BRT Offers Up Higher Tax Rates on Pass-Through Businesses

The Business Roundtable (BRT), an association of some of America’s largest multinational corporations, today sent a letter to congressional leaders and the President calling for comprehensive tax and entitlement reform, but also leaving the door open for higher tax rates on individuals and smaller businesses.

In response, Brian Reardon, Executive Director of the S Corporation Association issued the following statement:

“We agree with the Business Roundtable that the only way to address our long-term fiscal challenge is through comprehensive reform of both the tax code and our entitlement programs, but we disagree that Congress should consider raising marginal rates on pass-through businesses as part of those reforms.”

“Both the Congressional Budget Office and Ernst & Young have made clear that higher marginal rates will result in fewer jobs now and in the future.  The business community needs to unite behind comprehensive tax reform that lowers marginal rates on all businesses, not just multinational corporations.”

S Corp Meets with House Leadership

S Corporation Association Board Member Dan McGregor participated in a small business roundtable with House Republican leadership yesterday as part of our ongoing effort to educate policymakers on the important role pass-through businesses, and particularly S corporations, play in job creation and investment.

Dan is Chairman of McGregor Metal Working, a group of metal-stamping companies located in the Springfield, Ohio area.  It’s been a family-owned business since 1965 and began as an eight-person tool and die shop.  Today, they employ 365 workers and have clients in the auto, agriculture, and lawn and garden industries.

A key part of Dan’s message yesterday was that higher tax rates means lower retained earnings, which means less capital to invest and create jobs.

Ironically, Dan’s trip to the Capitol occurred on the same day that FedEx founder Fred Smith argued that it’s a “myth” that McGregor Metalworking and similar pass-through businesses are an important source of jobs:

“The reality is the vast majority of jobs in the United States are produced by capital investment in equipment and software that’s not done by small business. It’s done by big business and the so-called ‘gazelles,’ the emerging companies like the new fracking oil and gas operations. It is capital investment and equipment and software that’s the solution to our economic problems, not the marginal tax rates of individuals.” 

The ignorance of this statement is remarkable, especially given the source.  As readers of our E&Y study know, fifty-four percent of all private sector jobs come from pass-through businesses — one quarter of all private sector jobs are at an S corporations.

Moreover, it’s hard to believe there’s a more capital-intensive industry than metal stamping, and for a private business like McGregor, there are few viable options for raising capital other than retained earnings.

If McGregor wants to grow, it needs to earn a profit and reinvest those profits in the business.  Raising taxes on McGregor — as proposed by the President — would increase McGregor’s effective tax rate sharply, which means less retained earnings and less ability to invest and grow.  As the President is fond of saying, “It’s just math.”

So the President can push for higher taxes on a million or so private businesses, and billionaires like Fred Smith and Warren Buffett can support him, but don’t pretend it’s not going to affect real people and real jobs.  It will.  It already has.

CBO Weighs In

S corporations sure are popular these days.  Unfortunately, they’re popular in the same way that big Tom Turkey is popular around Thanksgiving.  Yesterday, the Congressional Budget Office added to the feeding frenzy, releasing a report entitled “Taxing Businesses Through the Individual Income Tax.”

There’s actually good stuff in there, like how S corporations help to reduce the cost of business investment and how they reduce the tax code’s bias toward too much debt , but it’s all for naught.   Those big government types tying on their napkins and sharpening their knives will only see this:

The Congressional Budget Office (CBO) estimates that if the C-corporation tax rules had applied to S corporations and LLCs in 2007 and if there had been no behavioral responses to that difference in tax treatment, federal revenues in that year would have been about $76 billion higher.  

You can hear them drooling already — $76 billion a year will pay for lots of new government. But if there is no change in behavior?  And if there’s no interaction with the AMT?  That’s akin to saying, if there was no structural federal deficit, we wouldn’t need all these tax hikes.

Let’s start with the behavior.  For a sense of just how much taxpayer behavior would change if all pass-through businesses were suddenly subject to the double corporate tax, go back to pre-1986 tax reform and see how they behaved.  Tax sheltering ruled the day then, and we expect it would return to prominence again in a double tax world.  Here’s S-Corp Advisor Tom Nichols’ testimony before the Ways and Means Committee earlier this year:

Prior to the TRA ’86, successful business owners were regularly engaged in the tax planning process in order to minimize the substantial burdens under the double taxation regime.  Since that time, and with the migration of closely-held business activity to pass-through taxation treatment, business owners are no longer engaged in an ongoing struggle to navigate the heavy impositions of the double tax system.  They are less focused on tax planning than they were before the TRA ’86, and more focused on running their business.

The AMT exception is particularly important, too.  Just about every other business owner we know pays the AMT, so pretending it doesn’t play a significant role is less than credible. Moreover, why didn’t the CBO calculate the impact of the AMT?  E&Y did in our study on the impact of higher rates on jobs and investment.  They found that of the 2.1 million business owners with incomes high enough to pay the top two rates, 1.2 million of them already pay the AMT.

If E&Y can make that calculation, why can’t the CBO?

So the take-away for the “tax the rich” crowd will be that they’re losing $76 billion a year by allowing pass-through businesses.  But that number’s not real.  Congress will never collect it.

On the other hand, the higher cost of capital is real.  Here’s how E&Y put it: 

The income of C corporations is instead subject to two levels of tax (the “double tax”), first when income is earned at the corporate level, and again when the income is paid out to shareholders in the form of dividends or retained and later realized by shareholders as capital gains.

The double tax affects a number of important economic decisions. In particular, the double tax:

• Increases the cost of capital, which discourages investment and reduces capital formation and economic growth.
• Increases the cost of equity finance, which encourages greater leverage among C corporations.

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. 

Bottom Line:  All businesses should be taxed as S corporations, not the other way around.  It would mean more investment, more jobs and higher wages.

Isn’t that the whole point?     

Retained Earnings v. Distributions

Speaking of myths, one of the arguments we’ve heard from reporters and others in recent days is that because wages are deductible, hiring will not be impacted by higher tax rates.

This argument reflects a basic misunderstanding of how pass-through businesses, including S corporations, are taxed.  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, and it’s critical to understanding the concern that higher marginal rates will result in less job creation.

Here’s an example:

Start with a two-shareholder S corporation where each owner has a 50 percent interest.  If the S corporation makes $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 President’s approach, next year the marginal rates on our shareholders will rise to 39.6 percent, so the business would need to distribute $40 to both shareholders.  As a result, the business’ working capital is reduced to $120.

But these higher statutory rates are only one of three rate hikes facing pass-through businesses next year.  There’s also the marginal impact of reinstating the Pease cap on itemized deductions.  That has the effect of raising the marginal rate by 1.2 percent.

And then there’s the imposition of the new 3.8 percent investment surtax enacted as part of health care reform.  That only applies to shareholders who don’t work at the business, but it’s another 3.8 percent on top of the other two tax hikes.

The net result will be to raise the top marginal rate on S corporation shareholders from 35 percent to around 45 percent (not including state and local taxes).  With those rates, our business’ working capital would be reduced from $130 to $110, a reduction of 15 percent!

Interestingly, that’s just about the same percentage that E&Y estimated the cost of capital would rise for pass-through businesses if the President gets his way on tax rates.  Think of it as a reverse sale — instead of 15 percent off that new equipment, next year it’ll be 15 percent more.

And that’s why higher rates cost jobs.  Higher rates mean lower after-tax earnings and less money to invest in jobs and equipment.  Period.

Health Reform Investment Taxes Will Hit S Corps

The IRS waited until a Friday afternoon after the elections to release 159 pages of proposed regulations on the new 3.8 percent investment tax.  While the rule is not final, the IRS is telling taxpayers to rely on this temporary guidance until they can get around to making them final.  Here’s what the IRS says:

Taxpayers may rely on the proposed regulations for purposes of compliance with section 1411 until the effective date of the final regulations.

Just to remind folks distracted by the fight over extending the Bush tax cuts, two of the new taxes enacted to pay for health care reform will take effect beginning January 1:

• A 3.8 percent tax on all net investment income for taxpayers earning more than $250,000 ($200,000 if you’re single); and
• An additional .9 percent Medicare tax on salaries and wages for taxpayers making more than $250,000 ($200,000 if you’re single).

The rule released Friday addresses the investment tax.  Forbes has a nice write up together with some examples of how taxpayers might be impacted.  For S corporations, income from the business is not subject to the new 3.8 percent investment tax if the taxpayer is active in the business and the income is active rather than passive in nature.  Here’s the Forbes example:

Example: Walter White owns an interest in two S corporations. Both corporations are engaged in the active conduct of a trade or business, and neither corporation is a trader in financial instruments. Walter spends 520 hours on S Corporation 1, but only 40 hours on S corporation 2. Under the Section 469 regulations, absent an election to group the two activities, Walter would materially participate in S Corporation 1, but not S Corporation 2.

Assuming the interests in the two corporations represent an appropriate economic unit, Walter may group them together for purposes of testing material participation. Because Walter spends 560 hours on the combined activity, he materially participates in both S corporations and neither activity is passive to Walter. As a result, income earned in the ordinary course of the trade or business of both S Corporation 1 and S Corporation 2 will not be considered net investment income.

We’ve commented on these new taxes previously, but suffice it to say that this guidance should make clear to policymakers that we’re not returning to the 1990s tax rates next month — we’re going well beyond.

Pass-Through Coalition Weighs In on Fiscal Cliff

The S Corporation Association joined with more than 40 other organizations in a letter to Congressional leadership calling for action on to pursue comprehensive tax reform that lowers rates on all forms of business income while also addressing entitlement spending.  States the letter:

 [W]e call on Congress to avoid raising marginal tax rates on employers, either as part of negotiations over the fiscal cliff, or as part of larger effort to reform the tax code. Instead, Congress should seek to enact comprehensive tax reform that simplifies the tax code and encourages economic growth for both pass-through businesses and corporations….

[W]e are eager to see Congress enact permanent, comprehensive tax reform, but this alone will not solve the long-term fiscal imbalance.  The Trustees to Social Security and Medicare have made clear that, absent reform, these programs are unsustainable.  While Congress should commit to tackling comprehensive tax reform, it is also imperative that Congress agree to develop a long-term plan to address America’s entitlement programs as well.

Simply put, we need to reform our tax code and we need to reform our entitlements.

Spearheaded by your S-CORP team, the letter was sent up to the Hill yesterday and immediately garnered attention on the Hill and in the press, including a Fox News segment on the fiscal cliff.  You can check it out in the segment below.

Ways and Means Republicans and House Majority Whip Kevin McCarthy were among those who rapidly issued statements in reinforcing the message in the letter.   Said McCarthy, “The role of small businesses in our economy must never be understated – they are the engine of job growth in this county, and their voice belongs at the table.” We couldn’t have said it better.

With everybody focused on the fiscal cliff negotiations, S-CORP and a coalition of organizations representing pass-through businesses are doing our best to make sure the voices of private businesses are heard.  Our next task is to take this letter to the Hill to help reinforce this message.

More on the Buffett Tax

Warren Buffett continues his crusade to raise taxes on everyone but himself.  We’ve pointed out the flaws of his arguments in past posts, including the observation that by almost every credible measure of respective tax burdens, the underlying premise of the “Buffett Tax” is flawed — as the federal tax code is already sharply progressive.

Rather than repeat the same points, this time we’ll turn to Harvard Professor Greg Mankiw to make the obvious more clear:

A Master of Tax Avoidance

Warren Buffett has an op-ed in today’s NY Times on one of his most popular themes: The rich should pay more in taxes.  At first blush, his position seems noble: A rich guy says that people like him should pay more to support the commonweal.  But on closer examination, one realizes that Mr Buffett never mentions doing anything to eliminate the tax-avoidance strategies that he uses most aggressively.  In particular:

1. His company Berkshire Hathaway never pays a dividend but instead retains all earnings.  So the return on this investment is entirely in the form of capital gains.  By not paying dividends, he saves his investors (including himself) from having to immediately pay income tax on this income.
2. Mr. Buffett is a long-term investor, so he rarely sells and realizes a capital gain.  His unrealized capital gains are untaxed.
3. He is giving away much of his wealth to charity.  He gets a deduction at the full market value of the stock he donates, most of which is unrealized (and therefore untaxed) capital gains.
4. When he dies, his heirs will get a stepped-up basis.  The income tax will never collect any revenue from the substantial unrealized capital gains he has been accumulating.

To be sure, there are pros and cons of changing the provisions of the tax code of which Mr. Buffett takes advantage. Tax policy always involves difficult tradeoffs.  But it seems odd to me that whenever Mr. Buffett talks about taxing the rich more, the “loopholes”that he uses never seem to enter into the conversation.

S-CORP Responds to Washington Post Fact Checker

The art of fact checking had its highs and lows over the course of the last election, but the Washington Post’s recent review our study by Ernst & Young has to be a new low.

The Post reviewed the study conducted by Ernst & Young looking at the long-term economic effects of higher marginal tax rates on wage and investment income.  The study was entitled the “Long-run macroeconomic impact of increasing tax rates on high-income taxpayers in 2013” and it found that allowing rates to rise to President Obama’s preferred levels would result in lower levels of employment, wages and investment.

This finding is consistent with numerous other rigorous studies of the impact of higher marginal rates on investment and job creation over time, and it is also consistent with a recent analysis by the Congressional Budget Office (CBO) which makes clear that these same policies will have negative economic consequences in the short-term as well.

But the Post focuses on none of these aspects. Instead, it begins by questioning the credibility of the trade associations that asked for the study and then it heads downhill from there. So much for a “just the facts, ma’am” approach to fact checking.

Here are the key points made by the Post and our response:

Washington Post: “According to an aide, Sessions obtained his figure from a study prepared last year by two economists at Ernst & Young for the Independent Community Bankers of America, the National Federation of Independent Business, the S Corporation Association and the U.S. Chamber of Commerce — all opponents of the president’s agenda.

That might be the first clue that this is potentially not a neutral document. One of the authors is also a former official in George W. Bush’s Treasury Department.”

Response:  The Post dismisses the study because of the identity of the trade associations that asked E&Y to produce it?  Seriously?  By this standard, anything written in the Washington Post can be dismissed since it endorsed President Obama’s reelection efforts.

Moreover, the organizations listed represent literally millions of businesses employing tens of millions of workers.  If these organizations are not allowed to have a point of view in a debate over tax rates and economic growth, who is?

Oh, and the study was released this year, not last.

Washington Post:“The study is titled “Long-run macroeconomic impact of increasing tax rates on high-income taxpayers in 2013.”  In other words, this is not an immediate impact, but the “long run.””

Response: Yes, the study is titled, “Long-run macroeconomic impact of increasing tax rates on high-income taxpayers in 2013.”  Enough said.  For the short-term effects, refer to the CBO fiscal cliff analysis released last week.

Washington Post: “Oh. So, even if one accepts the assumptions in this model — a big “if” — it still means that the loss of 700,000 jobs would not come in the first year, or by the end of Obama’s second term, or even a decade from now.”

Response: Why is it a “big” if?  Exactly what assumptions are in question?  The Post only lists one specific assumption (addressed below).  Are there others?  Is this “fact checker” skilled enough to determine which assumptions made in a general equilibrium model put together by two skilled economists employed by one of the top accounting firms in the world are credible and which are not?  Of course not.

Washington Post: “There is also another revealing endnote: “Using the additional revenue to reduce the deficit is not modeled.” That means the analysts did not even study the effect of Obama’s stated purpose for raising taxes; the 700,000 figure assumes that the revenue raised from the tax increase would be used for increased government spending. Yet presumably any deal on fixing the fiscal cliff would result in a lower federal deficit, since all sides agree they have that goal.”

Response:  The Post questions one of the key assumptions in the E&Y study — that higher tax rates would lead to higher spending — by making its own policy assumption– that the revenues from higher rates would be used for deficit reduction.

Certainly, the Post is free to believe the new revenues will be used for deficit reduction and not spent, but is that belief credible?  Is there a history of that happening?  Our perspective is that history and evidence fall on the side of the study — tax increases tend to be spent, not saved.

To argue otherwise is an opinion, not a fact.

Washington Post: “In other words, focusing just one variable — an increase in taxes — is a bit simplistic. By itself, raising taxes likely leads to a reduction in employment. But the use of that additional revenue over the long term is also important — such as whether it is used to reduce budget deficits or boost government spending.”

Response: And there you have it — the Post agrees with E&Y that raising marginal tax rates leads to lower employment, but it then assumes that other policies not studied by E&Y would offset those losses. But the whole point of the E&Y study was to look at the impact of higher rates in isolation.  All things being equal, higher marginal rates lead to lower levels of investment and job creation.

Perhaps if we agreed with all the assumptions made by the Post’s “fact checker” then maybe E&Y would have produced a different study.  But we don’t agree with those assumptions and we like this study.  We are confident it accurately reflects the long-run impact of raising tax rates on wage and investment income.  It is consistent with other studies produced on this question, and it should be taken seriously during this debate.  That’s a fact.

200+ Organizations Call on Congress to Make Moves on Entitlement Reform

S-CORP joined with 231 other organizations in a letter sent to the President and Congress last week calling for financially sustainable entitlements.  Spearheaded by the U.S. Chamber of Commerce, the letter implores policymakers to “immediately begin a process to fundamentally restructure our nation’s entitlement programs — Medicare, Medicaid and Social Security — and to put these valued and important programs on a sustainable financial path.”

The letter also calls for immediate action on the fiscal cliff—something our Washington Wire readers may have heard us mention a time or two — and echoing past calls (such as ours) for policymakers to firmly commit to tackling comprehensive tax reform in the next Congress.  As the letter concludes:

Short term action is not a substitute for long term fundamental fiscal reform. In addition to immediate action on the fiscal cliff, we also urge you to:

• Firmly commit to tackling comprehensive tax reform in the next Congress; and
• Agree to develop a long term plan to address America’s excessive spending, particularly entitlement spending.

“Small Businesses Support Tax Hikes” Poll Flawed

A poll for a group called the Small Business Majority released last week claims that small businesses support raising taxes on top income earners.  As The Hill reports:

A majority of small-business owners believes raising taxes on the highest earners would do less harm to the economy than cutting spending in key sectors, according to a poll conducted for a liberal advocacy group.

The poll for Small Business Majority found that 57 percent of owners said raising taxes on the top 2 percent of earners would be preferable to rolling back spending on education, healthcare and infrastructure. 

On items like this, we are big believers in going to the source.  The poll can be found here, and the question on raising taxes asks:

Please indicate which of these statements comes closer to your point of view, even if neither one is exactly right.

• Cutting spending on education, health care and infrastructure will do more harm to the economy than raising taxes on the wealthiest two percent.
• Raising taxes on the wealthiest two percent will do more harm to the economy than cutting spending on education, healthcare and infrastructure.

Fifty-seven percent of respondents agreed with the first statement, while 32 percent agreed with the second.  But followers of the fiscal cliff debate will recognize the false choice in this question — Congress is not confronted with a decision between higher taxes or lower spending on health care, highways and education.  Spending on those items has gone up significantly in recent years, and it’s scheduled to rise even higher in coming years.  The resolution of the fiscal cliff is unlikely to change that.

On the other hand, taxes are going to go up on nearly one million small businesses unless Congress acts.  The CBO says these rate hikes will costs us 200,000 jobs in the beginning of next year.  Our E&Y study says the job losses will grow to over 700,000 over time.   Congress can forego those tax hikes, and save those jobs.

That’s the real choice Congress faces this Lame Duck.

Fiscal (Slope) Cliff Forecast

While everyone in Washington waits for Tuesday’s election results, this story in The Hill caught our eye:  “Fiscal cliff already weighing on economy.”  According to the story:

While the expiring tax cuts and automatic spending cuts that make up the cliff do not take effect until the beginning of 2013, Pawlenty said he is hearing from financial firms that businesses are already halting business activity because they are not sure what will happen.

For example, 61 percent of JPMorgan’s U.S. clients are altering their hiring plans because of the cliff, and 42 percent of fund managers for Bank of America identify it as their greatest investment risk.

That’s consistent with what our S-CORP members are telling us.  Faced with higher tax rates, uncertain health insurance prospects, and lagging employment growth, the S corporations we hear from are choosing to forego hiring and investment decisions until they feel more confident about the future of public policy and the economy.

This suggests the so-called fiscal cliff is more of a downward slope, and we’re already on it.  Employers are holding back, which is suppressing investment and hiring decisions right now, and that’s reflected in the less-than-stellar jobs and GDP numbers we’ve been seeing for the past six months.

That also means that any signal that Congress is prepared to address the cliff and block these tax hikes would help the economy immediately– not just after January 1^st.

So, what’s at stake for S corporations?  Here’s a short list:

Tax Rates:  The best case is that current rates are extended for 2013.  The worst case is total gridlock in Congress and rates rise to their pre-2001 levels and beyond.  (Beyond because of the tax hikes included in health care reform).  Here’s a table summarizing the options:

Keep in mind, the best case scenario includes both extending current rates and repealing the new 3.8 percent investment tax imposed under Obamacare.  Not impossible if Romney wins and Republicans take the Senate, but not easy either.

AMT:  One of the findings in our E&Y study released this summer was the significant number of pass-through owners who pay the AMT.  According to E&Y, of the 2.1 million business owners who earn more the $200,000 annually, 900,000 pay the top two tax rates, while 1.2 million pay the AMT.  This suggests that the expiration of the so-called AMT patch last year may have more impact on pass-through business owners than the expiration of the lower rates.  Treasury estimates that 30 million additional taxpayers will be pulled into the AMT April 15^th under the current rules (if the AMT patch remains expired).  The findings of E&Y suggest many of those taxpayers are business owners.  Business owners most at risk are those with dependent children and those living in high-tax states like New York and California.

Extenders:   Congress has gotten into a [bad] habit of ignoring the expiration of all those tax provisions falling under the title of “extenders” — the R&E tax credit, the state and local tax deduction, the shorter built-in gains holding period, etc.  The Senate Finance Committee has passed a package of extensions, but the House has yet to act.  If and how these important issues are addressed during the lame duck are still to be determined, and unfortunately seem to have taken a backseat to dealing with the “must-do” broader 2001/2003 extenders that are set to expire at year’s end.

Those are the tax provisions directly impacting the S corporation community. Couple them with the spending cuts scheduled to begin January 1^st, and the total makes up the $700-plus billion fiscal cliff.

What might happen?

Our friends at International Strategy & Investment in the past suggested that the choice before Congress is not “all or nothing” and we agree.  Rather than be constrained by the idea that we will either fall off the cliff or step back entirely, our view is that Congress will take a half-step back, avoiding the most damaging pieces of the cliff while allowing others to take effect.  Here’s a list with those cliff provisions most likely to be avoided starting at the top:

More Likely 

• AMT
• Middle-Class Tax Relief
• Sequestration
• Doc Fix
• Tax Extenders
• Extended UI Benefits
• Upper Income Tax Relief
• Health Care Reform Tax Hikes
• Discretionary Spending

Less Likely

We’ve highlighted the tax rates on upper income taxpayers, including S corporations, since their extension depends almost entirely on who wins the White House.  The odds they get extended is close to zero under President Obama, and perhaps 50-50 under a new Romney Administration.  Romney has made clear he will push for them, as has the House — it’s the Democrats in the Senate that are the wild card.  As for the rest of the provisions, there may be some movement based on the elections, but not much.

In addition to the policies, there’s a question of timing.  The general notion is that any deal on the fiscal cliff must occur before the end of 2012, but several of the provisions listed above could just as easily be dealt with in the first few weeks of 2013 with little additional harm to the economy, particularly if Congress and the incoming Administration effectively signaled what they had in mind.  Moreover, with only a few weeks between the elections and the holidays, there may simply be insufficient time for the differing parties to come together.

But that doesn’t mean it’s okay to wait.  Action immediately after the election to address the entire fiscal cliff — including the top tax rates — would help improve people’s lives now through increased hiring and increased business investment.  Congress should act, and act quickly.

But will they?  Not if their recent behavior, particularly in the Senate, is any indication.  So our best pre-election guess is that Congress will act eventually, but only at the last minute, and that most of the fiscal cliff will be averted either prior to the end of the year or shortly thereafter.

S Corporations Featured in Presidential Debate

This week’s Presidential debate featured both of our recent S-Corp studies — the first highlighting how many Americans work for pass-through businesses, and the second making clear that the pending higher tax rates will result in fewer jobs, lower wages, and less capital investment.

On pass-through jobs:

Governor Romney:  But let’s get to the bottom line.  That is, I want to bring down rates.  I want to bring the rates down, at the same time, lower deductions and exemptions and credits and so forth, so we keep getting the revenue we need.  And you think, well, then why lower the rates?  And the reason is, because small business pays that individual rate.  54 percent of America’s workers work in businesses that are taxed not at the corporate tax rate, but at the individual tax rate.  And if we lower that rate, they will be able to hire more people.

On the impact of higher rates:

Governor Romney:  Now, I talked to a guy who has a very small business.  He’s in the electronics business in St. Louis.  He has four employees. He said he and his son calculated how much they pay in taxes — federal income tax, federal payroll tax, state income tax, state sales tax, state property tax, gasoline tax.  It added up to well over 50 percent of what they earned.  And your plan is to take the tax rate on successful small businesses from 35 percent to 40 percent.  The National Federation of Independent Businesses has said that will cost 700,000 jobs.

Washington Wire readers will recognize those statistics as coming from the two studies we’ve commissioned by Ernst & Young in the past two years.  You can access these studies here:

• Ernst & Young Study on Top Rates
• Ernst & Young on Flow-Through Businesses and Tax Reform

The point of these studies was to arm policymakers with good information about how pass-through businesses like S corporations are a key source of jobs.  Based on this week’s debate, we’d say they worked.

Small Business Sector Afraid of Fiscal Cliff

More evidence that the current environment of increased regulatory activity and looming higher tax rates are hurting private businesses and job creation: according to a new poll by the Tax Foundation, 55 percent of business owners and manufacturers would not have started their businesses in today’s economy, while 69 percent say that President Obama’s regulatory policies have hurt their businesses.  Here’s the summary from Roll Call:

Of 800 small business and manufacturers surveyed, 55 percent said the national economy is in a worse position for them to succeed than it was three years ago.

The survey, which was released today, was commissioned by the National Federation of Independent Businesses and the National Association of Manufacturers and was conducted by Public Opinion Strategies.

The study showed that two-thirds of the respondents believe economic uncertainty in the market makes it hard for them to grow and to hire more workers, for which they hold the Obama administration or Congress responsible.

The finding that entrepreneurs would refrain from starting new businesses or hiring new workers in this lousy economy is reinforced by new research by Tim Kane at the Hudson Institute.  According to Kane’s research:

1. Startup businesses have historically been the source of all net new job creation; Startups create an average of 3 million new jobs a year, while established companies lose on average one million per year.
2. Since 2006, startup job creation has fallen sharply, declining each year through 2011; and
3. Startup job creation under President Obama is the lowest of any President in the last 24 years.

You might recognize this point from the Presidential debate.  Governor Romney cited Tim’s work too:

Governor Romney:  It’s small business that creates the jobs in America.  And over the last four years, small business people have decided that America may not be the place to open a new business, because new business startups are down to a 30-year low.  I know what it takes to get small business growing again, to hire people.

Obviously, the two studies are connected.  Faced with an uncertain level of taxation and regulation, entrepreneurs are holding back on hiring and investment decisions.  That’s what these studies are telling us, and that’s what we hear from our membership.  Hopefully, Congress and the Administration will hear them as well and do something about it in the Lame Duck.

Tax Outlook

With the Republican convention behind us and the Democratic one this week, we thought it would be worthwhile to assess what the business community can expect on taxes in the next six months.  We break the outlook into three buckets:

1. First, the need to extend the tax policies set to expire on January 1;
2. Second, the need to make more fundamental changes to the tax code; and
3. Third, what to do about those pesky tax “extenders”?

2001 & 2003 Tax Cuts

Bucket one is easiest, since both sides have outlined their positions.  The Republican House adopted legislation to generally extend all the 2001 and 2003 tax policies for one year (together with expedited consideration of broader tax reform).  One big deviation from previous Republican actions was the decision to extend current estate tax rules ($5 million and 35 percent top rate) rather than the repeal included in the original 2001 legislation.

Senate Democrats countered with legislation (which failed to muster the necessary 60 votes) to extend the middle-class portions of the 2001 and 2003 tax relief only.  Investors, business owners, and income-earners making more than $250,000 ($200, 000 for single filers) would see their taxes go up.  An exception in the Senate bill was the dividend rate, which would rise to 20 percent rather than the 39.6 percent rate called for under current law.  Also, current estate tax rules were not extended, meaning the top rate would revert back to 55 percent next year coupled with a lower, $1 million exemption.

(Neither the House nor the Senate bill addressed the pending new 3.8 percent tax on investment income enacted as part of the health care reform, by the way.)

As to the outlook, the odds of either side prevailing in this fight depend heavily on the election outcome.  The election won’t change any votes before next year — the President and Congressional leadership will stay the same — but moral authority plays a key role in moving legislation in lame duck sessions, so, if either side can declare a conclusive electoral victory, their respective position will gain momentum.  That’s the positive outlook for action.

Inaction is also possible, however, and should be taken seriously.  Several Senate Democrats are already on record arguing against taking any action this year — they say the fiscal cliff is more of a fiscal slope and that there will be time to address these issues in early 2013.  Meanwhile, it’s difficult to see how House Republicans accept the Senate position and proactively vote for legislation that raises tax rates on anyone in this political and economic environment.

It’s also difficult to see how President Obama pivots off his current position and signs into a law a comprehensive extension.  Finally, the inability or unwillingness of Senate Majority Leader Harry Reid to successfully move large, complex bills in the Senate is a particular challenge and should not be discounted.

For those reasons, we believe a Republican victory in November will signal that Congress will adopt something very close to the House bill — a one-year extension of everything coupled with some sort of expedited reform process — or, if the Senate and President stand firm, do nothing at all.  If Democrats prevail, then the likely outcomes shift to either the Senate-debated position of extending just the middle-class relief or, if the House refuses to go along, nothing at all.  So, regardless of who wins in November, there’s an even chance nothing gets done.

Additional variables that could affect the outcome include the pending sequestration cuts to defense and the strength of the economy.  The worse the economy does, the more likely it is that Congress takes action, and vice versa.  Meanwhile, the push by hawks and conservatives to stop the pending cuts to defense could result in them giving in other areas, including tax policy.  Something to keep an eye on.

Tax Reform

Bucket two includes tax reform or changes to the tax code broad enough that they look like tax reform.  We believe there’s a good chance Congress will act on such a package beginning early next year for the following reasons:

• It will need to raise the debt limit (again);
• There’s broad agreement that the deficit needs to be addressed;
• There’s agreement that our corporate rate is too high; and
• The annual game of extending all these tax provisions, including rates, the AMT patch, estate tax parameters, and traditional extenders is simply unsustainable and needs to end.

Put another way, Congress will need to raise the debt ceiling sometime early in 2013.  To get the House on board, significant spending cuts will need to be part of the package, just like in 2011.  To gather additional support, particularly in the Senate, taxes will also need to be part of the package.  This tax package could be budget neutral, or it could raise significant levels of revenue.  The elections will largely determine that mix.

Let’s say the President and Congressional leaders agree to raise the debt limit coupled with $4 trillion in deficit reduction over the next ten years.  An Obama Administration and Democrat-run Senate might seek a 50-50 package of spending cuts and tax increases.  A Romney Administration coupled with a Republican Senate might shoot for 100 percent spending cuts.  Compromises necessary to move the package through the Congress under either scenario would argue that the final package will fall somewhere in between.

What sort of base-broadening might apply?  Likely groupings include:

• Previously targeted business tax items like LIFO, Section 199, and carried interest;
• Traditional extenders that fail to gain sufficient support; and
• Individual tax expenditures, including at least some portion of the exemption for employer-provided health insurance.

So, broad tax changes are likely to be on the table in 2013.  A revenue-neutral package would broaden the tax base by eliminating certain tax expenditures and unpopular provisions and use all those revenues to cut rates, while a tax-increasing package would do the same, but cut rates to a lesser degree.  As long as the House remains in Republican hands, a package that actually raises headline rates is highly unlikely.

Could Congress get through 2013 without considering broad tax legislation?  It’s unlikely but possible, particularly if the Senate remains under Democratic control.  The Senate has refused to act in other critical areas in recent years, like doing a budget.  But just as the debt ceiling fight forced the Senate’s hand in 2011, we expect the same dynamic to play out in 2013.  A budget resolution is optional; raising the debt ceiling is not.

Tax Extenders

Bucket three is the large list of tax extenders, many of which already expired at the beginning of the year.  Both the Ways and Means and Finance Committees have taken action to define and adopt a package of tax extenders in recent months, but the ultimate outcome remains unclear.

Just prior to the August break, the Senate Finance Committee adopted legislation to extend a package of expired or expiring tax extenders through 2013.  The $205 billion package includes a two-year AMT patch together with an extension of the state sales tax deduction, the higher Section 179 expensing amounts, the R&E tax credit, and the energy production credit and other energy incentives, among other items.  Importantly for Washington Wire readers, the package also extends built-in gains tax relief and the basis adjustment for S corporations making charitable contributions of property.  The Committee report and legislative language were released last week.

In a foreshadowing of the fight to come this fall, Committee leaders noted that their extender package deleted 20 provisions from extender packages of prior years, while several dissenting Republicans argued that the Committee should have gone further and that they look forward to further reducing the list as part of comprehensive tax reform.  Senate leaders are hopeful to consider this legislation on the Senate floor in the few remaining legislative days before the November election, but it’s a full schedule already with only a few days of session.

On the House side, the Ways and Means Committee began their examination of tax extenders back in April, when members had the opportunity to advocate on behalf of their favorite extenders.  In June, a panel of tax experts testified on which is the best framework to test each extender provision and eliminate those that fall short.  It is unclear if the Select Revenue Subcommittee will hold another hearing in September, but Subcommittee Chairman Pat Tiberi (R-OH) was reported as noting that the House will not act on its version of an extender package until after the November elections, not before.

At that point, the tension between considering an extenders package separately this year or rolling these decisions into a broader tax reform package will have to be addressed.  Given that Congress also will face the broader issues of the 2001/2003 tax cuts, sequestration cuts, the FY2013 appropriations process and the rest of the congressional kitchen sink, there’s not a lot of time and continued broad disagreement over direction.

For that reason, we believe it is fifty-fifty that Congress acts on extenders this year, with success most likely tied not to policy, but rather to whether Congress is able to move on some of these other fiscal matters.  Movement in those areas would suggest an agreement over extenders is also possible, while a stalemate on the 2001/2003 cuts, spending and sequestration might bleed into the extender debate.

Just to be clear, this is our outlook, but it’s not our preference.  Here at S-CORP, our fingers are crossed that Congress returns after the election and resolves all of these critical tax questions.  For the business sector, action and clarity are better than inaction and uncertainty, so let’s hope this year’s lame duck session does not live up to its name and is instead positive and productive.

Rate Debate Update

The rate debate continues.  Last week, the Senate failed to extend all the current tax rates and policies by a vote of 45-54.  Two Republicans voted against the measure because of a refundable credit issue and one Republican missed the vote due to illness, but even if you adjust for those votes, the Senate still came up short of a majority for not raising taxes on employers during a period of severely high unemployment.

Very disappointing and something pass-through businesses and the markets should pay sharp attention to.

We expect better results today and tomorrow when the House votes on two related bills.  One, H.R. 8, would extend through 2013 all the current Bush tax cuts.  The other, H.R. 6169, would create an expedited process for Congress to consider tax reform next year.

To help with the vote, the S Corporation Association and our allies drafted and helped circulate the following business community letter in support of the legislation.   As the letter states:

Business owners in this country crave clarity.  They do not know what the tax laws will be moving forward and this uncertainty is having a material and negative impact on investment and job creation.  

Absent action, the Congressional Budget Office has made clear the combination of higher taxes and lower spending will send the economy into a tailspin starting early next year.  Our members report that the prospect of the country going over the fiscal cliff is discouraging them from making investment and hiring decisions right now, slowing our already sluggish economy.

To address this uncertainty, Congress needs to act quickly on tax legislation that would accomplish two critical goals.  First, the legislation must shrink the fiscal cliff and provide employers with a clear sense of the tax rules for 2013 by extending all of the expiring tax provisions for one year.  

Second, because it is long past time for comprehensive reform to create a pro-business, pro-competitiveness and pro-jobs tax code, the legislation should outline exactly how and when Congress will consider a comprehensive rewrite of the individual, corporate and international tax codes.  This legislation should instruct Congress to broaden the tax base while lowering overall rates, and include rules for expedited consideration of the legislation to prevent delay or filibuster to provide the long-term certainty our economy needs to flourish.

This letter has been signed by more than 100 business trade groups, which should send a strong signal to policymakers in both chambers that the employer community needs to see action.  The House plan is the most responsive to the needs of our members, and we hope Congress will adopt it.

Finance Hearing on Pass-Through Businesses

The Finance Committee held a hearing on tax reform and business entities today.  Entitled “Reform:  Examining the Taxation of Business Entities,” the goal of the hearing was to:

…explore the different taxation of business entities structured as corporations versus pass-throughs, and to consider proposals to alter those rules.  Baucus and the witnesses will explore the history of the two-tiered corporate tax system, compare the U.S. taxation of pass-throughs to the systems of other countries and consider whether the current system distorts business decisions in ways that hurt job creation and economic growth.

This topic is obviously of great importance to S corporations and we submitted some excellent testimony from S-Corp Advisor Tom Nichols that outlines our views on tax reform and entity choice.  His testimony is consistent with last fall’s trade association letter signed by 47 major business organizations that outlines three key priorities pass-through businesses would like to see under tax reform:

1. Reform needs to be comprehensive and include the individual and corporate codes;
2. The top rates for individuals, pass-through businesses, and corporations should stay the same; and
3. Congress should continue to reduce the double tax on corporate income.

The final priority here is particularly important.  If the goal of tax reform is to improve incentives for domestic job creation and investment, it needs to address the burden of the double tax on American corporations.  Congress has proactively worked to reduce this burden for the past three decades, and that progress should continue in any future tax reform.  As our Ernst & Young study authors observed in the report they did for us last year:

In addition, the flow-through form helps mitigate the economically harmful effects of the double tax on corporate profits, in which the higher cost of capital from double taxation discourages investment and thus economic growth and job creation. Moreover, double taxation of the return to saving and investment embodied in the income tax system leads to a bias in firms‟ financing decisions between the use of debt and equity and distorts the allocation of capital within the economy. As tax reform progresses, it is important to understand and consider all of these issues with an eye towards bringing about the tax reform that is most conducive to increased growth and job creation throughout the entire economy.

We’re grateful that a number of today’s witnesses sounded the same theme, but remain concerned that Finance Chairman Max Baucus continues to suggest that large pass-through businesses should pay taxes as C corporations.  From his opening statement:

While a valuable tool for small businesses, we should examine if the use of pass-throughs have disrupted the level playing field for larger non-public companies and their public competitors. 

Ideally, our tax code should cause as few distortions in business as possible. Businesses should plan and organize based on growth and job creation – not the tax code.

One of my main goals of tax reform is to make the system more competitive, but also keep it fair.

These comments build on remarks he made last year, stating that, “We’re going to maybe, have to look at pass-throughs, and say they have to be treated as corporations if they earn above a certain income.”

As we said, most of the witnesses and Members supported the notion that tax reform done right would reduce the double tax on corporate income, not increase.  As the Chairman’s remarks make clear, however, that goal is not universally agreed to and the pass-through community needs to be on watch.

Good News on BIG!       

In other Finance news, the Committee announced last night that it would mark up tax extender legislation tomorrow.  You can read the description of the bill here, coupled with the score by the Joint Committee on Taxation.  Major provisions in the legislation include:

• A one year extension of the AMT patch (2012);
• A two-year extension of the R&E tax credit (2012 and 2013); and
• Higher limits under Section 179 expensing (2012 and 2013).

The highlight for the S corporation community is the two-year extension of the shorter, five-year holding period for built-in gains.  Extending the five-year period has been one of our priorities for the past year.  The current, overly long ten-year holding period prevents companies from accessing their own capital at a time when capital is scarce.  What make more sense than extending the more reasonable five-year period?

The bill announced yesterday does not include 18 provisions that had been previously extended by Congress, and more provisions could potentially be added or deleted tomorrow during the mark-up.  So, there’s still a lot of work to do before important built-in gains relief is enacted into law.

Fortunately, we have plenty of allies in the Senate on this provision from both sides of the aisle — Senators Cardin, Snowe, Hatch, Landrieu, Grassley, and Roberts have been key advocates on this issue through the years — and we’ll be working closely with them to get this provision across the finish line!  Stay tuned.

Rate Debate Begins

Majority Leader Harry this week filed a motion to proceed to the Senate Democratic bill (S 3414) to extend the Bush tax cuts for all taxpayers except the top two brackets. A procedural vote is scheduled for tomorrow.

Senate Republicans will push to have a vote on their own version which will extend current tax policies for all brackets. If an agreement is not reached on allowing alternatives, Republicans could try to block consideration of the Democratic bill.

So we now have competing proposals before the US Senate, which begs the question, does Leader Reid have the votes?  He starts with 53 Democratic votes in the Senate, so he should be able to block the Republican plan even if he is unable to move forward on his own, but a number of Democratic Senators have either expressed explicit support for extending all the rates, including Joe Lieberman and Jim Webb, or have kept quiet on exactly what their position is.

As to the specifics, the Democratic bill would extend all the 2001 and 2003 Bush tax cuts with the following exceptions:

The top two income tax rates;

• The top rates on capital gains and dividends for taxpayers making more than $250,000 ($200,000 for singles);
• The rates and exemption for the estate tax; and
• The repeal of limits on itemized deductions.

One key difference between the Senate Democratic legislation and the Administration’s position is that the Democratic bill would raise dividend tax rates to 25 percent, rather than the 45 percent under the President’s budget.

While not an exact fit, the Ernst & Young study released last week should give policy makers a clear idea of the long-term consequences of allowing the top rates to rise on income earners and business owners.  It would mean fewer jobs, lower wages, and a smaller economy.

House Introduces Plan

 Meanwhile, the House has released their own plan to keep tax rates stable while putting into place a process for tax reform.  Encompassed in two bills — HR 8 and HR 6169 — the legislation would:

Extend for an additional year, through 2013, the tax reductions originally enacted in 2001 and 2003;

• Provide a two-year AMT patch (covering 2012 and 2013); and
• Provide for expedited consideration of tax reform in the 113^th Congress.

As to what tax reform would look like, the legislation calls on Congress to take up a bill that “contains at least each of the following proposals:

  (1) a consolidation of the current 6 individual income tax brackets into not more than two brackets of 10 and not more than 25 percent;

(2) a reduction in the corporate tax rate to not greater than 25 percent;

(3) a repeal of the Alternative Minimum Tax;

(4) a broadening of the tax base to maintain revenue between 18 and 19 percent of the economy; and

(5) a change from a ‘‘worldwide’’ to a ‘‘territorial’’ system of taxation.”

In other words, the legislation outlined here appears to be fully consistent with the principles included in our Pass-Through Coalition Letter sent up to the Hill last fall and are something the business community, particularly those who represent a significant number of pass-through businesses, should support.

Taxing Employers

One key statistic that emerged from last week’s roll-out of the Ernst & Young study was something we had overlooked from the Treasury report on small businesses, published last August.  Our friends at NFIB pointed it out.

The study, entitled “Methodology to Identify Small Businesses and Their Owners,” was prepared by the Office of Tax Analysis with an eye towards redefining away small business, but many of its numbers have been extremely helpful in defending business owners, including this one:

• 28 percent of business employers in the United States have incomes exceeding $200,000.

You read that correctly — more than one in four business employers has income high enough to be subject to the higher tax rates at the center of the rate debate.

How exactly does this number compare to the favorite talking point of the other side — that these rates apply to less than three percent of small business owners?  Here are a couple differences:

• The larger number includes employers only — people who create jobs.  The three percent number includes taxpayers reporting any level of business income, no matter how small.
• The larger number includes taxpayers with more than $200,000 in income, while the smaller number is restricted to those who pay the top two rates.
• And finally, the larger number includes those employers who pay the Alternative Minimum Tax.  They may have income high enough to pay the top two rates, but they pay the AMT instead.

This latter point is something that came out our of Ernst & Young study.  More than half the business owners who would otherwise pay the top two rates are actually captured by the AMT instead (1.2 million out of a total 2.1 million) and are not counted in estimates of how many business owners would be affected.  If Congress were to reform or eliminate the AMT, they would suddenly become part of the pool.

So what is our take-away?  This is a debate about jobs and investment, and the Treasury estimate above suggests that proposals to raise the top two rates will directly impact a large number of employers, and has the potential to impact even more — just more evidence that raising rates on private businesses will be bad for jobs and investment.

New S-CORP Study in the News

As our Washington Wire readers know, S-CORP released an important study on Tuesday by Bob Carroll and Gerald Prante from Ernst & Young. The new study focuses on the rate debate in Congress and its impact on job creation and business investment, concluding that allowing the top rates on individual, business, and investment income to rise starting next year would, over time, result in fewer jobs, lower wages, and less investment.  The study also found that more than 72 percent of S corporation income is earned by the 500,000 S corporation owners who pay the top two rates.

The study has received some great attention in the news and with policy makers. Below is some of the coverage we’ve seen in the press, and we certainly anticipate more to come.

• Washington Post
• Speaker Boehner
• House Ways & Means
• Sen. McConnell’s Floor Statement
• Bloomberg News
• National Journal
• Washington Examiner
• Washington Free Beacon
• The Hill
• Yahoo! News

Fox News anchor Bret Baier also had study author Bob Carroll and S-CORP’s Executive Director Brian Reardon on his show  last night to talk about the study, which was rolled out yesterday at the National Federation of Independent Business.  You can view the segment, “Do tax increases hurt job creation?” below.

We’re going to follow up the study with a series of Hill briefings for members and staff.  All of this effort is in anticipation of votes in both the House and the Senate later this summer on extending the rates.

Visit our New “Take Action” Page

In an effort to be even more impactful on Capitol Hill, we encourage all of our Washington Wire readers to visit our website and the new “Take Action” page.  We put this up in anticipation of our efforts to support legislation to extend the current rates and it’s already having an impact — dozens of messages from S corporation owners around the country have been sent to their House and Senate representation.

Don’t delay!  Visit the “Take Action” page and let your voice be heard in this important debate.