The release of Finance Committee tax reform discussion drafts on cost recovery and international tax have laid bare a reality that’s been hiding just below the surface for two years now – the visions for reform embraced by the key House and Senate tax writing committees are dramatically different and move in opposite directions.
The international drafts are a good example. The Ways and Means draft would move the tax treatment of overseas income towards a territorial system, while the Baucus draft would move towards a more pure worldwide system by largely eliminating deferral. Here’s how the Tax Foundation described it:
Of the 34 most advanced countries, 28 use a territorial tax system, while only 6, including the U.S., use a worldwide tax system with deferral. No developed country imposes a worldwide tax system without deferral, though some have tried it with near disastrous effects.
Exactly how the two committees could bridge these broad differences in vision is unclear.
For pass-through businesses, the differences are just as stark. Neither committee has released details on overall rates or the treatment of pass-through businesses, but both have made clear the general direction they plan to take.
The Ways and Means Committee seeks comprehensive reform where the top rates for individuals, pass- through businesses, and corporations would be lowered and the differences between them reduced, helping to restore the rate parity that existed from 2003 to 2012. Other provisions in Chairman Camp’s draft would seek to close the differing treatment of partnerships and S corporations, creating a stronger, more coherent set of pass-through rules.
Finance Chairman Max Baucus, on the other hand, appears to actively oppose rate reductions for individuals and pass-through businesses even as he constructs his reform package around a core of cutting rates for C corporations. The inherent inconsistency of lowering corporate rates to make US businesses “more competitive” while simultaneously defending significantly higher rates on pass-through businesses is stark. The Baucus draft does make a vague reference to “considering” the impact on pass-through businesses, but it is clear that consideration amounts to nothing more than increased small business expensing or something similarly limited.
So the Finance Committee would cut corporate rates and ask S corporations and other pass through businesses to help pay for them. In the end, C corporations would pay a top rate of 28 or 25 percent, while pass-through businesses would pay rates 13 to 20 percentage points higher.
How do they justify this disparate treatment? The double tax on corporate income is often raised as leveling factor. As the Washington Post recently reported, “Today, the Treasury estimates, as much as 70 percent of net business income escapes the corporate tax.”
But “escaping” the corporate tax is not the same as escaping taxation. The simple fact is that pass through businesses pay lots of taxes, and they pay those taxes when the income is earned. The study we released earlier this year found that S corporations pay the highest effective tax rate (32 percent) followed by partnerships (29 percent) and then C corporations (27 percent on domestic earnings).
These findings include taxes on corporate dividends, so some of the double tax is included. They do not include capital gains taxes due to data limitations. Including capital gains would certainly close the gap between C and S corporations, but enough to make up 5 percentage points of effective tax? Not likely. Meanwhile, the study focused on US taxes only, so it doesn’t attempt to capture the effects of base erosion or the ability of C corporations to defer taxes on foreign income for long periods of time.
All in all, the argument against pass through businesses is based on some vague notion that these businesses are not paying their fair share. The reality is just the opposite. By our accounting, they pay the most. That means that, all other things being equal, today’s tax burden on S corporations makes them less competitive than their C corporation rival down the street.
Real tax reform would seek to make all business types more competitive by lowering marginal rates while also helping to level out the effective tax rates paid by differing industries and business structures. That’s the basis behind the three core principles for tax reform embraced by 73 business trade associations earlier this year – reform should be comprehensive, lower marginal rates and restore rate parity, and continue to reduce the double tax on corporate income.
These principles are fully embraced by Chairman Camp and the Ways and Means Committee. They appear to have been rejected by the Finance Committee. Which begs the question: What exactly is the goal of the Finance Committee in this process? Is it just to raise tax revenues? You don’t need “reform” to do that.
Whatever their goal, the gap between the House and the Senate is enormous, and unlikely to be closed anytime soon. Chairman Camp continues to press for reforms that would improve our tax code, but he’s going to be hard pressed to find common ground with what’s being outlined in the Senate.
With the timeline for tax reform being pushed back, there is a bit more discussion of what to do about tax extenders. The whole package of more than 60 provisions expires at the end of the year and to date there’s been little discussion regarding how or when to extend them. As the Tax Policy Center noted this week:
It isn’t unusual for these mostly-business tax breaks to temporarily disappear, only to come back from the dead a few months after their technical expiration. But this time businesses are more nervous than usual. Their problem: Congress may have few opportunities to continue these so-called extenders in 2014. This doesn’t mean the expiring provisions won’t be brought back to life. In the end, nearly all will. But right now, it is hard to see a clear path for that happening.
While the future is murky as always, a few points of clarity do exist:
- Nothing will happen before the end of the year. The House will recess this weekend and not return for legislative business until mid-January. Even if it took up extenders promptly after returning, which is highly unlikely, the soonest an extender package can get done would be February or March.
- Coming up with $50 billion in offsets to replace the lost revenue will also be a challenge. Congress is tackling a permanent “Doc Fix” right now, which requires nearly three times that level of offsets. Coming up with an additional $50 billion will not be easy.
- The lack of an AMT patch also is hurting urgency for the package. Congress permanently addressed the Alternative Minimum Tax earlier this year, which is good news, but that action also removed one of the most compelling catalysts for moving the annual extender package. Annually adopting the AMT patch protected 20 million households from higher taxes. That incentive is now gone.
All those points suggest that the business community has a long wait before it can expect to see an extender package move through Congress.
Or does it? One of the most popular extenders is the higher expensing limits under Section 179. This small business provision allows firms to write-off up to $500,000 in capital investments in 2013, as long as their overall amount of qualified investments is $2 million or less.
Beginning in 2014, these limits will drop to $25,000 and $200,000 respectively.
You read that correctly. Starting January, business who invest between $25,000 and $2 million in new equipment will no longer be able to write-off some or all of that cost in year one. Talk about an anti-stimulus. Coupled with the loss of bonus depreciation, the R&E tax credit, and the 5-year holding period for built in gains, and the expiration of extenders will have a measurable effect on the cost of capital investment for smaller and larger businesses alike.
This reality is beginning to sink in both on Main Street and the investment community, where certain industries rely on these provisions as a core part of their business plans in coming years. It’s too soon to see how much momentum the loss of these provisions will generate in coming months, but cutting the expensing limit from $500,000 to $25,000 in one year is bound to attract somebody’s attention.
The agreement earlier this month between Senators Reid and McConnell reopened the government for a few months, but it failed to resolve any of the issues that precipitated the shutdown in the first place. There’s still no consensus on spending levels or tax policy beyond the end of the year. Key dates in the agreement are:
- December 13th — Target for budget conferees to agree to a uniform budget
- January 15th — Current government funding resolution (CR) expires
- February 7th — Debt limit reached again
At this point, agreeing to a budget resolution would be a big deal. Not only could it establish spending levels for next year, it also could put into place expedited procedures for tax and entitlement reforms stretching over the next decade and beyond. For observers cheering for something big, including comprehensive tax reform, a successful budget conference is an essential first step.
The odds of a positive outcome, however, are slim. The huge gap between Republicans and Democrats remains while the December 13th target date lacks any enforcement mechanisms — if the conferees fail to agree by that date, nothing happens.
Meanwhile, Senate Majority Leader Harry Reid and House Minority Leader Nancy Pelosi oppose any reduction in the sequester cuts that doesn’t include higher taxes — Reid went so far as to say people “want” to pay more taxes — while Senate Budget Committee Ranking member Jeff Sessions has made clear he opposes swapping the sequester for similar sized entitlement cuts.
So those folks hoping for a narrower deal will just have to wait, too.
On the tax front, Chairman Dave Camp continues to push his leadership, committee and conference to support a comprehensive, budget neutral package by the end of the year. We’re on record strongly supporting this effort, and it appears he’s making progress. Meanwhile, Finance Chair Max Baucus plans to begin releasing “discussion” drafts outlining various parts of his plan as early as next week, with the first release likely focused on international reforms. That’s good news and certainly a step forward.
But the big barrier holding tax reform back has less to do with drafts and House Republicans, and more to do with basic objectives. Senate Majority Leader Harry Reid and the President continue to insist on a package that raises taxes, which obviously is a non-starter with the House. Until they work out the top line number, getting an agreement on what the underlying policies will look like is next to impossible.
Meanwhile, there’s a long list of tax provisions set to expire at the end of the year, including the higher limits ($500,000) on Section 179 expensing, the R&E tax credit and the 5-year holding period for built-in gains. Until the budget and tax reform questions are resolved, there’s little appetite on the Hill for discussing the prospects for these provisions, so everything is on hold. As the Hill wrote this week:
Renewal of a package of tax breaks for businesses and individuals worth tens of billions of dollars has become something of a holiday tradition in Washington. Each November and December tax writers battle over which benefits are really worth keeping while business lobbyists launch fevered campaigns to keep their tax bills low.
In the end, most of the package is often renewed, attached to some other must-pass piece of tax legislation.
But this year, lawmakers will likely not even go through the motions.
Members of the Senate Finance and House Ways and Means Committees expect to spend all of their remaining time this year working on drafting comprehensive tax reform legislation. The extenders package would be a distraction from that work, they say.
So the December target date for producing a budget resolution appears to be less of a deadline and more like a warning track, letting policymakers know that the end of the year is fast approaching and that there’s limited time to move forward on tax reform or, failing that, extenders.
It doesn’t have to be that way, of course. Outside forces could emerge in the next two months to bring the two sides together. For example, we always thought there was an inverse relationship between the success of the Affordable Care Act and the prospects for tax reform. The worse the roll out, the more motivated the Obama Administration would be to change the subject and work with Congress on comprehensive reform.
It’s hard to imagine a worse roll out than what we’ve seen over the past month, and yet the prospects for common ground between the House, Senate, and Administration don’t appear to be increasing. Based on his comments in Boston this week, the President certainly doesn’t seem to want to change the subject. Maybe it will take a little time. Or maybe nothing will happen. Right now the latter appears to be the most likely outcome. Given how much work Chairman Camp has put into the tax reform effort and how much a well-thought out plan is needed, that would be a shame.
Marty Sullivan always writes interesting and provocative pieces on tax policy, so when we saw his recent piece in Forbes on tax reform (“Should Small Business Have Veto Power Over Corporate Tax Reform?”), we read it eagerly.
It’s provocative, alright, but we do have a couple observations.
Marty argues that pass through business advocates “willfully omit” the existence of the corporate double tax “from their spin and howl” regarding tax reform. Really?
We don’t howl, and we don’t ignore the existence of the double corporate tax. It’s a central part of our message on how to build a foundation for good tax reform. Our “Pass-Through Tax Reform” letter signed by more than 70 business organizations calls for reform that embraces three basic principles:
- Reform should be comprehensive;
- Reform should restore rate parity; and
- Reform should reduce the double tax on corporate income.
It’s hard to “omit” the double tax when its reduction is one of your key principles.
There are lots of other examples, but the testimony one of our advisors presented before the House Ways & Means Committee back in 2012 stands out:
First, 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. Moreover, it has the benefits of simplicity and transparency.
Marty should remember that testimony. He was sitting right next to him.
Marty argues that our effective rate study says that “corporations are getting away with murder…” Again, not true. The study’s focus is on the effective tax burden paid by pass through businesses. To our knowledge, this analysis has never been done before and it shows that S corporations and partnerships will pay very high effective tax rates in 2013:
- S Corps: 32 percent
- Partnerships: 29 percent
Large S corporations making more than $200,000 will pay even higher rates – 35 percent!
The study does calculate C corporation effective rates for comparison purposes, but makes clear there are many ways to calculate the C corporate rate and that foreign income and taxes are a complication that needs to be acknowledged. An alternative measure included in the study, looking only at domestic C corporation income, has the C corporation effective rate at 27 percent.
The study doesn’t omit the double tax either. The C corporation calculation includes dividends payments (but not capital gains taxes due to data limitations). The study finds that the dividend tax does not increase effective tax rates significantly:
Our results suggest that C corporation dividends raises their average effective tax rate by only 2 percentage points. The primary reason for this result is that C corporations do not pay significant amounts of dividends. IRS SOI data indicate that approximately 4.5 percent of C corporations paid cash dividends in 2009.
Finally, we have to say something about the title of the piece. We know writers don’t get to pick their headlines, so we’ll lay this bit of logical inconsistency at the feet of the Forbes editors.
The pass through business community is not asking to veto anything. They are asking not to have their tax burden raised substantially on top of the tax hike they just shouldered starting 2013. Budget neutral, corporate-only reform – as outlined by the Obama Administration, among others – would do just that. It would cut taxes for large corporations and raise them for pass through businesses.
If the point of reform is to encourage domestic job creation and investment, only reform that includes pass through businesses will get you there. Ernst & Young reported that pass through businesses employ more people and contribute more to national income than their C corporation friends, so raising their taxes in order to cut taxes for C corporations is not going to help encourage hiring or investments.
Moreover, creating a tax code where similar business income is subjected to two very different rates – 28 percent for C corporations but nearly 45 percent for individuals and pass through businesses under the Obama plan – would encourage the gaming and income shifting prevalent in the tax shelter days before 1986. Again from Tom’s 2012 testimony:
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.4 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. Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.
Under corporate-only tax reform, we would be right back in the pre-1986 world Tom is describing. It is anti-tax reform, in every sense.
More on Business Tax Reform
The pass through community has a new ally. In an op-ed posted on CFO.com, Douglas Stransky, a partner at the law firm Sullivan & Worcester, pushed back on President Obama’s corporate-only tax reform proposal introduced earlier this year:
If you want to stimulate the economy through tax reform, however, you should also pay attention to the tax burden on the companies creating the most jobs. According to the U.S. Small Business Administration, firms with less than 500 employees accounted for 67 percent of the new jobs since the recession ended. Those are companies led by entrepreneurs, who are building businesses around new products or services and expanding their payrolls.
Yet the discussion about corporate tax reform has only focused on large, multinational corporations, and not small businesses…The S Corp, partnership and sole proprietorship tax rate has not been the focus of corporate tax reform in Washington. But it should be. If the C Corp rate of 35 percent is reduced to 28 percent it will leave an inequity in the tax structure between large and small businesses. This is senseless, especially when it’s assumed that lower income tax rates would enable employers to have more money to reinvest in their companies and create more jobs.
…The average American thinks corporate tax reform will apply to any U.S. business. But what is being discussed will apply only to a small percentage. Small businesses are the engine of our economy. If we reform taxes for S Corps as well as C Corps, that engine will run more efficiently.
Put on your “must read” list a new paper from our friends at the Tax Foundation highlighting the importance of pass-through businesses to jobs and employment. It’s the best written and most comprehensive summary of the issue we’ve seen to date. Here’s how it starts:
Support for lowering the corporate tax rate—now the highest in the OECD—has been expressed by both Democrats and Republicans in order to improve the competitiveness of American businesses. However, they differ in their plans for the individual tax code. While Republicans have proposed lowering the top individual rate from 39.6 percent to 25 percent, in parity with the proposed corporate tax rate, Democrats are less willing to consider lowering the individual tax rate.
The implications of these policy differences are considerable because of the tremendous growth in non-corporate business forms over the past thirty years. Today, there are vastly more non-corporate businesses than traditional corporations and they now earn more net income than traditional corporations. These businesses face top marginal tax rates higher than 50 percent in some states. Thus, ignoring the top individual tax rate—even while lowering the corporate rate—means the United States will continue to expose a broad swath of business to high tax burdens.
And how it ends:
As lawmakers consider policies to improve the competitiveness of American businesses, they should not forget that individual income tax rates are just as important to business activity as the corporate rate. The various proposals to raise income taxes on high-income earners, either by increasing the top marginal rate, closing “loopholes,” limiting deductions, or implementing a minimum tax, would fall very heavily on America’s non-corporate businesses. Pass-through businesses are currently facing top marginal rates on average between 44.5 percent and 47.5 percent and as high as 51.8 percent in California. These pass-through businesses account for a large percentage of business income and employment in the United States. Raising taxes on them could curtail their hiring and other investment plans, putting more strain on an already struggling economy.
The paper adds something new to the defense of the pass-through structure. Past arguments in support of a strong pass-through sector include:
- Best Tax Policy – S corporations are the way business income should be taxed. It’s taxed once, when the business earns the money, and then that’s it.
- High Effective Tax Rates – As our recent Quantria study demonstrates, pass-through businesses already pay a high level of tax, and they pay it when the income is earned.
- More Progressive – By taxing business income using the progressive individual tax rates, policymakers ensure that business income is taxed in a progressive manner, with high income shareholders paying a higher rate, and lower income shareholders paying a lower one.
- Diversification – Pass-through businesses spread investment and employment decision making across the country and into local cities and communities. As the recent financial crisis makes clear, diversification of these actions is critically important.
Thanks to the Tax Foundation, we can now add to that list “Economic Stability.” As the Tax Foundation notes:
It is also interesting to note the relative stability of pass-through business income to the volatility of C corp income. The period between 1999 and 2010, shown on Figure 2, is a good example of how volatile corporate income can be. After the tech bubble burst in 2000, C corp income plunged 24 percent over the next two years, after adjusting for inflation, and then rebounded 119 percent by 2005. After this temporary peak, C corp income fell again by nearly 33 percent over the next five years.
By contrast, pass-through income has not experienced such wild gyrations. After the tech bubble burst in 2000, pass-through business income actually increased in 2001. In 2002, net income fell by just 2 percent but then rebounded by 5 percent in 2003. In the four years after the 2003 tax cuts, the net income of pass-through businesses grew by nearly 60 percent, after adjusting for inflation. In 2010, pass-through business income exceeded C corp receipts by 40 percent.
Is there anybody remaining in Washington who still doesn’t understand the importance of pass-through business to our economic health? If you find them, please send them this Tax Foundation paper!
Breaking Up Tax Reform
Last week, Politico Pro is reporting something we’ve been concerned about for a while:
PATH TO PASSAGE? SENATE FINANCE COULD USE SMALL BILLS TO APPROVE TAX REFORM: The universal truth of tax reform is that it is, and always will be, hard to pass. But the folks over at the Senate Finance Committee are considering various ways to more easily push tax reform legislation through Congress – including splitting a comprehensive reform bill into smaller measures. Our Kelsey Snell reported for Pros that “separating business tax reform from the more contentious individual tax code would allow [Senate Finance Committee Chairman Max] Baucus to continue debate on corporate taxes, the international tax code and the treatment of some benefits for small businesses – where there’s more agreement between the parties – without opening a battle over how much revenue should be raised through changes to the individual code.”
The news outlet subsequently filed a couple corrections that left the story’s ultimate meaning in doubt, but the notion that you can split tax reform into small bites is definitely out there. Comprehensive is just too hard, some say, so let’s do a corporate bill where there’s more agreement.
Our concern with this approach is two-fold: First, we reject the idea that you can separate out the corporate tax code without doing significant harm to the pass through business sector. Corporate-only proposals to date would either raise taxes significantly on pass through businesses or they would treat them like second class citizens, instead of the majority source of employment and business income in the United States (see story above).
Second, the “consensus” on corporate reform is less than it appears and it will depend on the same, top line question confronting comprehensive reform — should it be budget neutral or raise revenue? Until that question is answered (and you know where we stand on that), any reform effort is going to face an uphill climb.
We support corporate tax reform, but only as part of a broader effort to reform the entire tax code.
Since its release yesterday, the effective tax rate study put out by S-Corp and the National Federation for Independent Business has been getting traction both on the Hill and in the media. The study shows that S Corporations pay the highest effective rates of any business type, and its results come at a critical time for tax reform.
Following the release, the Ways and Means Committee issued a statement:
“The study adds to the growing momentum for tax reform expressed by Democrats and Republicans alike who have called for fixing the broken tax code for job creators of all sizes. Those calls are a stark contrast to the Administration’s most recent appeal to lower the corporate rate, while leaving the vast majority of the nation’s job creators – small businesses – struggling with high rates and a more complex tax code.”
The study also grabbed the attention of a number of news outlets. Writing for The Hill, Bernie Becker shared his analysis:
“[The study] serves as pushback against President Obama, who renewed his call to reform only the corporate tax code last week. GOP lawmakers, the NFIB and the S Corporation Association say that idea will leave behind the millions of businesses that organize as pass-throughs and pay taxes through the individual code.”
Michael Cohn of Accounting Today said:
“The results of this study come at a critical time for tax reform. House Ways and Means Committee chairman Dave Camp, R-Mich., and Senate Finance Committee chairman Max Baucus, D-Mont., are focusing on crafting a comprehensive tax reform plan that they hope to unveil this year. With the release of the study, the lobbying groups hope to provide lawmakers in Congress with their perspective on how much they believe is paid in taxes by various types of business entities.”
“They also positioned the study in reaction to a speech last week by President Obama highlighting his proposals for business tax reform, which mainly focused on eliminating corporate tax loopholes and increasing investment in jobs to rebuild infrastructure and encourage more manufacturing.”
And writing for Politico, Kelsey Snell had this to say:
“A new study from the NFIB found that S corporations will face a 31.6 percent effective tax rate this year and partnerships will see a 29.4 percent rate while the big dogs filing under the corporate code will pay an effective rate of just 17.8 percent…The study is the latest attempt to rebut President Obama’s proposal to do corporate-only tax reform to help finance a new jobs package.”
Today, the National Federation of Independent Business and the S Corporation Association released a new study showing that S corporations pay the highest effective rates of any business type.
The study, authored by Quantria Strategies, LLC, compares the tax burden different business entities will shoulder in 2013 and finds that S corporations will pay the highest average effective tax rate (31.6 percent of their income), followed by partnerships (29.4 percent), C corporations (17.8 percent) and Sole Proprietorships (15.1 percent).
The results of this study come at a critical time for tax reform. Ways and Means Chairman Dave Camp and Finance Committee Chairman Max Baucus have made clear they intend to spend August crafting their respective tax reform plans. A better understanding of exactly who pays what will help them construct a more thoughtful and successful reform. As the study states:
While many people think of the statutory tax rate when they consider the effect of federal income taxes, the reality is that the statutory tax rate does not represent the best measure of the effect of taxes on a business. Average effective tax rates are a better measure of whether a particular industry or business form faces greater or lesser federal income taxes relative to other industries or business forms.
This is only the second time the tax burden of S corporations and other pass through businesses has been measured. A previous study by the folks at Quantria looked at firms under $10 million in receipts and came up with similar results. Every other attempt to measure effective tax rates, however, has focused exclusively on publicly-traded C corporations. As such, this study sheds important light on their respective tax burdens and policymakers should pay attention.
According to the study, S corporations will pay the highest effective tax rate of any business type in 2013 – 31.6 percent. Those S corporations making more than $200,000 will pay 35 percent! In other words, the effective tax rate on successful S corporations is equal to the marginal tax rate paid by the most successful C corporations.
Moreover, the study shows that the S corporation tax burden is highly progressive, with the smallest S corporations paying 19 percent in tax, while the largest pay 35 percent. The progressive nature of pass-through taxation is one of the reasons we argue that pass-through taxation is the best means of taxing business income.
This study makes clear that pass-through businesses, especially S corporations, are paying their fair share and then some. Remember, their tax rates just went up January 1. That’s why the pass-through community is united behind the principle that reform should restore marginal tax rate parity to the tax code, so that everybody pays the same top tax rate. This study makes clear that effective tax rate parity should also be a goal.
Key members of the Ways and Means Committee understand the importance of measuring effective rates. As Congressman Dave Reichert (R-WA) stated:
The study released today by NFIB and the S Corporation Association makes clear that comprehensive tax reform is the only way to ensure we make the tax code more fair and equitable for all employers. We know Main Street businesses employ most of the workers, and this study shows they pay lots of taxes too. The President’s plan to raise their taxes further in order to cut tax rates for big business is simply a non-starter. Tax reform needs to be comprehensive, and it needs to level out the tax burden paid by businesses of all types.
Rep. Tim Griffin (R-AR) also had this to say:
“This study confirms what many Americans already know: Our broken tax code is too complex and imposes an unfair burden on small businesses – the lifeblood of local economies. And with even more taxes kicking in thanks to Obamacare, we must act quickly to create a fairer, flatter, simpler tax code that encourages job growth and is easier for millions of hardworking Americans to understand.”
Coupled with previous Ernst & Young studies measuring pass-through employment levels, the threat of corporate-only tax reform to the pass-through community and the adverse effects higher marginal tax rates on employment and investment, this study is going to be a centerpiece of the on-going advocacy efforts of the S Corporation Association and all the trade groups representing pass-through businesses.
Today, President Obama is announcing a repackaging of the corporate tax reform proposal he put forward back in 2012. Based on the White House fact sheet, the plan is a restatement of his 2012 plan coupled with a call to raise “one-time” revenues to pay for new spending.
To recap the 2012 plan, the President proposed to:
- Cut the C corporation top tax rate to 28 percent;
- Reduce the top rate on C corporation manufacturers to 25 percent;
- Eliminate tax deductions, preferences and credits used by C corporations and pass-through businesses alike to offset the lower C corporation rates; and
- Increase expensing limits to $1 million.
There are many other details included in the 2012 plan, but these are the big ideas, and with the limited exception of increased expensing, they uniformly spell out a bad deal for S corporations and other pass-through businesses. In effect, the President’s plan calls for raising taxes on pass-through businesses in order to cut them for larger C corporations.
How much? Our 2011 study from Ernst & Young showed that pass-through businesses will see their tax burden rise by 8 percent ($27 billion) per year under budget neutral, corporate-only tax reform. Industries most affected by the tax hike are agriculture (22 percent), construction (9 percent), retailers (9 percent), manufacturing (8 percent), and real estate (8 percent). This same study made clear that pass-through businesses employ the majority of private sector workers in the US.
So the President is proposing to hike taxes on the majority of employers in order to cut them for a smaller segment of C corporations.
Moreover, these estimates came before the recent rate hikes on pass-through businesses, so the total impact of the President’s proposal today should be higher. To the extent the President wants to raise revenue, that too would increase the hit to pass through businesses.
Ways and Means Chairman Camp and Finance Committee Chairman Baucus have both committed to comprehensive tax reform that addresses both the individual and the corporate tax codes because it’s the only way to increase the competitiveness for all US employers while making the tax code more fair and simple. Just last week, more than 70 national trade groups wrote Congress to reiterate their support for comprehensive reform.
We support the efforts of the tax committee Chairmen and call on them to reject the idea of “corporate only” tax reform. It was a bad idea when it was first proposed in 2012. It’s a worse idea today.
Today is the deadline for the so-called “clean slate” process in the Senate, and while S corporations and other pass-through business entities are (properly so) not tax expenditures, we thought it was important that the priorities of this community be made clear to tax writers as they begin drafting their reform plans over August.
With that in mind, today more than 70 (!) national business trade associations, including the American Farm Bureau, the National Federation of Independent Business, the National Restaurant Association, and the S Corporation Association, signed a letter reiterating the three tax reform priorities of the pass-through community:
First, tax reform needs to be comprehensive. Most private sector workers are employed at pass-through businesses that pay taxes at the individual rates, not the corporate rates. To ensure that we avoid harming a large segment of American employers, tax reform needs to be comprehensive and include both the individual and the corporate tax codes.
Second, Congress needs to keep the tax rates paid by individuals and corporations at similar, low levels. The resolution of the fiscal cliff resulted in individuals and pass-through businesses paying, for the first time in a decade, a significantly higher top marginal tax rate than C corporations. Splitting business income and taxing it at different rates penalizes pass through businesses and encourages planning to circumvent the higher rates, ultimately resulting in wasted resources and lower growth. To ensure that tax reform results in a simpler, fairer and competitive tax code, Congress needs to keep top tax rates low, and it needs to keep them at similar levels.
Third, Congress should continue to reduce the incidence of double taxing business income. A recent study by Ernst & Young made clear that the predominance of pass-through businesses in the United States, and the single layer of tax they face, results in higher levels of investment and employment. This prevalence of pass-through taxation is the result of purposeful and explicit reforms enacted by Congress over the past half-century. A key goal of tax reform should be to continue this progress to tax business income only once.
In addition, S-CORP has sent in its own statement of priorities to the Senate Finance Committee, making clear that any reform of the tax code should recognize and promote the interests of America’s pass-through community. As the statement begins:
The United States is unique among developed countries in the emphasis it places on pass-through business structures – S corporations, partnerships (including Limited Liability Companies), and sole proprietorships. Pass-through businesses make up 95 percent of all U.S. businesses, they employ the majority of private sector workers, and they contribute the majority of business income to our GDP.
This reliance on pass-through businesses is not an accident or a byproduct of other priorities. Rather, it was done purposefully by successive Congresses seeking to strengthen the role of private businesses in the American economy. These deliberate actions date back to the creation of the S corporation structure in 1958 and they have worked to the benefit of the businesses themselves, the people they employ, and the communities they serve. America has more jobs, higher wages, and a more diverse economy because of the strength of its pass-through business sector.
It is critical for Congress to understand this history as it seeks to tackle tax reform in the coming months.
You can read the entire statement here.
Tax Reform Outlook
With the close of the “clean slate” process, it’s a good time to step back and assess the future of tax reform and how it fits into the broader fiscal debates coming this fall. For a while now, we’ve been focused on the remarkable number of fiscal issues converging this fall, including:
• Debt Limit (October/Novermber)
• Start of the Fiscal Year (October 1)
• Roll Out of Obamacare (October 1)
• Second Round of Sequestration
• Farm Bill Expires
Add into this mix the possibility of tax reform. Chairman Baucus announced this week that the Senate Finance Committee will begin marking up a comprehensive tax reform bill this fall, after Congress returns from its August recess. This puts him on a similar timeline as Chairman Camp, who has said that he wants a tax bill voted out of his Ways and Means Committee by year’s end, which suggests the following timetable for both bodies:
• August: Craft draft reform package
• September: Make draft public and open to comments
• October/November/December: Markup in Ways and Means and Finance Committee
So the timetables look similar. So do the basic parameters. Both Chairmen have promised comprehensive reform that includes individuals, pass-through businesses (yea!), and corporations within a general approach of lowering marginal rates and broadening the tax base.
That said, several significant differences remain that could derail the process, including the basic problem that there’s no agreement on the revenue target – is tax reform going to be revenue neutral or should reform raise money?
There also is considerable distance between the approach embraced by Baucus – lower rates, broader base – and the views of key members of his party, including President Obama and Majority Leader Reid – higher rates with more revenues coming from wealthy taxpayers and successful businesses.
Those differences would appear to sound the death knell for tax reform, except for all those other fiscal items coming due this fall. How does Congress come together to raise the debt limit? How does it resolve differences on spending, the Farm bill, and sequestration? Will the roll out of Obamacare be successful, or such a disaster that the President is eager to change the subject?
All these variables suggest no one knows what will happen this fall. It could be a piffle, it could be a grand bargain, or anything in between. What we do know is that there will be two tax reform drafts just sitting there, waiting for an opportunity to be considered by the House and the Senate. And we have two motivated Chairmen, eager to finish this process and produce some legislation.
Coalition for Fair Effective Tax Rates
Earlier this week, a group of more than a hundred business trade associations, including the S Corporation Association, announced a new business coalition focused on making sure that tax reform results in a fairer distribution of tax burdens.
Today, two of the leaders in the coalition – the National Federation of Independent Business and the Retail Leaders Association – penned an op-ed that highlights the current unfairness of the burden the tax code imposes of different industries:
Another argument for reform is the sometimes large disparity in effective tax rates among industries in the U.S. For example, the retail industry, the second largest private-sector employer in the U.S., is taxed at an effective tax rate that is significantly higher than other industries. Some retailers, even the largest of them, tend to have effective tax rates in the 30s. This contrasts sharply with other industries whose effective tax rates are often in the teens or lower.
This critique applies to business types too. A report sponsored by the Small Business Administration back in 2009 found that S corporations pay the highest effective tax rates of any business type. With the higher marginal rates in effect for 2013, we expect the unequal tax burden shouldered by S corporations is higher today than before. We’ll have an update on that report soon, and we’ll make sure it is a key part of the policymaking discussion moving forward.
Yesterday, Senate Finance Committee Chairman Max Baucus and Ranking Member Orrin Hatch ruined the July 4th vacation plans of every tax lobbyist in town with they laid out their new “blank slate” approach to tax reform.
In a letter sent to fellow senators, the two announced that they would work under the assumption that all exclusions, deductions, and credits currently written in the tax code have been repealed, and that only the most defensible provisions would be put back in. Sens. Baucus and Hatch called on their colleagues to defend the tax breaks they see as important, and gave senators until July 26 to submit their recommendations on which should be preserved. As the letter states:
In order to make sure that we end up with a simpler, more efficient and fairer tax code, we believe it is important to start with a “blank slate.”
…To make sure that we clear out all the unproductive provisions and simplify in tax reform, we plan to operate from an assumption that all special provisions are out unless there is clear evidence that they: (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.
A subsequent colloquy between the two Senators made clear the “blank slate” approach is all about exposing the trade-off between lowering marginal rates and preserving tax expenditures. As Hatch put it:
We wanted everybody to know there’s a tradeoff involved. That is, when you keep tax expenditures, there’s going to be an increase in rates, certainly compared with what otherwise we start with. And the more tax expenditures there are, the less revenue there is for a rate reduction and deficit reduction and the more complicated our tax code will end up being.
Limited to making clear the trade-off between rates and expenditures, the “blank slate” approach is a helpful tool to educate members. It will certainly get them active on tax reform. Beyond that, however, it does have serious limitations, including its failure to answer two key questions:
- What is the starting point for rates?
- Is this exercise budget neutral, or will it try to raise revenues?
Remember, starting this year, S corporations and other pass through businesses now pay a top marginal tax rate that is significantly higher than the top rate paid by C corporations, putting them at a competitive disadvantage. That rate increase means that pass through businesses already gave at the office when it comes to deficit reduction, too.
Any tax reform effort worth supporting would start with the assumption of marginal rate parity. The top tax rates for individual, pass through businesses, and corporations should be the same and as low as possible. Effective tax rate parity is important too. Pass through businesses shoulder a higher overall tax burden than many of their corporate competitors. Properly constructed, tax reform would help level tax burdens as well as marginal rates. The Baucus-Hatch letter leaves both these issues unaddressed.
Setting those concerns aside, do S corporations and other pass through businesses pass the blank slate test? Pass through tax treatment is (appropriately) not a tax expenditure, but just for fun let’s see how well they stack up to the three questions outlined in the Baucus-Hatch letter?
Do S corporations help grow the economy?
You betcha. According to the 2011 Ernst & Young study, the prominence of pass through businesses in the United States means there’s more jobs, more capital, and higher wages than if every business was subject to the double corporate tax. Here’s the key paragraph:
The flow-through form provides an important benefit to the economy by reducing the economically harmful effects of the double tax and therefore allowing for a greater opportunity for job creation and capital investment. Moreover, the flow-through form provides businesses with flexibility that may better match their ownership structure requirements and capital needs.
Moreover, the recent hike in top rates on pass through businesses is costing us jobs. According to the 2012 Ernst & Young study, the marginal rate hikes that went into effect this year will result, in the long term, in fewer jobs and lower wages. According to the study:
This report finds that these higher marginal tax rates result in a smaller economy, fewer jobs, less investment, and lower wages. Specifically, this report finds that the higher tax rates will have significant adverse economic effects in the long run: lowering output, employment, investment, the capital stock, and real after-tax wages when the resulting revenue is used to finance additional government spending.
Tax reform should start by reversing this rate hike on American’s employers. That would “help grow the economy.”
Do S corporations make the tax code fairer?
Yes they do. According to the 2009 SBA study on effective rates, S corporations pay the highest effective tax of any businesses structure, slightly higher than partnerships and significantly more than C corporations. The pass through structure helps to reduce this imbalance by applying a single layer of tax on these businesses. Marginal tax rates are important in affecting behavior and should be lowered, but effective tax rates measure the amount of tax you actually pay. Tax reform should seek to level out the tax burden among various business structures.
Do S corporations effectively promote other important policy objectives?
YES! They promote economic diversity and economic security. There are 4.5 million S corporations and more than 3 million partnerships and LLC’s. These businesses come in every size imaginable and they are in every industry, every state and every community. They contribute more to our national income than C corporations and they employ the majority of American workers. This diversity of industry, size and location strengthens our economy by spreading out economic power and decision making away from the financial centers and away from the corporate boardrooms. How important is that diversity to our economic security? Think back to 2008 and the financial crisis. Main Street didn’t cause the crisis, but it did act as the backstop.
So pass through businesses pass the ‘blank slate” test with flying colors.
What’s our outlook for tax reform and congressional action? To us, the big news yesterday was that Chairman Baucus intends to mark-up a tax reform bill this fall. That synchs with expected action by the Ways and Means Committee, and puts tax reform on the front burner right about the time Congress will have to enact FY 2014 spending and raise the debt limit.
Could be a window of opportunity for something really big.