Game On!

This morning, Ways and Means Committee Chairman Dave Camp announced that the House would act this fall, prior to the November elections, to extend current tax rates while outlining a process whereby the Committee would consider broad, comprehensive reforms to the tax code in 2013. This is obviously very welcome news to S-Corps and other job creators! Here’s what he had to say:

I can firmly say our goal is: One, block massive, job-killing tax increases; and, two, enact – not just pass – comprehensive tax reform. And, there is strong support to use the expiration of the 2010 compromise as leverage to force action in 2013 on comprehensive tax reform.  How?  Simple: in addition to extending current low-tax policies originally enacted in 2001 and 2003, we should enact fast track procedures to compel comprehensive tax reform next year…

I intend to continue taking an open approach to tax reform, because I believe Congress wants and needs to hear from a variety of voices.  We want to hear from small businesses who for too long have been living in fear because they are worried they will be used as the next “pay for” on something like a student loan bill.

Chairman Camp’s comments reinforce House Speaker John Boehner’s remarks made earlier this week at the Fiscal Summit sponsored by the Peterson Foundation:

Any sudden tax hike would hurt our economy, so this fall – before the election – the House of Representatives will vote to stop the largest tax increase in American history.  This will give Congress time to work on broad-based tax reform that lowers rates for individuals and businesses while closing deductions, credits, and special carveouts.  …

Our bill to stop the New Year’s Day tax increase will also establish an expedited process by which Congress would enact real tax reform in 2013.  … The Ways & Means Committee will work out the details, but the bottom line is: if we do this right, this will be the last time we ever have to confront the uncertainty of expiring tax rates.  We’ll have replaced the broken status quo with a tax code that maintains progressivity, taxes income once, and creates a fairer, simpler code.

The sooner the House votes on the package outlined by Camp and Boehner, the better. Its only 229 days before we fall off the “fiscal cliff” and how the House plan will be received in the Senate is anybody’s guess. Will the Senate act and prevent Taxmageddon or, as with the budget, will it ignore the pressing needs of the economy and simply do nothing?  The sooner the House acts, the longer the business community has to put pressure on the Senate to follow suit.

Senate Defeats S-Corp Tax Hike

Good news for job creators!  The Senate just voted against moving forward on legislation that would increase taxes on S corporations by $9 billion.  The legislation was opposed by a broad coalition of business groups, led by the S Corporation Association, including the US Chamber of Commerce and the National Federation of Independent Business.  A motion to close debate and proceed to the bill was defeated on a party-line vote — 52-45. (Sixty votes are required to end debate in the Senate.)

This is the second time in two years the business community has successfully blocked legislation to increase payroll taxes on S corporations and partnerships.  Two years ago, a similar provision was blocked from moving forward on a 56-40 vote.  This time, S-Corp was joined by 37 other business groups on a letter to Senate leadership detailing the negative impact this tax increase would have on closely-held businesses, and we’re happy to see that the Senate stood with us.

Just How High Can Rates Go?

A question we’re hearing increasingly raised, particularly by policymakers seeking to raise taxes, is just how high marginal rates can go before they start to impede economic growth and become counter-productive.  That is, begin to cost the government revenue rather than raising it.

For example, Ezra Klein of the Washington Post polled several prominent economists back in 2010 and got some hair-raising responses:

• Emmanuel Saez,University of California at Berkeley: Revenue maximizing rate “means a top federal income tax rate of 69% (when taking into account the extra tax rates created by Medicare payroll taxes, state income tax rates, and sales taxes) much higher than the current 35% or 39.6% currently discussed.”
• Brad DeLong, University of California at Berkeley:  “At 70%.”
• Dean Baker, Center for Economic and Policy Research: “It would be somewhere around 70 percent and possibly a bit higher.

These responses would be ‘fall out of your chair’ funny if they weren’t being taken so seriously in Congress.  Which makes the Alan Reynolds piece in today’s Wall Street Journal so important.  Reynolds takes an in-depth look at a couple of recent papers, the first by Peter Diamond from MIT and Emmanuel Saez from Berkeley, and the second by Saez and Thomas Piketty of the Paris School of Economics, that form the intellectual foundation for these claims.  Here’s Reynolds:

The authors arrive at their conclusion through an unusual calculation of the “elasticity” (responsiveness) of taxable income to changes in marginal tax rates. According to a formula devised by Mr. Saez, if the elasticity is 1.0, the revenue-maximizing top tax rate would be 40% including state and Medicare taxes. That means the elasticity of taxable income (ETI) would have to be an unbelievably low 0.2 to 0.25 if the revenue-maximizing top tax rates were 73%-83% for the top 1%. The authors of both papers reach this conclusion with creative, if wholly unpersuasive, statistical arguments.

But the ETI for all taxpayers is going to be lower than for higher-income earners, simply because people with modest incomes and modest taxes are not willing or able to vary their income much in response to small tax changes. So the real question is the ETI of the top 1%.

So what is the real tax responsiveness of this top 1%?

A 2010 study by Anthony Atkinson (Oxford) and Andrew Leigh (Australian National University) about changes in tax rates on the top 1% in five Anglo-Saxon countries came up with an ETI of 1.2 to 1.6. In a 2000 book edited by University of Michigan economist Joel Slemrod (“Does Atlas Shrug?”), Robert A. Moffitt (Johns Hopkins) and Mark Wilhelm (Indiana) estimated an elasticity of 1.76 to 1.99 for gross income. And at the bottom of the range, Mr. Saez in 2004 estimated an elasticity of 0.62 for gross income for the top 1%.

A midpoint between the estimates would be an elasticity for gross income of 1.3 for the top 1%, and presumably an even higher elasticity for taxable income (since taxpayers can claim larger deductions if tax rates go up.)

But let’s stick with an ETI of 1.3 for the top 1%. This implies that the revenue-maximizing top marginal rate would be 33.9% for all taxes, and below 27% for the federal income tax.

Just as a reminder folks, we’re at a top rate of 35% now, and scheduled to hit almost 45% at the end of the year, so this has direct consequences to the pass-through community and S corporations. Congress will be debating rates as early as this fall, and unlike the corporate rate debate, where there seems to be some consensus over what the rate should be in the future, the debate over the top individual rates is all over the map.  For that debate, papers like the Diamond/Saez paper have their audience.  That’s what makes the Reynolds response so important.

Business Groups United Against Payroll Tax Hike

In advance of next week’s vote to raise taxes on S corporations by $9 billion, a group of 38 business associations wrote Senate leadership strongly opposing the provision.  Signed by S-Corp, the US Chamber, NFIB and other leading groups, the letter details the numerous flaws in the provision.  As reported in The Hill:

A coalition of business groups is pushing back against a Democratic proposal to pay for lower student loan rates with tax revenue.  The U.S. Chamber of Commerce, along with roughly three dozen other groups, said…the plan “could increase the payroll tax burden on business owners who are already fully complying with the law. For those businesses, this provision represents a tax increase rather than a clarification of existing tax burdens,” the groups wrote in a letter to Senate leaders…

Under current law, S corporations pay taxes through the individual code. Democrats say that some business owners are underpaying their payroll taxes by counting certain income as company profits that have “passed through” to the owner…The Democrats say their proposal, which is scheduled for a vote next week, would end that practice for those making more than $250,000 per year…But Republicans have said that the Democratic efforts would undercut entitlement programs because the payroll tax helps fund Social Security and Medicare.

And this in the National Journal:

In a letter to Senate Majority Leader Harry Reid, D-Nev., and Minority Leader Mitch McConnell, R-Ky., the business groups said they opposed legislation supported by Democrats that would cover the $6 billion cost of keeping interest rates on federal student loans from doubling by subjecting S Corporations to payroll taxes.

They said the bill would make tax collection “less enforceable than current law and will do little to increase compliance.”

The Senate plans to take up the student-loan legislation, with the S Corporation pay-for, next week. … Increasing taxes on S Corporations has long been viewed as a potential revenue raiser, but the offset is unlikely to survive at this time.

As the Journal indicates, they are scheduled to vote on Tuesday on cloture to close out debate on a motion to proceed to the bill.  It takes 60 votes to close debate in the Senate, and we expect they are well short of that level of support for raising taxes on closely-held businesses.  The underlying student loan issue is popular, however, so assuming this version fails, we expect a scramble by both House and Senate leadership to identify a $6 billion offset that can clear the Senate.  Let’s hope the new version doesn’t target Main Street.

Senators Come Up BIG!

On the positive front, four S-Corp champions in the Senate — Senators Cardin (D-MD), Snowe (R-ME), Roberts (R-KS), and Landrieu (D-LA) — wrote to the Finance Committee Chairman this week in support of extending the shorter, five-year built in gains provision.

As Washington Wire readers know, this shorter holding period expired at the end of last year along with all the other so-called tax extenders and it’s been a priority for us to see it renewed.  This letter in the Senate builds on the testimony last week in the House by Congressman Reichert (R-WA) and sends the signal that BIG relief enjoys strong support in both bodies.

According to the letter:

S corporations are the cornerstone of the business community.  Such corporations are located in every state, participate in a broad range of industries, and employ one out of every four private-sector workers.  For many of these Main Street businesses, access to capital is a primary challenge that inhibits their ability to invest, expand, and create jobs.  Much like bonus depreciation, the shorter, five-year holding period serves as a powerful incentive for these closely-held businesses to increase their investment efforts.

Could not have said it better ourselves.  Thanks to all the Senators who signed the letter.  We’ll be working to build on that support this spring and summer.

BIG (Built-In Gains) Day

The Ways and Means Committee Subcommittee on Select Revenue Measures heard from Members last week on the tax extenders they care most about.  Given the relative dearth of legislative opportunities this year, there was lots of interest in the session and lots of member involvement.  Twenty-seven Members showed up to state their case for the tax breaks they believe should be made permanent and would create jobs and help the economy.

From our perspective, they saved the best for last, as the final witness of the day was S-Corp champ Congressman Dave Reichert (R-WA), who made the case for the common-sense provision that reduces the holding period for converted S-Corporation built-in gains. He highlighted the bill that he introduced with Representative Ron Kind (D-WI) to help businesses access their own capital, especially in these times when business capital is much-needed and so hard to come by.

Here’s the case Representative Reichert made to the Subcommittee:

I know many Members will join me in expressing support for long-standing, ‘traditional’ incentives like the research tax credit that help American businesses innovate and grow. But I want to emphasize today two extensions of current tax law that I authored that have a demonstrated ability to leverage private capital and create jobs: the renewable energy production tax credit (H.R. 3307) and the five-year holding period for built-in gains for small businesses organized as S corporations (H.R. 1478)….

The reduced five-year holding period for built-in gains in small businesses organized as S corporations is another tax provision that leverages private capital and creates American jobs. This common sense measure that I authored as part of a broader package with Congressman Ron Kind (D-WI) enables S corporations to access their own capital sooner. An April 2011 study by Dr. Robert Carroll (Ernst &Young) found that businesses organized as flow-through entities account for more than half of all private sector jobs in the United States, and 56% in Washington State. One out of every four of these workers is employed by an S corporation.

Enabling scores of these businesses to continue unlocking their own capital sooner is one of many actions Congress can take to help small businesses access the resources needed to grow their businesses and create jobs. The holding period for built-in gains reverted to 10 years with the expiration of this provision in 2011 – meaning that if Congress fails to act, businesses that converted to S corporation status must wait a decade to access their own capital or face a punitive tax.

I am grateful that Subcommittee Chairman Tiberi cosponsored my S Corporation Modernization Act, and I would also like to submit for the hearing record a letter from 13 organizations representing millions of small businesses across America who support an extension of this provision.

Congressman Reichert’s testimony was reinforced by a letter signed by 13 business trade groups, including S-Corp, NFIB, and the U.S. Chamber, arguing for a permanent extension of the five-year holding period.  As the letter states:

Unlike public companies, these closely-held businesses have little or no access to the public capital markets. They rely on banks, they rely on relatives, and they rely on their own assets for investment and working capital. An overly long built-in gains tax exacerbates this disadvantage by preventing converted S corporations from putting the capital they already control to better use.

Many thanks to Congressman Reichert and the business groups for helping to bring this provision to the Ways and Means Committee’s attention.

More on the Payroll Tax Hike

When the Senate returns next week, it will consider the student loan bill that includes a $9 billion tax hike on S corporations.

The bill, S. 2343, was introduced last week and placed directly on the Senate Calendar without any consideration from the committee of jurisdiction.  On Thursday night, Majority Leader Harry Reid made a motion to proceed to the bill and file cloture to end debate on the motion.  The Senate will vote on that motion on Tuesday, May 8^th.  It takes 60 votes to close out debate, and while the student loan issue appears to have broad bipartisan support, few people think Majority Leader Reid has nearly that many votes on the bill to raise taxes by $9 billion on Main Street businesses.

Here at S-Corp, we are relieved the Senate is expected to reject the Reid payroll tax language.  It’s bad policy put forward without any legislative review or history, and it shows.  The minority staff at the Senate Finance Committee put out talking points Friday night to highlight some of those deficiencies, including this apparent drafting error:

An S Corporation is owned 1/3 by a father, 1/3 by his son, and 1/3 by his daughter. The father does not contribute substantial services to the business, but both the son and daughter do. The S Corporation has $900,000 of income. Under current law, for income tax purposes, $300,000 of income would be attributed to the father, $300,000 to the son, and $300,000 to the daughter.

However, for payroll tax purposes, under the Democratic proposal, the father’s $300,000 of income would be entirely attributed to the son and entirely attributed to the daughter. In other words, the son will have $600,000 subject to payroll tax and the daughter will have $600,000 subject to payroll tax. Therefore, a total of $1.2 million will be subject to payroll tax, even though S Corporation’s income was only $900,000. The father’s $300,000 of income would be subjected to payroll tax twice.

But there’s more.  Due to the adoption of the Affordable Care Act, the father’s S corporation income is already subject to the new 3.8 percent investment tax starting next year.  And the ACA raised the Health Insurance (HI) tax rate from 2.9 percent to 3.8 percent.  So under the Reid bill, the father’s $300,000 in non-active S corporation income next year would be subject to regular income taxes (39.6 percent), plus the HI tax twice (7.6 percent), plus the 3.8 percent investment tax, for a total tax hit of 51 percent, all to close a “payroll tax loophole” on a guy who doesn’t work at the business and is earning a return on capital, not labor.

Another challenge highlighted in the minority talking points is the $250,000 threshold.  This new threshold creates a couple of challenges.  First, it creates a rate cliff for S corporation owners as their incomes approach $250,000.  This cliff would not only include the extra HI taxes owed by the active shareholder on their S corporation dividends, but also HI taxes on the S corporation income of any related, non-active shareholders.  As the minority talking points make clear, one dollar of extra income could result in tens of thousands in extra payroll taxes.  Not exactly how you want to structure the tax code if your goal is simplification, job creation and economic growth.

Second, the threshold undermines the argument that the provision is just a “loophole closer.”  If we are closing a loophole here, why do we need a threshold?  Shouldn’t a loophole be closed regardless of the taxpayer’s income?  The simple fact is that this isn’t a loophole, and the Reid bill will raise taxes on business owners already fully compliant with the law.

The argument for the threshold also isn’t helped by the fact that the most recent IRS enforcement in this area, Watson v. US, involves a case where the defendant had overall S corporation income below $250,000.  The Eighth Circuit decision against the defendant teaches us a couple of things: (1) the IRS already has the tools in place to go after taxpayers who underpay themselves in order to avoid payroll taxes — its tax avoidance, not a tax loophole – and, (2) since the defendant’s income was less than $250,000, it shows that new Reid provision will be less than effective at going after future Watsons and other taxpayers abusing the S corporation rules.

The Reid payroll tax hike has many flaws beyond those listed above — it uses Medicare funding to pay for non-Medicare spending, it uses permanent tax hikes to pay for temporary spending programs, it applies payroll taxes to the return on capital as well as the return on labor, it replaces an imperfect but thoroughly vetted “reasonable compensation” standard with an even more imperfect and wholly untried “principal rainmaker” test, etc. — and it deserves to fail.

Just how to apply payroll taxes to S corporation income is a serious challenge and it deserves a serious discussion.  We hope that discussion could take place as part of a larger debate over tax reform and the future direction of the tax code where a thorough review will be part of the process.

S-Corp Payroll Taxes on the Table (Again)

The S-Corp payroll tax issue is back in play.  According to the Associated Press and others, Senate Democrats are planning to raise taxes on S corporation shareholders by $6 billion to offset the cost of extending low interest rates for student loans.  According the AP:

Democrats are considering trying to make it harder for owners of so-called S corporations to avoid paying Social Security and Medicare payroll taxes on some of their earnings, said a Senate Democratic aide speaking on condition of anonymity to reveal an emerging party strategy.

Though decisions have not been finalized, the proposal would affect such companies with earnings of at least $250,000 annually and would raise roughly $5 billion to $6 billion over the coming decade, the aide said. Democrats might use it to help pay for an upcoming effort being pushed by President Barack Obama to keep college students’ loan rates from doubling this summer, to finance another initiative or for deficit reduction.

This Democratic plan, which has been under discussion among congressional and Obama administration aides, would tighten the definition of S corporation income on which payroll taxes must be paid. The idea is likely to face strong Republican opposition in the Senate, but Democrats believe there would be political value in forcing GOP senators to vote on the measure, win or lose.

This issue was last debated two years ago in the Senate.  S-CORP led the successful fight to defeat the previous effort, and we have serious concerns about this one, especially given the lack of transparency that accompanied today’s announcement.  What exactly is the proposal this time?  They haven’t released anything and nobody knows, but the National Journal description gives a little more detail:

The bill will require S Corporations with three or fewer shareholders who declare income of at least $250,000 a year to pay employment taxes, Harkin said. An S Corporation is a specially structured entity that pays taxes under rules that allow earnings or losses to be passed through shareholders, reducing federal tax payments.

Two years ago, a group of 27 business associations, including the National Federation of Independent Business and the Chamber of Commerce, joined together to defeat a similar provision.  Back then, the group wrote Congress with the following concerns.

[The provision] would raise taxes by $11.2 billion on privately-held businesses located in every state of this country. While it has been described as a “loophole closer” and a “payroll tax” it is neither. It is a new tax on small employers that will overturn more than fifty years of established tax policy. We share the concerns of Congress that certain taxpayers are underpaying their payroll taxes, but we believe Section 413 is overly broad and will result in more increased tax collections than increased tax compliance.

This new tax would hurt job creation. It would be imposed regardless of whether the affected firms make distributions to the targeted shareholders and partners, or retain that income to reinvest in jobs and capital equipment. Shareholders and partners of “flow-through” businesses are taxed on their firm’s income even when that income is not actually distributed. As a result, this provision will reduce the capital these employers have to create jobs and invest in their businesses…

Finally, this new tax is an excellent example of what happens when the legislative process is short circuited. It was never the subject of hearings or public review, it was made public just a few short weeks ago, and it has been attached to legislation that already passed both the House and the Senate. It is an accident of the legislative calendar that we are in a position to offer our views at all.

These same concerns appear to apply to the new effort.  We don’t know exactly what the new provision is, but we do know that it’s likely to be overly broad, to apply to business owners who are already fully complying to the spirit and the letter of the law, to increase uncertainty (as well as taxes) at a time when businesses are already facing a remarkable level of policy uncertainty, and to take taxes dedicated for the Medicare Trust Fund and spend them on unrelated programs.  None of that is good.

As you can imagine, S-CORP will be working closely with our allies to review this provision closely.  From what we’ve read, we expect to oppose it, and we expect to have lots of allies join us.   More to follow.

Keeping Rates the Same

It’s Easter recess here in D.C. and we’ve had a chance to catch up on our reading.  Topping the stack was Marty Sullivan’s Tax Notes piece from March 26th.  It’s a rebuttal to our tax reform principles letter signed by 45 business groups here in town, so we thought a rebuttal to the rebuttal was in order.

As a reminder, our letter calls on Congress to reform the tax code by adhering to three broad principles: make reform comprehensive, keep the rates low and the same, and continue to reduce the incidence of double taxing corporate income.  Marty appears to quarrel with all three, but this piece is focused primarily on the second principle — keeping rates the same.

He begins with the premise that we need to cut corporate tax rate.  Here’s his rationale:

A lower corporate rate is chicken soup for the code. It helps cure many ills with few adverse side effects. It would increase capital formation and add to growth. It would increase compliance. It would reduce the tax bias for issuing debt over equity, for retained earnings over distributions, and for booking profits offshore instead of in the United States.

We all like chicken soup and we agree lower marginal rates would be good.  But why just for corporations?  What about the other half of business income earned by pass-throughs?  Fifty-four percent of employment takes place at S corporations, partnerships, and sole proprietorships — wouldn’t those workers benefit if their employers enjoyed lower rates, too?  And what about the tax rates paid by the shareholders of corporations?  Doesn’t the marginal tax they pay on corporate income ultimately determine the cost of corporate equity investment here in the U.S.?  These questions are left unaddressed.

Instead, Marty focuses on how to pay for the corporate rate cut.  Marty argues that higher rates on capital gains and dividends could offset the cost of the lower corporate rates, plus they would help ensure that C corporations don’t become tax shelters for folks trying to avoid the higher rates applied to individual income.

We’re less confident that would work.  First, sharply higher rates on capital gains and dividends are already current law, so the potential for raising revenue is limited.  Second, any time you have wide differentials in tax rates, taxpayers have a powerful incentive to move their income into the lower tax bucket.

Here’s where the Ways and Means testimony from S-Corp Advisor Tom Nichols comes in handy.  As Tom explains, in the pre-1986 tax world, using C corporations to hide income was exactly what they did:

When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent. This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher….

This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations….

Since the taxes at stake could be substantial, the tax opportunities and pitfalls inherent in this system provided tax advisors with a significant source of business. For example, Section 1.537-1(b)(1) of the Treasury Regulations provides that “the corporation must have specific, definite, and feasible plans for the use of such accumulation” in order for such plans to be taken into account for purposes of justifying such accumulation and avoiding the accumulated earnings tax. This led many closely-held business owners to hire attorneys to hold meetings and/or draft corporate minutes when they would otherwise not have incurred the time and expense of documenting such plans so formally.

Cutting today’s corporate rate down to the mid-twenties while allowing rates on individuals and pass-through businesses to rise to the mid-forties would effectively return us to the pre-1986 days of tax shelters and gaming.  Marty recognizes this danger, and spends a remarkable amount of time listing all the enforcement tools needed to minimize the games: accumulated earnings tests, personal holding company rules, eliminating step-up in basis at death, limiting charitable donations of stock, taxing passive investment earned by C corporations at individual rates, and limiting C corporation profits to some standard return on investment test.  See, it’s easy.

Or, you could just keep rates similar and all these rules would be unnecessary – hence, our reform principle.

Second, Marty may ignore the economic harm caused by high marginal rates on pass- through business and investment income, but it’s there nonetheless.  Why is it good to cut the corporate rate?  Because it makes U.S.-based businesses more competitive, it reduces distortions in the tax code that hurt growth, and it makes the U.S. a more attractive place to invest.  Why doesn’t this same argument apply to tax rates on income earned by pass-through businesses and the shareholders of C corporations?  Dead silence.

Marty’s ultimate proposition is to draw a bright line between publicly-held businesses and those in private hands.  If you’re public, you get to be a C corporation and pay the new lower rate.  If you’re privately held, you get pass-through treatment and pay the new, higher rates.  Again, this might make sense as a reform in a world where top tax rates are similar, but here Marty is using it as a tool to ensure that taxpayers don’t game the system in his low-corporate-tax, high-taxes-on-everybody-else world.

It’s possible the Ways and Means Committee chooses to do this, albeit without the huge delta between corporate and non-corporate tax rates.  It’s something Jeffrey Kwall has written about on several occasions and he testified about it before the Ways and Means hearing, too.  Something to keep an eye on.

CRS on Taxing Large Pass-Throughs as Corporations

More reading.  The CRS weighed in recently on the issue of forcing large pass-through businesses to pay taxes as C corporations.  The March 30^th report entitled “Taxing Large Pass-Throughs As Corporations: How Many Firms Would Be Affected” discusses an idea pushed by the Obama Administration primarily, although key members of Congress have hinted at it as well.

You know our position on this — why does it make sense to cut tax rates for really large C corporations and pay for it by raising taxes on smaller pass-through businesses?  It doesn’t.  The fact that the CRS paper is almost written in a “How to Raise Taxes on Pass-Throughs in Three Easy Steps!” style, however, doesn’t help much, but it does include one or two nuggets that will be useful in coming debate.

Nugget one is the report makes clear that the businesses affected are anything but the “hedge funds and law firms” targeted by the advocates.  Table 5 on page 10 breaks the affected firms down by industry.  The top five affected industries for S corporations?  Manufacturing, Wholesale/Retail, Mining, Transportation, and Construction.

Nugget two, it makes clear that if your goal is to reduce the disparity in taxation between C corporations and pass-through businesses, further integration of the corporate tax could get you there:

At the same time, an alternative policy prescription that is generally more appealing to economists—integration of the corporate and individual tax systems—could also achieve these objectives.

And third, the report raises an issue we haven’t spent a whole lot of time talking about but we probably should — the lack of an economic case for treating all businesses the same.  Here’s what CRS says:

Taxing large pass-throughs as corporations would also allow for lower tax rates as it would broaden the corporate tax base. Lower tax rates combined with a reduction in the tax disparity between the corporate and non-corporate sectors could improve business tax equity and the allocation of resources relative to current policy.

Applied to economic activity, this sort of analysis is well established.  Tax breaks for homeownership encourage increased investment in residential real estate and less investment elsewhere.  The result is an over-investment in houses and a less efficient economy.

But business structure isn’t business activity.  Different rules for S and C corporations don’t push business investment into housing or any other sector of the economy.  Contrary to the above example, the growth of pass-through businesses doesn’t necessarily encourage residential real estate at the expense of manufacturing or other sectors.  You can be either an S or C corporation and still be active in both.

On the other hand, there are offsetting benefits to giving entrepreneurs a choice in selecting a business structure.  They can pick the structure that best fits their capital, management, and transition needs.

Forcing some pass-through businesses to pay the corporate tax should be viewed as a pay-for and nothing more.  It’s not tax reform, and it’s not going to lead to a more efficient economy or tax code.  It’s certainly not going to reduce the cost of business investment in the United States — it will do the opposite under the Administration’s proposals.

Bloomberg on S Corps and Payroll Taxes

Bloomberg’s BGOV put out a nice summery of the recent appeals court decision Watson v. U.S.  This is the Iowa case where an accountant set up an S corporation to block paying Medicare taxes.  The lower court ruled for the IRS and its use of the “Reasonable Compensation” test to require him to pay the correct amount in taxes.  The appeals court agreed.  Here’s the BGOV summary:

The U.S. District Court for the Southern District of Iowa ruled in favor of the IRS in David E. Watson, P.C. v. U.S. The corporation appealed the decision to the U.S. Court of Appeals for the Eighth Circuit, which affirmed the lower court’s conclusion that Watson’s salary for services rendered should have been $91,044 per year. This represents 40 percent of the S corporation’s total distributions to Watson for 2002 and 46 percent for 2003.

In arriving at the $91,044 figure, the Appeals Court agreed with the lower court’s findings: Watson “was an exceedingly qualified accountant” with 20 years of experience; the 35 to 45 hours per week Watson worked made him “one of the primary earners in a reputable firm” that had earnings of about $2 million in 2002 and $3 million in 2003; and Watson’s $24,000 annual salary was “unreasonably low compared to other similarly situated accountants.”

We don’t support taxpayers who use the S corporation to block payroll taxes they would otherwise legally owe.  That’s not the purpose of the S corporation.  And we’re glad the IRS is successfully using the tools it already has to go after these taxpayers.  A few more high profile cases like this, and you might see the problem shrink.

The Ryan Budget & Taxes

The budget introduced in the House today calls for a couple broad items on the tax front.  First, it calls for extending all the tax provisions set to expire January 1^st.  That’s the rate cliff we’ve been warning S corporations about for the past couple months.  Marty Feldstein made the case clearly this week in the Financial Times as to why Congress needs to act:

But the most important cloud on the horizon is the large tax increase that will occur next year unless legislation is passed to block it. The Congressional Budget Office predicts that, under current law, the revenue of the federal government will rise from $2.4tn in the current fiscal year, which ends in September, to $2.9tn in the following fiscal year. That increase of $512bn is equivalent to 2.9 per cent of GDP, bringing federal revenue as a share of GDP from 15.8 per cent this year to 18.7 per cent next year.

The higher revenue would reflect an increase in personal tax rates, higher payroll taxes, as well as higher taxes on dividends, capital gains and corporate incomes. Revenue would continue to rise in future years – as a share of GDP it would increase to 19.8 per cent in 2014 and would stay above 20 per cent for the remainder of the decade.

A sustained tax increase of that magnitude would push the US into a new and deep recession next year. So, it is important to recognize that legislation is required to prevent such a tax rise.

Second, the budget calls for comprehensive, budget-neutral reform of the tax code, with a goal of getting the top rates on both corporate and individual income down to 25 percent, fully offset by eliminating tax expenditures to broaden the base.  Here again, the budget anticipates the concerns the business community has raised regarding tax reform.  Recall our three key principles for doing tax reform right, endorsed by 45 business groups in D.C.:

• Make it comprehensive;
• Keep the top corporate and individual rates the same; and
• Continue to reduce the double tax on corporate income.

Where the Obama corporate-only reform plan failed each of these three principles, the reform outline included in the Ryan budget embraces each of them — its comprehensive, the top rates are the same, and it reduces the burden of the double corporate tax.   Here are the major reform points from the budget:

• Consolidate the current six individual income tax brackets into just two brackets of 10 and 25 percent.
• Reduce the corporate rate to 25 percent.
• Repeal the Alternative Minimum Tax.
• Broaden the tax base to maintain revenue growth at a level consistent with current tax policy and at a share of the economy consistent with historical norms of 18 to 19 percent in the following decades.

Rates are the same, its comprehensive, and lowering the corporate rate helps to reduce the double tax on corporate income.  Check, check, and check.  Now this is what we were talking about.

S-CORP’s Crystal Ball

It’s tough to predict, particularly about the future.  But we’ll try.

With the introduction of the House Republican budget today, the budget process in Congress appears to be done.  Members of Congress and the media will fight over the details of the Ryan budget for the next couple days, and the House will have to vote on it next week, but those are mere trees.  The forest is simpler.  The President produced a budget.  House Republicans produced a budget.  The Senate will produce nothing.

That means no overriding statement of congressional priorities on spending and revenue.  It also means no reconciliation instructions in the Senate, which means it would take 60 votes to move the tax legislation described above through that body, rather than 50 plus the Vice President if they were moving the bill as a reconciliation bill created by the budget resolution.  Those ten votes make a big difference in the odds something could pass, and they pretty much doom the Senate to inactivity on tax issues until after the elections.  They may have the votes for a small business extender bill — we hope so — but probably little else.

Lame duck session and another debt limit fight, here we come.

That’s the consensus in D.C. — lots of debate on tax issues but nothing actually happens until after the elections.  After the elections, motivated by the pending expiration of all the current tax policies and the need to raise the debt limit again, Congress acts either in the six weeks between the elections and Christmas or, even more frightening, waits until early in 2013.

In the meantime, the business community looks to be stuck without the R&E tax credit, bonus depreciation, shorter built-in gains holding periods, and other small-business-friendly provisions that expired at the end of last year.  Business owners will also have to plan for paying taxes in 2013 without knowing what those rates will be.  Neither situation is healthy, and it’s bound to have an effect on hiring and investment decisions moving forward.

We hope we’re wrong, and that the House and the Senate take up legislation to address the business-friendly extenders and the expiration of all the tax rates soon.  The sooner they begin discussing these challenges, the sooner they can come to a solution.

Buffett Rule Tax Score

The Joint Committee on Taxation released its revenue estimate for legislation implementing a version of the so-called Buffett Tax.  This estimate is in anticipation of the Senate voting on this idea in the near future.

The bill, S. 2059, was introduced by Senator Sheldon Whitehouse (D-RI) earlier this year and would impose a new tax equal to 30 percent of a taxpayer’s AGI less a modified charitable deduction for taxpayers with incomes exceeding $1 million.  The impact of the tax is phased in for taxpayers making between one and two million to avoid a massive rate cliff when somebody’s earnings rise one dollar from $999,999 to $1 million.

Even so, as S-CORP Advisor Tom Nichols pointed out in testimony before the Ways and Means Committee several weeks ago, taxpayers would still face marginal rates well in excess of 30 percent as their business incomes rose from $1 million to $2 million.

The score itself, $47 billion over ten years, is extraordinarily small for such a broad-reaching policy.  There are a couple reasons for this.  First, the most obvious reason is that most people making more than $1 million a year are already expected to pay a substantial amount of tax, particularly if marginal tax rates go up as scheduled under current law.  (That tax burden doesn’t include their share of corporate taxes paid, either.)

The second reason is that the Alternative Minimum Tax (AMT) is already in place as a second tax code.  It looks back at the tax burden of families and makes those whose tax burden is too low pay more.  Sound familiar?  We already have a Buffett Rule tax, and it’s broken – it reaches down and raises the tax burden not just on millionaires, but on families making $75,000 or less.  Since the Whitehouse bill thresholds are not indexed, over time this migration into the middle class would happen with his bill, too.

The Obama Administration hinted in their budget documents and subsequent testimony that they would like to use the Buffett Rule tax to replace the current AMT.  Their actual budget, however, includes neither the Buffett Tax nor a repeal of the AMT.  This is a policy the President talks about nearly every day, yet somehow it didn’t make it into his budget proposal.  The reason for this is simple math.  There’s no way the revenues raised by the Buffett Rule could ever replace the revenues gathered by the AMT over the next ten years.  As the Obama budget estimates, merely holding the AMT to its current size and reach reduces revenues by $1.9 trillion over the decade!

So what we have is the worst of all worlds – the Senate is considering layering on a third tax income tax (fourth really, if you include payroll taxes) onto the two we already have.  All this despite the fact that the United States already has one of the most progressive tax codes in the world.  It’s the movie “Animal House” all over again.

Tiberi Introduces Bonus Depreciation Bill

This week Ways and Means Member Pat Tiberi (R-OH), one of our more vocal S-Corp champions, introduced legislation (H.R. 4196) to extend 100 percent bonus depreciation through the rest of this year. Bonus depreciation allows businesses of all sizes to immediately expense the cost of property purchased and placed into service.  S-Corp Advisor Tom Nichols spoke of the advantages of expensing in his testimony before the Ways and Means hearing last week.

“Probably the most important of these proposals for most closely-held businesses would be the possibility of extending and/or expanding the option of expensing investments in capital equipment under, among other provisions, Sections 179 and 168(k) of the Code. Most closely-held business owners intuitively evaluate their business on the basis of cash flow, rather than financial statement net income. This is especially important for them because they often do not have access to substantial cash reserves or credit, especially in times of stress where cash flow is threatened.

I learned this lesson early in my career. A client, who had just earned his first million dollars, had then spent the money on equipment and other capital expenditures that were sorely needed in his rapidly-growing business. He called me after the end of the year to discuss the “problem” raised by his accountant that he now owed income tax. Trained as I was in tax law and accounting, I calmly explained to him that the reason he owed tax was that these capital expenditures still had value at the end of the year and would be depreciated for tax purposes only as they were consumed in the business over the next several years. Less calmly, he said to me “Tom, you don’t understand. I have no cash.”

Over the years, I have come to more fully appreciate the wisdom of his statement. Most closely-held business owners correctly think of money spent on equipment and other capital expenditures as still at-risk in the business, and as not “earned” until it comes back to the business in the form of collections upon sales. From a tax policy perspective, allowing businesses to deduct their equipment and other capital expenditures makes more intuitive sense when you consider the fact that the seller of the equipment or other item will be required to take the entire sales proceeds into income. This is consistent with the perspective of many closely-held business owners, i.e., that it is the seller that experiences the income in this transaction.”

Observers know that this provision was allowed to lapse at the end of 2011 when tax extenders were left out of the payroll tax extension package, despite the support of the Congress, the business community, and the Administration and broadly within the business community.  Congressman Tiberi agrees, saying at the time of the bill’s introduction:

“I’ve heard time again from small business owners in Ohio, that extending bonus depreciation is the single, biggest factor in allowing their businesses to grow this year,” said Congressman Tiberi, Chairman of the Ways and Means Subcommittee on Select Revenue Measures.  “Allowing job creators to use these tools for capital reinvestment is a common-sense way to encourage job creation.”

With real tax reform still at least a year away, we’re glad to see Mr. Tiberi, and other S-Corporation allies like Rep. Erik Paulsen (R-MN.), continuing to push this important issue.

Hassett and Viard Agree with Us

Great piece by Glenn Hubbard and Kevin Hassett in the Wall Street Journal earlier this week.   Here’s the core of their argument:

First, U.S. tax policy can no longer treat the U.S. as a closed economy. Capital and business activity are increasingly mobile across national boundaries and highly responsive to variation in the net tax paid across locations. Second, the word “business” is not synonymous with “corporation”—pass-through (noncorporate) businesses are almost as important in the aggregate as old-fashioned corporations. Third, economic research has stressed that both corporate taxes and investor-leveltaxes on dividends and capital gains contribute to the tax burden on corporate equity. Investors factor in the total capital tax, both individual and firmlevel, when making decisions.

Sound familiar?  It should to Washington Wire readers, since we’ve been pointing this out for a year.  Tax “reform” that ignores the importance of pass through businesses to employment and income and ignores the effect shareholder taxes have on business investment decisions is mindless and counterproductive.  Here’s more from the authors:

Mr. Obama’s plan, as if designed by Rip Van Winkle, is blind to this major shift and is thus a weak tonic for the flagging economic recovery. While the president proposes reducing the corporate tax rate, other changes that are portrayed as “loophole closing” on multinational firms make his plan a net increase in corporate taxes collected.

Mr. Obama, ignoring the second reality, would also raise taxes on noncorporate business, in the interest of requiring the “rich” to pay for the “privilege” of being an American, to paraphrase a recent statement by Treasury Secretary Tim Geithner. Noncorporate business accounts for 36% of business receipts, 44% of business taxes, and 54% of private-sector employment.

A unifying characteristic of the many types of noncorporate businesses is that their owners pay taxes at individual rates. A substantial body of economic research has found that changes in individual marginal tax rates clearly impact noncorporate firms’ investment levels, hiring practices and wages.

And finally:

A 21st-century business tax policy would recognize the roles of globalization, the side-by-side organizations of corporate and noncorporate business, and double taxation of corporate equity returns. Mr. Obama’s tax reform proposal takes a wrong turn in each area and appears motivated by a poor understanding of the impact of capital taxation on business behavior and the welfare of middle-class Americans.

Ways and Means Hearing

S-corporation taxation took center stage on the Hill last week.

Carrying the S-Corp flag before the House Ways and Means Committee was Association Advisor Tom Nichols of Meissner Tierney Fisher & Nichols S.C. Tom had been invited to represent the S Corporation Association and testify at a hearing entitled “Tax Treatment of Closely-Held Businesses in the Context of Tax Reform” along with five other witnesses representing other trade groups and academia. Tom’s testimony made clear to the tax writers what we’d like to see when they pursue tax reform:

“As much as possible, the business tax system in the United States should move toward a single tax structure, and away from the punitive double tax C corporation system. Especially for closely-held businesses, a single tax system substantially reduces complexity and eliminates the opportunity and incentive for non-productive tax planning and strategizing.”

“Second, broadening the tax base and lowering and flattening the tax rates would serve all segments of society. The lower the rate on a given amount of marginal income, the more likely it is that a business owner is going to expend the effort and take the risks in order to earn that income, and the less effort he or she will expend trying to defer or otherwise mitigate the tax consequences of having done so.”

“Third, it is important that whatever tax reform is implemented be comprehensive. Since pass-through business owners employ over half of the workforce in the country, lowering the tax rate for all taxpayers (rather than just the headline rate for C corporations) should be the goal of comprehensive tax reform.”

S-Corp’s perspective was reinforced by witnesses representing the National Federal of Independent Business (NFIB) and the Financial Executives International, both of whom made clear that comprehensive reform as the only means to making all businesses sectors more competitive. NFIB’s Dewey Martin also made the case for the shorter built-in gains holding period:

Finally, reducing the holding period for the built-in gains tax would do much to promote flexibility for small businesses. The built-in gains tax locks-in capital assets if a C-Corporation elects to change to S-Corporation status, and reduces economic efficiency. NFIB appreciates that the holding period has been reduced from 10 years to 5 years, and, at the very least, this should be extended.

During Q&A, Tom had a chance to highlight the importance of built-in gains relief during a back-and-forth with S Corporation Modernization sponsor Dave Reichert of Washington state:

With everything up in the air right now, it is more important than ever for business owners and their representatives in Washington D.C. to step up and be heard on these important issues. We appreciate Tom’s willingness to testify along with the other witnesses at last Wednesday’s hearing. We hope policymakers were listening.

Large Pass-Through Businesses and Double Taxation

There’s a small but vocal group of C-corporations arguing that Congress should force large pass-through businesses to pay taxes like C-corporations — i.e. pay two layers of tax on their business income rather than just one. Just exactly how raising taxes on large pass-through businesses in order to cut them for even larger C-corporations would encourage investment and growth here in the United States is left unexplained.

But what about the complexity of such a rule? Wouldn’t an arbitrary cut-off based on revenues or employment be difficult to administer and enforce? Tom’s testimony before the Ways and Means Committee last week is the best exploration we’ve seen of the overwhelming tax administration challenges such a policy would face.

It should be must reading for anybody involved in tax reform. Here’s what he said:

“There have also been proposals to force double tax C corporation treatment on large pass-through entities, say those having gross receipts over $50 million. In addition to imposing a substantial additional compliance and tax burden on the most productive members of the pass-through sector of our economy, such a provision would require a detailed and complicated system of inter-related rules. For example, how would an entity be treated that hovers both above and below the $50 million trigger point? Would the built-in gains tax apply when the entity re-elects S status after having been forced into C corporation status as a result of having extraordinarily good receipts during the testing period? Would an entity be trapped in C corporation status even though it no longer had $50 million of gross receipts, because of higher receipts during the testing period? If not, would closely-held business owners not be in a position to know whether they will be subject to a C corporation or S corporation tax regime until after the end of the year in question?

Also, I am assuming that there would have to be some type of aggregation rules so that closely-held business owners could not simply split their business into two or more entities and avoid the C corporation regime in that fashion. As you can imagine, such aggregation rules are extremely difficult to administer. For example, if various business entities were to constitute a series of overlapping aggregated control groups or affiliated service groups, how would that be handled? If one of the groups was below the threshold and another of the groups was above the threshold, would the owners of the group that was below the threshold be forced into double tax C corporation status, even though some of them owned only an interest in a relatively small business?

Even in the absence of multiple overlapping groups, how would you handle the numerous complexities that are involved when multiple entities are treated as a single unit? The consolidated return regulations span over 440 pages in the standard edition of the CCH Income Tax Regulations, dealing with issues such as inter-company transactions, stock investment accounts, calculation of credits, allocation of income tax liabilities and numerous other matters. These complexities are difficult enough for groups of business entities that voluntarily choose to treat themselves as a single affiliated group, but this level of complexity would be multiplied many times by forcing aggregate treatment for all tax purposes on an amalgamation of corporations, partnerships, limited liability companies and other entities that happen to be linked by common ownership or activities.

This forced amalgamation might also have the unintended consequence of opening up opportunities for aggressive tax planning and tax shelters. For example, if dividends are treated as coming from the aggregate earnings and profits of the amalgamated entity, could the C corporation owners of one of the amalgamated entities drain off all of the earnings and profits on a tax-preferred basis, while allowing the remaining individual owners to achieve the equivalent of S corporation treatment as a result of non-dividend distributions? If not, would the individual owners of one of the separate entities with separately treated earnings and profits be able to achieve S corporation-type treatment by carefully managing the operations of that entity?

In addition to these workability concerns, making an arbitrary and involuntary cutoff for pass-through tax treatment is simply not good tax policy. For the reasons indicated at the outset of this testimony, the double tax C corporation system is not preferred tax policy. Moreover, the $50 million trigger (or whatever number is chosen as the trigger) would clearly discourage growth in companies that are approaching that level, and such companies would be incentivized to engage in a great deal of sophisticated and expensive tax planning to avoid being involuntarily subjected to the double tax system. Such maneuvers might nonetheless be justified if such a proposal were enacted, because one additional dollar of gross receipts could literally trigger millions of dollars of federal tax consequences. Such cliff-like triggers are obviously not favored for policy purposes.

Finally, just because an entity has $50 million of gross receipts does not mean that it is profitable. There are many such entities (or amalgamations of such entities) that actually have losses, which, under current law, are appropriately taken into account (and if necessary carried over) at the individual level. Forcing individual owners at that level of activity to forego the ability to deduct these losses would unavoidably impact their willingness to continue to fund these enterprises, with the concomitant impact on the jobs and financial security of their employees. Even profitable entities would not seem to merit such draconian treatment. For example, a low-margin 1 percent-of-sales business could easily have $50 million of gross receipts, but have only $500,000 of actual taxable income. Triggering C corporation status in these circumstances seems entirely unwarranted.”

Backwards Tax Reform

So earlier this month, we warned that you might hear a new argument when it comes to tax reform: cut corporate tax rates but raise them on shareholders. The idea is that corporations are mobile, whereas shareholders are not. So cut the corporate tax to encourage more firms to locate here, and raise taxes on shareholders because they’re stuck and can’t go anywhere anyway.

Well, we didn’t have to wait long to hear this flawed argument again. At last Tuesday’s Senate Finance Committee hearing, Dr. Robert Atkinson he believed in corporate tax reform that raises taxes on high-income individuals and lowers them on the corporate side is the way to go, saying that while “rich people are not going to move to Mexico or Taiwan, corporations will do that.” He went on to say that the idea that we cannot raise taxes on the rich is a mistake, and that it is much more important to get this right on the corporate side.

Here’s the clip of his testimony:

Setting aside the corporate governance issues of further separating the interests of management from the interests of shareholders, the principle challenge with this argument is that it ignores the most mobile commodity of all: capital. Raising the overall tax burden on business investment in the United States is not going to encourage additional investment here, even if it’s done in a manner that reduces one tax rate while hiking another. As Alex Brill and Alan Viard wrote last week, the tax hike under consideration is remarkably large:

The president’s proposal would allow the 2003 dividend tax cut to expire for high-income households at the end of the year, pushing the top dividend tax rate up from 15 to 39.6 percent. That’s a dramatic increase in its own right. But, other provisions make the true increase even larger. The president also wants to bring back a provision phasing out deductions for high-income taxpayers, which will cause each additional dollar of dividends to trigger 1.2 cents of extra taxes. And, beginning next year, the president’s health care law will impose an additional 3.8 percent tax on dividends and other investment income of high-income households. Under the president’s proposal, the top all-in dividend tax rate will be 44.6 percent – almost triple today’s 15 percent rate.

You can pretend that shareholders are not the real owners of businesses organized as public corporations, and maybe those businesses behave like they have no shareholders for short periods of time, but eventually those shareholders makes themselves known by voting with their feet and capital will flow out the U.S. and into those countries with a lower overall tax burden on equity investment.

These days, that’s just about everybody else.

Taxing Business Investment

Our position on tax reform is simple and outlined in the letter 45 business groups sent to Congress last fall:

• Pursue comprehensive reform that includes both the corporate and individual tax codes;
• Keep the top rates on corporate and individual income low and at the same level; and
• Continue to reduce the incidence of the double tax on business income.

This last principle is premised on the idea that the pass-through structure is the correct way to tax business income, as Eric Toder told the Senate Finance Committee last year:

Senator Snowe: I appreciate that. Does either one of you want to comment, Dr. Chetty, Dr. Toder?

Dr. Eric Toder: I would certainly agree with most of what Dr. Carroll said, and really note that the ideal way to tax business income is the way we tax S corporations. We would like to attribute the income to the owners and the only reason we have a corporate tax is for large and frequently traded companies–very hard to do that and identify the owners who would pay the tax.  So where you can do that, we should do that, and that is the right treatment.  And I also believe we can’t look at corporate tax reform in isolation without looking at the effect on flow-throughs, and also the effect on the taxation on corporate income at both the individual and the corporate level.  Part of the reason we’ve given tax breaks to individuals in very low capital gains and dividends rates is to adjust the double taxation of corporate income.  And so if we are going to reduce the corporate rate we might think about how we tax individuals and maybe we don’t need to give them as much preferential treatment.  But I think putting things in a box—corporate tax here and individual tax there—is not the right way to go.

The Administration’s plan released last week violates all three of our principles.  It’s corporate-only reform, it creates all sorts of tax avoidance opportunities by taxing corporate income nearly 20 points lower than pass-through and individual income, and it increases the incidence of the double tax by sharply raising rates on shareholders and forcing more employers into this inefficient double tax model that economist after economist says discourages investment and job creation.

But what about Dr. Toder’s final point?  We’re hearing that line of reasoning increasingly, most recently this week in Politico.  The article highlights a 2010 proposal from the Urban-Brookings Tax Policy Center’s Roseanne Altshuler, Benjamin Harris, and Dr. Toder who suggest the combination of cutting corporate rates to 26 percent while raising shareholder taxes (capital gains and dividends) to 28 percent would improve our treatment of corporate income:

The basic economic argument is that corporate-level taxes are largely “source-based” — driven by the returns of company investments in the U.S. — while shareholder-level taxes are “residence-based” — imposed on worldwide dividends and equity of American citizens. In today’s world of mobile capital, higher corporate-level taxes can distort investment flows and create opportunities for tax avoidance by shifting income overseas. Taxing shareholders is then more efficient, and if Congress were to lower the corporate rate at the same time, the U.S. would be more competitive and better positioned to consider other international reform options favored by House Ways and Means Committee Chairman Dave Camp (R-Mich.).

Or, as the Brookings paper notes in its introduction:

The increase in international capital mobility over the past two decades has put pressure on the tax treatment of corporate equity income. Corporate-level taxes distort investment flows across locations and create opportunities for tax avoidance by shifting income across jurisdictions. Outward flows of capital shift part of the burden of the corporate-level tax on equity income from capital to labor, thereby making its incidence less progressive. Individual-level taxes on corporate equity income lower the after-tax return to savings but have less distorting effects on investment location and are more likely to fall on owners of capital than workers. This logic suggests there may be both efficiency gains and increases in progressivity from shifting taxes on corporate equity income from the corporate to the shareholder level.

The idea is to bring our statutory corporate rate more into line with other OECD countries while shifting the tax burden towards investors because they are less mobile.  Here’s what we had to say about this proposal back in November when the idea was brought up by Martin Sullivan:

There’s a certain level of reasonableness to this argument — from a tax collector’s point of view if not a politician’s — but it fails to recognize the most mobile asset of all: capital.  The double tax on corporations is a tax on capital — the money people invest in the company.  By cutting corporate rates, but raising rates on dividends and capital gains, you are failing to reduce the overall tax on capital, so you’re failing to encourage more of it to come here.

Our concern applies especially to the Administration’s new proposal, since in their plan the trade-off between lower corporate rates and higher rates on corporate shareholders and pass-through businesses is not budget neutral, but rather an extremely large tax hike.  Their plan may increase progressivity, but at the expense of significantly higher costs for businesses that invest in the U.S.

Expect to hear the Brookings argument made increasingly over the next year as the debate over tax reform builds.  It’s the only rationale we’ve seen to date that attempts to explain the virtue of cutting one corporate tax rate while raising another.  It’s not compelling, but so far it’s all they have.

Snowe to Retire

Senator Olympia Snowe (R-ME), one of the few occupants of the political center in the United States Senate and a fierce and steady advocate for S corporations and Main Street businesses throughout her career, announced this week that she will not seek re-election when her current term expires this year.

Senator Snowe’s departure comes as sad news here at S-CORP.  In addition to being a lead on our efforts to modernize the rules governing S corporations, she also stood up to defend pass-through businesses on numerous occasions in her 18 years in the Senate.

We are fortunate to have such a strong, thoughtful voice in our corner to highlight the needs of privately-held businesses and stand up to policies that would hamper our ability to compete, raise capital, and create jobs. A year ago she took this stand:

“It is becoming increasingly clear, and increasingly concerning, that the Administration is proposing to raise taxes on America’s small businesses, either by forcing them to reorganize as subchapter C corporations solely for tax reasons and be subjected to new and additional taxes, or, by allowing them to remain organized as flow-through entities – such as limited partnerships and subchapter S corporations – where they will face massive increases after 2012 when current tax rates expire. I urge my colleagues to join me in saying to those who would raise taxes on the millions of businesswomen and businessmen we are counting on to create the jobs we need to put the recession firmly behind us – no thank you.”

We’re looking forward to working with Senator Snowe in the coming year and we salute her many years of distinguished service.