November 14, 2013 by admin ·
Last week, Senate Democrats released a paper highlighting a dozen tax increases they would like to use to offset spending cuts in the current budget negotiations. As Politico reported:
Tax expenditures topping the list include the deduction corporations take when they move operations overseas and the carried interest loophole, which allows private equity and some other investment advisers to pay the lower capital gains tax rate on some of their income.
Also on the list is our old nemesis, the S corporation payroll tax hike. Labeled the Edwards Loophole by Republicans and the Gingrich Loophole by Democrats, the issue is that some professionals are using the S corporation structure to avoid paying payroll taxes. According to the Democrats’ release:
Some wealthy business owners knowingly mischaracterize their income as business profits instead of salary to avoid Medicare and Social Security payroll taxes. Ending this loophole would save about $12 billion over the next ten years.
We have a number of objections to this characterization. First, using your S corporation to avoid payroll taxes is not a loophole, it’s tax avoidance. The current “reasonable compensation” rules are clear and the IRS has a history of going after offenders and winning.
Second, the proposals offered to date are worse than the existing rules. The JCT might score them as raising $12 billion over ten years, but it’s hard to see how the IRS would be able to come up with that level of enforcement.
For example, the provision defeated by the Senate back in 2012 would have replaced reasonable compensation with a “principle rainmaker” test where the IRS would have to determine whether 75 percent or more of the gross income of the S corporation is attributable to the service of three or fewer shareholders. Oh, that’s easy. As a letter signed by 38 business organizations observed:
This new approach, particularly the “principal rainmaker” test, is neither clear nor more enforceable than existing rules. These rules have been in effect for over half a century, and the IRS has repeatedly and successfully used them to ensure that active S corporation shareholders pay themselves a reasonable wage, most recently in Watson v. US (2011).
The business community responded strongly in 2012 and that opposition remains today. We do not support the misuse of the S corporation structure to avoid payroll taxes, but any replacement to the current “reasonable compensation” test must be easier for the IRS to enforce and for businesses to comply with.
For those who want more, here are links to the business community letter as well as a longer history of the issue:
SBA Weighs in on Corporate Tax Reform
A new study sponsored by the Small Business Administration adds to the case that corporate-only tax reform, as advocated for by the Obama Administration, would shift the tax burden on to smaller, private companies. As reported by Politico:
Cutting corporate tax rates by trimming costly breaks is a popular selling point for a tax code overhaul, but some small businesses could wind up unintended victims, an independent government agency on Wednesday said, lending support to Republican concerns.
…new data from the Small Business Administration warn that the trade-off would be a double whammy to smaller businesses that file taxes as individuals.
…These businesses get nothing from a corporate rate cut but they could still lose their tax breaks. The SBA study found that these businesses account for about $40 billion in tax benefits, or about one-third of the $161 billion spent each year on all business “tax expenditures.”
…The top U.S. corporate rate is 35 percent, among the highest in the industrialized world. Although the code is riddled with breaks and loopholes that allow some companies to pay far less, others pay much more.
By contrast, the top rate for individuals, including these so-called pass-through entities, is more than 40 percent.
The study compared the value of tax expenditures for all businesses with those used by pass through and corporate businesses with annual receipts under $10 million. As the study notes:
Of the largest tax expenditure provisions utilized by all businesses in 2013, small businesses will utilize approximately $40 billion out of a total of $161 billion. The estimates indicate that small businesses will utilize approximately 25 percent of the largest business tax expenditure provisions in 2013.
So any effort to eliminate tax expenditures to pay for a lower corporate tax rate would also hit pass through businesses that pay at the individual rates. Not good. As our 2011 E&Y study made clear, such a policy would increase taxes on pass through businesses by $27 billion a year.
October 31, 2013 by admin ·
The agreement earlier this month between Senators Reid and McConnell reopened the government for a few months, but it failed to resolve any of the issues that precipitated the shutdown in the first place. There’s still no consensus on spending levels or tax policy beyond the end of the year. Key dates in the agreement are:
- December 13th — Target for budget conferees to agree to a uniform budget
- January 15th — Current government funding resolution (CR) expires
- February 7th — Debt limit reached again
At this point, agreeing to a budget resolution would be a big deal. Not only could it establish spending levels for next year, it also could put into place expedited procedures for tax and entitlement reforms stretching over the next decade and beyond. For observers cheering for something big, including comprehensive tax reform, a successful budget conference is an essential first step.
The odds of a positive outcome, however, are slim. The huge gap between Republicans and Democrats remains while the December 13th target date lacks any enforcement mechanisms — if the conferees fail to agree by that date, nothing happens.
Meanwhile, Senate Majority Leader Harry Reid and House Minority Leader Nancy Pelosi oppose any reduction in the sequester cuts that doesn’t include higher taxes — Reid went so far as to say people “want” to pay more taxes — while Senate Budget Committee Ranking member Jeff Sessions has made clear he opposes swapping the sequester for similar sized entitlement cuts.
So those folks hoping for a narrower deal will just have to wait, too.
On the tax front, Chairman Dave Camp continues to push his leadership, committee and conference to support a comprehensive, budget neutral package by the end of the year. We’re on record strongly supporting this effort, and it appears he’s making progress. Meanwhile, Finance Chair Max Baucus plans to begin releasing “discussion” drafts outlining various parts of his plan as early as next week, with the first release likely focused on international reforms. That’s good news and certainly a step forward.
But the big barrier holding tax reform back has less to do with drafts and House Republicans, and more to do with basic objectives. Senate Majority Leader Harry Reid and the President continue to insist on a package that raises taxes, which obviously is a non-starter with the House. Until they work out the top line number, getting an agreement on what the underlying policies will look like is next to impossible.
Meanwhile, there’s a long list of tax provisions set to expire at the end of the year, including the higher limits ($500,000) on Section 179 expensing, the R&E tax credit and the 5-year holding period for built-in gains. Until the budget and tax reform questions are resolved, there’s little appetite on the Hill for discussing the prospects for these provisions, so everything is on hold. As the Hill wrote this week:
Renewal of a package of tax breaks for businesses and individuals worth tens of billions of dollars has become something of a holiday tradition in Washington. Each November and December tax writers battle over which benefits are really worth keeping while business lobbyists launch fevered campaigns to keep their tax bills low.
In the end, most of the package is often renewed, attached to some other must-pass piece of tax legislation.
But this year, lawmakers will likely not even go through the motions.
Members of the Senate Finance and House Ways and Means Committees expect to spend all of their remaining time this year working on drafting comprehensive tax reform legislation. The extenders package would be a distraction from that work, they say.
So the December target date for producing a budget resolution appears to be less of a deadline and more like a warning track, letting policymakers know that the end of the year is fast approaching and that there’s limited time to move forward on tax reform or, failing that, extenders.
It doesn’t have to be that way, of course. Outside forces could emerge in the next two months to bring the two sides together. For example, we always thought there was an inverse relationship between the success of the Affordable Care Act and the prospects for tax reform. The worse the roll out, the more motivated the Obama Administration would be to change the subject and work with Congress on comprehensive reform.
It’s hard to imagine a worse roll out than what we’ve seen over the past month, and yet the prospects for common ground between the House, Senate, and Administration don’t appear to be increasing. Based on his comments in Boston this week, the President certainly doesn’t seem to want to change the subject. Maybe it will take a little time. Or maybe nothing will happen. Right now the latter appears to be the most likely outcome. Given how much work Chairman Camp has put into the tax reform effort and how much a well-thought out plan is needed, that would be a shame.
October 16, 2013 by admin ·
Marty Sullivan always writes interesting and provocative pieces on tax policy, so when we saw his recent piece in Forbes on tax reform (“Should Small Business Have Veto Power Over Corporate Tax Reform?”), we read it eagerly.
It’s provocative, alright, but we do have a couple observations.
Marty argues that pass through business advocates “willfully omit” the existence of the corporate double tax “from their spin and howl” regarding tax reform. Really?
We don’t howl, and we don’t ignore the existence of the double corporate tax. It’s a central part of our message on how to build a foundation for good tax reform. Our “Pass-Through Tax Reform” letter signed by more than 70 business organizations calls for reform that embraces three basic principles:
- Reform should be comprehensive;
- Reform should restore rate parity; and
- Reform should reduce the double tax on corporate income.
It’s hard to “omit” the double tax when its reduction is one of your key principles.
There are lots of other examples, but the testimony one of our advisors presented before the House Ways & Means Committee back in 2012 stands out:
First, as much as possible, the business tax system in the United States should move toward a single tax structure, and away from the punitive double tax C corporation system. Especially for closely-held businesses, a single tax system substantially reduces complexity and eliminates the opportunity and incentive for non-productive tax planning and strategizing. Moreover, it has the benefits of simplicity and transparency.
Marty should remember that testimony. He was sitting right next to him.
Marty argues that our effective rate study says that “corporations are getting away with murder…” Again, not true. The study’s focus is on the effective tax burden paid by pass through businesses. To our knowledge, this analysis has never been done before and it shows that S corporations and partnerships will pay very high effective tax rates in 2013:
- S Corps: 32 percent
- Partnerships: 29 percent
Large S corporations making more than $200,000 will pay even higher rates – 35 percent!
The study does calculate C corporation effective rates for comparison purposes, but makes clear there are many ways to calculate the C corporate rate and that foreign income and taxes are a complication that needs to be acknowledged. An alternative measure included in the study, looking only at domestic C corporation income, has the C corporation effective rate at 27 percent.
The study doesn’t omit the double tax either. The C corporation calculation includes dividends payments (but not capital gains taxes due to data limitations). The study finds that the dividend tax does not increase effective tax rates significantly:
Our results suggest that C corporation dividends raises their average effective tax rate by only 2 percentage points. The primary reason for this result is that C corporations do not pay significant amounts of dividends. IRS SOI data indicate that approximately 4.5 percent of C corporations paid cash dividends in 2009.
Finally, we have to say something about the title of the piece. We know writers don’t get to pick their headlines, so we’ll lay this bit of logical inconsistency at the feet of the Forbes editors.
The pass through business community is not asking to veto anything. They are asking not to have their tax burden raised substantially on top of the tax hike they just shouldered starting 2013. Budget neutral, corporate-only reform – as outlined by the Obama Administration, among others – would do just that. It would cut taxes for large corporations and raise them for pass through businesses.
If the point of reform is to encourage domestic job creation and investment, only reform that includes pass through businesses will get you there. Ernst & Young reported that pass through businesses employ more people and contribute more to national income than their C corporation friends, so raising their taxes in order to cut taxes for C corporations is not going to help encourage hiring or investments.
Moreover, creating a tax code where similar business income is subjected to two very different rates – 28 percent for C corporations but nearly 45 percent for individuals and pass through businesses under the Obama plan – would encourage the gaming and income shifting prevalent in the tax shelter days before 1986. Again from Tom’s 2012 testimony:
When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent.4 This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher…
This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations. Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.
Under corporate-only tax reform, we would be right back in the pre-1986 world Tom is describing. It is anti-tax reform, in every sense.
More on Business Tax Reform
The pass through community has a new ally. In an op-ed posted on CFO.com, Douglas Stransky, a partner at the law firm Sullivan & Worcester, pushed back on President Obama’s corporate-only tax reform proposal introduced earlier this year:
If you want to stimulate the economy through tax reform, however, you should also pay attention to the tax burden on the companies creating the most jobs. According to the U.S. Small Business Administration, firms with less than 500 employees accounted for 67 percent of the new jobs since the recession ended. Those are companies led by entrepreneurs, who are building businesses around new products or services and expanding their payrolls.
Yet the discussion about corporate tax reform has only focused on large, multinational corporations, and not small businesses…The S Corp, partnership and sole proprietorship tax rate has not been the focus of corporate tax reform in Washington. But it should be. If the C Corp rate of 35 percent is reduced to 28 percent it will leave an inequity in the tax structure between large and small businesses. This is senseless, especially when it’s assumed that lower income tax rates would enable employers to have more money to reinvest in their companies and create more jobs.
…The average American thinks corporate tax reform will apply to any U.S. business. But what is being discussed will apply only to a small percentage. Small businesses are the engine of our economy. If we reform taxes for S Corps as well as C Corps, that engine will run more efficiently.
September 10, 2013 by admin ·
Put on your “must read” list a new paper from our friends at the Tax Foundation highlighting the importance of pass-through businesses to jobs and employment. It’s the best written and most comprehensive summary of the issue we’ve seen to date. Here’s how it starts:
Support for lowering the corporate tax rate—now the highest in the OECD—has been expressed by both Democrats and Republicans in order to improve the competitiveness of American businesses. However, they differ in their plans for the individual tax code. While Republicans have proposed lowering the top individual rate from 39.6 percent to 25 percent, in parity with the proposed corporate tax rate, Democrats are less willing to consider lowering the individual tax rate.
The implications of these policy differences are considerable because of the tremendous growth in non-corporate business forms over the past thirty years. Today, there are vastly more non-corporate businesses than traditional corporations and they now earn more net income than traditional corporations. These businesses face top marginal tax rates higher than 50 percent in some states. Thus, ignoring the top individual tax rate—even while lowering the corporate rate—means the United States will continue to expose a broad swath of business to high tax burdens.
And how it ends:
As lawmakers consider policies to improve the competitiveness of American businesses, they should not forget that individual income tax rates are just as important to business activity as the corporate rate. The various proposals to raise income taxes on high-income earners, either by increasing the top marginal rate, closing “loopholes,” limiting deductions, or implementing a minimum tax, would fall very heavily on America’s non-corporate businesses. Pass-through businesses are currently facing top marginal rates on average between 44.5 percent and 47.5 percent and as high as 51.8 percent in California. These pass-through businesses account for a large percentage of business income and employment in the United States. Raising taxes on them could curtail their hiring and other investment plans, putting more strain on an already struggling economy.
The paper adds something new to the defense of the pass-through structure. Past arguments in support of a strong pass-through sector include:
- Best Tax Policy – S corporations are the way business income should be taxed. It’s taxed once, when the business earns the money, and then that’s it.
- High Effective Tax Rates – As our recent Quantria study demonstrates, pass-through businesses already pay a high level of tax, and they pay it when the income is earned.
- More Progressive – By taxing business income using the progressive individual tax rates, policymakers ensure that business income is taxed in a progressive manner, with high income shareholders paying a higher rate, and lower income shareholders paying a lower one.
- Diversification – Pass-through businesses spread investment and employment decision making across the country and into local cities and communities. As the recent financial crisis makes clear, diversification of these actions is critically important.
Thanks to the Tax Foundation, we can now add to that list “Economic Stability.” As the Tax Foundation notes:
It is also interesting to note the relative stability of pass-through business income to the volatility of C corp income. The period between 1999 and 2010, shown on Figure 2, is a good example of how volatile corporate income can be. After the tech bubble burst in 2000, C corp income plunged 24 percent over the next two years, after adjusting for inflation, and then rebounded 119 percent by 2005. After this temporary peak, C corp income fell again by nearly 33 percent over the next five years.
By contrast, pass-through income has not experienced such wild gyrations. After the tech bubble burst in 2000, pass-through business income actually increased in 2001. In 2002, net income fell by just 2 percent but then rebounded by 5 percent in 2003. In the four years after the 2003 tax cuts, the net income of pass-through businesses grew by nearly 60 percent, after adjusting for inflation. In 2010, pass-through business income exceeded C corp receipts by 40 percent.
Is there anybody remaining in Washington who still doesn’t understand the importance of pass-through business to our economic health? If you find them, please send them this Tax Foundation paper!
Breaking Up Tax Reform
Last week, Politico Pro is reporting something we’ve been concerned about for a while:
PATH TO PASSAGE? SENATE FINANCE COULD USE SMALL BILLS TO APPROVE TAX REFORM: The universal truth of tax reform is that it is, and always will be, hard to pass. But the folks over at the Senate Finance Committee are considering various ways to more easily push tax reform legislation through Congress – including splitting a comprehensive reform bill into smaller measures. Our Kelsey Snell reported for Pros that “separating business tax reform from the more contentious individual tax code would allow [Senate Finance Committee Chairman Max] Baucus to continue debate on corporate taxes, the international tax code and the treatment of some benefits for small businesses – where there’s more agreement between the parties – without opening a battle over how much revenue should be raised through changes to the individual code.”
The news outlet subsequently filed a couple corrections that left the story’s ultimate meaning in doubt, but the notion that you can split tax reform into small bites is definitely out there. Comprehensive is just too hard, some say, so let’s do a corporate bill where there’s more agreement.
Our concern with this approach is two-fold: First, we reject the idea that you can separate out the corporate tax code without doing significant harm to the pass through business sector. Corporate-only proposals to date would either raise taxes significantly on pass through businesses or they would treat them like second class citizens, instead of the majority source of employment and business income in the United States (see story above).
Second, the “consensus” on corporate reform is less than it appears and it will depend on the same, top line question confronting comprehensive reform — should it be budget neutral or raise revenue? Until that question is answered (and you know where we stand on that), any reform effort is going to face an uphill climb.
We support corporate tax reform, but only as part of a broader effort to reform the entire tax code.
August 8, 2013 by admin ·
Since its release yesterday, the effective tax rate study put out by S-Corp and the National Federation for Independent Business has been getting traction both on the Hill and in the media. The study shows that S Corporations pay the highest effective rates of any business type, and its results come at a critical time for tax reform.
Following the release, the Ways and Means Committee issued a statement:
“The study adds to the growing momentum for tax reform expressed by Democrats and Republicans alike who have called for fixing the broken tax code for job creators of all sizes. Those calls are a stark contrast to the Administration’s most recent appeal to lower the corporate rate, while leaving the vast majority of the nation’s job creators – small businesses – struggling with high rates and a more complex tax code.”
The study also grabbed the attention of a number of news outlets. Writing for The Hill, Bernie Becker shared his analysis:
“[The study] serves as pushback against President Obama, who renewed his call to reform only the corporate tax code last week. GOP lawmakers, the NFIB and the S Corporation Association say that idea will leave behind the millions of businesses that organize as pass-throughs and pay taxes through the individual code.”
Michael Cohn of Accounting Today said:
“The results of this study come at a critical time for tax reform. House Ways and Means Committee chairman Dave Camp, R-Mich., and Senate Finance Committee chairman Max Baucus, D-Mont., are focusing on crafting a comprehensive tax reform plan that they hope to unveil this year. With the release of the study, the lobbying groups hope to provide lawmakers in Congress with their perspective on how much they believe is paid in taxes by various types of business entities.”
“They also positioned the study in reaction to a speech last week by President Obama highlighting his proposals for business tax reform, which mainly focused on eliminating corporate tax loopholes and increasing investment in jobs to rebuild infrastructure and encourage more manufacturing.”
And writing for Politico, Kelsey Snell had this to say:
“A new study from the NFIB found that S corporations will face a 31.6 percent effective tax rate this year and partnerships will see a 29.4 percent rate while the big dogs filing under the corporate code will pay an effective rate of just 17.8 percent…The study is the latest attempt to rebut President Obama’s proposal to do corporate-only tax reform to help finance a new jobs package.”