Administration Offers Corporate Tax Reform

The Administration released its outline for “business” tax reform today.  Described by its authors as more than a set of principles but less than a fully-realized plan, the 22-page joint Treasury-White House release raises more questions for us than it answers.

Core to the plan is a reduction in the top corporate tax rate from 35 to 28 percent.  Pass-through businesses would not benefit from the rate reduction. Manufacturing businesses would see a further reduction down to 25 percent through the use  of a manufacturing deduction.  Advanced manufacturing would receive a yet more generous deduction.

To offset the cost of the lower corporate rate and the more generous manufacturing deductions, the Administration would repeal LIFO accounting, repeal accelerating depreciation, tax carried interest as ordinary income, reduce (unspecified how much) the deductibility of interest, impose a new minimum tax on foreign income, and make larger-through business pay C corporation taxes.  Several other small business tax expenditures would also be repealed.

The proposal includes some provisions to benefit smaller businesses, including expensing up to $1 million in investments, allowing cash accounting for firms under $10 million in gross receipts, and expanding the small business tax credit under health care reform.

Combined, the Administration indicates that the plan is designed to be revenue-neutral for the business sector.

Regarding our concerns, topping the list would be how pass-through businesses are treated.  It’s no secret that a majority of business activity in the United States, measured either by employment or income, takes place within business structures other than C corporations — S corporations, partnerships, and sole proprietorships.

Despite this reality, today’s proposal from the Administration pays little attention to pass-through businesses except to raise their taxes.  The base broadening would increase the taxable income of businesses that use LIFO, accelerated depreciation, and interest deductions, while the policy of forcing larger pass-through businesses to pay the corporate double tax would break from Congressional history and shift the tax burden onto large pass-through businesses and off even larger C corporations.

The report doesn’t specify a threshold, but last spring’s Ernst & Young study on pass-through businesses found that one-sixth of all private sector workers (nearly 20 million) work for large pass-through businesses with more than 100 employees.  Those are the same employers likely to be forced into the harmful double corporate tax under the Administration’s proposal—a model that has been criticized by economist after economist as inefficient and actually discouraging of job creation and capital investment.

Our second concern is the proposal’s schizophrenic treatment of corporate earnings.  Lowering the corporate rate is motivated by a desire to make our corporate tax system more competitive.  OECD rates are lower (including Japan’s as of April 1^st) and they generally offer at least some relief from the double tax on corporate profits.  Reducing the corporate rate from 35 percent to 28 percent is an effort to level the playing field.

But what about the second layer of tax?  If reducing the corporate tax rate will make our firms more competitive, why is the Administration proposing to raise the dividend rate, which would have the opposite effect?  The important number here is the total tax on new investment, which would combine the corporate tax with the investor tax.  Today, the two layers are 35 percent and 15 percent, so a dollar earned by a corporation would be reduced to 55 cents by the time an investor gets it.

Under the Administration’s proposal, the two layers would be the 28 percent corporate rate and the 39.6 percent dividend rate, plus 3.8 percent for the new health care surtax, plus 1.2 percent for the reinstatement of Pease.  Combined, those tax rates reduce a dollar of corporate income down to just 40 cents.  Add in the repeal of accelerated depreciation, LIFO accounting, the limitation on interest expenses, etc., and it’s likely the overall impact of the Administration’s proposal will be to raise the cost of new business investment compared to the cost today.

What’s particularly confusing about this outcome is that the report makes clear that Treasury understands this analysis.  Throughout the report, they refer to effective tax rates and the cost of capital.  Table A2 in the Appendix identifies the effective marginal tax rates on new business investment for the years 2013-2022 with both the corporate and the investor tax layers included.

So, under the banner of making our corporate sector more competitive, the Administration is proposing to raise the overall marginal effective tax on new business investment for corporations and pass-through businesses alike.  Some smaller firms may see their effective tax go down through the expanded expensing provisions, etc., but the burden on the entire business community will likely go up.

And what’s the point of “reform” if the end result is a higher tax burden and a less competitive tax system?  We expect this issue to be discussed extensively for the next year, with more details from the Administration on what they have in mind.  Our initial glance, however, suggests there’s lots to oppose here, and little to support.

President’s Budget and S Corps

The President’s budget came out today, and despite the fact that it and the many proposals it contains are unlikely to move through Congress, there are a number of items of specific concern to S corporations that are worth a look.  You can find the overall budget documents at the OMB website.  For S corporations, the items that jump out at us include:

1. Expiration of current rates for higher income taxpayers.
2. Imposition of a new “Buffett Tax” on taxpayers earning more than $1 million.
3. Principles for tax reform.

We’ll get to these items, but first, a note about baselines.  One possible area of confusion moving forward is the unique baseline used by this Administration to measure how its policies might raise or lower the deficit.  The Congressional Budget Office uses a current law baseline, so that any effort to extend all or part of the Bush tax cuts would be scored as raising the deficit, since the Federal government would be foregoing revenues it would otherwise collect under current law.

The Administration, however, uses what might be termed a “modified” current services baseline, so they score the expiration of the Bush tax relief for higher income tax payers as a tax increase, even though its already set in law.  Because the Administration uses a different baseline, their deficit reduction claims will not match up with the numbers used by Congress.  As an example, the Administration claimed that last year’s budget reduced the deficit by several trillion dollars, whereas the CBO determined that the President’s budget actually increased spending and the deficit over the ten year budget window.  Expect the same dynamic this year.

On the Bush tax relief, the Administration remains consistent in its effort to cap the lower tax rates and other tax benefits to those taxpayers making $250,000 or less ($200,000 for single taxpayers).  This means that owners of S corporations and other pass-through businesses who earn more than $250,000 will see tax rates rise on their business income.  How much?

Current Law Top Rate:           35%

Sunset of Current Rate:          4.6%

Expiration of Pease:                1.2%

New Investment Surtax:         3.8%

Total:                                       44.6%

Layered on top of this tax increase is the new proposal for a Buffett tax on taxpayers, including business owners, who make more than $1 million.  Here’s what the budget says:

Observe the Buffett Rule. No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay. As Warren Buffett has pointed out, his effective tax rate is lower than his secretary’s. And, the President is now specifically proposing that in observance of the Buffett rule, those making over $1 million should pay no less than 30 percent of their income in taxes. The Administration will work to ensure that this rule is implemented in a way that is equitable, including not disadvantaging individuals who make large charitable contributions. And he is proposing that the Buffett rule should replace the Alternative Minimum Tax, which now burdens middle-class Americans rather than stopping the richest Americans from paying too little as was originally intended.

Beyond this description, details on the Administration’s Buffett Rule are wholly lacking, including any sense of how the Buffett Rule would replace the AMT.  It may resemble the legislation introduced in the Senate recently, but we don’t know since neither an explanation of the Buffett Rule nor an idea of how it would replace the AMT are included in the explanatory Treasury “Green Book” released along with the budget.  For our purposes today, suffice it to say that the Buffett Rule tax will impose a new, higher layer of tax on taxpayers who make more $1 million a year, four out of five of whom own businesses.

On the tax reform front, the Administration reiterates the five principles it first outlined back in September:

1. “Simplify the Tax Code and Lower Tax Rates. The tax system should be simplified and work for all Americans with lower individual and corporate tax rates and fewer tax brackets.
2. Reform Inefficient and Unfair Tax Breaks— Eliminating Them for Millionaires While Making All Tax Breaks at Least as Good a Deal for the Middle Class as for Wealthy Americans. Reform should cut and simplify tax breaks that are now inefficient, unfair, or both, so that wealthiest Americans cannot avoid their responsibilities by gaming the system, that middle class working Americans receive their fair share, and that Americans can spend less time and money each year filing taxes. That means eliminating tax subsidies for millionaires that they do not need; there is no reason that those making over $1 million should get any tax subsidies for housing, health care, retirement, and child care. And it means ensuring fair incentives for the middle class to buy a home or save for retirement, as opposed to allowing the most well-off to get two to three times as much.
3. Decrease the Deficit While Protecting Progressivity. Reform should cut the deficit by $1.5 trillion over the next decade through tax reform, including the expiration of tax cuts for single taxpayers making over $200,000 and married couples making over $250,000. And it should do this while keeping the tax code at least as progressive as if the high-income 2001 and 2003 tax cuts were eliminated, as the President proposes.
4. Increase Job Creation and Growth in the United States. The tax code should make America stronger at home and more competitive globally by increasing the incentive to work and invest in the United States. This includes fundamental corporate tax reform. That is why, in addition to these principles, the President is proposing a roadmap for corporate tax reform that will make America more competitive and create jobs here at home.
5. Observe the Buffett Rule.

Several of these principles sound great, but the descriptions don’t seem to match up with the actual policies promoted by the President.  For example, nearly every tax policy expert in Washington agrees with the general idea that we should broaden the income tax base by eliminating many deductions and exemptions and couple that with lower rates.  Principle 1 enjoys broad support on both sides of the aisle.

But how does the Administration couple that principle with Number 3, which argues for raising tax rates on anybody making more than $250,000?  Or Number 2, which argues for making existing deductions and exemptions more valuable for a majority of taxpayers?  First they say let’s broaden the base and reduce rates, and then they say let’s raise rates and narrow the base.  All in the same set of tax “principles”.

Regarding the “roadmap for corporate tax reform” there doesn’t appear to be any description included in today’s budget release.  Word is, the roadmap will be coming out later this month, and that like the principles outlined above, it will move in a completely different direction than the prevailing tax reform discussion in town.  A couple weeks ago, a Bloomberg article hinted at the underlying rationale for this divergence:

John Buckley, a professor at the Georgetown University Law School in Washington and a former chief tax counsel for Democrats on the Ways and Means Committee, said the goal of a tax overhaul is shifting. While Republicans have focused on lowering rates and broadening the tax base, Democrats are tapping into the tension over income inequality and the loss of manufacturing jobs, he said.

“The tax reform debate from the Democratic perspective will focus on equity and the attempt to restore manufacturing jobs,” Buckley said. “The visions are quite different.”

That the President has a different vision is obvious.  Whether this vision can be called reform is less so.

Extensions for Main Street

Three cheers for Sen. Olympia Snowe (R-ME) and Sen. Mary Landrieu (D-LA) for fighting to move extensions of expired tax provisions benefiting Main Street businesses!  Senators Snowe and Landrieu introduced the Small Business Tax Extenders Act of 2012 (S. 2050) this week to extend through 2012 those tax provisions benefiting Main Street businesses that were allowed to expire last year – including, an S-CORP priority, built-in gains (BIG) relief.  Other provisions include extensions of the:

• Temporary 100 percent exclusion of gains on certain small business stock;
• 5-year carryback of general business credits of eligible small businesses;
• AMT rules for general business credits of eligible small businesses;
• Increased Section 179 expensing limitations and treatment of certain real property;
• Special rule for long-term contract accounting;
• Increased amount allowed as a deduction for start-up expenditures; and,
• Allowance of the deduction for health insurance in computing self-employment taxes.

We appreciate Senators Snowe and Landrieu for recognizing the importance of protecting Main Street businesses and in particular for supporting BIG relief.   Senator Snowe’s floor statement gives a great explanation of the importance of this relief measure:

Additionally, the Small Business Jobs Act of 2010 provided for a temporary reduction in the recognition period for S corporation built-in gains tax. When businesses convert from a C corporation to an S corporation, they have been required to hold their appreciated assets for a full decade or face a punitive level of double taxation. In such instances, first the built-in gain corporate tax rate of 35 percent is applied and then all other applicable federal, state and local shareholder tax rates are applied, often totaling near 60 percent in most states, including Maine. In effect, the built-in gain tax locks-up businesses’ own capital and forces them to look elsewhere–a particular challenge for S corporations since closely-held businesses have limited access to the public markets and therefore fewer options for raising needed capital.

Recent law changes temporarily shortened this holding period to 7 years, but that is still too long. By infusing capital–that is, releasing their own capital–this provision in the Small Business Jobs Act, reducing the holding period from 7 years to 5 years, enabled companies that have long been S corporations to redeploy this capital to invest in and grow their businesses. Extending this provision also underscores how vital access to capital is for small businesses, while preserving the original policy intent of the holding period and making it more reflective of the shorter business planning cycles of the 21st century.

We couldn’t agree more, and will continue to work with them and our other congressional allies to advocate for immediate relief.

So the question remains, when is Congress going to deal with the tax extenders that have expired?  Will it be during the payroll tax conference?  There doesn’t appear to be a clear path on that train quite yet – but the entire business community is with us trying.  Or will the issue be saved for broader tax reform?  Let’s hope not, as we don’t see real action on comprehensive tax reform coming prior to the end of 2012.  As Caroline Harris from the U.S. Chamber testified before the Senate Finance Committee hearing entitled “Extenders and Tax Reform: Seeking Long-Term Solutions” –

The Chamber believes that this Committee and Congress need to act immediately to prevent the negative impact on jobs and the fragile economy that is likely to result from inaction on these annual extenders…

…The Chamber applauds this Committee’s continuing work towards comprehensive fundamental tax reform.  However, we believe that the extension of these annual extender provisions cannot be delayed until work on comprehensive tax reform is complete. Taxpayers need stable and predictable rules they can rely upon while that important process is completed.

“Buffett Rule” Bill Introduced

Legislation to enact the so-called “Buffett Rule” has been introduced in the United States Senate.  The bill, entitled the “The Paying a Fair Share Act” was introduced by Senators Sheldon Whitehouse (D-RI), Tom Harkin (D-IA), Bernie Sanders (I-VT) and others.  According to the authors:

Whitehouse’s legislation would apply only to taxpayers with income over $1 million – including capital gains and dividends.  Taxpayers earning over $2 million would be subject to a 30% minimum federal tax rate.  The tax would be phased in for incomes between $1 million and $2 million, with those taxpayers paying a portion of the extra tax required to get them to a 30% effective tax rate.   The bill also includes language to preserve the incentive for charitable giving.

The Wall Street Journal has a few more details:

The legislation introduced Wednesday by Sen. Sheldon Whitehouse (D., R.I.) would ensure that anyone earning more than $2 million in income each year, including from capital gains, would pay a minimum 30% federal tax rate, Mr. Whitehouse said on the Senate floor Wednesday morning. Wealthy taxpayers who face a tax rate above 30% would still pay the higher rate.

The “fair share tax” would be gradually phased in for those earning between $1 million and $2 million in annual income. They would pay a portion of the extra tax needed to get them to the 30% rate, the lawmaker said.

“This way, we make sure that no taxpayer is ever in a situation where earning an additional dollar of income will increase his or her taxes by more than that dollar,” Mr. Whitehouse said in his remarks prepared for the Senate floor. The new tax would not affect anyone making less than $1 million.

We have several complaints with this effort.  First, as we’ve pointed out before, the Warren Buffett’s of the world don’t pay a lower effective tax than their secretaries.  Congressional Budget Office estimates make clear that the existing tax code is strongly progressive, with wealthy taxpayers paying significantly higher levels of tax – both in absolute terms and as a percentage of their overall income – than middle-class and low-income Americans.

Second, if enacted, this new legislation would impose a third tax code (and calculation) on individual taxpayers.  We already have two codes, the regular income tax and the Alternative Minimum Tax.  Now we would have three:

• Regular Income Tax
• Alternative Minimum Tax
• Fair Share Tax

Third, the author takes pains to point out that no taxpayer will face marginal rates of more than 100 percent on additional earnings, but exactly how high would the effective marginal rates reach as a taxpayer’s income rises above $1 million?  The dead weight economic loss imposed by a tax increases by the square of the rate hike, so the potential cost to the economy is significant.

Nor is it clear the Fair Share tax would successfully target the rich.  The AMT was created four decades ago to ensure that the same taxpayers targeted by the Fair Share tax pay at least a “minimum” amount of tax.  Over the years, however, the tax has morphed into a burden on middle- and upper-middle income taxpayers.  Actual millionaires are less likely to pay the AMT than a middle-class family with three children living in a high tax state.  What’s the guarantee that the Fair Share bill will not make the same progression into the middle class?

Finally, you’ll notice the bill contains an exemption for charitable donations.  Think of it as the “Buffett Loophole” to the “Buffett Rule” since one of the more glaring ironies of the whole debate is that Warren Buffett has aggressively planned his estate to avoid paying any tax on most of his accumulated wealth.  According to press accounts, he’s given most of his money away to foundations run by his children and Bill Gates.  This new “Buffett Tax” won’t touch those transfers.

So we now have legislation to fix a problem that doesn’t exist in order to impose a new tax on a billionaire who’s already figured out how to avoid paying it.  In the meantime, real taxpayers with real companies and real employees who aren’t in a position to hide all their wealth inside a foundation will be stuck paying the bill.  Not helpful.

S Corporations and Payroll Taxes, Again

The release of Newt Gingrich’s tax return has returned the issue of payroll taxes and S corporations to the public’s attention.  This issue first came to prominence during the 2004 election cycle, when Vice Presidential nominee John Edwards was accused of using an S corporation to avoid paying Medicare taxes on some of his income as a lawyer.

Now it appears Newt Gingrich may be using a similar structure.  USA Today has an excellent report on the issue.  Here are a couple excerpts:

Gingrich’s tax return shows his S Corporation, Gingrich Holdings, accounted for the bulk of his $3,142,066 adjusted gross income in 2010. The corporation paid him nearly $2.5 million in distributions beyond his salary and wages total of $252,500, his tax return and 2011 federal financial disclosure filing show.

Non-salary distributions from S Corporations are not subject to the 2.9% Medicare tax rate, half paid by the corporation and half by the employee.

But the IRS requires S corporations to pay “reasonable” salary compensation to employees for their services before paying non-wage distributions. That’s designed to prevent the corporations from avoiding Medicare taxes by issuing disproportionate payments in distributions, rather than wages.

An IRS publication about S Corporations states that if most of the gross receipts and profits are associated with an employee’s personal services, “then most of the profit distribution should be allocated as compensation.”

DeSantis said the candidate’s speaking engagements and television appearances produced the bulk of the payments received by Gingrich Holdings.

McKenzie said the IRS would typically ask how much investment an S corporation filer put into her or his business. Gingrich Holdings was renamed Gingrich Productions last year, corporate records in Georgia show and his spokesman confirmed. Gingrich’s federal financial disclosure report, filed in July, lists Gingrich Productions as an asset valued at between $500,001 and $1 million.

“The general rule of thumb they’ll usually apply is they don’t view anything greater than a 20% return on investment as reasonable. The rest should be paid as salary,” said McKenzie.

As USA Today points out, the IRS has two tools it can use to test whether a taxpayer is paying the appropriate level of tax — a “reasonable compensation” test and a “reasonable return” test on the businesses capital investments.

Several years ago, the House tried to replace these enforcement tools and re-write the rules surrounding how and when S corporation income is subject to payroll taxes.  The effort was badly flawed and with the help of Main Street allies, it died in the Senate.

Well, now it’s back.  House Ways and Means Member Peter Stark (D-CA) introduced legislation this week called the “Narrowing Exceptions for Withholding Taxes (NEWT) Act.”  The bill appears to be identical to the changes that passed the House back in 2010.  According to a summary, Congressman Stark’s concern is that the current reasonable compensation test is too dependent on the facts and circumstances of each individual case.  In our view, however, the fix he is proposing is worse.  Here’s how it’s described:

Certain employee-shareholders of S corporations would have to calculate their Medicare payroll tax obligation based on their share of the S corporation’s profits or dividends, not just income reported as wages. The individuals subject to the provision are the employee-shareholders of a professional service business where the principal assets of that business are the skills and reputations of three or fewer individuals.

How is a “principal asset” test easier to enforce than the existing “reasonable compensation” test?

1. It would require affected businesses to get a valuation of each of its significant assets in order to determine which asset was its “principal” asset.
2. This analysis would require the valuation of assets that are very difficult to value (i.e., skill and reputation).
3. The bill taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except that it has four key employees.
4. The bill requires difficult legal conclusions about uncertain areas.  For example, whose asset is an employee’s “skill and reputation”- the employee’s or the company for which the employee works?
5. The bill provides no definition of “asset”- it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single “asset” for purposes of determining the “principal” asset of a company.

The bottom line is that the IRS already has sufficient tools to combat the payroll tax problem and it has successfully litigated cases in which taxpayers have taken compensation that was less than reasonable.

They can apply a “reasonable compensation” test to the shareholder’s salary income, or they can apply a “reasonable return” standard to the company’s capital investment.   And while it’s true that these tools are dependent on the facts and circumstances of each particular business, so is the new standard outlined above.  Only more so.

Presidential Candidates and Their Tax Returns

So, we now have the tax returns for President Obama, Governor Romney, and Speaker Gingrich.  Did anybody notice that the S corporation owner is the one with the highest effective tax rate?

Seriously, of the three, Newt Gingrich paid the highest effective tax (32 percent), followed by President Obama at 26 percent and then by Governor Romney at 14 percent.    Given that the Wall Street Journal is reporting that S corporations pay no tax at all, that result might come as a surprise to their readers.

On the other hand, readers of the more authoritative S-Corp Washington Wire understand that of the four business structures — S corporations, partnerships, C corporations, and sole proprietorships — the Small Business Administration found that S corporations paid the highest effective tax rate for firms with less than $10 million in revenues.  S corporations paid 27 percent, while C corporations paid just 18 percent.

To be fair, this estimate doesn’t include the second layer of tax paid by C corporation shareholders.  Add in the shareholder tax on capital gains and dividends, and the effective rates for C and S corporations are probably about the same.  We’ve been pointing that out for two years now.

But wait.  Doesn’t this same “second layer of tax” apply to some of Mitt Romney’s income?  A cursory look at his return suggests that a good portion of it is investment income that has already been subject to the corporate layer of tax.  In that case, his real effective tax rate — including any taxes paid by corporations he owns — should be significantly higher.  The same can be said for Warren Buffett.

Which brings us to the President’s State of the Union speech.  In it, he called for a new “minimum tax” to ensure millionaires pay a minimum tax to the federal government.  Here’s what he said:

Tax reform should follow the Buffett Rule.  If you make more than $1 million a year, you should not pay less than 30 percent in taxes.  And my Republican friend Tom Coburn is right:  Washington should stop subsidizing millionaires.  In fact, if you’re earning a million dollars a year, you shouldn’t get special tax subsidies or deductions.  On the other hand, if you make under $250,000 a year, like 98 percent of American families, your taxes shouldn’t go up. You’re the ones struggling with rising costs and stagnant wages.  You’re the ones who need relief.

Now, you can call this class warfare all you want.  But asking a billionaire to pay at least as much as his secretary in taxes?  Most Americans would call that common sense.

The 30 percent threshold is new.  Before, the rhetoric around the Buffett Rule was simply that the millionaire should pay more than the secretary.  This new approach is described in the “Blueprint” document that accompanied the speech.  It says:

Make the tax code fairer and simpler for the middle class and make sure millionaires and billionaires follow the Buffett Rule by paying at least 30% in taxes.

Later, the Blueprint calls for corporate reform that, among other things, lowers corporate rates:

The President believes that we need comprehensive corporate tax reform that will close loopholes, lower rates, and eliminate incentives that make it more attractive to ship jobs overseas…

So, the President is advocating for raising rates on capital gains and dividends, but he’s also advocating for cutting corporate rates.  The former is part of his “fairness” agenda and the latter is part of a “jobs” agenda.

How does it balance out?  The total tax on corporate profits equals the corporate tax combined with the dividend and capital gains tax paid by shareholders like Mitt Romney.  Today, that tax is equal to 45 percent (35 percent corporate first and 15 percent dividends/cap gains second).  Assuming the President calls for a 25 percent corporate rate as part of his corporate tax reform, then the total tax on corporate profits in the future would be 25 percent first and 30 percent second, or 47.5 percent.  The tax on corporate profits would go up.

In other words, the President’s “fairness” agenda totally trumps the President’s “jobs” agenda.  Kind of shows you where his priorities are.

Wall Street Journal Misleads its Readers

Two weeks ago, the Wall Street Journal ran a front-page piece entitled, “More Firms Enjoy Tax-Free Status.”  While you could argue the story itself was less biased than the headline, its overall bent leaves the very strong impression that S corporations and other pass through businesses pay no taxes.   The subsequent interview of the author on WSJ Live is even worse:

Author:  The vast majority of US businesses essentially don’t have to pay any tax.  They are organized as what are called pass-throughs, meaning that there’s no tax paid by the enterprise; instead the tax is paid by the owners of the enterprise.

Interviewer:  These figures are just baffling.  How does one construct themselves such that they completely avoid the tax exposure?  I think anybody seeing these statistics would just want to shake their heads… and want to be that person.

Author:  Yeah, and several million business owners have had that same idea.

This, of course, is highly inaccurate.  S corporations and other pass through businesses pay lots of tax on their business income, they just do it at individual rather than corporate rates and they only pay tax once, not twice like C corporations sometimes do.

As leaders in the fight to eliminate the double tax on business income, we responded immediately to the story.  The WSJ chose not to post our response, so we’ll post it here instead:

To the Editor:

A significant obstacle for job creation and investment in the United States is the double tax imposed on corporate income.  Most of our major trading partners provide explicit relief from the double tax, as did the US from 1913 to 1953 through a dividend exclusion.

Just five years after repealing the dividend exclusion, the Congress created the S corporation in 1958, which eliminated the double tax through a different mechanism.  In fact, Congress has engaged in numerous other reforms over the past fifty years to reduce the harmful effects of the double tax, most recently in 2003 when it cut the rate on corporate dividends to 15 percent.

This narrative of a purposeful and beneficial migration away from the double tax might be lost on readers of “More Firms Enjoy Tax-Free Status” (WSJ January 10th).  Calling these businesses “tax free” is simply inaccurate.  They pay roughly 44 percent of all business taxes.  The only difference is they pay tax at individual shareholder rates rather than corporate rates.

Pass-through businesses contribute significantly to job creation as well.  When the Administration first floated the idea of double taxing pass-through businesses last spring, we asked Ernst & Young to estimate how many Americans they employ.  The result?  More than half of private sector workers work at a pass-through business, while one in four is employed by an S corporation.

Viewed both historically and internationally, the US practice of double taxing corporate profits is the outlier in this debate, resulting in lower levels of employment and investment here in the US.  If Congress wants to make American business more competitive, it should finish its fifty-year effort and eliminate the double tax on corporate income for all businesses.

WSJ Readers Respond

We weren’t the only ones to have a problem with the article.  Of the 150+ comments on the WSJ website, all but a handful were highly critical and angry.  We went through them and pulled the best ones.  The Winner:

There are two issues with the C corp status. One is the higher tax rates for companies generating nearly all their revenues in the US.  The other is the double taxation of the dividends when distributed to the owners. This creates an insanely high marginal tax rate on C corporation earnings. This is an obstacle to job creation.

If Income from earnings were taxed once at the same flatter tax rate, the business case of the pass through entities diminishes.

Rather than attack the large number of privately held businesses utilizing pass through tax status to build and grow their business, Congress again should focus on lowering the tax rates, simplifying the deductions and credits, etc.

Amen to that!

Runners Up:

“Terrible, terrible article. It is completely inaccurate to describe pass through entities as “tax free”. This article is more on par with the tabloid of choice of the 99% than even the NYT. If the WSJ is going to sink to shameless propaganda, it should at least be supply-side in nature.”

Did the WSJ hire a writer from OWS? 100% of earnings are paid at the individual income tax level… that’s not enough?

“This article is disturbing, because it creates the false impression that no taxes are paid at all. This is false, because the taxes are ultimately paid by the “pass-through” recipient like an individual, who likely will pay a higher tax rate than a corporation. S Corps, LLC’s and Limited Partnerships are all structured this way and there is no nefarious special interest benefiting from such a structure. These types of entities are a time-honored part of the tax code. The main benefit of such a structure that gives a participant a thin shield of liability.”

“They should simply abolish the corporate income tax altogether and tax all income to the individual shareholder, as they do for partnerships. That would dramatically simplify the tax code, and at the same time eliminate business taxes and place the tax where it belongs, and actually is visited, and that is on the individuals.”

“The payment of the tax by the business is imputed – to the owner(s) of the business. The business certainly generates a tax liability which is then met with quarterly tax payments and on Form 1120 when the owner(s) file(s) their annual returns. If you don’t believe the businesses pay taxes, raise marginal rates 5 or 10 points, enact millionaire surcharges, etc, and see what happens to hiring and sustained investment at those businesses. I guess these are the unicorns Harry Reid was seeking.”

“Let’s get it straight. It’s not Tax-free; the tax obligation is passed on to the holder who pays is under their rate. If the holder is a pension, foundation, trust, etc. there is still an obligation, even if it’s under UBTI. The WSJ only damages its credibility by misleading its readers and making it the headline.”

“Real reform would tax all legal entities uniformly after reducing entity level income by the total of all distributions to the entity’s constituents treating dividends, interest and any other distributions equally.”

“In an S corp, profits are taxed whether they are distributed or not, this only encourages distributions to the stockholder who is taxed and than generally will need to loan back to corporation for working capital and growth.”

“The headline on this article and the article itself is terribly misleading. There are taxes paid on these companies. The taxes are paid by the shareholders and not by the companies. It is totally misleading to call them tax-free. Shame on the editors of WSJ.”

And:

“So now S Corps are evil? Give me a break…”

With that one, we’ll conclude.

New Year, Similar Outlook

It’s a new year but the outlook for tax policy remains remarkably unchanged.  The list of possible to-do items Congress might take on this year is pretty much the same and includes:

• Extension of the Payroll Tax Holiday;
• Extension of the Tax Extenders package that expired at the end of last year;
• Extension of the 2001 and 2003 tax cuts that expire at the end of 2012; and
• Tax reform.

You might view this list chronologically.  If Congress were to take up each of these separately, the Payroll Tax Holiday is sure to be first, whereas any tax reform effort, while highly unlikely, is sure to be last.

The list also correlates with the degree of difficulty.  Most observers believe conferees will come together in February and extend the Payroll Tax Holiday (along with extended UI benefits and the so-called Doc Fix) through the end of the year.  They might also attach the Tax Extender Package (R&E tax credit, state and local sales tax deduction, etc.) to that legislation.

But, it’s less likely that Congress will come to an agreement on extending some or all of the 2001 and 2003 tax cuts before November 6th.  These items are at the center of the 2012 election debate, and any movement on them is almost certain to be reserved for a lame duck Congress, if at all.

Finally, while there is always talk about tax reform, the environment is simply too toxic for the broad-based concessions necessary to get a package through Congress.

So what do we expect?  We expect Congress to focus on finishing the Payroll Tax Holiday conference next month.  We also expect House Leadership to float the possibility of including the Tax Extenders package as well.  Their challenge for extenders is whether to offset their revenue loss, and with what?  The House would use spending cuts if it moves forward on this, while the Senate is sure to push for offsetting tax hikes.

Bridging the difference will be a challenge, but it’s not insurmountable, so your S-Corp team is focused on making certain that the five-year holding period for built-in gains is extended as part of any such extender package.   This shorter holding period expired at the end of the year along with all the other tax extenders, which means tens of thousands of Main Street businesses are now looking at a ten-year window before they can access their own capital and divest any assets with built-in gains.

S-Corp Comments on International Draft

As we’ve observed, Ways and Means Chairman Dave Camp’s release of his international tax reform draft late last year was a refreshing reminder that some members of Congress are prepared to do the hard work necessary to produce good tax policy.  Being thorough and taking into consideration the views of stakeholders takes discipline and time, so we appreciate the Chairman’s willingness to take this route with tax reform.

As part of that process, your S-Corp team met with the Ways and Means staff last week to relay our thoughts about the international draft.  We also passed on written comments that summarize our concerns.   Here’s the introduction:

The S Corporation Association commends the Committee on Ways and Means (the “Committee”) international tax reform discussion draft (the “Discussion Draft”) as part of the Committee’s broader effort on comprehensive tax reform that would lower top tax rates for both individuals and employers.  We particularly appreciate the Chairman’s willingness to be transparent in this process and the opportunity to weigh in on these matters.  The comments below should be viewed as a friendly effort to recommend areas where we believe the Discussion Draft could be improved.

Based on our initial review and analysis of the Discussion Draft, a number of provisions appear to unintentionally apply to Subchapter S corporations such that the income of these corporations would be subject to double taxation.  Therefore, we respectfully request that the Discussion Draft be appropriately modified to prevent such unintended instances of double taxation for Subchapter S corporations.  We would be pleased to work with the Committee to ensure the appropriate treatment of Subchapter S corporations.

You can read the full comments here.

A Word From Our Chairman

Dear S-Corp Member:

Happy New Year!  I am writing to thank you for your continued support of the S Corporation Association and the important work we do in defense of the S Corp community.  As the incoming Chairman of the Association, I have lots of plans for 2012 that I want to share with you.

First, 2011 was a tough year for the stock and labor markets, but it was a productive year for the Association. As Congress began laying the groundwork for tax reform, we funded research exploring the vital contribution of flow-through businesses to jobs and investment in the United States, we nearly doubled our membership and we created a new S-CORP PAC (Political Action Committee) to help us support those members of Congress who support us—our S Corp champions.

Speaking of champions, in April, Ways & Means Committee members Dave Reichert (R-WA) and Ron Kind (D-WI) introduced the S Corporation Modernization Act of 2011 (H.R.1478) to modernize the outdated rules that apply to S corporations.  The Reichert-Kind legislation makes it easier for S corporations to raise capital, invest in new buildings and equipment, and hire new workers.  Among other items, the bill would permanently reduce the built-in gains holding period to five years allowing S corporations to access their own locked-up capital, increase access to capital by allowing non-resident aliens to invest in S corporations through small business trusts, reduce the negative impact of the so-called sting tax, and encourage charitable giving by S corporations by simplifying related rules.

Perhaps our biggest achievement this year was our Ernst & Young study documenting the impact of flow-through businesses on private sector jobs and economic activity in the U.S.  The study proved to be an important tool for our allies on Capitol Hill, arming them with the information and statistics they need to defend Main Street businesses, particularly in the context of tax reform.  And while the study released last year was a good start, more is needed to defend S corporation employers as policymakers contemplate restructuring the tax code–more studies, more education, more ally recruitment in the business community and on the Hill.

With that in mind, for 2012 we have asked Ernst & Young to conduct another study for us, this time focusing on the pending rate hikes scheduled for 2013.  Unless Congress acts, tax rates on S corporations and other pass-through businesses are set to rise from 35 percent to 45 percent and beyond.  It is important for policymakers to understand the employment and investment implications of this unprecedented tax hike on employers.  We expect this study will arm our allies with the facts they need to win this fight.

Other priorities for 2012 include improving the rules that govern how S corporations operate.  Therefore, we will be fighting for built-in gains reform, non-resident alien relief, and other reforms included in our S Corp Modernization bill.  The bill has been introduced in the House and we expect a companion bill in the Senate soon.  If Congress moves tax legislation this year, we expect our provisions to be under active consideration.

For the PAC, we expect to build on last year’s success by broadening both contributions to the PAC and donations to our allies in Congress.  Fundraisers are already scheduled for early 2012 for our S Corp champions, and more will be on the way.

Those are the S Corporation Association goals for 2012, but to accomplish them, we’re going to rely more than ever on our members and their active participation.  What can you do to help?

• Renew your membership for 2012.  S-CORP is not flashy, and we don’t have lots of bells and whistles.  What we do have is great advocacy, and advocacy starts with our members.  Renew today!
• Spread the word.  Our best ambassadors and recruiters are our members.  Let other private businesses in your community know about S-CORP and the important work that we do.
• Contribute to the S-CORP Political Action Committee (PAC) to ensure our S corp champions can help us keep fighting and winning in Congress.  It is important that we get widespread support from our membership at any level and it is imperative that we support those members that support S corporations.

I am deeply appreciative of your support and look forward to working with you in 2012 to defend the greatest tool ever invented for private enterprise — the S corporation.

Sincerely,

Tony Simmons

Chairman, The S Corporation Association

Executive Vice President, McIlhenny Company

Nobody Here But Us Unicorns

Last week, National Public Radio ran a story suggesting that while business groups are focused on the pending rate hikes and the impact they will have on jobs and investment, actual business owners are less concerned.  According to NPR:

We wanted to talk to business owners who would be affected. So, NPR requested help from numerous Republican congressional offices, including House and Senate leadership. They were unable to produce a single millionaire job creator for us to interview.

So we went to the business groups that have been lobbying against the surtax. Again, three days after putting in a request, none of them was able to find someone for us to talk to.

The White House jumped on the story, joking that opposition their “Millionaire Surtax” was “bogus.”  As White House Spokesman Jay Carney told reporters:

And it’s what you all write in your stories when you say, the President and Democrats support this surtax, or this way of paying for job-creating measures or tax cuts; Republicans say no because it will hurt small business.  Well, one news organization decided to ask the leadership offices of the Republicans on the Hill whether or not — or just to give them an example of the small businesses that would be affected.  And for three days they got nothing.  And there’s a reason for that.  Because, as the Treasury Department has done in its study, the simple fact of the matter is, is that less than 1 percent of all small businesses would be affected by this kind of request that millionaires and billionaires pay a little bit more.  That’s just a fact.

So next time you write a story, or produce a spot that cites that opposition, I think a second sentence might be worth adding, which is that it’s bogus.

This week, Senate Majority Leader Harry Reid joined the chorus, stating on the Senate floor:

Republicans have opposed our plan to pay for this legislation with a tiny surtax on a tiny fraction of America’s highest earners.  The tax would only apply to the second million the wealthiest Americans earn.

But Republicans say the richest of the rich in this country – even those who make millions every year – shouldn’t contribute more to get our economy back on track.  They call our plan a tax on so-called “job creators.” Yet every shred of evidence contradicts this red herring.

National Public Radio went looking for one of these fictitious millionaire “job creators.”  A reporter reached out to business groups, the anti-tax lobby and Republicans in Congress hoping to interview one of these millionaires. Days ticked by with no luck.

Millionaire job creators are like unicorns – impossible to find.

That’s because only a tiny fraction of people making more than $1 million – about one percent – are actually small business owners. And only a tiny fraction of that tiny fraction is traditional job creators.  Most of those business owners are hedge fund managers or wealthy lawyers.

They don’t do much hiring. And they don’t need more tax breaks.

A couple points of clarification.  First, the Treasury report cited by the Majority Leader doesn’t say that only 1 percent of people who make more than $1 million are small business owners – it says that only 1 percent of all small business owners make more than $1 million. The report actually says that 84 percent of people who make more than $1 million had some income from a flow-through business income.  That’s 84 percent, not 1 percent.

As we have pointed out before, the number of firms is irrelevant. What matters is the volume of activity. The report showed that people making more than $1 million earned 39 percent of all flow-through income. Similarly, the Joint Committee on Taxation estimates that 34 percent of all active flow-through business income would be hit by the tax.

Second, the surtax proposed in the Senate in recent months is only one of three marginal rate hikes set to begin January 1, 2013.  The other two are the expiration of the lower 2003 tax rates (including the restoration of the Pease deduction phase-out, which is effectively a 1.2 percent surtax) and the imposition of the new 3.8 percent tax on investment income.   Shareholders of profitable S corporations today pay a 35 percent tax on their business income.  If the surtax before the Senate is adopted, that top rate will rise to 50 percent beginning in 2013.

These proposed tax hikes will hit shareholders with as little as $200,000 in income.  The rhetoric is all about millionaires and billionaires, but the policy being pushed will affect business owners with just a fraction that much income.

2013 Rates Married Single

36%                             $250,000         $200,000

39.6%              $390,050         $390,050

3.8% Surtax                $250,000         $200,000

5.1% Surtax                $1 Million        $1 Million

Does it make a difference?  Ask the Administration and those members of Congress eager to cut the corporate rate.  Why cut the corporate rate?  Because the current 35 percent rate is out of synch with the rest of the world and it makes our large businesses less competitive.  So what’s different about flow-through businesses?  They employ more Americans and contribute more to economic output than those firms that pay the corporate rate.  Marginal rates affect their competitiveness too.

Or ask Christina Romer, the former Chair of President Obama’s Council of Economic Advisors who’s done an enormous amount of work in this area.  The paper she co-wrote with her husband back in 2007 found that tax cuts and hikes not targeted at fiscal stimulus, as the surtax and other pending 2013 tax hikes certainly are not, have a large impact on economic output.  As summarized by David Henderson of the Hoover Institute in Forbes:

The Romers carefully sift through all federal tax cuts and tax increases from 1947 to 2005 to figure out, based on the discussion at the time, whether the changes in tax policy were motivated by a desire to offset the business cycle or by other goals. When they strip out the tax changes meant to offset the business cycle, they find that the other tax changes were highly effective. A tax decrease of 1% of GDP raised GDP by about 3%, and, symmetrically, a tax increase of 1% of GDP reduced GDP by about 3%.

So how big is the proposed tax cliff awaiting flow-through businesses in 2013?  The Reid 5.1 percent surtax is estimated to raise $24 billion in 2013, while the Obama 3.8 percent surtax would raise $20 billion that year.  Meanwhile the expiration of the top two rates is another $35 billion.  Add them all up, and the total hit is $79 billion, or about 0.5 percent of projected GDP for 2013.  These estimates come from different reports, so there may be interaction not represented in the total, but the scale of what is being proposed is significant and disturbing.

Another point of clarification.  The businesses affected by these tax hikes are not limited to “hedge fund managers or wealthy lawyers”.  Eighty-one percent of all manufacturers in this country are organized as flow-through businesses.   Meanwhile, one of the key findings of the Ernst & Young study we requested last spring was that larger flow-through businesses — those with 100 or more employees — accounted for one in six private sector jobs.  That’s a lot of people working for so-called “unicorns”.

We’re not sure what steps NPR took to find business owners affected by the surtax, but it’s not surprising that taxpayers with large businesses to run are wary of spending time showing their personal tax returns to NPR. But the evidence from Treasury and the Joint Committee on Taxation is clear: the cumulative rate hikes under consideration to begin in 2013 are large and they will impact a significant percentage of overall business income.  That’s what S-CORP is worried about.

Yet Another “Millionaire Surtax” Introduced in the Senate

Yesterday, Senators Collins (R-ME) and McCaskill (D-MO) introduced legislation to extend the payroll tax holiday, among other things, and to pay for it with a mixture of tax hikes.  Primary among the tax hikes is yet another modified version of the millionaire’s surtax.  By our count, this is the fifth surtax considered in the Senate in the last three months.

In this case, the surtax is two percent and would apply to incomes exceeding $1 million, excluding small business income where the taxpayer works at the business.  The goal of this exception is to avoid the charge that the surtax would fall heavily on small business and its owners.  As Senator Collins stated in the introduction of the bill:

“A substantial number of Republican senators have said that they oppose the surtax because of the impact on small business. So our bill eliminates that argument.”

Well, not really.  Throughout the “rate debate” – spanning the expiration of the top two marginal tax rates at the end of last year, the imposition of a new, 3.8 percent investment surtax as part of health care reform, and now this new millionaire surtax – we have been struck by how the two sides in the debate talk past one another: one side focuses on who is being taxed, while the other focuses on what is being taxed.

Advocates for higher rates consistently point out that the taxes would be shouldered only by the wealthy – the one, two, or three percent of taxpayers who can afford to pay more.  Opponents, on the other hand, including S-CORP, point out that what is being taxed is a substantial portion of business income, i.e. business activity.

For the debate over the top two rates, somewhere between one-fourth and one-third of all business income would face higher rates, which means less business investment and less job creation.  The target is the wealthy, but the burden would be shouldered by the broader economy.   In the case of the millionaire surtax, four out of five of the affected taxpayers are, by Treasury’s latest data, business owners with significant business income.

The Collins-McCaskill carve-out attempts to exempt those business owners, but because they are focused on the who rather than the what, they missed.  The who they are trying to protect are active shareholders at active businesses – i.e. “real” business owners.  But their approach is flawed.

Consider the case of two shareholders who each own fifty-percent of an S corporation, and one shareholder runs the business while the other works elsewhere.  Under the Collins-McCaskill plan, both taxpayers would pay the surtax on their wage income, but only the passive shareholder pays the surtax on his S corporation income.

Why?  There’s no economic difference between the profit and loss attributed to one shareholder over the other.  The active shareholder gets paid a salary by the business, after all, and under reasonable compensation rules must pay himself a market salary for his work.  Any business earnings over that amount are a return on his capital investment, not a return on his labor; in other words, the same type of return as earned by the passive shareholder.  But under the Collins-McCaskill carve-out, only the passive shareholder’s business income is subject to the surtax.

The Collins-McCaskill carve-out raises other issues as well.  It doesn’t appear to exempt profits from the sale of a business, so decidedly middle-class business owners could get hit when they sell their business and their annual income spikes.  The surtax would last nine years, while the payroll tax relief lasts only one year.  At the end of 2012, will these same sponsors be back with yet another surtax to pay for another extension?

Finally, and perhaps most importantly, these rate hikes will drain capital from Main Street businesses.  S corporation shareholders must pay taxes on any income earned by the business — whether the income is distributed to the shareholders or not.  This is an important feature of S corporation taxation that many observers fail to grasp completely.  Moreover, since S corporations are allowed only one “class” of stock, all earnings must be distributed evenly.

In the 50/50 ownership example above, if the S corporation made $200 dollars in a quarter, each shareholder would be required to pay taxes on the $100 in earnings attributed to them – regardless of whether the shareholders actually received any distribution.  Most S corporations make sure to distribute at least enough earnings each quarter to cover the shareholder’s taxes.  In this case, both shareholders are in the 35 percent bracket, so the business would distribute $35 to each to cover their taxes, and retain the remaining $130 as working capital for the business.

Under the Collins-McCaskill approach, the passive shareholder’s tax level would rise to 37 percent, so the business would need to distribute $37 to both shareholders.  (Even though the active shareholder is exempt, distributions must reflect ownership share, not tax burden.)  As a result, the business’ working capital is reduced to $126.

This may seem like a small amount, but consider that this surtax is just one of an avalanche of rate hikes facing pass-through businesses.  First, it’s this surtax, then the scheduled expiration of the current marginal rates, and then the imposition of the 3.8 percent investment surtax enacted as part of health care reform -all beginning January 1 of 2013.  The net result will be to raise the top marginal rate on S corporation shareholders from 35 percent to around 47 percent.  With those rates, our business’ working capital would be reduced from $130 to $106, a reduction of 18 percent!

The authors of the proposal appear to understand that raising tax rates on business income is bad policy, but in their attempt to define “who” was going to pay the tax, they ended up with a solution that addresses neither side’s concerns.  If the focus is on who gets taxed, then advocates of the surtax need to be comfortable raising taxes on a significant amount of business activity.  That’s who the wealthy are.

If instead, they choose to focus on what gets taxed, as in not raising taxes on investment and job creation, that approach would lead them towards comprehensive tax reform and the need to fix our entire tax code.  That’s where the Chairman of the Ways and Means Committee would like to go, and we support his efforts.

In the meantime, we are going to be subject to serial tax hike proposals, one after another, each with slightly different details, but all embracing the same theme:  Let’s raise taxes on these taxpayers because of who they are, and ignore completely what they do.