Having described the taxonomy of the US Tax Code in the last article, it is worth taking a look at two of the most discussed areas of the Code: Partnerships (Subchapter K) and Corporations (Subchapter C).
Corporations and Passthroughs
The latest tax proposal – the one that must be passed or the Republicans should get used to the idea of losing control of Congress in 2018 – talks a lot about corporations and passthroughs. Corporations pay tax before passing on to shareholders dividends from what remains. Shareholders then pay tax on dividends and on any gains they make on selling shares. The result is two levels of taxation.
Partnerships do not suffer two levels of taxation: the partners, and not the partnership, are liable to pay tax on the profits made by the partnership. The partners pay the tax whether or not the partnership distributes any cash to them.
Partnerships, sole proprietorships and S Corporations (a slightly different kind of passthrough entity) account for over 31 million business tax returns. Whereas in 1980, there were more tax returns filed by corporations than by partnerships and S Corporations, by 2012, there were more than four times as many tax returns filed by partnerships and S Corporations than by regular corporations.
Historically, while corporations have been taxed at one rate, partners have been taxed on their partnership income at the same rates as individuals on their income.
Tax Reform Proposal
In considering the changes in tax policy being proposed by the Trump administration, it is helpful to know how much tax revenue comes from corporations and how much from individuals. According to the Office of Management and Budget, the sources of Federal tax revenue showed just over 9% coming from corporations and just over 47% from individuals. Income from passthroughs is captured in the individual segment.
The current proposal marks a significant departure in proposing that certain passthrough businesses be taxed at a maximum rate. In effect, it would create an additional category of income. It is not clear if this is intended to be administered and collected as part of the individual or corporate tax system. Where will it fit in the current taxonomy of the Code?
Background to the Existing System
The corporate tax rate has varied over the last century from as low as 1% at the beginning of the twentieth century to over 50% at various points. The effective rate, however, has been different. The effective rate is the rate that corporations pay measured as taxes paid compared to pre-tax income before they have taken advantage of the many deductions available to reduce taxable income. This is called tax planning and is generally carried out with the assistance of tax lawyers and accountants. The effective rate has been as much as 20% below the stated corporate tax rate.
Tools available to create deductions and reduce taxable income include: the use of borrowing to capitalize operations where possible to generate interest expense; leasing rather than owning corporate assets to generate rent expense; paying royalties to overseas subsidiaries in low-tax jurisdictions to generate expense in the US and move income overseas. The amount of foreign earnings moved overseas by companies such as Apple is estimated to be around $2.6trn.
Passthroughs, while they do not have the same tools available to them, can still use several techniques – one of the most talked about is the carried interest loophole– to pass the income through to entities or jurisdictions that pay less than the stated individual rate of tax of 39.6%.
Changing the Incentives
The solution proposed by the Trump administration to address these issues is, while sensible in some respects – mainly the way it is packaged and presented – probably unworkable in its most radical form.
The proposal would lower the corporate tax rate to 20%. It would also lower the top individual tax rate to 35% from 39.6% and reduce the number of bands to three from seven.
Lower tax rates create less incentive to avoid taxes. Lowering the tax rate would cost tax revenue. The proposal addresses that by eliminating some of the tools available to reduce the effective tax rate. Some amount of interest expense for corporations would cease to be deductible.
Individuals would no longer be able to deduct their state and local income taxes against their federal taxable income. The deductibility of property taxes would also be reduced. Mortgage interest and charitable contributions would continue to be deductible.
The proposal to change to a territorial system of taxation for corporations is radical. Currently, corporations are taxed on their worldwide income at the US corporate tax rate. There are certain exceptions to this. When corporations do business through overseas subsidiaries that are active, as opposed to passive holding companies, they do not pay US tax on the profits they generate until they repatriate those profits to the US.
They may pay some tax overseas, however. If the tax paid overseas is less than or equal to the tax that would be payable in the US, they will receive a credit for the foreign tax paid and only pay the difference when they repatriate the earnings.
Territorial taxation, by contrast, exempts from tax all dividends received by US corporations from foreign subsidiaries in which they hold above a certain threshold ownership interest (this proposal specifies 10%). To transition to this system, there would be a one-time tax on the repatriation of the $2.6trn unrepatriated foreign earnings.
To discourage corporations from moving profits to low-tax countries and returning them tax free, the proposal is to introduce a worldwide tax on global corporations at a special reduced rate. There are no details currently on what this rate may be or how it is expected to interact with foreign taxes. It is not clear whether the current foreign tax credit system will be scrapped or retained.
More Obvious Problems
The extent to which interest expense for corporations will continue to be deductible is not clear. Banks and other financial services companies are assuming that they will continue to be able to deduct interest expense in full. Their business consists in being able to borrow at one rate, lend at a higher rate and make a profit on the spread. If some portion of the interest expense on their borrowings is not deductible for tax purposes, their business model will be challenged.
Mutual funds and other registered investment companies avoid taxation at the corporate level, even though they are corporations, if they distribute all their net investment income. If a portion of their interest expense in not deductible for tax purposes, they will be unable to meet this requirement. Like banks, their business model will no longer function as intended.
The proposal is that income earned by small and family-owned businesses through passthrough entities such as LLCs, partnerships and S corporations will be taxed at a lower rate: 25%. There is no substantive discussion of what constitutes a small or family-owned business. The Treasury Secretary has said that firms providing personal services, such as law and accounting firms, will not benefit from the 25% rate. He has not explained how the definition will be crafted.
It also appears that there may be some material distinction between private equity firms and hedge funds, both of which raise and allocate investment capital through the partnership structure. Again, there is no clarity what this distinction may be.
In addition to the above, the administration proposes:
1. Introducing the expensing (in effect 100% first year depreciation) of new business investment (excluding structures) for a period of at least five years;
2. The abolition of the estate tax (after a lifetime of paying taxes, accumulated wealth is taxed on death);
3. the repeal of most business credits (a 1:1 reduction of taxes owed by the amount of a credit given for certain activities such as renewable energy or research and development), except for research and development and low-income housing credits;
4. The abolition of the alternative minimum tax (AMT) for corporations and individuals
The complexity inherent in the above proposals is considerable. The goal to produce radical change is a good one. Radical change, however, requires careful planning and skillful drafting. The current administration excels in neither.
The tension between the goals, the timeframe and the political will (and competence) to get points on the board has become greater with each legislative failure. Either this proposal will fail because its inherent complexity will make it unfathomable to lawmakers; or it will pass in a form that creates more complexity than it solves.
Neil is the CEO of Sevara Capital Advisors. He is passionate about solving tax, accounting and regulatory problems for institutions that have invested billions of dollars of capital in multiple jurisdictions. His company provides solutions for banks, insurance companies and hedge funds to tackle their problems related to tax returns, financial statements, accounting and internal finance matters. Neil holds a master’s degree in Law from the University of Cambridge.