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February 22, 2012 by admin ·
The Administration released its outline for “business” tax reform today. Described by its authors as more than a set of principles but less than a fully-realized plan, the 22-page joint Treasury-White House release raises more questions for us than it answers.
Core to the plan is a reduction in the top corporate tax rate from 35 to 28 percent. Pass-through businesses would not benefit from the rate reduction. Manufacturing businesses would see a further reduction down to 25 percent through the use of a manufacturing deduction. Advanced manufacturing would receive a yet more generous deduction.
To offset the cost of the lower corporate rate and the more generous manufacturing deductions, the Administration would repeal LIFO accounting, repeal accelerating depreciation, tax carried interest as ordinary income, reduce (unspecified how much) the deductibility of interest, impose a new minimum tax on foreign income, and make larger-through business pay C corporation taxes. Several other small business tax expenditures would also be repealed.
The proposal includes some provisions to benefit smaller businesses, including expensing up to $1 million in investments, allowing cash accounting for firms under $10 million in gross receipts, and expanding the small business tax credit under health care reform.
Combined, the Administration indicates that the plan is designed to be revenue-neutral for the business sector.
Regarding our concerns, topping the list would be how pass-through businesses are treated. It’s no secret that a majority of business activity in the United States, measured either by employment or income, takes place within business structures other than C corporations — S corporations, partnerships, and sole proprietorships.
Despite this reality, today’s proposal from the Administration pays little attention to pass-through businesses except to raise their taxes. The base broadening would increase the taxable income of businesses that use LIFO, accelerated depreciation, and interest deductions, while the policy of forcing larger pass-through businesses to pay the corporate double tax would break from Congressional history and shift the tax burden onto large pass-through businesses and off even larger C corporations.
The report doesn’t specify a threshold, but last spring’s Ernst & Young study on pass-through businesses found that one-sixth of all private sector workers (nearly 20 million) work for large pass-through businesses with more than 100 employees. Those are the same employers likely to be forced into the harmful double corporate tax under the Administration’s proposal—a model that has been criticized by economist after economist as inefficient and actually discouraging of job creation and capital investment.
Our second concern is the proposal’s schizophrenic treatment of corporate earnings. Lowering the corporate rate is motivated by a desire to make our corporate tax system more competitive. OECD rates are lower (including Japan’s as of April 1st) and they generally offer at least some relief from the double tax on corporate profits. Reducing the corporate rate from 35 percent to 28 percent is an effort to level the playing field.
But what about the second layer of tax? If reducing the corporate tax rate will make our firms more competitive, why is the Administration proposing to raise the dividend rate, which would have the opposite effect? The important number here is the total tax on new investment, which would combine the corporate tax with the investor tax. Today, the two layers are 35 percent and 15 percent, so a dollar earned by a corporation would be reduced to 55 cents by the time an investor gets it.
Under the Administration’s proposal, the two layers would be the 28 percent corporate rate and the 39.6 percent dividend rate, plus 3.8 percent for the new health care surtax, plus 1.2 percent for the reinstatement of Pease. Combined, those tax rates reduce a dollar of corporate income down to just 40 cents. Add in the repeal of accelerated depreciation, LIFO accounting, the limitation on interest expenses, etc., and it’s likely the overall impact of the Administration’s proposal will be to raise the cost of new business investment compared to the cost today.
What’s particularly confusing about this outcome is that the report makes clear that Treasury understands this analysis. Throughout the report, they refer to effective tax rates and the cost of capital. Table A2 in the Appendix identifies the effective marginal tax rates on new business investment for the years 2013-2022 with both the corporate and the investor tax layers included.
So, under the banner of making our corporate sector more competitive, the Administration is proposing to raise the overall marginal effective tax on new business investment for corporations and pass-through businesses alike. Some smaller firms may see their effective tax go down through the expanded expensing provisions, etc., but the burden on the entire business community will likely go up.
And what’s the point of “reform” if the end result is a higher tax burden and a less competitive tax system? We expect this issue to be discussed extensively for the next year, with more details from the Administration on what they have in mind. Our initial glance, however, suggests there’s lots to oppose here, and little to support.
February 13, 2012 by admin ·
The President’s budget came out today, and despite the fact that it and the many proposals it contains are unlikely to move through Congress, there are a number of items of specific concern to S corporations that are worth a look. You can find the overall budget documents at the OMB website. For S corporations, the items that jump out at us include:
- Expiration of current rates for higher income taxpayers.
- Imposition of a new “Buffett Tax” on taxpayers earning more than $1 million.
- Principles for tax reform.
We’ll get to these items, but first, a note about baselines. One possible area of confusion moving forward is the unique baseline used by this Administration to measure how its policies might raise or lower the deficit. The Congressional Budget Office uses a current law baseline, so that any effort to extend all or part of the Bush tax cuts would be scored as raising the deficit, since the Federal government would be foregoing revenues it would otherwise collect under current law.
The Administration, however, uses what might be termed a “modified” current services baseline, so they score the expiration of the Bush tax relief for higher income tax payers as a tax increase, even though its already set in law. Because the Administration uses a different baseline, their deficit reduction claims will not match up with the numbers used by Congress. As an example, the Administration claimed that last year’s budget reduced the deficit by several trillion dollars, whereas the CBO determined that the President’s budget actually increased spending and the deficit over the ten year budget window. Expect the same dynamic this year.
On the Bush tax relief, the Administration remains consistent in its effort to cap the lower tax rates and other tax benefits to those taxpayers making $250,000 or less ($200,000 for single taxpayers). This means that owners of S corporations and other pass-through businesses who earn more than $250,000 will see tax rates rise on their business income. How much?
Current Law Top Rate: 35%
Sunset of Current Rate: 4.6%
Expiration of Pease: 1.2%
New Investment Surtax: 3.8%
Total: 44.6%
Layered on top of this tax increase is the new proposal for a Buffett tax on taxpayers, including business owners, who make more than $1 million. Here’s what the budget says:
Observe the Buffett Rule. No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay. As Warren Buffett has pointed out, his effective tax rate is lower than his secretary’s. And, the President is now specifically proposing that in observance of the Buffett rule, those making over $1 million should pay no less than 30 percent of their income in taxes. The Administration will work to ensure that this rule is implemented in a way that is equitable, including not disadvantaging individuals who make large charitable contributions. And he is proposing that the Buffett rule should replace the Alternative Minimum Tax, which now burdens middle-class Americans rather than stopping the richest Americans from paying too little as was originally intended.
Beyond this description, details on the Administration’s Buffett Rule are wholly lacking, including any sense of how the Buffett Rule would replace the AMT. It may resemble the legislation introduced in the Senate recently, but we don’t know since neither an explanation of the Buffett Rule nor an idea of how it would replace the AMT are included in the explanatory Treasury “Green Book” released along with the budget. For our purposes today, suffice it to say that the Buffett Rule tax will impose a new, higher layer of tax on taxpayers who make more $1 million a year, four out of five of whom own businesses.
On the tax reform front, the Administration reiterates the five principles it first outlined back in September:
- “Simplify the Tax Code and Lower Tax Rates. The tax system should be simplified and work for all Americans with lower individual and corporate tax rates and fewer tax brackets.
- Reform Inefficient and Unfair Tax Breaks— Eliminating Them for Millionaires While Making All Tax Breaks at Least as Good a Deal for the Middle Class as for Wealthy Americans. Reform should cut and simplify tax breaks that are now inefficient, unfair, or both, so that wealthiest Americans cannot avoid their responsibilities by gaming the system, that middle class working Americans receive their fair share, and that Americans can spend less time and money each year filing taxes. That means eliminating tax subsidies for millionaires that they do not need; there is no reason that those making over $1 million should get any tax subsidies for housing, health care, retirement, and child care. And it means ensuring fair incentives for the middle class to buy a home or save for retirement, as opposed to allowing the most well-off to get two to three times as much.
- Decrease the Deficit While Protecting Progressivity. Reform should cut the deficit by $1.5 trillion over the next decade through tax reform, including the expiration of tax cuts for single taxpayers making over $200,000 and married couples making over $250,000. And it should do this while keeping the tax code at least as progressive as if the high-income 2001 and 2003 tax cuts were eliminated, as the President proposes.
- Increase Job Creation and Growth in the United States. The tax code should make America stronger at home and more competitive globally by increasing the incentive to work and invest in the United States. This includes fundamental corporate tax reform. That is why, in addition to these principles, the President is proposing a roadmap for corporate tax reform that will make America more competitive and create jobs here at home.
- Observe the Buffett Rule.
Several of these principles sound great, but the descriptions don’t seem to match up with the actual policies promoted by the President. For example, nearly every tax policy expert in Washington agrees with the general idea that we should broaden the income tax base by eliminating many deductions and exemptions and couple that with lower rates. Principle 1 enjoys broad support on both sides of the aisle.
But how does the Administration couple that principle with Number 3, which argues for raising tax rates on anybody making more than $250,000? Or Number 2, which argues for making existing deductions and exemptions more valuable for a majority of taxpayers? First they say let’s broaden the base and reduce rates, and then they say let’s raise rates and narrow the base. All in the same set of tax “principles”.
Regarding the “roadmap for corporate tax reform” there doesn’t appear to be any description included in today’s budget release. Word is, the roadmap will be coming out later this month, and that like the principles outlined above, it will move in a completely different direction than the prevailing tax reform discussion in town. A couple weeks ago, a Bloomberg article hinted at the underlying rationale for this divergence:
John Buckley, a professor at the Georgetown University Law School in Washington and a former chief tax counsel for Democrats on the Ways and Means Committee, said the goal of a tax overhaul is shifting. While Republicans have focused on lowering rates and broadening the tax base, Democrats are tapping into the tension over income inequality and the loss of manufacturing jobs, he said.
“The tax reform debate from the Democratic perspective will focus on equity and the attempt to restore manufacturing jobs,” Buckley said. “The visions are quite different.”
That the President has a different vision is obvious. Whether this vision can be called reform is less so.
February 3, 2012 by admin ·
Three cheers for Sen. Olympia Snowe (R-ME) and Sen. Mary Landrieu (D-LA) for fighting to move extensions of expired tax provisions benefiting Main Street businesses! Senators Snowe and Landrieu introduced the Small Business Tax Extenders Act of 2012 (S. 2050) this week to extend through 2012 those tax provisions benefiting Main Street businesses that were allowed to expire last year – including, an S-CORP priority, built-in gains (BIG) relief. Other provisions include extensions of the:
- Temporary 100 percent exclusion of gains on certain small business stock;
- 5-year carryback of general business credits of eligible small businesses;
- AMT rules for general business credits of eligible small businesses;
- Increased Section 179 expensing limitations and treatment of certain real property;
- Special rule for long-term contract accounting;
- Increased amount allowed as a deduction for start-up expenditures; and,
- Allowance of the deduction for health insurance in computing self-employment taxes.
We appreciate Senators Snowe and Landrieu for recognizing the importance of protecting Main Street businesses and in particular for supporting BIG relief. Senator Snowe’s floor statement gives a great explanation of the importance of this relief measure:
Additionally, the Small Business Jobs Act of 2010 provided for a temporary reduction in the recognition period for S corporation built-in gains tax. When businesses convert from a C corporation to an S corporation, they have been required to hold their appreciated assets for a full decade or face a punitive level of double taxation. In such instances, first the built-in gain corporate tax rate of 35 percent is applied and then all other applicable federal, state and local shareholder tax rates are applied, often totaling near 60 percent in most states, including Maine. In effect, the built-in gain tax locks-up businesses’ own capital and forces them to look elsewhere–a particular challenge for S corporations since closely-held businesses have limited access to the public markets and therefore fewer options for raising needed capital.
Recent law changes temporarily shortened this holding period to 7 years, but that is still too long. By infusing capital–that is, releasing their own capital–this provision in the Small Business Jobs Act, reducing the holding period from 7 years to 5 years, enabled companies that have long been S corporations to redeploy this capital to invest in and grow their businesses. Extending this provision also underscores how vital access to capital is for small businesses, while preserving the original policy intent of the holding period and making it more reflective of the shorter business planning cycles of the 21st century.
We couldn’t agree more, and will continue to work with them and our other congressional allies to advocate for immediate relief.
So the question remains, when is Congress going to deal with the tax extenders that have expired? Will it be during the payroll tax conference? There doesn’t appear to be a clear path on that train quite yet – but the entire business community is with us trying. Or will the issue be saved for broader tax reform? Let’s hope not, as we don’t see real action on comprehensive tax reform coming prior to the end of 2012. As Caroline Harris from the U.S. Chamber testified before the Senate Finance Committee hearing entitled “Extenders and Tax Reform: Seeking Long-Term Solutions” –
The Chamber believes that this Committee and Congress need to act immediately to prevent the negative impact on jobs and the fragile economy that is likely to result from inaction on these annual extenders…
…The Chamber applauds this Committee’s continuing work towards comprehensive fundamental tax reform. However, we believe that the extension of these annual extender provisions cannot be delayed until work on comprehensive tax reform is complete. Taxpayers need stable and predictable rules they can rely upon while that important process is completed.
“Buffett Rule” Bill Introduced
Legislation to enact the so-called “Buffett Rule” has been introduced in the United States Senate. The bill, entitled the “The Paying a Fair Share Act” was introduced by Senators Sheldon Whitehouse (D-RI), Tom Harkin (D-IA), Bernie Sanders (I-VT) and others. According to the authors:
Whitehouse’s legislation would apply only to taxpayers with income over $1 million – including capital gains and dividends. Taxpayers earning over $2 million would be subject to a 30% minimum federal tax rate. The tax would be phased in for incomes between $1 million and $2 million, with those taxpayers paying a portion of the extra tax required to get them to a 30% effective tax rate. The bill also includes language to preserve the incentive for charitable giving.
The Wall Street Journal has a few more details:
The legislation introduced Wednesday by Sen. Sheldon Whitehouse (D., R.I.) would ensure that anyone earning more than $2 million in income each year, including from capital gains, would pay a minimum 30% federal tax rate, Mr. Whitehouse said on the Senate floor Wednesday morning. Wealthy taxpayers who face a tax rate above 30% would still pay the higher rate.
The “fair share tax” would be gradually phased in for those earning between $1 million and $2 million in annual income. They would pay a portion of the extra tax needed to get them to the 30% rate, the lawmaker said.
“This way, we make sure that no taxpayer is ever in a situation where earning an additional dollar of income will increase his or her taxes by more than that dollar,” Mr. Whitehouse said in his remarks prepared for the Senate floor. The new tax would not affect anyone making less than $1 million.
We have several complaints with this effort. First, as we’ve pointed out before, the Warren Buffett’s of the world don’t pay a lower effective tax than their secretaries. Congressional Budget Office estimates make clear that the existing tax code is strongly progressive, with wealthy taxpayers paying significantly higher levels of tax – both in absolute terms and as a percentage of their overall income – than middle-class and low-income Americans.
Second, if enacted, this new legislation would impose a third tax code (and calculation) on individual taxpayers. We already have two codes, the regular income tax and the Alternative Minimum Tax. Now we would have three:
- Regular Income Tax
- Alternative Minimum Tax
- Fair Share Tax
Third, the author takes pains to point out that no taxpayer will face marginal rates of more than 100 percent on additional earnings, but exactly how high would the effective marginal rates reach as a taxpayer’s income rises above $1 million? The dead weight economic loss imposed by a tax increases by the square of the rate hike, so the potential cost to the economy is significant.
Nor is it clear the Fair Share tax would successfully target the rich. The AMT was created four decades ago to ensure that the same taxpayers targeted by the Fair Share tax pay at least a “minimum” amount of tax. Over the years, however, the tax has morphed into a burden on middle- and upper-middle income taxpayers. Actual millionaires are less likely to pay the AMT than a middle-class family with three children living in a high tax state. What’s the guarantee that the Fair Share bill will not make the same progression into the middle class?
Finally, you’ll notice the bill contains an exemption for charitable donations. Think of it as the “Buffett Loophole” to the “Buffett Rule” since one of the more glaring ironies of the whole debate is that Warren Buffett has aggressively planned his estate to avoid paying any tax on most of his accumulated wealth. According to press accounts, he’s given most of his money away to foundations run by his children and Bill Gates. This new “Buffett Tax” won’t touch those transfers.
So we now have legislation to fix a problem that doesn’t exist in order to impose a new tax on a billionaire who’s already figured out how to avoid paying it. In the meantime, real taxpayers with real companies and real employees who aren’t in a position to hide all their wealth inside a foundation will be stuck paying the bill. Not helpful.
February 1, 2012 by admin ·
The release of Newt Gingrich’s tax return has returned the issue of payroll taxes and S corporations to the public’s attention. This issue first came to prominence during the 2004 election cycle, when Vice Presidential nominee John Edwards was accused of using an S corporation to avoid paying Medicare taxes on some of his income as a lawyer.
Now it appears Newt Gingrich may be using a similar structure. USA Today has an excellent report on the issue. Here are a couple excerpts:
Gingrich’s tax return shows his S Corporation, Gingrich Holdings, accounted for the bulk of his $3,142,066 adjusted gross income in 2010. The corporation paid him nearly $2.5 million in distributions beyond his salary and wages total of $252,500, his tax return and 2011 federal financial disclosure filing show.
Non-salary distributions from S Corporations are not subject to the 2.9% Medicare tax rate, half paid by the corporation and half by the employee.
But the IRS requires S corporations to pay “reasonable” salary compensation to employees for their services before paying non-wage distributions. That’s designed to prevent the corporations from avoiding Medicare taxes by issuing disproportionate payments in distributions, rather than wages.
An IRS publication about S Corporations states that if most of the gross receipts and profits are associated with an employee’s personal services, “then most of the profit distribution should be allocated as compensation.”
DeSantis said the candidate’s speaking engagements and television appearances produced the bulk of the payments received by Gingrich Holdings.
McKenzie said the IRS would typically ask how much investment an S corporation filer put into her or his business. Gingrich Holdings was renamed Gingrich Productions last year, corporate records in Georgia show and his spokesman confirmed. Gingrich’s federal financial disclosure report, filed in July, lists Gingrich Productions as an asset valued at between $500,001 and $1 million.
“The general rule of thumb they’ll usually apply is they don’t view anything greater than a 20% return on investment as reasonable. The rest should be paid as salary,” said McKenzie.
As USA Today points out, the IRS has two tools it can use to test whether a taxpayer is paying the appropriate level of tax — a “reasonable compensation” test and a “reasonable return” test on the businesses capital investments.
Several years ago, the House tried to replace these enforcement tools and re-write the rules surrounding how and when S corporation income is subject to payroll taxes. The effort was badly flawed and with the help of Main Street allies, it died in the Senate.
Well, now it’s back. House Ways and Means Member Peter Stark (D-CA) introduced legislation this week called the “Narrowing Exceptions for Withholding Taxes (NEWT) Act.” The bill appears to be identical to the changes that passed the House back in 2010. According to a summary, Congressman Stark’s concern is that the current reasonable compensation test is too dependent on the facts and circumstances of each individual case. In our view, however, the fix he is proposing is worse. Here’s how it’s described:
Certain employee-shareholders of S corporations would have to calculate their Medicare payroll tax obligation based on their share of the S corporation’s profits or dividends, not just income reported as wages. The individuals subject to the provision are the employee-shareholders of a professional service business where the principal assets of that business are the skills and reputations of three or fewer individuals.
How is a “principal asset” test easier to enforce than the existing “reasonable compensation” test?
- It would require affected businesses to get a valuation of each of its significant assets in order to determine which asset was its “principal” asset.
- This analysis would require the valuation of assets that are very difficult to value (i.e., skill and reputation).
- The bill taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except that it has four key employees.
- The bill requires difficult legal conclusions about uncertain areas. For example, whose asset is an employee’s “skill and reputation”- the employee’s or the company for which the employee works?
- The bill provides no definition of “asset”- it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single “asset” for purposes of determining the “principal” asset of a company.
The bottom line is that the IRS already has sufficient tools to combat the payroll tax problem and it has successfully litigated cases in which taxpayers have taken compensation that was less than reasonable.
They can apply a “reasonable compensation” test to the shareholder’s salary income, or they can apply a “reasonable return” standard to the company’s capital investment. And while it’s true that these tools are dependent on the facts and circumstances of each particular business, so is the new standard outlined above. Only more so.
January 30, 2012 by admin ·
So, we now have the tax returns for President Obama, Governor Romney, and Speaker Gingrich. Did anybody notice that the S corporation owner is the one with the highest effective tax rate?
Seriously, of the three, Newt Gingrich paid the highest effective tax (32 percent), followed by President Obama at 26 percent and then by Governor Romney at 14 percent. Given that the Wall Street Journal is reporting that S corporations pay no tax at all, that result might come as a surprise to their readers.
On the other hand, readers of the more authoritative S-Corp Washington Wire understand that of the four business structures — S corporations, partnerships, C corporations, and sole proprietorships — the Small Business Administration found that S corporations paid the highest effective tax rate for firms with less than $10 million in revenues. S corporations paid 27 percent, while C corporations paid just 18 percent.
To be fair, this estimate doesn’t include the second layer of tax paid by C corporation shareholders. Add in the shareholder tax on capital gains and dividends, and the effective rates for C and S corporations are probably about the same. We’ve been pointing that out for two years now.
But wait. Doesn’t this same “second layer of tax” apply to some of Mitt Romney’s income? A cursory look at his return suggests that a good portion of it is investment income that has already been subject to the corporate layer of tax. In that case, his real effective tax rate — including any taxes paid by corporations he owns — should be significantly higher. The same can be said for Warren Buffett.
Which brings us to the President’s State of the Union speech. In it, he called for a new “minimum tax” to ensure millionaires pay a minimum tax to the federal government. Here’s what he said:
Tax reform should follow the Buffett Rule. If you make more than $1 million a year, you should not pay less than 30 percent in taxes. And my Republican friend Tom Coburn is right: Washington should stop subsidizing millionaires. In fact, if you’re earning a million dollars a year, you shouldn’t get special tax subsidies or deductions. On the other hand, if you make under $250,000 a year, like 98 percent of American families, your taxes shouldn’t go up. You’re the ones struggling with rising costs and stagnant wages. You’re the ones who need relief.
Now, you can call this class warfare all you want. But asking a billionaire to pay at least as much as his secretary in taxes? Most Americans would call that common sense.
The 30 percent threshold is new. Before, the rhetoric around the Buffett Rule was simply that the millionaire should pay more than the secretary. This new approach is described in the “Blueprint” document that accompanied the speech. It says:
Make the tax code fairer and simpler for the middle class and make sure millionaires and billionaires follow the Buffett Rule by paying at least 30% in taxes.
Later, the Blueprint calls for corporate reform that, among other things, lowers corporate rates:
The President believes that we need comprehensive corporate tax reform that will close loopholes, lower rates, and eliminate incentives that make it more attractive to ship jobs overseas…
So, the President is advocating for raising rates on capital gains and dividends, but he’s also advocating for cutting corporate rates. The former is part of his “fairness” agenda and the latter is part of a “jobs” agenda.
How does it balance out? The total tax on corporate profits equals the corporate tax combined with the dividend and capital gains tax paid by shareholders like Mitt Romney. Today, that tax is equal to 45 percent (35 percent corporate first and 15 percent dividends/cap gains second). Assuming the President calls for a 25 percent corporate rate as part of his corporate tax reform, then the total tax on corporate profits in the future would be 25 percent first and 30 percent second, or 47.5 percent. The tax on corporate profits would go up.
In other words, the President’s “fairness” agenda totally trumps the President’s “jobs” agenda. Kind of shows you where his priorities are.
