Today, the S Corporation Association released a new study by Ernst & Young focused on the rate debate in Congress and its impact on job creation and business investment.
According to the study, 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. Key documents include:
- Ernst & Young Macroeconomic Study on Rate Hikes
- Highlights of the E&Y Study
- S Corporation Association Press Release
Authored by Dr. Robert Carroll and Gerald Prante of Ernst & Young, the study examines the economic impact of the higher tax rates at the heart of the rate debate in Washington right now:
- The top two rates on individual and flow-through income;
- Tax rates on capital gains, dividend, and interest income earned by taxpayers making more than $250,000;
- The reinstatement of the phase-out of itemized deductions (Pease); and
- The addition of the new 3.8 percent tax on investment income.
The study points out that this policy would raise the top tax rate on S corporation and other flow-through income from 35 percent to nearly 45 percent. As a result, the marginal effective tax rate on new business investment would be more than 15 percent higher than it is today, discouraging businesses from investing in new plant and equipment and resulting, overtime, in fewer jobs and lower wages. As the study concludes:
Through lower after-tax rewards to work, the higher tax rates on wages reduce work effort and labor force participation. The higher tax rates on capital gains and dividend increase the cost of equity capital, which discourages savings and reduces investment. Capital investment falls, which reduces labor productivity and means lower output and living standards in the long-run.
- Output in the long-run would fall by 1.3%, or $200 billion, in today’s economy.
- Employment in the long-run would fall by 0.5% or, roughly 710,000 fewer jobs, in today’s economy.
- Capital stock and investment in the long-run would fall by 1.4% and 2.4%, respectively.
- Real after-tax wages would fall by 1.8%, reflecting a decline in workers’ living standards relative to what would have occurred otherwise.
These results suggest real long-run economic consequences for allowing the top two ordinary tax rates and investment tax rates to rise in 2013. This policy path can be expected to reduce long-run output, investment and net worth.
For the past year, the S Corporation Association has partnered with NFIB, the US Chamber, and other business groups to highlight the challenge the pending Fiscal Cliff poses for pass-through businesses and their employees. This study builds on the 2011 Ernst & Young study which found that pass-through businesses are the majority employer in the United States, providing 54 percent of private sector employment.
Larger pass-through businesses contributed significantly to this employment level, employing approximately one out of six private sector workers. Meanwhile, a recent CRS report found that the five industries most affected by raising taxes on large S corporations (those with more than $10 million in revenues) were manufacturing, wholesale and retail, mining, transportation, and construction. Those are the industries most at risk if rates rise starting next year.
Moving forward, the S Corporation Association plans to take this new study and related materials up to Congress to continue to educate policymakers on the important role pass- through businesses play in job creation and investment. The Congressional Budget Office predicts that failure to address the Fiscal Cliff will send the economy into recession in the short term. The new Ernst & Young study shows that failure to stop just the top rates from rising has the potential to cause long term harm as well. It’s an important contribution to the on-going debate, and we’re going to make sure it’s heard.
It’s been an active week for supporters of an extension of built-in gains (BIG) tax relief.
First, Sens. Olympia Snowe (R-ME) and Mary Landrieu (D-LA) worked to find another way to highlight an extension of built-in gains relief, culminating in a package of small business tax and other provisions that got 57 votes on the floor today.
Together with Sens. Ben Cardin (D-MD) and Pat Roberts (R-KS), our Senate allies have continued to press the need to extend this important access to capital provision for small and closely-held businesses, and we appreciate their efforts.
Second, Reps. Jim Gerlach (R-PA) and Ron Kind (D-WI) introduced a bill last night to permanently extend several important small business provisions that have expired, including BIG relief. In addition to permanently extending the five year holding period for built-in gains assets, the bill, H.R. 6102, would also extend on a permanent basis the:
- 100 percent exclusion of gain on certain small business stock.
- 5-year carryback of general business credits of eligible small businesses
- Alternative minimum tax rules for general business credits of eligible small businesses
- Increased expensing limitations and treatment of certain real property as section 179 property made permanent
- Special rule for long-term contract accounting made permanent
- Increase of amount allowed as a deduction for start-up expenditures made permanent
- Allowance of deduction for health insurance in computing self-employment taxes made permanent
Third, we’ve added some cosponsors to the S Corporation Modernization Act, H.R. 1478, introduced by Reps. Dave Reichert (R-WA) and Ron Kind (D-WI) which also includes a permanent extension of the five year holding period. Rep. Richie Neal (D-MA) and Pete Sessions (R-TX) have been added to the cosponsor list, and we are thankful!
Three cheers for our BIG supporters in the House and Senate! Now, let’s keep our fingers crossed for some action on important provisions like BIG in the near future!
S Corp in the News
Just 173 days until we reach the Fiscal Cliff, and the volume of the debate has picked up sharply.
The S Corporation Association was featured on NPR’s “Marketplace” Wednesday. The story, authored by Mitchell Hartman, focused on the national debate over tax rates and their impact on jobs, and provided S-Corp with a good opportunity to highlight our new Ernst & Young numbers on how many S corporations are harmed by the higher rates.
Mitchell Hartman: I started with a group called the S Corporation Association. They represent business owners who pass their business’s income through a corporation, partnership or sole proprietorship. Then they file a personal income tax return. These are the people whose taxes might go up.
There are 25 million of them, says executive director Brian Reardon.
Brian Reardon: Of those 25 million, 2.1 make more than the $250,000 threshold.
Mitchell Hartman: The other 23 million? They don’t make enough to get dinged under the president’s proposal. Let’s ignore them.
But not all the business owners who make $250,000 actually pay the top rate. A lot of them pay the alternative minimum tax. So the real number whose taxes might go up? Just under a million.
Still, they’re important, says Reardon. Their businesses make most of the profits and employ half of all American workers. But would they slow down their hiring if they had to pay more in taxes?
Our take-away from this story is how much education we still need to do on the impact higher taxes, and particularly higher tax rates, have on the decisions employers make. And, by the way, those 1.2 million AMT-paying business owners aren’t out of the woods thanks to the new healthcare law and the impending 3.8 percent investment income tax hike.
There remains a consistent theme in certain circles of, “Oh, don’t worry. It’s only a small percentage of taxpayers that could get hit.” Well, that small percentage of taxpayers is generating more than 50 percent of pass-through business income. Does America need that much of its economy to be hit with higher taxes? You can guess what our answer is.
We would rather incent them to keep investing and creating more jobs – not less.
New Tax Foundation Numbers
A new report by the Tax Foundation gets it right. Here are the operative paragraphs:
It is often assumed that a tax increase on high-income individuals will have little impact on business activity because only 2 or 3 percent of taxpayers with business income are taxed at the highest rates. While this statistic is true, the more economically meaningful statistic is how much overall business income will be taxed at the highest rates. For example, Treasury data for 2007 indicates that 50 percent of all pass-through income is earned by taxpayers subject to the top two tax brackets of 33 percent and 35 percent.
As Table 1 indicates, the vast majority (66 percent) of pass-through business income was reported by taxpayers earning more than $250,000. Millionaire tax returns earned 36 percent of this private business income while taxpayers earning between $250,000 and $1 million earned 30 percent. Meanwhile, taxpayers with incomes below $100,000 earned 13 percent of all private business income.
These numbers are consistent with the estimates Ernst & Young produced for us earlier this week and make clear the threat raising top rates poses for pass-through business owners in general, and S corporation shareholders in particular – not to mention the broader economy.
President Obama announced yesterday his continued support for raising tax rates on Americans earning more than $250,000 ($200,000 for single filers). As the Wall Street Journal reported today, these policies would hit a large number of business owners:
Congress’s Joint Tax Committee—not a conservative outfit—estimates that in 2013 about 940,000 taxpayers will have enough business income to meet Mr. Obama’s tax increase threshold. And of the roughly $1.3 trillion in net business income, about 53% will get hit with the higher tax rates.
New numbers from Ernst & Young reinforce the impact these higher rates will have on S corporations and other pass-through businesses. According to Ernst & Young, business owners paying the top two rates earn:
- 72 percent of all S corporation income;
- 61 percent of all partnership income; and
- 13 percent of all sole proprietorship income.
As you can see, S corporations are more at risk of a tax hike than other pass-through businesses. Moreover, the numbers show that the more formal business structures — partnerships and S corporations — are more likely to have incomes exceeding $250,000 than the less formal sole proprietorships. More than half the business income at risk is earned by S corporation shareholders.
(Just as a reminder, the Congressional Research Service found the top five industries represented by large S corporations were manufacturing, retail and wholesale, mining, transportation, and construction. Those are the industries at risk here.)
And this doesn’t account for the 1.2 million business owners who make more than the President’s threshold but pay the AMT instead. They too will be paying higher taxes though thanks to the President’s health care law and the new 3.8 percent tax on investment income.
S corporations employ one out of every four private sector workers. All pass-through businesses — including S corporations, partnerships, and sole proprietorships — employ one out of two. The President would raise taxes on most of their income.
We knew raising taxes on employers during a period of high unemployment was particularly dangerous. Now we have a better idea of just how dangerous.
The S Corporation Association today responded to reports that President Obama would press to raise taxes on S corporation owners and other taxpayers earning more than $250,000 a year:
“Pass-through businesses like S corporations employ the majority of private sector workers. The President is proposing to raise taxes on a large number of their employers, putting those jobs at risk. According to the Joint Committee on Taxation, more than half of all pass-through income is taxed at the top two tax rates. Raising taxes on that much economic activity at a time when unemployment is already too high is harmful and dangerous. Instead of advocating for tax hikes, the President should embrace the House of Representatives plan to extend all rates for one year while putting into place a process for considering much-needed tax reform next year.”
ABC News on Pass-Through Tax Hike
A fact checker gets the jobs story right:
The Supreme Court upheld the constitutionality of the individual mandate today. For health care agencies, providers, insurance companies, and states that means they have 18 months to rework their entire health care system, including creating the network of state-based exchanges where people will buy health insurance starting in 2014. It’s time for them to get busy.
For S corporation shareholders and other taxpayers, it means higher taxes starting in 2013. Specifically, the ruling preserves the new, 3.8 percent tax on investment income that will take effect next year. Coupled with the expiration of rates, the new top rates are:
- S Corporation and Partnership Income: For shareholders/partners who work at the company, the new top rate rises from 35 percent to 40.8 percent. For shareholders/partners who don’t work at the business, the top rate rises to 44.6 percent.
- Capital Gains: The top rate rises from 15 percent to 23.8 percent.
- Dividends: The top rate rises from 15 percent to 44.6 percent.
- Interest: The top rate rises from 35 percent to 44.6 percent.
Based on conversations with our members and other business groups, it is apparent that these higher tax rates on investment income are having a meaningful impact on investment and hiring decisions right now. Faced with this pending tax hike, employers are simply holding back.
These higher rates are also the reason S-Corp fully supports the House effort to pass legislation prior to the August break that would extend for one year all the current rates while setting into motion a process for tax reform in 2013.
With the Supreme Court ruling behind us, and the new 3.8 percent investment tax locked into place, it is even more important that the business community rally around the effort.
We have long argued that the American economy benefits from allowing entrepreneurs multiple business forms from which to choose.
Each business has its own unique capital, management, governance, and transition challenges, and allowing those businesses to choose between C corporations, S corporations, LLCs, partnerships, and sole proprietorships enables them to pick the structure that best suits their needs.
New data from SNL Financial focused on banks suggests entrepreneurial choice may also contribute to a bigger economy. As described in American Banker:
The return on assets at the median S corp has consistently outdistanced the median for C corps by a wide margin over the past six years, even after adjusting earnings for S corps as though they paid corporate taxes, according to data from SNL Financial. In 2011, the median was 0.89 percent for S corps and 0.58 percent for C corps. (Unadjusted, the median for the S corps was 1.13 percent.)
The median return on equity for the S corps also consistently beat the median for C corps by a large gap, while median leverage, as measured by equity to assets ratios, was roughly on par between the two groups. (Institutions considered here had less than $500 million of assets at yearend and did not change their tax status between 2006 and 2011.)
S corps are entities with fewer than 100 shareholders that elect to pass their tax liabilities through to their owners, avoiding the double taxation of income that applies to ordinary C corps.
There is no reason that S corp status should translate into better fundamental performance, but perhaps smaller ownership groups tend to demand more from executives. Or perhaps executives at S corps are more likely to have big ownership stakes themselves.
With less than 200 days left before Washington leads the economy over the fiscal cliff, the Joint Committee on Taxation (JCT) has offered up more evidence that Congress needs to act to extend the current tax rates for everyone, including those business owners with higher incomes. As Bloomberg reports:
President Barack Obama’s plan to raise tax rates for the top 2 percent of U.S. households would mean higher taxes on the people who report 53 percent of business income reported on individual returns, according to the Joint Committee on Taxation.
According to the JCT, in 2013 nearly 1 million business owners (940,000) will have incomes that put them into the top two tax rates — 36 or 39.6 percent. Perhaps more significantly, this policy would raise marginal rates on more than half of all pass-through business income (53 percent). When you couple this finding with the fact that more than half of all business income is earned by pass-through businesses, the bottom line is that proposals to raise taxes on upper income taxpayers would hike rates on more than one quarter of all business activity in the United States.
Senate Finance Committee Ranking Member Orrin Hatch (R-UT) requested the analysis and observed:
This independent analysis is further irrefutable proof of why we simply cannot allow the President to have his way by raising taxes on small business. With our economy as weak as it is, it makes absolutely no sense to hit more and more small businesses with a tax hike.
Proponents of raising taxes point to the relatively small percentage of taxpayers affected (3.5 percent) and argue that it won’t hurt the economy. But raising marginal tax rates on that much economic activity is bound to meaningfully reduce investment and job creation.
Moreover, the size of the tax hike is daunting. The highest marginal federal tax rate today is 35 percent. Starting next January, the top rate rises to 44.7 percent! That’s the 39.6 percent rate, plus the 3.8 percent surtax from the Affordable Care Act, plus another 1.3 percent from the return of the Pease phase-out. Put another way, a business whose shareholders pay the top marginal rate would see the after-tax return on a dollar of its income drop from 65 cents to just over 55 cents– a decrease of 15 percent.
As we’ve said before, this debate is the difference between focusing on who’s being taxed and what’s being taxed. In this case, what’s being taxed is a very large percentage of overall business activity in the country. In our view, this is the more compelling perspective. Considering the weak job creation numbers recently, the economy seems to agree.
House leadership has made clear they will take up legislation to extend the current tax rates and other policies through 2013, combined with expedited procedures for tax reform to be enacted in 2013.
This one-two punch is designed to address two challenges facing policymakers today. The first is the tax component of the “fiscal cliff” we face at the end of the year. The pending expiration of the lower rates on wages, business income, and investment income is having a tangible, negative impact on investment and job creation right now and, left unchecked, threatens to push the economy back into recession. Businesses simply don’t know what the rules are going to be moving forward, and are reluctant to tax risks and hire new people as a result.
The second goal is to address the underlying instability in the tax code and its impact on jobs and investment through tax reform. The code is rife with challenges, including:
- The devolution of the Alternative Minimum Tax into a tax on millions of middleclass families;
- The growth in the number of temporary tax provisions, including the estate tax rules, that need to be extended every year or so; and
- The emergence of the U.S. tax rates on corporations and pass-through businesses alike as the highest in the developed world.
The purpose of the expedited process is to enable Congress to more easily develop and pass legislation addressing these challenges, while cutting overall marginal rates and improving incentives for work and investment.
While there is an element of “wait and see” to the reform portion of this package, our view is that the legislation outlined by House leadership is the most promising and responsible path for Congress to take right now and it deserves our support. A little clarity for employers coupled with the promise of reform would go a long way to improving the economic outlook now and into next year.
What are the bill’s prospects?
The House appears to have the votes to pass the legislation described above — a strong bi-partisan majority is not out of the question — but what about the Senate? Doesn’t the Democratic majority in that body have the votes to kill it? Maybe not.
The Hill today highlights an emerging group of Senate Democrats who oppose raising taxes on anyone right now. According to The Hill:
A growing number of Senate Democrats are signaling they are not prepared to raise taxes on anyone in the weak economy unless Congress approves a grand bargain to reduce the deficit.
At least seven Democratic senators have declined to rule out supporting a temporary extension of the Bush-era income tax rates, breaking with party leaders who have called for letting the rates expire for people earning more than $1 million per year.
Combined with the 47 Senate Republicans, those seven votes would give the proposed House bill majority support in the Senate, which is certainly good news.
That doesn’t mean the House bill will pass, however. It’s clear a minority of Senators are willing to stand aside and watch as tax rates on higher income taxpayers and businesses go up, and perhaps middle income Americans too. Again, according to The Hill:
Some Senate Democrats in safe seats have even gone so far as to privately propose allowing all the Bush tax rates to lapse to maximize their bargaining power with Democrats.
Democrats in Republican-leaning states blanch at this idea. They do not want to have to explain an across-the-board tax hike to constituents when economic growth is sluggish and unemployment is high.
So the House will pass a one-year extension in the next month, and then this debate will shift to the Senate, where it appears a minority of Senators will work to block the legislation from passing that body.
What can the S Corporation Association and its members do? Make clear to members in both the House and the Senate that allowing the current tax rates on business and investment income to expire is simply not an option. They must be extended if the economy is to return to its normal growth rates.
We’ve been on the Hill with that message for over a year now, and its beginning to gain traction. The pending vote in the House is a big step in the right direction, and our goal is to get as many votes — Republican and Democratic — as possible to send a signal that the Senate needs to act.
Building on the oral testimony of Congressman Dave Reichert (R-WA) at the member’s hearing on tax extenders held by the Ways and Means Revenues subcommittee, Congressman Ron Kind (D-WI) also weighed in to support extending built-in gains relief this year.
An original author of the S Corporation Modernization Act, Kind, in his written comments to the subcommittee writes:
A provision of chief importance is the provision reducing the holding period for Built-In Gains from 10 years to five years for those small businesses known as S corporations. This provision allows our business community to create jobs in the United States. Unlike public companies, these closely –held businesses have little or no access to the public capital markets, and must be able to access their own capital in a timely manner in order to grow their businesses, create jobs, and remain competitive. The S Corporation Modernization Act (HR 1478) that I co-authored with Dave Reichert (R-WA) extends the five-year holding period, and ensures that S-corporations will continue to spur job growth.
Unless Congress extends the five-year holding period, it will revert back to 10-years, and S corporations will be forced to wait an entire decade to access their own capital without penalty.
Meanwhile, the business community has come out in strong support of legislation extending important small business tax provisions, including a shorter Built-In Gains (BIG) holding period. The bill, S. 2050, the Small Business Tax Extenders Act of 2012, is sponsored by Senators Olympia Snowe (R-ME) and Mary Landrieu (D-LA) and features a permanent extension of the 5-year BIG holding period. As stated in the letter:
The bill grants much needed relief to S corporations, by increasing their ability to access capital. It does so by reducing the built-in gains holding period for S corporations. When businesses convert from a C corporation to an S corporation, they have been required to hold their appreciated assets for up to a decade or else face a punitive level of double taxation.
The letter was signed by the U.S. Chamber of Commerce, the National Federation of Independent Businesses (NFIB), the S Corporation Association and 23 other business groups. Main Street businesses know that these days growing our businesses is about access to capital – that’s what this bill is all about, and that’s why the business community applauds the leadership of Senators Snowe and Landrieu.
As always, we appreciate Congressman Kind and Congressman Reichert’s steady support for the critical Built-In Gain provision, as well as the willingness of Senators Landrieu and Snowe to feature the BIG holding period in their small business extender bill. These are the pieces that set the stage for tax conversations on the immediate horizon, so their contributions are invaluable!
This morning, Ways and Means Committee Chairman Dave Camp announced that the House would act this fall, prior to the November elections, to extend current tax rates while outlining a process whereby the Committee would consider broad, comprehensive reforms to the tax code in 2013. This is obviously very welcome news to S-Corps and other job creators! Here’s what he had to say:
I can firmly say our goal is: One, block massive, job-killing tax increases; and, two, enact – not just pass – comprehensive tax reform. And, there is strong support to use the expiration of the 2010 compromise as leverage to force action in 2013 on comprehensive tax reform. How? Simple: in addition to extending current low-tax policies originally enacted in 2001 and 2003, we should enact fast track procedures to compel comprehensive tax reform next year…
I intend to continue taking an open approach to tax reform, because I believe Congress wants and needs to hear from a variety of voices. We want to hear from small businesses who for too long have been living in fear because they are worried they will be used as the next “pay for” on something like a student loan bill.
Chairman Camp’s comments reinforce House Speaker John Boehner’s remarks made earlier this week at the Fiscal Summit sponsored by the Peterson Foundation:
Any sudden tax hike would hurt our economy, so this fall – before the election – the House of Representatives will vote to stop the largest tax increase in American history. This will give Congress time to work on broad-based tax reform that lowers rates for individuals and businesses while closing deductions, credits, and special carveouts. …
Our bill to stop the New Year’s Day tax increase will also establish an expedited process by which Congress would enact real tax reform in 2013. … The Ways & Means Committee will work out the details, but the bottom line is: if we do this right, this will be the last time we ever have to confront the uncertainty of expiring tax rates. We’ll have replaced the broken status quo with a tax code that maintains progressivity, taxes income once, and creates a fairer, simpler code.
The sooner the House votes on the package outlined by Camp and Boehner, the better. Its only 229 days before we fall off the “fiscal cliff” and how the House plan will be received in the Senate is anybody’s guess. Will the Senate act and prevent Taxmageddon or, as with the budget, will it ignore the pressing needs of the economy and simply do nothing? The sooner the House acts, the longer the business community has to put pressure on the Senate to follow suit.