Many executives of big public companies have shared their ideas about corporate tax reform in hearings before policy makers lately. Just last week, the CEOs of Wal-Mart, Kimberly Clark, CVS and PMC-Sierra said they are willing to give up corporate tax breaks in exchange for lower tax rates. Higher-ups at Procter & Gamble, Siemens USA, The Boeing Company and Perrigo Pharmaceuticals are among others who have had their say.
But what about the little guys?
Non-publicly traded companies that are structured as so-called pass-through entities -- which are S corporations, partnerships and sole proprietors (LLCs) -- have been notably absent from the conversation.
This is no small omission. While most people probably have never heard of them, pass-throughs make up more than 90 percent of all U.S. businesses, and collectively account for about 40 percent of business revenue. “Business in America is generally conducted through partnerships and S corporations,” said Donald Williamson, executive director of the Kogod Tax Center at American University in Washington.
President Obama and Congress just signed off on major debt ceiling legislation which mandates a new joint committee to make recommendations for overhauling the federal tax code by Thanksgiving. If changes are made to the corporate tax code without addressing pass-throughs, “these kinds of businesses may see their taxes go up,” warns Robert McIntyre, director of the Institute on Taxation and Economic Policy.
Pass-throughs were originally designed to help make small businesses more competitive. These entities don’t pay corporate taxes – only C corporations, which are primarily public companies, do that. In pass-throughs, business income is taxed at individual income tax rates. But pass-through entities are tangled up in the corporate tax system because they get the benefit of corporate tax deductions and credits.
The top rate is 35 percent in both the corporate and individual income tax systems. So if the corporate tax rate is lowered from 35 percent and major corporate tax deductions are eliminated, pass-throughs would be at a major disadvantage. For many of them, deductions would disappear or shrink, yet their top tax rate would remain at 35 percent.
Some small- and medium-sized business owners are feeling uneasy about the possibilities for changes in the tax code looming on the horizon. “The success of the economy comes from the success of businesses of all sizes and structures. Not enough attention is paid to pass-through entities, period,” says Ray Monteleone, founding partner of Paladin Global Partners, a business consulting firm in Fort Lauderdale, Fla., that has two partners and four employees, and is set up as a partnership.
Monteleone says he also fears that rather than overhauling and simplifying the tax code, Congress will make piecemeal changes that will only increase the complexities. “Complexity is basically an indirect tax,” Monteleone says. “If I have to pay an advisor, attorney, CPA, or consultant to sort through everything, my outflow of cash still goes up. Instead of paying Uncles Sam I’m paying someone else.”
The main benefit of a pass-through is that it avoids the double taxation that C corporations must contend with. C corporations get taxed on income, and then -- when that money is distributed in dividends to shareholders -- it is taxed again.
“Many tax experts say that as lawmakers address the corporate tax code, they must also address the flaws in rules on pass-through entities. For example, it used to be that only small businesses with no more than 10 shareholders were able to be pass-throughs. But rules were relaxed through the 1990s and now the structure is possible for companies with up to 100 shareholders.
This is not only a departure from the original purpose of the pass-through entity – to help small businesses compete – it upends the level paying field for larger pass-throughs and their public competitors.
“Owners of a corporation who are also shareholders are paying tax at 35 percent, then getting dividends and capital gains out at 15 percent. Why is it okay for their competitor with partners to be taxed at the owners’ income tax bracket and never pay anything more?” asks Clint Stretch, director of legislative affairs at Deloitte & Touche.
Early this year, Obama raised the idea of taxing any firm with more than $50 million in revenues as a C corporation, “but there’s no conversation about that now,” Stretch says.
Another knock on the pass-through structure is that it invites fraud that is difficult for the Internal Revenue Service to detect. By underreporting income and overstating deductions, the IRS estimates that S corporations, partnerships and other pass-throughs account for $22 billion of uncollected taxes each year. Clearly lawmakers have some delicate work to do, to not only reform the system, but keep it fair.
During a June hearing before the House Ways and Means Committee, Rep. Sander Levin, D-Mich., the ranking member, said that in corporate tax reform, “the inevitable consequence is a shifting of the burden of the current level of taxation, and there will be winners and losers.”
Maybe so, but let’s hope lawmakers can minimize the imbalance for the sake of raising levels of employment and getting the economy back on track.