Senate Small Business and Entrepreneurship Committee Hearing

Congress created S corporations over fifty years ago explicitly to encourage private enterprise -- and it worked. Today there are 4.7 million S corporations. n1 They are in every community and they are engaged in every type of industry. Their emergence has made the US economy larger and more flexible, resulting in more employment, more investment, and a stronger safety-net against economic downturns like the recent financial crisis.

Despite this success, the debate over reforming business taxation has focused primarily on C corporations and their challenges. US-based C corporations pay some of the highest tax rates in the world, and they are hamstrung by an outdated worldwide system that chases their income wherever it is earned. As a result, the tax code encourages our public companies to shift jobs, investment, and even their headquarters overseas. To address this, Congress needs to enact reforms that fix the tax code for C corporations.

But pass through businesses, including S corporations, face the same challenges as C corporations. The C corporation tax rate may be among the highest in the world, but the tax rate paid by S corporations is even higher. Moreover, pass through businesses have a bigger economic footprint than C corporations - they employ more people and they contribute more to national income. So any reform needs to be permanent, comprehensive, and treat pass through businesses as equal partners.

This is an argument we have been making for several years, and during that time we have developed a number of themes that help explain both the importance of the pass through community to investment and jobs here in the United States, and the reasons why Congress should enact permanent, comprehensive tax reform that reduces tax rates for pass through businesses and C corporations alike.

1. Start with S Corporations

The S corporation structure is the correct way to tax business income. If Congress were starting from scratch, it would begin with the S corporation as the base model. There are three key reasons why this is the case.

. First, S Corporation income is taxed just once, which is the correct way to tax business income. Multiple layers of taxation raise effective tax rates and they distort business behavior. There is a reason why only a small minority of C corporations pay dividends - they are adjusting their behavior to avoid that second layer of tax. Business income should be taxed once at a reasonable rate and then that's it.

. Second, S corporation income is taxed when it is earned and it is taxed regardless of whether the income is "distributed" to shareholders. There is no election or deferral in paying tax on S corporation income.

. Finally, S corporation income is taxed at progressive rates tied to a shareholder's income. Wealthy S corporation shareholders pay high marginal rates while lower income shareholders pay lower rates. This contrasts with the C corporation model where, with few exceptions, most C corporation shareholders pay the same marginal tax, regardless of their income.

Congress should keep these advantages in mind as it tackles tax reform. Tax reform should move the tax code towards the pass through model, not away from it.

2. The Business Tax Base is Growing, Not Shrinking

We often hear observation that the corporate tax base has shrunk since 1986, usually as a prelude to calling for expanding the reach of the corporate tax. The reality, however, is that the overall business tax base is growing, not shrinking. Businesses play a bigger role in the American economy today than they did prior to 1986, entirely due to the contributions of pass through businesses, including S corporations.

Prior to 1986, traditional C corporation income made up approximately 8 percent of GDP while pass through income, including S corporations, made up just one percent, for a total of 9 percent. Today, C corporations contribute 5 percent of GDP while pass through businesses add 6 percentage points - a total of 11 percent of GDP. n2 That bigger share of the overall economy means more jobs and more investment.

So instead of decrying the "erosion" of the corporation tax base, the tax community should be celebrating the growth of the "business" tax base. It's a good news story.

3. The Business Community Has Voted for a Single Layer of Tax

This shift away from the traditional corporate form is reflective of a broader theme, where the business community is migrating away from the harmful double corporate tax. For example, the Tax Foundation found that in 2012 that pass through businesses earned nearly 60 percent of business income (single layer) while C corporations earned only 40 percent (double taxation). n3 These income numbers suggest a majority of business income today is not subject to the double tax.

The shift to a single layer of tax is even more profound than those numbers suggest. The Tax Policy Center n4 recently reported that only one-quarter of US corporate stock today is owned in taxable accounts, down from four-fifths back in 1965. The rest is held by qualified plans, endowments, charities, foreign accounts, etc. This suggests that about 90 percent of all business income (pass through income plus three-quarters of C corporation income) is subject to a single layer of tax.

Congress may be seeking ways to improve the tax code and reduce the double tax on corporate America, but the business community is already there. Proposals to integrate the corporate tax, as suggested by Chairman Hatch (R-UT) and the Bush Treasury Department, would help the tax code catch up to the reality of business taxation today.

4. Pass Through Business Employ Most Workers

While businesses organized as S corporations, partnerships and sole proprietorships are generally labeled "small," their cumulative contribution to the economy is large, starting with employment.

The most recent numbers from the Tax Foundation found that 57 percent of private sector workers were employed at pass through businesses, with S corporations employing one in four n5. According to the Tax Foundation:

. Pass Through Businesses - 73 million (57 percent)

. S corporations - 33 million

. Partnerships - 14 million

. Sole Proprietorships - 26 million

. C Corporations - 54 million (43 percent)

States with the highest levels of pass through employment include Montana, South Dakota, Idaho and Vermont. Only Hawaii has pass through employment levels below 50 percent. Large pass through businesses are also a significant source of employment, with more than 10 million people working at pass through businesses with more than 500 employees.

5. Pass Through Businesses Pay Their Fair Share of Tax

A critique of S corporations is that they "avoid" the corporate tax, with the implication being that they either don't pay taxes at all or pay insufficient levels of tax. This critique is simply untrue. S corporations pay taxes on their business income when it is earned, and often at higher rates than C corporations.

In 2013 we asked an econometric firm to measure n6 the effective tax rates of businesses by type - C corporation, S corporation, partnership, and sole proprietorship. They found that S corporations, and particularly large S corporations, pay the highest effective federal tax rate:

. Sole Proprietorships: 15 percent

. C corporations: 27 percent

. Partnerships: 29 percent

. S corporations: 32 percent

. Large S corporations: 35 percent

For pass through businesses, these results show what you might expect. Sole proprietorships are generally informal smaller enterprises with lower effective tax rates while partnerships and S corporations tend to be larger and more formal, so they tend to have higher effective tax rates.

And while effective rates on C corporations have been studied extensively with varying results, the point here is that pass through businesses, and in particular S corporations, already pay their fair share and then some. Policymakers should keep this in mind as they seek to reform how businesses pay tax.

6. Pass Through Taxes Just Went Up

Finally, it is important to remind policymakers that, as a result of the resolution of the fiscal cliff and the implementation of a new Affordable Care Act tax, marginal tax rates on pass through businesses went up sharply beginning in 2013.

First, top marginal rates on pass through businesses rose from 35 to 39.6 percent. Second, the restoration of the Pease limitation on itemized deductions has the effect of increasing marginal rates by another 1.2 percent. And finally, the implementation of the new ACA Investment Surtax adds another 3.8 percent on S corporation shareholders who do not work at the business.

The cumulative effect of these changes was to raise the top marginal rate on S corporation shareholders and other pass through business owners from 35 to more than 44 percent.

The resulting high rates drain working capital from these businesses. One of our members, McGregor Metal Working, testified back in 2015 n7 that prior to 2013 they were able to retain up to 66 cents of every dollar of after-tax earnings for working capital and hiring new workers. Post 2013, they only are able to retain up to 59 cents, a decrease of 16 percent in retained earnings potential. That is a huge reduction, and it means fewer jobs and less investment.

Pass Through Businesses and Tax Reform

Beginning in 2011, the Treasury Department began to push the idea of "corporate-only" tax reform. Under this plan, the business tax base would be broadened by eliminating certain deductions and tax credits with the resulting revenue used to pay for lower rates for C corporations.

The challenge this approach poses to pass through businesses is obvious. They use the same deductions and credits as C corporations, but unlike C corporations, their rates just went up, not down. The result would be pass through businesses paying top tax rates 15 to 20 percentage points higher than C corporations. This disparity would be simply unsustainable.

To assess how harmful this approach would be to pass through businesses, we asked Ernst & Young to study n8 the effect of corporate-only tax reform. They found that corporate-only reform would increase the tax burden on pass through businesses by about $27 billion per year. Industries most affected would include agriculture, construction, and retail.

Consider the impact on McGregor. The fiscal cliff raised their effective tax rate (including federal, state and local) from 34 to 41 percent. If Congress enacted corporate-only reform that lowered the corporate rate while eliminating McGregor's access to LIFO, section 199, and the R&E tax credit, their effective rate would rise to over 50 percent.

No amount of small business expensing or cash accounting could help to offset that tax hit.

Pass Through Principles for Tax Reform

So the pass through community opposes corporate-only tax reform. What do we support? In 2016, more than one hundred trade groups, including the National Restaurant Association, the National Federation of Independent Business, and the American Farm Bureau, signed a letter articulating the following three principles for tax reform:

1. Reform needs to be comprehensive and improve the code for individuals, pass through businesses, and corporations alike;

2. Reform should reduce rates on individuals, pass through businesses, and corporations and seek to restore the rate parity that existed from 2003 to 2013; and

3. Reform should continue to reduce or eliminate the double tax on corporate income.

The difference between a "corporate only" approach that treats pass through businesses as an afterthought and true comprehensive reform that treats them as equal partners is rate reduction. Tax reform needs to reduce rates on corporations and pass through businesses alike and seek to restore the rate parity that existed prior to 2013.

Capping Pass Through Rates

One option to achieve this parity is to create a special, lower rate for pass through businesses. The House "Blueprint", the plan outlined by Senators Rubio (R-FL) and Lee (R-UT), and the Administration's tax reform outline all call for a new, lower top pass through rate. But separating pass through business and individual rates brings its own challenges - defining the new pass through tax base and including enforcement provisions to prevent cheating.

For the first, the tax base for pass through businesses should mirror the tax base for corporations and include all the active business income earned by S corporations and other pass through businesses. Provisions to limit the new rate's application based on shareholder status or the size of the business are inappropriate. Senators Susan Collins (R-ME) and Ben Nelson (D-FL), along with Representative Vern Buchanan (R-FL), have introduced legislation that demonstrates how the pass through tax base can be defined effectively.

For the second, establishing a separate rate for pass through business income creates an enforcement challenge by taxing active pass through business income at a lower rate than individual wage and salary income. The bigger the difference in rates, the bigger the enforcement challenge.

In addressing this challenge, Congress needs to make sure it doesn't undermine the value of the lower rate to business owners. Separating the return on owner's labor from the return on their investment in the business is not easy, but guidelines to reinforce the new pass through rate should include:

1. Exempting non-active owners from the enforcement provisions. If an owner of a pass through business does not materially participate in the operation of the business, then there is no issue.

2. Recognizing the investment pass through businesses make in their capital and employees. The new rule needs to recognize that some businesses make significant investments in both capital and employees and that much of the business' profits derive from these investments.

3. Ensuring the new rules are easier to comply with -- and enforce -- than the existing "reasonable compensation" rules the IRS uses today.

S Corporation Modernization

Beyond tax reform and rate reduction, there are other ways Congress can encourage the creation and growth of Main Street businesses. Since its inception, the S Corporation Association has promoted legislation to improve the rules that govern S corporations, some of which date back over half a century. This Congress, the S Corporation Modernization Act (H.R. 1696 and S. 711) was sponsored by Senators Thune (R-SD) and Cardin (D-MD) and Representatives Reichert (R-WA) and Kind (D-WI).

Key provisions in the bill would enable S corporations to attract foreign investment, reduce the bite of the so-called "Sting Tax" on excessive passive income, and ensure that S corporation assets passed on from one generation to the next are treated similarly to assets held by a partnership. The S Corporation Association is working with our sponsors to include these provisions in the tax reform legislation to be considered by Congress later this year.

Withdraw Section 2704 Rule

Finally, not all tax issues critical to S corporations fit under the umbrella of tax reform. Last August, the Treasury Department proposed changes to Section 2704 that would, if left intact, result in increased estate and gift tax valuations of family-controlled businesses of 30 percent or more.

The S Corporation Association has vigorously opposed these rules since their publication, submitting extensive comments, speaking at the public IRS hearing held in December, and organizing a trade association letter to congressional leadership requesting their assistance in defeating the rules.

Most recently, we released a critical study sponsored by the S Corporation Association and several other trade groups. Authored by Clinton Administration economist Robert Shapiro, the study quantifies the economic harm the pending rules would have on employment and economic output. As the study concludes, over the next decade the rule would:

. Reduce GDP by $154 billion; and

. Reduce employment by 105,990 jobs.

The Trump Administration supports estate tax repeal and has asked Treasury to list out those existing and pending regulations that should be repealed or, in the case of pending rules, withdrawn. The S Corporation Association has encouraged Treasury to include the 2704 rules on that list and intends to continue to press this issue until they are withdrawn.

Conclusion

Constructed correctly, tax reform can literally take us from one of the worst tax codes in the world to one of the best, but only if Congress pursues permanent, comprehensive reform that builds on the remarkable success of the S corporation.

By adopting reforms that conform to the three pass through principles articulated above, Congress can completely redo how we tax business activity in the United States, helping to ensure that all businesses, public and private, large and small, are able to compete and grow on a level playing field.

In turn, those businesses and the people who run them will respond with more investment, more jobs, and higher wages than if Congress did nothing. Tax reform is a generational opportunity, and like the S corporation, it needs to start on Main Street.

n1 IRS SOI

n2 http://taxfoundation.org/article/america-s-shrinking-corporate-sector?mc_cid=275125da58&mc_eid=8aee3da63d

n3 https://taxfoundation.org/pass-through-businesses-data-and-policy/

n4 http://www.taxpolicycenter.org/taxvox/only-about-one-quarter-corporate-stock-owned-taxable-shareholders

n5 https://taxfoundation.org/pass-through-businesses-data-and-policy/

n6 http://www.s-corp.org/wp-content/uploads/2013/08/Quantria_Study_ETR_8-6-13_Final_pm.pdf

n7 https://smallbusiness.house.gov/uploadedfiles/4-15-2015_mcgregor_testimony.pdf

n8 EY reference

Read this original document at: https://www.sbc.senate.gov/public/?a=Files.Serve&File_id=99ACCE4F-D469-4E21-9643-8ACB2A3EF6C2