By Ryan Ellis
This week, the U.S. Senate will consider their version of fundamental tax reform. A key area of debate here has been the treatment of non-corporate businesses–sole proprietorships, Subchapter-S companies, partnerships, and LLCs–compared to incorporated firms.
Unlike corporations, these flow through businesses don’t pay taxes themselves. Rather, the taxes “flow through” or “pass through” to the business owner, who pays taxes on the business profits at his own marginal income tax rate.
Senator Ron Johnson (R-Wisc.) and others have raised the concern that the corporations are getting a better deal than the flow throughs. Below are some answers to this concern:
The worst tax treatment for flow through firms is current law. Should tax reform fail, mature flow through firms will face taxation under current law. That means a federal income tax rate of 39.6 percent, plus either a self-employment or an investment income surtax of 3.8 percent, to create a total federal flow through tax of over 43 percent. And that’s just the federal tax. These are the highest tax rates faced by businesses anywhere in the developed world even before state income taxes are factored in. The OECD (developed nation) average business marginal tax rate is under 24 percent. This is very problematic considering flow through firms:
- are 90 percent of all businesses, and corporations only 10 percent
- employ a majority of the private sector workforce
- report more than one-third of business receipts and a majority of business profits
- result in the owners paying 44 percent of all business taxes
Should tax reform fail, these highest-in-the-world tax rates on flow through firms will continue to burden our job producers.
|Flow Though Firm Pre-Tax Income||$1.00|
|Flow Through Firm Tax (39.6% Income Tax Rate + 3.8% SECA/NIIT Rate)||$0.43|
|After-Tax Flow Through Income||$0.57|
Flow through firms get a big tax rate cut under the Senate tax reform bill. The 39.6 percent income tax rate on mature flow through firms is reduced to 31.8 percent in the Senate bill. This, combined with the 3.8 percent SECA/NIIT tax, results in a tax reform rate of about 36 percent on flow through firms.
When compared with the all-in federal flow through rate of 43 percent under current law, a reduction to 36 is pretty significant–a rate reduction of sixteen percent. That is a very large tax cut, and it’s available to most flow through firms. There are restrictions for affluent white-collar professionals to prevent tax evasion, and there is a requirement that bigger companies maintain a healthy payroll (not an issue for a bona fide larger flow through firm), but the rate relief is still pretty broad–the rate cuts apply no matter what tax bracket you are in.
|Flow Though Firm Pre-Tax Income||$1.00|
|Flow Through Firm Tax (31.8% Income Tax Rate + 3.8% SECA/NIIT Rate)||$0.36|
|After-Tax Flow Through Income||$0.64|
As you can see, the after-tax income of a mature flow through company rises from $0.57 to $0.64 under the Senate tax reform bill, a healthy twelve percent increase in after tax profits right out of the gate. To reverse the poles, that’s a cut in the top flow through tax rate from 43 percent under current law to 36 percent under tax reform.
We haven’t even factored in things like increased small business expensing, relief from accrual accounting rules, and an increased ability to write off interest compared to corporations.
Flow through firms only pay one layer of tax, but corporations pay two. We’ve already established that the Senate bill is a big tax cut for flow through companies compared to current law. But how does the bill’s treatment of flow through firms compare to its treatment of corporations?
The Senate bill reduces the federal corporate income tax rate from 35 percent today (also, when including states, the highest in the developed world) to 20 percent under tax reform.
At first blush, this appears to be treating corporations much better. After all, corporations get a 20 percent rate compared to an all-in flow through firm tax rate of 36 percent. But that ignores the fact that the flow through rate pays only one layer of tax (at the owner level), but corporations pay a double tax–once at the corporate level, and once at the shareholder level.
Shareholders pay tax at a top rate of 23.8 percent. This occurs either as a capital gains tax to the shareholder on retained after-tax corporate earnings, or as a dividend to the shareholder on distributed after-tax corporate earnings. Here’s how it works:
|Corporate Pre-Tax Income||$1.00|
|Corporate Income Tax (20%)||$0.20|
|Shareholder Layer of Tax (23.8%)||$0.19|
|Corporate After-Tax Income||$0.61|
That’s the apples-to-apples: $0.64 of after-tax flow through income vs. $0.61 of after-tax corporate income. To reverse the poles, that’s a 36 percent flow through tax rate vs. a 39 percent corporate-plus-shareholder tax rate. A cut for both, and right in the same ballpark.
What about the objections that the flow-through community has raised? Brian Reardon of the S-Corporation Association has raised some objections to the analysis above, which I should say has been the conventional analysis for many decades. You can read his objections here.
His first objection is that the shareholder layer of tax is more theoretical than actual. He cites non-profits, inheritance beneficiaries, foreign shareholders, and pension plans/401(k)s as examples of those who don’t pay the shareholder tax. What he fails to mention is that the death tax is a redundant layer of tax on these profits for inheritors, that foreign shareholders are often subject to U.S. tax withholding under treaty rules, and that pension plans pay out their balances as fully taxable retirement benefits. I would also point out that many partnership earnings flow through to the same non-profits, inheritance beneficiaries, foreign shareholders, and pension plans–and according to his logic, face no taxation whatsoever. This is not a unique problem for corporations.
He also cites the reality of corporate deferral without acknowledging that corporations won’t put their deferred after-tax earnings under a proverbial mattress. They will earn profits on investments made with the money, use old deferred money to pay new dividends or wages, invest in new plant and equipment, pay off debt, and generally slosh the money around in taxable ways. Corporations are not in the habit of creating Uncle Scrooge’s money bin to take an afternoon swim in. Flow through firms can also retain earnings, of course, and many large ones do.
Reardon also says that the income tax rate reduction for flow-through firms is too stingy–not only in size, but also in how one qualifies for it. Under a complex formula, mature flow through firms need to pay wages equal to 35 percent of profits in order to get full tax relief. Those who pay less in wages as a percent of business receipts get less rate reduction. This is by design. The rate relief is intended for mature flow through firms. Companies that employ workers–and many do, considering that a majority of private sector jobs are created by flow through companies–are far less likely to be tax shelters and far more likely to be real world businesses. Ditto for the provision preventing high earning professional services flow through owners from benefiting–there’s got to be some mechanism to stop sophisticated white collar taxpayers from turning in their W-2 for a 1099-MISC or a K-1.
It’s also worth mentioning that any flow through owner making less than $500,000 if married ($250,000 if single) fully qualifies for the rate reduction, whether or not the flow through business pays any W-2 wages at all, and whether or not the firm is in the professional services business. This will take care of the overwhelming majority of business owners, which is why the bill has been endorsed by the NFIB.
Finally, Reardon points out that corporations can continue to deduct their state and local taxes (SALT) as an ordinary and necessary business expense, but owners of flow through firms cannot. To that I would say that it’s been longstanding conservative tax policy to repeal the SALT deduction because it gives an unfair subsidy to state governments that have chosen to impose a high tax burden. Reardon is right that we should also repeal SALT for corporations, but that’s hardly a reason to deny rate relief to flow through firms now when we have the opportunity to–nor is it a reason to argue for a restoration of SALT for flow through owners. Less SALT is always positive tax policy.
The Senate tax reform bill is not perfect–for anyone. The flow through community and their biggest boosters in the Senate make it sound like they are the biggest (only?) losers in tax reform.
First, that’s not true–flow through companies will be getting large, substantial cuts in their marginal tax rates. Their top tax rate declines from 43 percent to 36 percent. Their after-tax profits rise by twelve percent. This is a very big win for the flow through business community.
Second, it’s tough all over. Everyone involved in tax reform is taking half a loaf, corporations included. Ask some of them what they think about the interest deduction cap, or the new base erosion rules around territoriality, or the new net operating loss provisions. You’ll get an earful. The same is true for anyone else. Budget reconciliation rules have their limits. The $1.5 trillion net tax cut the budget resolution establishes has its limits. The Byrd Rule imposes its limits. The political reality of any three Republican senators killing tax reform has its limits. The trick is to work within these limits, be smart enough to take half a loaf, and move on.
Third, this is not the last tax bill the United States Congress will ever pass. As the rate relief for flow through firms is implemented, future Congresses can and will want to revisit the policy. What’s working well? What’s working not so well? Should we change the wage payment requirement? Can we open up the rate relief to more professional service firms? How have IRS regulations and audits been doing? These are all things that will continue to get refined for many years, but we need to start somewhere.
The Senate’s tax reform bill is that starting point for flow through firms. Their alternative is to continue to suffer under the highest business tax rates in the developed world. It would be a shame if making the perfect the enemy of the good on flow through tax policy sank tax reform for millions of American families and small businesses.
Read more here.