Tuesday, June 21, 2011

Do Passthroughs Cost the Treasury Money?

Treasury Secretary Timothy Geithner started a bit of firestorm on February 15 in testimony before the Senate Finance Committee. By way of context, the White House is seeking to overhaul the corporate tax code. There is much discussion about doing away with certain deductions (the domestic production activities deduction, LIFO) in order to reduce corporate rates. As I have commented before, the U.S. has the second-highest corporate tax rate in the world.

Well, an ancillary issue is the tax treatment of “small business.” You know, the businesses that make up the client list of almost all U.S. CPA firms except those that begin with the names “Deloitte,” “Ernst,” “KPMG,” and “PwC.”

Here is the Secretary:

“Congress has to revisit this basic question about whether it makes sense for us as a country to allow certain businesses to choose whether they’re treated as corporations for tax purposes or not.”

Let’s have a quick and rough review of selected statistics. Business tax collections in 2007 were approximately $2.2 trillion, of which $1.4 was from “traditional” corporations, the balance being from S corporations, partnerships, LLC’s and proprietorships. Let’s look at the number of returns: of approximately 13 million business returns, slightly less than half were from “traditional” corporations.

Here is the Secretary again:

“What’s a little unique about our system relative to other countries is we do give a lot of businesses the choice of how their income should be taxed.”

We have a certain amount of choice on how we are taxed. Isn’t that quaint?

Today I was reading an article in Tax Notes by Martin A. Sullivan titled “Passthroughs Shrink the Corporate Tax by $140 Billion.” He points out that…

“Nowhere is the inefficiency of the tax more apparent than in the porous border between one group of business that must pay the tax and the group that can escape it.”

I have a plea for Mr. Sullivan: please tell me how my clients can “escape it.” Apparently I have been giving out erroneous tax advice for two decades. My advice is to reduce and minimize, but that’s about all I can do. Unless minimizing constitutes “escaping it,” in which case I have wasted a career in public practice. I should have finished my PhD and lectured on what I had never done in a profit-making capacity. I could then go on to a government office, maybe even the Cabinet.

The issue here is the how a C corporation is taxed. If a C has profits and pays dividends, the dividends are taxed a second time to the shareholder. If a C liquidates, it has to pay tax on any profit inherent in its assets; the distribution is then taxed again to the shareholder. C corporations may have a higher tax rate. Passthroughs try to avoid much of this by having one level of tax. If I own an S corporation, for example, the profit will be taxed once – to me and on my personal return. There are exceptions, but let’s set them aside for the moment.

Mr. Sullivan goes on:

“But the rise of S corporations and LLCs has also taken a big bite out of the taxable corporate sector.

“If the corporate sector’s share of business stayed at the same level as it was in 1999, it (the corporate tax) would be about 10% larger.”

Well, yes. The way that - if I stayed the same as I was in 1999 - my knees would not hurt me occasionally and my energy level would be 20% higher. Things change. Business owners – and advisors like me – would have responded with change, and it is hard to say what the results would have been, much less that they would have been to the government’s liking.

One last quote:

"Many would like to keep tax reform confined to the corporate sector. But politics aside, isn’t it reasonable to suggest that passthrough businesses that are relatively lightly taxed pay more to reduce taxes on C corporations?”

Rick and I could poll ALL OF OUR CLIENTS and see if they consider themselves “lightly taxed.”Keep you informed on that.

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