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S-Corp has had 24 hours to digest the Section 199A bill introduced by Senator Wyden yesterday, and the more we look, the less we like it. Here are some additional thoughts:
Not an Expansion
Wyden’s office says the bill would raise $147 billion over ten years. That is a large tax hike in anybody’s book, but you wouldn’t know that reading the media coverage, where the bill has largely been framed as an “expansion” of Section 199A, not a roll-back. For example, here’s Law360:
Sen. Ron Wyden introduced a bill Tuesday that would let owners of service businesses, like law firms and accounting firms, claim a pass-through tax deduction created in 2017.
The Small Business Tax Fairness Act would remove restrictions that prevented service business owners from taking the 20% deduction provided under Internal Revenue Code Section 199A for certain income from pass-through businesses. The change would allow owners of businesses such as law firms and accountant firms to claim the deduction while phasing out the incentives for individuals with incomes above $400,000. (Emphasis added)
That’s the equivalent of leading a report on the Titanic by observing that the iceberg survived. The point of the Wyden bill is to eliminate the Section 199A deduction for larger businesses and raise lots of revenue. That has to be the lede of any reasonable coverage. The expansion of the deduction for taxpayers making less than $400,000 is extremely limited and hardly worth the headline.
Less Than Meets the Eye
Just how limited? Section 199 applies to all qualified business income for businesses owners making less than an income threshold indexed to inflation. In 2022, accountants and lawyers making less than about $335,000 should be eligible for the full 199A deduction. The Wyden bill would increase the threshold to $400,000. That is it. As Richard Rubin with the Wall Street Journal tweeted yesterday:
This is good for some lawyer/accountants. Individual lawyer making $350k today gets no 20% break. Would under Wyden. Bad for very large pass-throughs that qualify now (big S corp manufacturers).
The only way the manufacturer identified by Rubin gets the 199A is if they have lots of employers and/or capital investment. Those employment limitations don’t apply to Wyden’s revised deduction, so Wyden favors accountants and lawyers who may or may not create jobs and punishes manufacturers who create lots of them?
Violates the Biden $400k Pledge
Another nuance that escaped our attention yesterday is that the Wyden bill would violate the President’s pledge not to raise taxes on taxpayers making less than $400,000 a year. How? His bill would preclude trusts and estates from the 199A deduction:
(ii) APPLICATION TO TRUSTS AND ESTATES. — Section of such Code is amended by adding at the end the following new subsection:
‘‘(j) DEDUCTION FOR QUALIFIED BUSINESS INCOME. — No deduction shall be allowed under section 199A to an estate or trust.’’
Including trusts and estates in the 199A deduction was a big fight during the TCJA debate (see here, here, and here) that wasn’t resolved until the conference report. The rationale for excluding trusts and estates was never articulated, whereas the case for including them is plain to anybody engaged in family businesses. As S-Corp wrote to the TCJA conferees:
Many family businesses will pay higher taxes under the Senate bill… because it precludes trusts and estates from using the deduction. This is not a small issue – every family business subject to the estate tax has these trusts. They are designed to help the business survive from one generation to the next and have nothing to do with income taxes. Most of these trusts already pay tax at the highest rates.
The conferees ultimately decided this issue in our favor. Now, four years later, Senator Wyden would reverse this policy and exclude trusts and estates from receiving the 199A deduction. But as practitioners know, having the stock of a family business held in a trust is common practice and is not limited to large businesses. Family businesses of all sizes use them, so excluding them from the deduction will inevitably hit smaller businesses and lower income owners – just the people President Biden promised to protect.
Massive Rate Hike
Also lost in the Wyden bill’s coverage is where it would leave tax rates on pass-through businesses. The bill is part of a larger package to be considered by Congress, including:
- Raising the top individual tax rate from 37 to 39.6 percent, while lowering the rate’s threshold to $509,300.
- Expand the application of 3.8 percent surtaxes (NIIT, SECA, HI) to all forms of business income, including LLCs and the active owners of S corporations and partnerships.
For a manufacturer over the threshold and getting the full deduction, their top tax rate would increase from 29.6 percent all the way up to 43.4 percent.
These new, higher rates would apply to a significantly larger tax base. Base broadening under consideration includes repealing like-kind exchanges and making permanent the TCJA’s loss-limitation rules, on top of prior base-broadening from the TCJA, including the new 163(J) interest deduction cap, the new Loss Limitation/NOL rules, the new cap on SALT deductions, repeal of the old 199 deduction, and repeal of the Section 212 deductions.
The net result is a top tax rate 13.8 percentage points higher imposed on a significantly expanded income tax base. This is not a modest policy. It is a direct assault on family businesses nationwide. Next time members of the press write about it, they might try interviewing some affected businesses. At the very least, they might avoid describing a massive tax hike merely as an expansion of an existing tax benefit.
Last month, over 100 trade associations voiced their strong opposition to changes to the Section 199A pass-through deduction. Their message was clear: now, more than ever, businesses across the country are relying on Section 199A to stay afloat.
Despite this broad opposition, Finance Committee Chair Ron Wyden today announced that he was pressing ahead with a bill to phase out the deduction for taxpayers with incomes over $400,000, while eliminating it altogether for those with incomes exceeding $500,000.
Section 199A offers business owners a 20-percent deduction on their qualified business income, but the benefit is phased out for “specified service” trade or business owners (such as lawyers and doctors) making over $315,000 (joint filers in 2018). For qualified businesses whose owners’ incomes exceed those thresholds, the deduction is limited to half of the W-2 wages paid, or 25 percent of W-2 wages plus a portion of the company’s capital expenditures.
In other words, Section 199A is designed to be laser-focused on job creation and investment. For business owners above the threshold, the only way to receive the deduction is to go out, invest and create jobs. According to the Senator, however:
Few policies showcase Republicans’ commitment to giveaways to the top 1% like the pass-through deduction created in their 2017 bill. The mega-millionaires get to write-off 20% of their income while middle-class accountants are cut out. This makes no sense, and my bill would overhaul the deduction to ensure it’s benefiting Main Street small businesses.
Senator Wyden would divide the business world into two divergent groups: billionaires on one end and small startups on the other. That simply is not how the business community is organized, and his bill will hurt the employers – and their workers – who occupy the middle. These businesses number in the hundreds of thousands and they employ millions of workers. The 199A deduction is designed to reduce their effective tax rates, but only to the extent they employ people and/or have significant levels of investment.
Meanwhile, although the bill is advertised as expanding the credit to middle-class accountants and other service providers by doing away with the rules that block service businesses from receiving the deduction, those restrictions don’t apply to business owners making less than about $325,000 (joint filer), and the restrictions are phased out as income dips below $425,000, so the population of actual beneficiaries is going to be limited to a very small range of service providers.
Finally, the bill includes other changes that should alarm business owners. For example, estates and trusts would no longer be eligible for the deduction. This restriction was part of the original Senate bill back in 2017, but it was removed when the sponsors realized just how many family businesses are held in trusts – not for tax purposes, but to ease the transition from one generation to the next. Eliminating trusts would punish thousands of established, family-owned businesses for no good reason, and it will hit a large number of owners whose incomes are well below $400,000 a year.
Pass-throughs comprise 95 percent of all businesses in this country and employ the majority of private-sector workers. For these firms, Section 199A enables them to keep more of what they earn and to reinvest in their employees and the communities they serve.
Rather than “overhauling” and improving the deduction, Sen. Wyden is seeking to do away with the very features that make it effective. The changes he proposes won’t bring fairness to the tax code; instead, they amount to a direct tax hike on America’s Main Street businesses and would result in fewer jobs, lower wages, and less economic growth.
Our latest podcast guest is Ryan Ellis, President of the Center for a Free Economy and an IRS enrolled agent. Ryan gives us his take on a proposal to increase IRS funding and create new bank reporting requirements, recent “tax gap” estimates, and the fate of the $3.5 trillion budget agreement unveiled earlier in the week.
This episode of Talking Taxes in a Truck was recorded on July 14, 2021, and runs 26 minutes long.
Yesterday, California became the latest state to adopt our SALT Parity legislation. The reform was included in the state’s budget for the new fiscal year, which is good news for the State’s 600,000 S corporations who, along with California partnerships and LLCs, can now deduct the full amount of their state and local tax (SALT) payments on their federal taxes. The California good news came on the heels of Minnesota Governor Walz signing into law that state’s SALT Parity bill – H.B. 9 — just yesterday afternoon.
By our rough estimates, that means some $1.7 billion in annual tax relief for businesses in these two states alone. That’s a lot of green – and it’s a benefit that’s spreading across the county (states in green have adopted SALT Parity):
That means SALT Parity has now been enacted in 16 states nationwide, with California and Minnesota beating out a handful of other key states in getting the reform enacted. Here’s a quick review of the progress being made in other states:
- Arizona: H.B. 2838 easily passed the state Senate on Third Read, 26-3, and is now headed to the Governor. The most recent state budget, which included funding for implementing H.B. 2838, is also sitting on Governor Ducey’s desk awaiting signature.
- Illinois: S.B. 2531 passed the Senate in April, the House in May, and the bill is currently awaiting signature by Governor Pritzker.
- Michigan: The state Senate adopted H.B. 4288 earlier this month and the bill is awaiting signature by Governor Whitmer.
- North Carolina: H.B. 334 passed the House in April and cleared the Senate in June. Our SALT Parity language has also been included in three other legislative vehicles.
- Oregon: S.B. 727 was recently introduced in the state Senate and is pending consideration.
- Pennsylvania: H.B. 1709 was introduced in the House just last week, making PA the most recent state to join the SALT Parity parade.
- Ohio: H.B. 124 was introduced back in February and remains pending in the Ways and Means Committee.
- Massachusetts: SALT parity language was included in the Senate version of the state’s FY2022 budget. The MA Department of Revenue has already endorsed the reform and the Governor included it in his budget.
At the beginning of the year, S-Corp set a goal of seeing our SALT Parity bills enacted in at least 20 states. We’re at 16 now, with three bills sitting on governors’ desks and five other states where we’re seeing progress, so our goal is within reach. Businesses in these states will save over $5 billion annually on their federal taxes.
At some point soon, there will be fewer states which haven’t adopted SALT Parity than those who have. That should send a clear signal to the remaining states that now is the time to take up this reform and unlock billions of dollars in relief for their Main Street businesses.
In our latest episode, Joe Lieber, Director of Research and Political Analyst at Washington Analysis, LLC, gives us his take on the bipartisan infrastructure deal, what a future tax package might look like, and what he’s cooking this Fourth of July weekend.
This episode of Talking Taxes in a Truck was recorded on July 1, 2021, and runs 19 minutes long.