twitter thread caught our eye. S-Corp typically avoids these Twitter feuds, but this is an important topic that deserves some clarity. Here’s the thread in question:

So Pomerleau thinks 199A is unnecessary while S-Corp and our Main Street Employers Coalition have long maintained that 199A is necessary for rate parity. Who is right?

Effective Statutory Tax Rates

Looking at Pomerleau’s paper, he uses three measures to examine the parity question – Effective Statutory Rates, Marginal Effective Tax Rates, and Average Marginal Effective Tax Rates.  For the first, here’s his table:

For somebody who has been advocating hard to eliminate Section 199A (here, here, here… you get the idea), this is pretty weak sauce. We believe the current rates represent rough parity and here it is — the average pass-through rate is somewhere in the low-40s and the average C Corp rate is somewhere in the low-40s. Close enough for tunnel work.

Moreover, the table tends to underestimate the pass-through rates and inflate the corporate ones.  For starters, not all large pass-throughs get the full 199A deduction. That’s because 199A includes guardrails that limit the deduction.  Treasury estimates these guardrails reduce qualifying 199A income by about 40 percent, so the starting rate for a large pass-through that otherwise qualifies for 199A can easily be higher than 29.6 percent.

Meanwhile, the estimates for the second layer of corporate tax look inflated too. As we’ve noted, most public corporation shareholders pay little or no federal tax, and very few corporations pay significant dividends.  The paper acknowledges this, but the “Distributed” column still assumes shareholders are fully taxed. The “Retained” column is inflated too, as the tax on capital gains should be reduced to account for exempt shareholders and those gains held until death. Here is a 2016 CRS description of the issue:

A Congressional Research Service (CRS) study estimates that the average tax rate at the margin on dividends is 14.7% and the average for realized capital gains is 15.4%. Half of capital gains are estimated not to be subject to tax because the gains are passed on at death, and thus the effective tax rate is 7.7%. Weighting the two tax rates by their estimated income shares results in an overall individual shareholder tax averaging 11.6%.

The 11.6% is not the additional tax, since it is applied to income net of the corporate tax rate. As will be discussed subsequently, this rate should be the effective corporate tax rate, which varies by investment; if corporate profits were taxed at 35%, the additional tax would be 11.6% times (1-0.35), or 7.6%

Another thing. Next year’s debate isn’t just about 199A. The rates that apply to pass-through income are also scheduled to go up. The paper doesn’t address this challenge, even though Pomerleau appears to support allowing the top rates to return to their pre-TCJA levels.

Finally, the table excludes any effects of the SALT cap. Pass-through income is subject to the cap but C corporation income is not. The paper notes that S-Corp has been successful with our SALT Parity efforts and that many pass-throughs now enjoy an election to restore the deduction. But those changes are by no means universal, and they definitely weren’t part of the original plan.

Showing rough parity despite having all the table’s biases leaning against the pass-through sector is just not a very convincing start.

Uniform Capital Weights and…

Next, Pomerleau looks at Marginal Effective Tax Rates (METRs) and Average Effective Tax Rates (AETRs). This is the core of the twitter thread:

The studies from Treasury et al listed there clearly show we achieved rough rate parity with Section 199A but that it disappears along with the deduction. That’s the question in front of us, isn’t it? Under the TCJA, who pays what?

Pomerleau objects. It appears his preferred analysis would focus on horizontal equity – a comparison of how much tax the same business would pay if it were organized under different forms.  Here is his explanation:

[T]his report seeks to compare the tax treatment of pass-through businesses and C corporations. To do that, differences that arise due to underlying economic parameters were eliminated. The ETRs on different types of business income were calculated assuming that the distribution of each form of business income has the underlying distribution of total business income. The distribution of the capital stock for each business form was assumed to be the distribution of all business capital. Other parameters, such as the share of new investment financed by debt, the real after-tax return, and the inflation rate, were also held constant across business forms. As a result, the differences in effective tax rates only reflect differences in tax treatment.

Horizontal equity has its uses but it is not the only valid comparison and it is very limited in what it tells us. Effectively, the paper substitutes calculations that reflect actual investment levels and tax burdens with a narrower view that assumes all businesses operate exactly the same.  Not very realistic and not very transparent.

For example, Table 6 says a closely-held business would pay an AETR of 29.9 percent as a pass-through with 199A, 33.4 percent without 199A, and 43.6 percent as a C corporation. A reader might infer that this means that generally, pass-throughs pay less, but that’s not accurate. Instead, all we learn is that a hypothetical family business whose shareholders are subject to the top rates either can pay 29.9 percent as a pass-through or 43.6 percent as a C corporation.

What they cannot do, and where the unfairness lies, is access that 21.2 percent rate that applies to public C corporations only. That is what Table 6 tells us.

New v. Old Investment

Another challenge is the paper (as with the similar CBO paper it references ) looks at new investment only and ignores the trillions of dollars of business capital already in place, earning income, and paying taxes. The typical defense here is that tax policies should be forward looking and not “reward” existing investments with lower rates. A couple of problems present themselves, however.

First, focusing on new investment exclusively while advocating for tax hikes elsewhere begs the question: Where will the new capital come from and where will the old capital go? Progressives like expensing and other new investment incentives because they can solicit corporate contributions while calling for tax hikes on everybody else. That might be a sustainable model for think tanks, but it is not sustainable for businesses. The money for new investment has to come from somewhere, and it won’t be available if Congress taxes it all away.

Second, focusing exclusively on new investment raises the question of what constitutes new investment. S-Corp has lost a number of members in recent years, often when a mature family business is purchased by a larger public company. Economically, nothing has changed — the business is the same, as are the assets. But the sale enables the business to receive an increased basis, while the TCJA’s more generous expensing rules enable the new owners to write off the new basis at faster rates. The corporate buyer has an advantage not because they are better managers, but because the tax code treats their new ownership more favorably.

It’s all About the Rates

Relying on his narrow analysis, Pomerleau makes claims like this:

Extending current policy without Section 199A would improve the tax code’s neutrality. Under this policy, pass-through business profits would be taxed more in line with other forms of income. However, pass-through business investment would still face a lower tax burden than C corporate investment.

As we’ve pointed out, that claim simply doesn’t hold water if you are comparing the average tax burdens of public companies verses pass-throughs:

Moreover, we are not sure that Pomerleau is correct within the narrow confines of horizontal equity. Our EY study shows that a closely-held business does better as a C corporation post-cliff — still worse than the public company, but better than the pass-through.

And here are the Effective Marginal Tax Rate estimates used by the CBO right now for their modeling – they show C corporations having a slight advantage with 199A in place and a much larger advantage without it.

It appears that Pomerleau is an outlier here.

Reality v. Spreadsheets

In the Twitter thread that started all this, somebody asked if we had seen significant conversions of S corporations post-TCJA.  The answer is yes, a number of our members converted post-TCJA and we expect to lose many more if we go over the fiscal cliff.

S-Corp’s remaining members are well aware of what’s coming and they are waiting to see what happens.  These are large, sophisticated family businesses with long-term planning horizons and the means to model out multiple policy outcomes.

The irony is that Pomerleau’s favored approach is exactly the analysis they are conducting. It tells them what their effective tax rates are under the current rules, and what they might be as S corporations and C corporations under the various fiscal cliff outcomes.

What it doesn’t tell them is how their situation compares to public companies. That analysis has been done by Treasury, CBO, EY and others, and it shows the public companies will continue to have a distinct advantage. That’s the threat of the fiscal cliff, and that’s why Congress needs to make permanent the 199A deduction.

CTA Update | July 16, 2024

admin2024-07-16T20:17:03+00:00July 16, 2024|

Notable Developments

• Appeals court sets hearing date
• Yellen grilled by House lawmakers
• New FinCEN guidance expands CTA’s reach

Legal Update

The Eleventh Circuit Court of Appeals announced a hearing in NSBA v Yellen, the case challenging the constitutionality of the CTA, will take place on September 27. While the court is working under an expedited timeline, that date is just three months ahead of the year-end filing deadline for existing entities.

To recap our latest alert, the total number of pending CTA challenges is currently at six nationwide:

• Massachusetts: BECMA et al v Yellen (5/29/2024)
• Texas: NFIB et al v Yellen (5/28/2024)
• Maine: William Boyle v. Yellen (3/15/2024)
• Michigan: Small Business Association of Michigan et al v. Yellen (3/1/2024)
• Ohio: Robert J. Gargasz Co., L.P.A. et al v. Yellen (12/29/2023)
• Alabama (appealed): NSBA et al v. Yellen (11/15/2022)

Regulatory Update (Part 1)

At a House Financial Services Committee hearing last week, Treasury Secretary Janet Yellen pushed back on calls to delay the CTA’s year-end reporting deadline. There were a couple notable interactions, summarized by American Banker:

Rep. Ralph Norman, R-S.C., asked Yellen to consider extending the deadline for compliance with the rule, pointing out that many constituents are likely unaware of the reporting requirement. “These businesses are struggling…your average plumber is not going to a website, and try to find out how to comply with the beneficial ownership,” he said. “Consider extending it.”

“As the Treasury, extend this deadline and work on bipartisan love with us to make sure that our small businesses are taken care of,” said Rep. Zach Nunn, R-Iowa. “My folks back home see a $500 fine per day as not only a gotcha but a very painful impact.”

Yellen also unveiled the latest beneficial ownership submission numbers, revealing a massive compliance gap:

According to Yellen’s update at the hearing, the database has received only about 2.7 million filings so far, only a fraction of the estimated 31 million businesses that must file by the deadline of January 1, 2025. 

Finally, the Treasury Secretary commented on the third tranche of regulations – the so-called customer due diligence rule – which have yet to be finalized:

When pressed by [Chairman Patrick] McHenry on finalizing updates to FinCEN’s customer due diligence requirement, Yellen said she estimates a revised rule could come as early as the fourth quarter. “So that’s something we’re working on revising to make sure it’s consistent with the requirements of the corporate Transparency Act and I believe that we’re hoping to get something out this fall,” she said. “We’re engaging right now with other stakeholder agencies to discuss the substance of the proposal, but we want to have a notice that will enable the public to weigh in with their own comments.”

We’re taking Yellen at her word that Treasury will not unilaterally pause the CTA, meaning the more viable path to relief is either through the courts or Congress.

Regulatory Update (Part 2)

As some outlets have recently reported, it appears that new guidance from FinCEN extends the CTA’s reach to include businesses which have been shuttered or otherwise dissolved. Here’s Inc.com:

In particular, this new guidance, which took effect in January, explains that businesses that began and dissolved this year must report their beneficial owners. Additionally, if owners started dissolving their companies in 2023 but didn’t finish until 2024, they too need to submit a BOI report.

“I think there will be tens of thousands of additional companies that are caught in the net here of mandatory reporting,” says David Suny, a corporate attorney at McCormack Suny who is focused on compliance.

The guidance referenced is an update to an FAQ document posted on FinCEN’s website (see sections C.13 and C.14, updated July 8, 2024), and lays out specifics regarding when a dissolved entity still must file a BOI report.

CTA in the News

• Jennifer Martin published a piece in the National Law Review entitled, “The CTA: HOAs Don’t Need That Kind of Transparency”
• Law360 lists NSBA v. Yellen as one of the “Top Cases to Watch in the Second Half of 2024”
• An op-ed in Crain’s New York has some helpful tips for navigating the state’s new LLC Transparency Act
• Last week we shared some handy tips for navigating the CTA. You can access that document here.
• Treasury continues to brand the CTA as a necessary tool in combatting “drug and human trafficking, fraud schemes, elder abuse, ransomware attackers, and other bad actors”

Tax Teams and Section 199A

admin2024-07-11T13:35:44+00:00July 11, 2024|

A couple of quick updates on the Ways & Means “Tax Team” front. First, the Main Street Employers Coalition today submitted comments making the case for a permanent Section 199A pass-through deduction.

The letter is addressed to the Main Street Tax Team, one of ten teams organized by Ways & Means Chairman Jason Smith to identify solutions to the 2025 fiscal cliff, and it covers the various key aspects of the 199A debate – why the provision is important, how Congress should define parity, why can’t family businesses just convert, etc.  As the letter notes:

The Main Street Employers Coalition (MSEC) is comprised of dozens of trade associations representing businesses operating in virtually every industry and community across the country. The vast majority of these businesses are structured as pass-throughs – S corporations, partnerships, and sole proprietorships – and they rely on the Section 199A pass-through deduction to help them grow, create jobs, and remain competitive.

You can read the entire letter here.

Second, just yesterday S-Corp champion Michelle Gallagher, whose Michigan-based accounting firm was one of our best allies in the battle to defeat the horrible Section 2704 rules, briefed the Rural America and Main Street Tax Teams on the estate tax, valuation issues, and Section 199A. It was a perfect opportunity for lawmakers to hear firsthand what farms and businesses are going through and how the 2025 fiscal cliff threatens their survival.

So things are moving on the fiscal cliff front.  The Tax Teams are up and running and the Main Street community is engaging with lawmakers on how to best address this looming threat. The coalition is grateful for the opportunity to share these perspectives and, alongside our allies and Representative Smucker, look forward to seeing his Main Street Tax Certainty Act enacted into law next year.

More to come…

Elusive Tax Cheats

admin2024-07-09T12:27:32+00:00July 9, 2024|

More evidence the campaign to target high-income taxpayers with more audits isn’t going too well. A new report by the Inspector General for Tax Administration at the Treasury Department (TIGTA) suggests the expanded audits are failing to raise the promised revenue.  Here’s the WSJ’s take:

Unlike bank robbers, IRS auditors tend to look where the money isn’t. That’s what happened after the agency started scrutinizing more tax returns from the wealthiest Americans. A new report says increased targeting of these taxpayers was hugely ineffective.

The policy, launched in 2020 by former Treasury Secretary Steven Mnuchin, required the IRS to audit 8% of taxpayers each year who earned more than $10 million. To hit that quota, the agency started examining returns with fewer irregularities. The efficiency drop was steep, according to the Treasury Inspector General for Tax Administration, or Tigta, which recently reviewed the results.

The average dollars assessed per return above $10 million “was nearly six times more productive prior to the 2020 Treasury Directive,” meaning the average examination recovered six times as much in unpaid taxes. Or to put it in terms of IRS productivity, after the policy change the money that auditors assessed per hour from this income group dropped 93%.

Reading the report provides a more nuanced picture. For example, this table appears to show that the audits are providing a positive return for the IRS:

The problem with these numbers is they ignore any audits that resulted in taxpayer refunds, plus they measure preliminary assessments only, not ultimate collections.  These are not small considerations.  For example, last year’s GAO report on the IRS’s new audit regime for large partnerships found the refunds actually exceeded the assessments:

The Internal Revenue Service (IRS) audits few large partnerships—54 in tax year 2019—and the audit rate has declined since 2007. More than 80 percent of the audits resulted in no change to the return on average from tax years 2010 to 2018, double the rate of large corporate audits. For those that did change, the average adjustment was negative $264,000. IRS officials attributed the declining audit rate to resource constraints. The Inflation Reduction Act of 2022 (IRA) provided IRS with $45.6 billion for enforcement activities through the end of fiscal year 2031, and in response IRS identified large partnerships as an enforcement priority. (emphasis added)

Meanwhile, the bulk of the TIGTA report suggests a less than successful effort. For example:

As shown in Figure 7, the average dollars assessed per hour on returns with TPI of $10 million or more were nearly 14 times more productive prior to the 2020 Treasury Directive. Overall, we found that the no change rate was lower and average dollars assessed per return and the average dollars assessed per hour were higher in TYs 2016 and 2017 prior to the 2020 Treasury Directive.

What to do?  The good news is Treasury has abandoned Mnuchin’s “8 percent” audit rule. The bad news is the current IRS leadership appears determined to arbitrarily target large pass-throughs and other high-income returns anyway.

Meanwhile, the chorus to target rich tax cheats continues unabated in Congress. People do cheat on their taxes, but the cheating is relatively rare (we have one of the highest compliance rates in the world) and it isn’t limited to any one taxpayer class.  The IRS needs to get back to dispassionately reviewing all returns and looking for specific indicators of tax evasion.  If they did that, perhaps they’d have more support on the Hill.

Defending 199A in Tax Notes

admin2024-06-25T14:28:38+00:00June 25, 2024|

Tax Notes ran a letter to the editor this week penned by S-Corp President Brian Reardon. It responds to a recent critique of the Section 199A deduction and serves as a useful “cheat sheet” in rebutting the various claims we’ve seen over the years.

The first is that extending 199A will add to the deficit. As the piece points out:

The deduction was packaged with numerous tax hikes — the state and local tax cap, the excess loss limitation, the interest deduction cap, and others — that target upper-income business owners. Many of these pay-fors stay in the tax code even as section 199A expires, which would result in a significant tax hike on passthrough businesses.

The use of the word “significant” here isn’t just hyperbole. Because many of those revenue raisers are permanent, the loss of Section 199A would lead to a large tax hike on Main Street businesses, not relative to current law but rather to the pre-Tax Cuts and Jobs Act code.

The second critique centers on the notion that upper-income taxpayers disproportionately benefit from 199A. Here’s the response:

Large passthroughs do get the section 199A deduction, but only if they employ lots of people or make significant investments. That’s because section 199A imposes so-called guardrails on large passthrough businesses, so, for example, they only get the deduction up to 50 percent of the W-2 wages they pay. A 2019 Treasury study shows how these guardrails exclude about 40 percent of their income from the section 199A benefit, while a recent Congressional Research Service report observes that the section 199A deduction is neutral with regard to progressivity.

What’s portrayed as some sort of smoking gun is the natural consequence of a tax structure where business income shows up on a taxpayer’s individual return. Per Treasury’s own estimates, four out of five taxpayers with incomes exceeding $1 million were business owners. Furthermore, as a recent CRS report notes, “The Section 199A deduction appears to have little effect on vertical equity, as it does not appear to diminish the progressivity of the federal income tax.”

The same cannot be said for the corporate rate cuts. According to the Urban-Brookings Tax Policy Center, the corporate rate cuts primarily benefited upper-income taxpayers and detracted from the code’s progressivity. Anyone looking for “tax cuts for the rich” should start on the corporate side of the tax code.

The third argument claims pass-through businesses are competitive without Section 199A. Based on countless conversations we’ve had with our members and others in the Main Street business community, that’s patently false. But don’t just take our word for it:

…effective rate estimates by Treasury, the Congressional Budget Office, EY, Robert Barro and Jason Furman, and Jason DeBacker and Roy Kasher…show that the Tax Cuts and Jobs Act resulted in rough parity between business forms.

If there is an imbalance, it goes the other way. The folks at Penn Wharton predicted that one sixth of all passthrough activity would shift to C corporations following adoption of the TCJA: “Prior to the TCJA, pass-through businesses were growing remarkably over time. We project that the TCJA will reverse this trend…” Keep in mind, this migration was supposed to occur with the section 199A deduction.

That claim also ignores perhaps the most salient feature of the ongoing tax debate – that most publicly traded corporation shareholders don’t pay tax. Why is that important? Because tax burden comparisons must estimate the burden of shareholder-level taxes. If 75 percent of corporate profits go to shareholders who pay little or no tax, then the overall C corporation rate is significantly lower than the advertised rate.

The good news is that the facts are on our side and we have a year to educate policymakers on why pass-throughs are critical to the US economy, and why Section 199A is important to these businesses.  More to come…