Carrying the S-CORP flag before the House Ways and Means Select Revenue Subcommittee was Tom Nichols, the Chairman of S-CORP’s Board of Advisors.  The hearing focused on pass through business taxation issues and, in particular, the merits and shortcomings of the “Pass Through Draft” that Chairman Camp released earlier this year.

From the beginning, Tom’s testimony hit the high notes of the advocacy we’ve been conducting for the past two years:

“Tax Reform needs to be comprehensive and address the individual, pass through, and corporate tax codes at the same time. Congress should continue to foster progress toward a single level tax system for all businesses, and continue to strive to keep the tax rates paid by businesses and individuals as low as possible.

In this regard, the bipartisan Tax Reform Act of 1986 stands out as an excellent template for Tax Reform. It expanded the tax base by eliminating numerous preferences and privileges for specific taxpayer groups, thereby creating room to dramatically decrease the tax rates for C corporations, pass through businesses and individuals alike.

This approach allowed many, if not most, owners and managers to get out of the tax planning business and immerse themselves in the operations of their real businesses instead. It is my hope that the current Tax Reform effort will build on the policies and lessons learned in 1986.”

Tom went on to highlight provisions in the discussion draft that would help S corporations, including those provisions taken from H.R. 892, the S Corp Modernization Act of 2013.  This legislation has been an S-CORP priority for years and forms the core of “Option 1” in the draft.

While the panel expressed some reservations regarding the more aggressive “Option 2,” Tom did highlight several positive ideas incorporated in the reform, including making public-private ownership the new, improved line of demarcation between pass-through and C corporation tax treatment.  That’s a reform that can and should be included in any tax reform package.

This hearing is one of several we expect over the course of the summer, all leading up to the possible House consideration of tax reform sometime this fall.  As we’ve observed previously, others have argued that enacting tax reform is just too big a lift this year, and that little will happen.  We’re not so sure about that.  Congress needs to raise the debt limit, and it needs to address the long-term deficit picture.  How that happens is anyone’s guess, but there’s a confluence of fiscal policies all coming to a head this fall together with two very determined chairs of the tax-writing committees which suggests consideration of a big package that includes tax reform should not be discounted.  We’re certainly not.

New York Times on Tax Reform

The New York Times has weighed in with a couple of tax reform stories in recent days.

The first, entitled “In Tax Overhaul Debate, Large vs. Small Companies,” focuses on the possible rift between US-based multinational corporations and privately-held businesses over the goals of tax reform.

As we’ve noted before, we believe this rift is overstated.  Yes, there are a couple large corporations that argue Congress should cut their taxes while making private companies pay more, but these businesses are a distinct minority and their voice is falling on deaf ears among tax-writers.  The vast majority of the business community is united behind a tax reform effort that would lower rates on all forms of business while broadening the tax base.

The NY Times piece featured a couple of S-CORP Board members making this case, as well as the need to reduce high effective tax rates as the best means of encouraging increased investment and job growth.  As the story notes:

Companies that switched said the simpler, generally lower single-tax rules gave them a leg up and helped them grow.

McGregor Metalworking Companies, a family-owned business in Ohio and South Carolina, had 80 employees when it converted in 1986 and now has a work force of 370.

“It has been a real force for reinvestment,” said Dan McGregor, 69, chairman of the company, which has seven shareholders.

This impact is not for metalworking companies alone.  As our first Ernst & Young study made clear, the existence of pass-through businesses in the US means more investment, higher wages, and more jobs than if every business was subject to the double tax.  That’s the reason why Principle Three in the Main Street Coalition’s Principles for tax reform calls for tax reform to reduce the existing double tax.

The second story appeared over the weekend and gets right to the heart of the challenge over tax reform – i.e. the looming battle between those firms and industries that pay a high effective tax and those that do not:

Corporate taxes burst into the spotlight last week, with the release of a Senate committee report on Apple’s tactics to reduce its tax payments. More quietly, but perhaps more significantly, the House Ways and Means Committee has begun work on a potential overhaul of the tax code. Edward D. Kleinbard, a tax expert and former Democratic Congressional aide, said he had been impressed so far by the seriousness of the committee’s work.

The effort has a long way to go, but if it succeeds, both liberal and conservative tax experts hope it will reduce the statutory rate while also eliminating tax breaks. The net effect could be to close the gap between companies that pay relatively little in taxes and those that pay much more. The market, rather than the tax code, would then play a bigger role in determining companies’ success and failure.

As the Times notes, done correctly, tax reform will help level the playing field between those companies and industries currently paying little or no tax, and those that are currently shouldering a much higher tax burden.

Lastly, we should point out that a reader of these Times articles might come away thinking that pass-through businesses, including S corporations, pay a lower effective tax rate than their larger competitors.  We’re confident that’s not the case.  Previous work has shown that S corporations pay the highest effective tax of any business structure, and their marginal tax rates just went up, not down.  Meanwhile, as the second Times story made clear, the news is full of stories about how our largest corporations pay little or no tax.

More on this to come…

As you recall, S Corporation Modernization made up a significant part of Option One of the Ways & Means Pass-Through Discussion Draft.  Now, a group of 19 business groups, including the National Federation of Independent Business, the National Restaurant Association, the National Roofing Contractors, the Printing Industries of America, and the S Corporation Association sent a letter to Congress expressing their strong support for the modernization of outdated S corporation rules.  As the letter states:

Main Street businesses are the growth engine of America’s economy and S corporations are the cornerstone of the business community.  There are more than 4.5 million S corporations nationwide.  They are in every community and every industry and they employ one out of every four private sector workers. 

Yet many of the rules that govern the day-to-day management of S corporations date back more than half a century.   These outdated rules hurt the ability of S corporations to grow and create jobs.  Many family-owned businesses would like to become S corporations, but the rules prevent them from doing so.  Other S corporations are starved for capital, but find the rules limit their ability to attract investors or even utilize the value of their own appreciated property. 

Next, the American Bar Association Section on Taxation also submitted comments supporting reform to the S corporation rules.  Under the heading of “Options for Tax Reform in Subchapter S” the authors list out a number of reforms to the rules governing S corporations that are consistent with many of the provisions included in H.R. 892, including Sting Tax Relief.  According to the authors:

Without a clear rationale for continuing the tax on excess net passive income, we believe that its repeal simplifies Subchapter S, eliminates traps for the unwary, reduces the administrative and recordkeeping requirements for S corporations, and promotes use of Subchapter S and the economic growth of small business corporations, without an appreciable loss of revenue.

Finally, an independent group of former and present chairs of the S Corporation Committee of the American Bar Association Tax Section submitted independent comments to the Pass-Through Working Group in support of reforming the rules governing S corporations.  As their letter states:

… we support permanently reducing to five years (from ten years) the built-in gains recognition period – the period following a C corporation’s conversion to S corporation status during which it must pay a corporate-level tax on certain net realized built-in gains…. The impact of the built-in gains tax may be quite significant when coupled with the individual-level tax imposed on the built-in gain passed through to the shareholders.  As a consequence, S corporations may avoid or delay restructurings or dispositions of assets no longer required or needed in the operation of the business, which can have an adverse effect on the business, and, in turn, can adversely affect the economy at large.  We believe that, once a reasonable period has passed to accomplish the purposes behind the built-in gains tax, the tax laws should no longer discourage sales of assets that no longer serve a productive purpose in the operation of a closely held business.  We further believe that a five-year period is sufficient to accomplish the purposes of the built-in gains tax, and that a longer period might well be counterproductive. 

Regarding other provisions included in the S Corp Modernization Act (as well as Option One of the Pass-Through Discussion Draft), the S corporation experts support many of those as well:

We also support the proposals with respect to charitable contributions, specifically modifying the shareholder basis adjustment rules for S corporations making charitable contributions and allowing a U.S. electing small business trust (an “ESBT”) to deduct charitable contributions made by the S corporation subject to the contribution limits and carryover rules applicable to individual donors.  We also support the proposal permitting non-resident aliens to be S corporation shareholders through an ESBT.  Because an ESBT is separately taxed on income earned from the S corporation, non-resident aliens will be subject to U.S. tax on their interests in S corporation income.

The S Corporation Association, with the help of its allies on and off the Hill, has been successful in its work to enact several of the S Corporation Modernization provisions over the years.  With strong support like that expressed above, we are hopeful we can repeat that success in the future.

The vast majority of policymakers view tax reform as embracing two fundamental goals:

• Increased simplicity for both taxpayers and the IRS; and
• Lower marginal tax rates imposed on a broader base of income.

The President’s budget , however, would take us in exactly the opposite direction.  Rather than simplify the tax code, it would make it more complicated, and rather than move towards lower rates and a broader base of income, it would selectively lower and/or raise rates based on priorities that have little to do with simplicity or overall economic growth.

Corporate-Only Tax Reform:  The business community is united behind the premise that tax reform should be comprehensive and address the tax treatment of individuals, pass-through businesses and corporations.  Nonetheless, the Obama Administration continues to push Congress to consider budget-neutral, “corporate only” tax reform instead.

Under this approach, Congress would eliminate business “tax expenditures” and use the new revenue to offset lower rates on C corporations.  A 2011 Ernst & Young study made clear the challenge corporate-only tax reform presents to pass-through businesses.  According to E&Y, a broad policy of eliminating business tax expenditures while cutting only corporate rates would raise the tax burden on pass-through businesses by approximately $27 billion per year – and that doesn’t include the additional hit to pass-throughs from their increased marginal tax rates beginning as of January 2013.  The most affected industries include agriculture and mining, followed by construction, retail trade, and manufacturing.

This shift in the tax burden happens because pass-through businesses use the same business deductions as their C corporation counterparts.  So, if a simple reform package eliminated the Section 199 manufacturing deduction in order to offset a reduction in corporate tax rates, a manufacturer organized as a C corporation would lose the use of that deduction, but they would get a lower corporate rate in return.  It is a mixed bag.

For the S corporation manufacturer down the street, however, there is nothing but downside.  They too would lose the use of Section 199, but unlike their C corporation competitor, the resulting higher tax base is not offset by lower tax rates.  Instead, tax rates on the pass-through manufacturer just went up.  Corporate-only tax reform represents a double whammy on pass-through businesses – higher tax rates imposed on a broader base of income.

To address this challenge, some advocates have suggested allowing pass-through businesses a deduction on their income, or even separating pass-through business income from individual income and taxing it at different rates.  While these options might mitigate the adverse impact of corporate-only tax reform on pass-through businesses, it also inflicts serious damage to the tax reform effort in general.

Prior to the 1986 Tax Reform Act, the tax rates on individuals and pass-through businesses were significantly higher than the tax rate imposed on C corporation income.  Here is how tax attorney Tom Nichols described the situation during his testimony before the Ways and Means Committee last year:

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.  These provisions included Internal Revenue Code (the “Code”) Sections 302 (treating certain redemptions of corporate stock as “dividends”) and 304 (treating the purchase of stock in related corporations as “dividends”), as well as Code Sections 531 (imposing a tax on earnings retained inside the corporation other than “for the reasonable needs of the business”) and 541 (imposing a tax on the undistributed income of “personal holdings companies” deriving most of their gross income from investments). 

In other words, business owners began making decisions based on the tax code and not on the needs of their business.  The 1986 Tax Reform Act ended this dynamic.  Corporate-only tax reform would restore it.  It is literally “anti-tax reform.”

Buffett Tax:  The Buffett Tax is again included in the President’s budget submission as a means of raising revenue while ensuring that the tax code is more progressive and fair.  Despite the frequency with which the President and others talk about the need for the Buffett Tax, the arguments in favor of the tax are uniformly weak.

Congressional Budget Office (CBO) analysis makes clear that the federal tax code is already strongly progressive.  According to the CBO, the top 1 percent of taxpayers in 2009 paid an effective tax rate of 29 percent, or nearly three times the effective tax rate paid by moderate income taxpayers (11 percent).

Moreover, we already have three tax codes for individual income, not counting the payroll tax system used to finance Social Security and Medicare.  That is, we already impose three distinct tax rate structures on three distinct definitions of income earned by individuals and pass-through business owners:

1. The Individual Income tax
2. The Alternative Minimum Tax (AMT)
3. The Affordable Care Act Investment Tax

By any reasonable standard, tax reform should seek to reduce rather than to increase the number of tax codes we impose on families.  Yet proponents of the Buffett Tax would impose yet a fourth tax code, this time on families and pass-through businesses earning in excess of $1 million dollars.

Under the Buffett Tax, families and business owners earning that much in income would need to calculate their taxes four different ways!  First, they would calculate their taxes under the Individual Income tax, then under the new Investment Surtax, then under the AMT, and then, after adding all those taxes together, they would need to calculate their overall Buffett Tax liability and see if it is higher.

On this basis alone, Congress should reject the Buffett Tax concept.

For S corporations and other pass-through businesses, however, there are other reasons for rejecting the Buffett Tax.  As discussed above, S corporations must make quarterly distributions sufficient for their shareholders to pay taxes on the business’ income.  The Buffett Rule would exacerbate this challenge by forcing an S corporation to calculate and distribute additional earnings, even if only one of its shareholders has (or might have) income subject to the Buffett Tax.  The result would be to drain additional capital and resources from S corporations seeking to build up their equity and working capital.

Finally, perhaps the most dramatic and unfair consequence of the Buffett Tax for closely-held business owners would occur in the context of a sale of the business.  The current federal tax rate for sale transactions is 20 percent (before taking into account the 3.8 percent additional tax on net investment income).  The Buffett Tax would increase this tax rate for taxpayers making more than $1 million, even if that higher income was triggered by a “once in a lifetime” transaction involving the sale of a business built up over decades, effectively punishing entrepreneurs for starting and building a successful business.

By definition, both corporate-only tax reform and the Buffett Tax would make the tax code more, not less, complex.  They are anti-tax reform and should be rejected by Congress.

As the letter states:

Every day, nearly 70 million Americans go to work at a firm organized as something other than a C corporation.  These “flow-through” businesses, structured as S corporations, partnerships, LLCs, or sole proprietorships, represent 95 percent of all businesses and they contribute more to our national income and our job base than all the C corporations combined.

Despite these contributions, recent press reports suggest that the Administration and some Members of Congress support budget-neutral legislation that would reform the tax code for C corporations only.  The proposal would be to reduce the tax rate on C corporations and offset those lower rates by eliminating or reducing tax deductions and credits used by all businesses.  

That approach means the same firms that just saw their tax rates go up on January 1^st will be subject to yet another tax hike, this time in the form of fewer business deductions and a broader base of taxable income. 

If these arguments sound familiar, they should.  The S Corporation Association and its allies have been warning Congress about the perils of “corporate-only” tax reform since the idea was first floated by the Treasury Department two years ago.  It was those warnings that caused us to ask Ernst & Young to study exactly what budget-neutral, corporate-only tax reform would mean to Main Street businesses.  The answer:  $27 billion a year in higher taxes.

And that was before tax rates on Main Street business went up in January.  The hit today would be much higher.

As before, the S Corporation Association supports reforming the corporate tax code.  Rates on public corporations are too high.  But every argument in support of reducing the corporate rate also applies to the tax rate imposed on pass-through businesses like S Corporations.

Ways & Means Chairman Dave Camp recognizes this key fact and is committed to comprehensive tax reform that addresses the individual, pass-through, and corporate tax codes.  We look forward to working with the Chairman and other policymakers to ensure that tax reform is broad and benefits all employers, including those located on Main Street.

Two Budgets – Two Visions

The House and Senate will consider their respective budgets this week.  You can find the pertinent documents at the following sites:

• House Budget Resolution
• Senate Budget Resolution

There is a lot of commentary flying around about which budget embraces the better vision for America, but we think the analysis by our friend Charles Blahous is the most straightforward.  Rather than getting bogged down in opaque world of baselines and savings figures, Charles focuses on the top line numbers instead – how much does the budget spend, how much does it tax, and what happens to the deficit and debt.  Here’s his chart for the spending:

As you can see, the there’s a significant difference in the projected size of government between the two budgets.  Spending currently is at inflated levels, and the Senate budget would continue those high levels with the prospect of even higher spending in the out years.  Meanwhile, the House budget would return spending to around its post-WWII average.

What happens to revenues?

Again, the Senate budget embraces higher-than-average tax collections for the next ten years, calling for an additional $1 trillion in taxes over current policy, while the House would lock in current revenue estimates and calls for revenue-neutral comprehensive tax reform.

So where does that leave the deficits and debt?

The House budget projects balance by the end of the ten-year budget window, whereas the Senate budget would result in steady-state deficits of between two and three percent of GDP for the next decade.  Moreover, because the Senate budget fails to tackle entitlement reform, it’s likely those deficits and debt levels would quickly rise in the following decade, placing increased pressure on Congress to raise taxes beyond the $1 trillion tax increase already called for in the Senate budget resolution.

It is this latter concern that has united the business community around the need for entitlement reform.  In recent months, the Chamber of Commerce and our Main Street Business coalition have issued broad statements signed by hundreds of business organizations calling on Congress and the Administration to reform our entitlement programs.

• Chamber Letter
• Main Street Business Coalition Letter

This unity of purpose is unprecedented in our experience and should act as a signal of the enormity of the challenge.  Unless we reform our entitlement programs, even the most successful tax reform bill enacted today will short lived and have to be revisited by a future Congress.

“The S Corporation Association strongly applauds Chairman Camp and the Committee for their efforts.

The Chairman is committed to a comprehensive reform of the tax code, and he’s made clear that the Committee intends to conduct this reform in a transparent and interactive process.  This means more work for them, but it also promises a better policy outcome for America’s businesses.    

The Committee draft released today would improve the rules governing S corporations, making it easier for them to raise capital, manage their businesses, and transfer the business on from one generation to the next. 

The S Corporation Association has a long history of supporting many of the provisions included in today’s draft, including making permanent the five-year holding period for built-in gains, expanding the ability of S corporations to have foreign shareholders, and reducing the harmful effects of the ‘sting’ tax.  Most recently, these provisions were included in the S Corporation Modernization Act (H.R. 892) introduced by Reps. Dave Reichert (R-WA) and Ron Kind (D-WI) last week.” 

While there are many details to work out, the draft presented today is an excellent start and we’re eager to work with the Committee and its Working Groups to construct the best possible framework for America’s small and closely-held businesses.”

Our plan for the next several weeks is to work with the pass-through business community to dive into the details and provide comments to the Committee and the Working Groups.  Expect to hear more on this soon.

Small Business Survey Supports Comprehensive Tax Reform

Last week, S-CORP ally NFIB released an impressive survey of small-business owners on the tax and spending issues before Congress.  The survey can be found here.

Our main take-away is that the small business community strongly supports tax reform.  NFIB found that eight out of ten business owners support comprehensive tax reform while a similar number believe tax reform means lower rates applied to a broader base.

Moreover, business owners are ready to put their money (preferences) where their reform is by identifying specific tax items that should be repealed or paired back.  The most popular preferences to reduce or eliminate include the mortgage interest deduction (73 percent), the employer-provided health insurance (57 percent) and tax-exempt bonds (47 percent).

Some other interesting points:

Thirty-four percent of owners have spent money planning for the estate tax while another 15 percent expect to spend money in the future.  So much for the old saw that “nobody is affected by the estate tax.”  If they’re not affected, why are all these business owners paying somebody to get prepared?

On the budget front, small-business owners are all about cutting spending.  More than one-third favor balancing the budget through spending cuts only, while nearly two-thirds believe that spending cuts should make up at least 75 percent of the deficit reduction.  This position fits with our recent letter to Congress supporting reforms to our entitlement programs and is consistent with the push for tax reform.  Without entitlement reform, pro-growth tax reform is simply not possible.

Oh, and finally, 45 percent of NFIB members are organized as S corporations!  No wonder we work so well with them!

Specifically, H.R. 892 would make needed changes to keep S corporations competitive and ensuring continued success of America’s predominant private business model by:

• Increasing the ability of S corporations to access much-needed capital;
• Modernizing the rules that apply to firms that have selected S corporation status; and
• Easing and expanding S corporations’ ability to make charitable donations.

Said Congressman Reichert of the bill in a press release—which also cites our 2011 Ernst & Young study—issued on Thursday:

This tax relief proposal that would make it easier for S corporations to access capital, compete, and hire new workers by modernizing outdated rules that currently stifle their growth. A 2011 independent study revealed tax law dealing with S corporations affects 31 million Americans as S corporations employ one out of four workers in the U.S. private sector.

“S corporations and similar businesses are responsible for more than half of the jobs in Washington State and across America,” Rep. Reichert said. “As our economy continues to struggle to regain sound footing, I’m proud to introduce bipartisan legislation to help these proven job creators access the capital needed to grow, compete, and get Americans back to work. Working with the Ways and Means Committee toward comprehensive tax reform, I am committed to supporting these small businesses by advocating for pro-growth tax policies.”

The Reichert-Kind legislation presents a realistic set of reforms that would improve the ability of 4.5 million S corporations to access much-needed capital and increase their hiring capabilities.  These reforms would improve the ability of S corporations to respond to the current business environment and remove impediments that prevent them from competing on a level playing field at home in the United States.

The bill is consistent with legislation introduced in the past, and we’re confident several of these provisions will be seriously considered this Congress.  Thank you Mr. Reichert and Mr. Kind!

The core tax hike in this package is our old friend – the Buffett Tax.  We’ve previously pointed out the serious flaws in both the premise and the execution of the Buffett Tax.   The provision contained in S. 388 suffers from all these flaws.

How would it work?

In this case, the bill would impose a new, minimum tax of 30 percent on taxpayers earning $5 million or more.  The minimum tax would begin to phase-in once a taxpayer’s income rises above $1 million.  In effect, the new tax would result in three distinct tax codes, each with its own rate schedule and definition of income:

• The Individual Income Tax
• The Alternative Minimum Tax
• The New Fair Share Tax

So, if enacted, shareholders of successful S corporations and other taxpayers would be forced to calculate their taxes three different ways.  First, they’d have to calculate their regular income tax, then they’d have to calculate their liability under the AMT, and then, finally, they’d have to calculate their new Fair Share tax obligation.  In the end, they would pay whichever is greater.

For successful S corporations and other pass-through businesses, this policy would just add to the long list of tax challenges they face.  C corporations would not pay the Buffett Tax just as they don’t pay the individual AMT (there is a corporate AMT, but it doesn’t seem as pervasive).  And unlike C corporations, the top rates on pass-through businesses just went up from 35 percent to a high of nearly 45 percent.

At a time when the rest of Washington is focused on tax reform, the Senate is considering policies that move in exactly the opposite direction.  This is anti-tax reform, but apparently it polls well, so it’s in the package.  The Senate will defeat this effort to swap lower spending for higher taxes today, and at some point, serious minds will assert themselves and begin to consider serious efforts at comprehensive tax reform that lowers the rates and broadens the base.  In the meantime, we have this.

“Corporate-Only” Tax Reform

It’s hard to distinguish “corporate” tax reform advocates with “corporate-only” advocates these days.  We like the former and work closely with them to support comprehensive tax reform – reform that includes individuals, pass-through businesses and C corporations.  On the other hand, the latter group seems to spend as much time pushing for higher taxes on pass-through businesses as they do calling for lower rates on C corporations.  They are definitely not our friends.

So, which category does this group fall into?

We are writing as a group of academic and consulting economists who believe that the U.S. corporate income tax rate should be reduced from its current 35 percent level to one that is competitive with the rates in almost all other major industrial countries….Such a move would likely lead to a more efficient allocation of resources, increased investment and employment in the United States, and higher wages.

Let’s be clear.  We agree that the 35 percent corporate rate is too high and should come down.  Moreover, many of the 20 economists who signed the letter are our friends and agree with us nine times out of ten on what constitutes “good tax policy.”

That being said, what about the rates imposed on pass-through businesses?  The letter is silent on them despite the fact that those businesses that earn most of the business income and employ most of the workers?  Their top rate is closer to 45 percent, not 35 percent. That higher rate also “undermines job creation and reduces wages,” doesn’t it?

You bet it does, but this economist statement fails to acknowledge even the existence of America’s flow-through sector and it ignores the impact of the new higher rates on pass-through businesses and the 70 million workers they employ.  Worse, by limiting its focus to rate reduction for C corporations, it lends credibility to those few remaining voices who argue that the “corporate-only” approach is both feasible and good policy.  The simple response is its not – Congress either tackles tax reform in a comprehensive manner or not at all.

Perhaps it’s time for a “Pass-Through Business Economist Statement.”

• Working with the tax committees to make their tax reform proposals as business friendly as possible;
• Fighting the Administration’s efforts to turn tax reform into another opportunity to raise taxes on Main Street Employers; and
• Fighting specific proposals to unfairly target S corporations and raise their taxes through discrete provisions like the payroll tax hike.

The President’s State of the Union address this week did little to change this outlook.  In a world where 99 percent of policymakers agree that tax reform means lower marginal rates imposed on a broader base of income, the President’s view (illustrated by last year’s corporate reform proposal and his continued support of higher marginal rates) is just the opposite – higher marginal rates coupled with more special interest tax provisions.   It’s the same anti-tax reform perspective offered by Senator Chuck Schumer late last year.

It’s this difference in perspectives that’s behind the pessimism over whether Congress will tackle tax reform this year.  The gap appears just too large for Congress to find common ground and it would require a very, very large catalyst to bridge it.

Well, it’s possible that just such a catalyst is right on the horizon.  The combination of sequestration cuts starting next month and the need for Congress to raise the debt limit before the August break is just the sort of “rock and a hard place” scenario that could compel action.

Here’s why.  The pain, political and otherwise, from the sequestration cuts will not be felt immediately but will instead grow over time.  Each month will bring additional stories of how the cuts are adversely affecting Americans and US policy.  Meanwhile, we know from experience that the House of Representatives will resist raising the debt limit without some sort of accompanying deficit reduction package.

So, starting this summer, Congress will be under tremendous pressure to revisit the sequestration cuts at the same time the tax-writers are talking tax reform and the House is insisting on additional deficit reduction.  All while Congress is facing a deadline to extend the “must-pass” debt limit.

For these reasons, we’re taking tax reform seriously.  The debt limit-tax reform scenario may play out differently, but the risk is simply too great to do otherwise.

We Are All for Comprehensive Reform Now

Two years ago, the S Corporation Association undertook the effort to combat “corporate-only” tax reform.  We support cutting the corporate rate, but tackling the corporate tax code in isolation is bad policy and bad politics, and with the help of our E&Y study on the subject, we were able to quantify just how bad it would be for businesses organized as pass-through businesses – “$27-billion-a-year-in-higher-taxes” bad.

House Ways and Means Committee Chairman Dave Camp has always understood this challenge and has been a consistent advocate for comprehensive reform.  Recent comments by Senate Finance Committee Chairman Max Baucus suggest he too understands the important role pass-through businesses play in jobs and investment— at 69 percent, his home state of Montana has the highest percentage of pass-through employment in the nation, after all.

With his comments in the State of the Union, it appears the President too has converted to the church of comprehensive tax reform.  Here’s what he said:

Now is our best chance for bipartisan, comprehensive tax reform that encourages job creation and helps bring down the deficit.  We can get this done. 

Of course, he coupled that statement with a call for raising tax rates on high-income individuals, raising taxes on the overseas operations of multinational corporations, and for continued use of the tax code to target specific industries and taxpayers, so we’re not getting too excited here.

But the word “comprehensive” remains significant.  Until somebody says otherwise, we’ll assume this means the President has backed away from his corporate-only proposal of last year.  Let’s hope so.

Sequestration Highlights Threat to Pass-Through Businesses

Efforts to replace the sequestration spending cuts have highlighted the on-going threat S corporations and other pass-through businesses face this Congress.

For example, on Tuesday, Senators Whitehouse (D-RI) Levin (D-MI), Harkin (D-IA) and Sanders (I-VT) introduced two bills to offset the sequester with tax hikes.  The first includes tax increases necessary to postpone the sequester until October 1, while the second would raise the taxes necessary to replace it entirely.  As you can see, it’s the usual suspects list of LIFO and Carried Interest tax hikes, etc.

Another list posted by Politico reported the other day includes even more items:

POSSIBLE SENATE DEM SEQUESTER REPLACEMENTS — These ideas are making the rounds:

“1) closing off a variety of “offshore tax shelters”;

 2) ending preferential tax treatment for many private equity and hedge fund managers’

3) taxing the exercise of stock options more heavily …

AMONG THE REVENUE ESTIMATES —

“1) Closing Carried Interest (14 billion);

2) Closing Corporate Jet (4 billion);

3) Closing Oil & Gas Credits (21 billion)

4) Farm Direct Subsidies (5 billion);

5) Closing S Corp pass Through (76 billion);

6) New Sen. White House Tax Proposals;

a) Set Min Rate for Millionaires;

b) higher rates for Oil & Gas;

c) SubPart F changes: Focus on Passive Income, Transfer Pricing & Loans to Parent Co.”

Again, it’s the usual list, but what is this?

“5) Closing S Corp pass Through (76 billion);”

Closing S corporations?  $76 billion?  That’s a new one, and the description is just vague enough that it could be anything.  That said, the only S corporation tax item out there with $76 billion attached to it that we know about originates with a Congressional Budget Office report from December entitled, “Taxing Businesses Through the Individual Income Tax.”

Here’s the key sentence:

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.

In other words, if Congress repealed the current tax status of around 7 million private companies and subjected them instead to the double corporate tax, the CBO says you might raise some money.   But $76 billion a year?  Not likely:

Behavioral responses-for example, owners of S corporations might have reduced those corporations’ taxable income by reporting larger amounts for their compensation (which would have raised payroll taxes and lowered corporate income taxes relative to CBO’s estimate)-would have changed the amount of additional tax revenue that would have been collected.  Furthermore, the estimate does not account for interactions with other tax provisions, such as the alternative minimum tax.

Later in the paper, the CBO makes clear such a policy would result in less investment, lower wages, and more debt:

Nevertheless, the trend toward pass-through entities’ accounting for a larger share of business activity has some positive aspects. For example, it has probably reduced the overall effective tax rate on businesses’ investments, thus encouraging firms to invest. (The effective tax rate combines statutory rates with other features of the tax code into a single tax rate that applies to the total income generated over the life of an investment.) The shift in activity toward pass-through firms has also reduced at least two biases associated with the current corporate income tax that influence what businesses do with their earnings and how they pay for their investments: 

• The bias in favor of retaining earnings rather than distributing them, which results from taxing dividends immediately but deferring the taxation of capital gains; and
• The bias in favor of debt financing, which results from allowing businesses, when they calculate their taxes, to deduct from their income the interest they pay to creditors but not the dividends they pay to shareholders.

It’s clear to us that whoever added this idea to the list likely had no clue what they were proposing, but it’s also in indication of just how desperate some in Congress are for revenue that they would even list something like this.

Forcing 7 million businesses into the double corporate tax is simply bad policy.  It moves the tax code in exactly the wrong direction – we should be reducing the double tax, not increasing it.  That’s the way to reduce the cost of capital and make American businesses more competitive.

That view may prove correct, but there remain several good reasons to believe taxes will be a big part of the policy conversation moving forward, including:

• Debt Limit:  The debt limit fight hasn’t been avoided, just delayed.  Congress will need to raise the limit prior to the August break, setting up a redo of the 2011 negotiations that resulted in $2 trillion in deficit reduction over ten years.
• Budget Season:  By delaying the debt limit fight, Congress put the focus back where it should be — on budgets and the long-term fiscal imbalance.  The House, Senate, and White House will all need to produce their vision for federal spending and taxes this spring, helping to set the table for the debt limit fight to follow.
• Sequestration:  The odds of sequestration will take effect as written beginning March 1^st ($85 billion in total cuts this year with $43 billion from defense and $11 billion from Medicare) are rising every day.  Republicans are determined to keep the focus on spending, and alternatives that replace some or all of the cuts with tax hikes stand no chance in the House.  That said, one or two months of sharp cuts to defense spending may be enough to convince Congress that it needs to replace the across-the-board cuts with more targeted ones.
• The CR:  And finally, Congress needs to extend funding for the government when the current continuing resolution expires on March 27^th.

Congress will have to deal with each of these items, either individually or in some combination, before the start of summer, which begs the question:  How does Congress get past all these fiscal hurdles without dragging tax policy into the discussion?  Add in the fact that both the Ways and Means and Finance committees have made clear that reforming the tax code is a priority for 2013, and we’re confident that tax policy will be part of the mix one way or another this year.

What does that mean for S corporations?  We see two distinct challenges moving forward.

The first challenge is to ensure that any broad-based changes to the tax code are a net positive for S corporations and other Main Street businesses.  As our coalition letter from last year made clear, tax reform needs to be comprehensive, it needs to keep rates on corporate, individual, and pass-through income uniform and low, and it needs to continue to reduce the double tax on corporate income.

Any tax reform that claims to make American businesses more competitive will need to embrace those three goals.

Second, we need to continue to fight ad hoc efforts to raise taxes outside of tax reform.  Congress is always hungry for revenues, and in recent weeks policymakers and left-leaning groups have released long lists of “revenue raisers” that include numerous threats to Main Street businesses, including:

• Increasing payroll taxes on S corporation income;
• Increasing the effective tax on inventories; and
• Hiking the estate tax by increasing valuations of family-owned businesses.

As long as federal spending is out of control, this thirst for new revenues will continue and will follow the predictable path from press conference to signing ceremony — target a group of taxpayers, marginalize their legitimacy, and then push to raise their taxes.

Which means the response to challenges 1 and 2 is the same — we need to educate policymakers and the tax press on the economic and social value of S corporations.  From our past studies, we know that one out of four workers wakes up every morning and goes to work at an S corporation.  We also know that S corporations are in every state, every district, and every industry.  Meanwhile, other studies show that S corporations already pay a very high effective tax.

Add it all up, and S corporations are a key and vital part of the local employment base in just about every community in America.  Far from being marginal actors in the economy, they are one of its cornerstones.

S-Corp Payroll Tax     

Speaking of ad hoc efforts to raise taxes, the S corporation payroll tax hike is raising its head again.

In the past couple weeks, several left-leaning groups and policymakers have put forward wish lists of whose taxes to hike and by how much.  Reports from the Senate Budget Committee Democrats, Citizens for Tax Justice (last year), and the Center for American Progress all encourage Congress to raise taxes on S corporations by making more of their income subject to payroll taxes.

Here’s the write-up from the Center for American Progress report:

Certain highly paid professionals sometimes take advantage of a tax loophole made infamous by former Speaker of the House Newt Gingrich (R-GA) and former Sen. John Edwards (D-NC). These professionals—lawyers, accountants, doctors, consultants, and entertainment professionals—form “S corporations,” whose profits are not subject to Medicare taxes and who characterize much of their income as profits of the business instead of salaries. Regular wage-earners can’t do this, and neither can the owners of other kinds of small businesses. Government watchdogs have flagged the S corporation loophole as an area of rampant abuse. Legislation introduced in the House and Senate in recent years would shut down this loophole, requiring these well-heeled professionals to pay their fair share into Medicare, which would raise $11 billion over 10 years.

Those who follow our efforts will understand that the issue before Congress is not one of loopholes but rather avoidance where the IRS has existing tools to fight it.  The IRS already requires the owner/operators of S corporations to pay themselves reasonable compensation for their work at the business.  Shareholders who underpay themselves in salary in order to avoid Medicare taxes can be and are successfully challenged.

For example, just last year the Eighth Circuit Court of Appeals ruled in favor of the IRS and against an Iowa CPA who was paying himself a minimal salary compared to his experience and efforts.  According to the Court:

Here, the district court found that DEWPC understated wage payments to Watson by $67,044 based on the following evidence:(1) Watson was an exceedingly qualified accountant with an advanced degree and nearly 20 years experience in accounting and taxation; (2) he worked 35-45 hours per week as one of the primary earners in a reputable firm, which had earnings much greater than comparable firms; (3) LWBJ had gross earnings over $2 million in 2002 and nearly $3 million in 2003; (4) $24,000 is unreasonably low compared to other similarly situated accountants; (5) given the financial position of LWBJ, Watson’s experience, and his contributions to LWBJ, a $24,000 salary was exceedingly low when compared to the roughly $200,000 LWBJ distributed to DEWPC in 2002 and 2003; and (6) the fair market value of Watson’s services was $91,044. Based on the record, the district court did not clearly err.

So the IRS already has the authority and the tools to go after Gingrich and Edwards if they choose.  Admittedly, these tools are “facts and circumstances” based, but so are the fixes proposed in Congress. The version that failed to pass the Senate last year is illustrative of the problem.  For example, the proposal applies to:

…any other S corporation which is engaged in a professional service business if 75 percent or more of the gross income of such business is attributable to service of 3 or fewer shareholders of such corporation.

Exactly how is the IRS supposed to determine if 75 percent or more of the gross income is “attributable” to the “service” of three or fewer shareholders?  Even if the test were made clearer, this standard might not bring in the revenue its authors claim.  In the court decision referenced above, it’s doubtful the CPA would have tripped this test — according to the court record, he came nowhere near generating 75 percent of his firm’s gross revenues.

So the Senate was attempting to fix a problem by giving the IRS less effective tools than it already has, and this was going to raise $11 billion.  Sure.

Which brings us back to the M.O. of tax-raisers listed in the first entry — identify a group of taxpayers, challenge their legitimacy, and then raise their taxes.  They’ve spent the last decade trying to apply payroll taxes to more S corporation income.  Too bad they didn’t spend more time getting the policy right.

As everyone knows, the President signed into law H.R. 8, the so-called mini deal addressing the fiscal cliff yesterday.

The agreement was the result of negotiations between Vice President Biden and Senate Republican Leader McConnell and effectively reduces tax revenues over the next ten years by just short of $4 trillion dollars.

It passed the Senate easily early New Year’s morning by an 89-8 vote and then, after a little drama with the House Republican conference, passed that body on a much closer 257-167 vote that evening.

For S corporations, the package is a mixed blessing.  Under the agreement, top rates are going up for shareholders making more than $450,000 (joint filers) starting January 1st, but those rates were going up anyway had Congress and the Administration failed to come together and now they are offset with permanent AMT relief, permanent estate tax rules, 179 expensing, and lower rates on dividends.

Bottom Line:  Compared to where tax policy would have been without an agreement, the S corporation world is in a much better place starting out 2013 with H.R. 8 signed into law.

Specific to the work we’ve been doing, the bill includes an extension of the five-year built-in gains (BIG) holding period for tax years beginning in 2012 and 2013! The specific language is in Section 326 (page 54) of the bill.  The bill also extends the basis adjustment to stock of S corporations making charitable contributions of property.

Many, many thanks to our congressional allies, including Sen. Ben Cardin (D-MD), Sen. Olympia Snowe (R-ME), Rep. Dave Reichert (R-WA), and Rep. Ron Kind (D-WI) for helping to ensure the BIG provision was included in the extender package.

Other highlights in H.R. 8 include:

• Permanent extension of the marginal rates for individuals making under $400,000 and couples under $450,000;
• Permanent extension of the PEP and Pease personal exemption and itemized deduction phase-outs for individuals making under $250,000 and couples under $300,000;
• Permanent extension of current capital gains and dividends rates for individuals making under $400,000 and couples under $450,000.  (For those over those thresholds, the rate for both cap gains and dividends is 20 percent (plus the new 3.8 percent tax from the healthcare bill));
• Permanent estate tax relief providing for a $5 million exemption ($10 million for couples) and a new top tax rate of 40 percent;
• Permanent AMT relief;
• Tax extenders, including built-in gains relief (generally for 2012 and2013);
• One-year extension of bonus depreciation;
• Five-year extension stimulus bill tax credits;
• One-year extension of unemployment benefits;
• One-year extension of the Medicare reimbursement rate for doctors (“Doc Fix”/SGR) offset with other healthcare related provisions;
• Two-month delay in the sequester offset in part with the new tax revenue generated from the package and inpart with spending cuts; and
• Extension of farm policies through September.

Outlook for 2013

With the fiscal cliff out of the way, attention will now shift to the upcoming debt limit fight and the possible contents of a deficit reduction package to accompany legislation to raise the debt limit.

Treasury announced in late December that federal debt had reached the current limit and that, by using extraordinary measures, it could keep overall debt under the caps only until sometime in late February or early March.  Which means that Congress, having just finished the contentious fiscal cliff fight, will have to turn almost immediately to a sure-to-be-just-as-contentious debt limit fight.

Other reasons tax policy will remain front and center in coming months:

• Ways and Means Chairman Dave Camp has promised to consider broad-based tax reform early 2013 – “We can and will do comprehensive tax reform this year, in 2013”;
• The two-month delay in across-the-board spending cuts (sequester) expires on March 1st; and
• The Continuing Resolution funding the federal government sunsets March 27th.

All these events suggest that, whether they want to or not, Congress will be knee deep in tax policy from now until all of this gets resolved.  Having just seen S corporation tax rates rise from 35 percent to nearly 45 percent, the S corporation community needs to be as active as ever in making the case why further tax hikes on pass-through employers is bad for jobs and economic growth.
That’s the message we’ll be taking to the Hill… starting now.