Aug.Senate Finance Committee Examines Taxation of Business Entities
AT TODAY’S SENATE FINANCE COMMITTEE HEARING, lawmakers examined the taxation of business entities in the context of tax reform. Chairman Max Baucus (D-Mont.) said despite the falling number of businesses filing for Initial Public Offering (IPO) or filing their taxes as C-corporations, the total number of new businesses has “increased steadily” over the past 20 years.
Baucus also hinted that many businesses seek to avoid higher taxes that come with listing on established stock markets, noting that 95 percent of all U.S. businesses are structured as “so called pass-through entities” which “give businesses the unique tax incentives that might discourage companies from accessing stock markets.” He added that pass-throughs “don’t pay corporate taxes; their business income is taxed at individual income tax rates” and concluded by saying the Committee “should examine if the use of pass-throughs have disrupted the level playing field for larger non-public companies and their public competitors.”
Ranking Member Orrin Hatch (R-Utah) noted that the earnings of a corporation may be subject to two levels of taxation and that it “makes no sense today to have two levels of taxation of corporate earnings….. All business income, whether earned by a C-corporation, a large pass-through entity, or a small business, should be subject to a single level of tax – either at the entity level or at the owner level.” Hatch also noted that such a move to a tax system in which all business income is subject to a single level tax, will be a “big challenge” as such a system “may raise less revenue than the current system.”
Hatch also discussed the 3.8 percent tax on net investment income of single taxpayers earning $200,000 and married couples earning $250,000, and mentioned the fact that capital gains and dividends will be subject to a 23.8 percent tax and 43.4 percent tax, respectively, in 2013 if the Bush era tax cuts expire at the end of this year. “The result would be a return to the classical system of taxing the earnings of a corporation with all the distortions that accompany such a system,” Hatch said.
Testimony
In his opening statement, Harrison LeFrak, Vice Chairman of the LeFrak Organization, stressed the need to maintain the current tax system to sustain the health of economy. Using his own organization as an example, LeFrak said that under the Obama Administration’s proposed corporate tax overhaul, half of corporate income would be taxed. He protested that the proposed tax changes would limit profits while inhibiting incentives to continue operations. LeFrak also warned that if implemented, the Administration’s proposal would increase offshore investment to countries that do not double tax partnership income. “My own family would have incentives to invest offshore, because we could avoid double taxation on our investments and benefit from foreign tax credits,” LeFrak said.
In his opening statement, Dana Trier, Adjunct Professor in Taxation at the University of Miami School of Law and Columbia Law School, argued the corporate tax rate should be decreased from the current 35 percent rate to increase U.S. competitiveness, but cautioned about a potential growing disparity between the maximum individual tax rate and the corporate tax rate. He also said the Committee should pay close attention to “the growing use of blockers and similar entities that cut off income.”Trier describes “blockers” in his testimony as “an entity inserted in a structure to change the character of the underlying income or assets, or both, to address entity qualification issues, to change the method of reporting, or otherwise to get a result that would not be available without the use of more than one entity.”
Trier went on to question whether the current tax system fully captures all of the taxable U.S. business income and advocated for the use of a one-level tax system for business income as a solution. Trier said he does not think that “we need to talk about treating big service companies as corporations subject to the two levels of tax” and expressed his satisfaction with the treatment of publicly-traded partnerships.
On dividend tax relief, Trier said “if the substantial reform effort fails, and no alternative integration mechanism is adopted, I would continue the experiment of partial dividend taxation relief into the future. In fact, I would extend the relief now pending further consideration of broader reform.” He added, “I also am somewhat influenced by what I perceive to be the possible behavioral responses of taxable investors like myself in the public markets if dividend relief is completely eliminated with respect to publicly traded stock in the context of a very low interest rate world with substantial uncertainty.”
In his testimony, Trier provided a historical overview of that taxation of business entities starting from the 1980s, before going on to provide his perspective on such taxation and contemporary issues pertaining to the taxation of business entities.
In his testimony, Alvin C. Warren, Professor of Law at Harvard University Law School, recommended reforming the “long standing” taxation of corporate entities in the US to reduce “distortions.” He said our current tax system results in a double tax on corporate incomes. These “distortions,” he said, have been exacerbated by the rise of “pass-through entities” like Limited Liability Companies (LLCs), and the growth of private equity. In closing, he said Congress must tax all business income “once, but only once. To the extent possible, the same tax rate should apply no matter how the business is organized or financed. The level of that rate is, of course, a separate question from how to structure the taxation of entities to advance the goal of neutrality.”
In his testimony, Fred C. De Hosson, Partner at Baker & McKenzie, outlined certain aspects of the European Union’s (EU) tax system. He said EU countries are making less use of pass-through entities and partnerships because lower tax rates on corporations make incorporating a cheaper and more appealing option. Since 1992, De Hosson said personal income rates have increased in the EU, while corporate tax rates have decreased significantly. Lastly, De Hosson said the double taxation of corporations is not a concern in the EU “as a result of a significant reduction of corporate income tax rates in almost all European countries.”
Question and Answer
Baucus asked Trier how business income allocable to a tax exempt or foreign investor “is able to set up a blocker or stopper to escape U.S. tax, and how this should be addressed.
Trier said a tax exempt or a foreign person could not directly invest in an ongoing business that is conducted in a passthrough. Trier said the “big issue” is “if the tax exempt gets its return from the blocker as debt, is there too big of interest deduction at the blocker level in effect pulling out income from the corporate sector and into the tax exempt sector.” More broadly, “we have so many different [blocker] entities that we’re not sure that things are working out correctly.”
Focusing on the “goal of simplicity,” Baucus asked Hatch asked what the panelists think about the Obama Administration’s proposal to double tax certain pass-through entities.
LeFrak harshly criticized the proposal saying it would cause job losses because it would increase tax complexity. Not only would employees at various partnerships be placed in a position “to work for the government more than nine months a year,” but the proposal would also cause pension funds to stop investing in domestic partnerships in favor of foreign partnerships, LeFrak said.
Trier said he had trouble fully understanding the proposal, calling it a “relatively sketchy document.” Trier said he is “not adverse to there being a single type of entity for business enterprises of all kinds. “What I am very adverse to,” he added, “is using that approach to move in a direction where there is more than one basic layer of tax. To the extent you’re talking about adding to that incremental one layer, I think it is a movement in the wrong direction.”
Hatch asked Warren whether he would recommend “one regime in which an entity level tax is imposed on all business entities and then a shareholder credit is used to eliminate the double tax on earnings, or would you establish two regimes in which a dividing line is created between taxable entities and pass-through entities and limit the shareholder credit system to the taxable entities?”
Warren said if “we’re going down the pathway to transform the corporate tax into some sort of withholding tax, my instinct would be to limit this to all business entities that were large, while letting smaller entities continue to pass-through.”
Sen. Mike Crapo (R-Idaho) asked the panelists whether they agreed that a single tax level for all business income “should be the objective of our efforts to reform the tax code.”
Warren said he agreed with the objective, but the question that remains, according to Warren, is what the level is going to be set at. “The fundamental choice the Committee needs to think about is are we going to try and tax investors on the income they earn through companies at the same rate they would earn on other income, or are we going to have a separate tax on entities that may be unrelated to what the individual taxes are?”
Pressed on how the level should be structured, Warren said he would start with the view that “however you earn your investment income, whether it is through a pass-through, a sole proprietorship, or through a company, in the end the same tax rate should apply. If we don’t do that, people are going to have all sorts of pressures to play all sorts of games.”
Crapo then asked whether the distinctions between capital gains income and ordinary income be maintained.
LeFrak said that distinction needs to be maintained, adding that one of the “most important reasons to have a lower capital gains rate is because it is not indexed for inflation. Without indexing… you’re just taxing people for doing a transaction, you’re not taxing their accession to wealth.”
Warren added that if inflation is the rationale for a lower rate for capital gains, “then you might want to rethink what the requirements are to get the lower rate. If inflation is really the problem, probably you don’t need to have a lower rate after an investment of six months or a year. Maybe the benefit should be on how long you held the asset.”
Trier said “if we’re not perfect in our integration system, the capital gains rate is having the effect of mitigating the second level of tax and therefore it is decreasing distortions.”
Sen. Ron Wyden (D-Ore.) cited a study from Ernst & Young which demonstrated that reforming the tax code for corporations alone would, in effect, raise income taxes for millions of small pass-through businesses. He asked the panel if tax reform should be comprehensive, including both the individual and corporate sides, to provide tax relief to the majority of Americans.
The panelists agreed with Wyden. Trier said he is not comfortable with a world that uses base broadening and rationalizes the corporate level rates applicable to public corporations, “but on the other hand you reintroduce the significant disparity between the pass-through world and individual world,” adding that in the end “me may have to live with some disparity.” LeFrak cautioned against hasty reform, noting the negative effects from the 1986 tax reforms on the real estate industry in the U.S.
Sen. Thomas Carper (D-Del.) asked the panel which type of integration system would be more effective to reduce any bias in favor of debt in the current tax code.
LeFrak said “if one is concerned with people receiving interest payments and inappropriately not paying tax on the receipt of those interest payments, then have a withholding tax on interest income. If one decides that the recipient is worthy of receiving that income without paying taxes, then credit back the withholding.”
Warren added that if there was a withholding tax on interest, “that would be an exact parallel to having a shareholder credit form of integration.” Warren cautioned the Committee against another pathway that would make dividends deductible as this would “eliminate the corporate tax for certain kinds of recipients, who themselves are not taxable.”
Sen. Ben Cardin (D-Md.) asked the panel whether it is a “good deal” to eliminate pass-through entities in order to lower the corporate tax rate.
Trier said he is skeptical that the U.S. can get to a 25 percent corporate tax rate. Trier said the Committee should accept “minor distortions” if it allows for the lowering of business income tax, at all levels, to a “modest level.” He added that the “last thing I want is for pass-throughs to be brought into the corporate world and then have a huge individual tax rate. I don’t think that is a forward movement. We have to keep the world that is inhabited by the LeFrak Organization, etc., relatively close to the corporate world; it doesn’t have to be identical.”
Cardin concluded by saying that while lawmakers support comprehensive reform, “we have to be realistic as to what is likely to happen here and we have got to be very careful if we’re going to go to double taxation as the solution to our problems. I for one am very concerned about movement away from or making it more difficult for pass-throughs.”
For more information on the hearing, please click here.
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AT TODAY’S SENATE FINANCE COMMITTEE HEARING, lawmakers examined the taxation of business entities in the context of tax reform. Chairman Max Baucus (D-Mont.) said despite the falling number of businesses filing for Initial Public Offering (IPO) or filing their taxes as C-corporations, the total number of new businesses has “increased steadily” over the past 20 years.
Baucus also hinted that many businesses seek to avoid higher taxes that come with listing on established stock markets, noting that 95 percent of all U.S. businesses are structured as “so called pass-through entities” which “give businesses the unique tax incentives that might discourage companies from accessing stock markets.” He added that pass-throughs “don’t pay corporate taxes; their business income is taxed at individual income tax rates” and concluded by saying the Committee “should examine if the use of pass-throughs have disrupted the level playing field for larger non-public companies and their public competitors.”
Ranking Member Orrin Hatch (R-Utah) noted that the earnings of a corporation may be subject to two levels of taxation and that it “makes no sense today to have two levels of taxation of corporate earnings….. All business income, whether earned by a C-corporation, a large pass-through entity, or a small business, should be subject to a single level of tax – either at the entity level or at the owner level.” Hatch also noted that such a move to a tax system in which all business income is subject to a single level tax, will be a “big challenge” as such a system “may raise less revenue than the current system.”
Hatch also discussed the 3.8 percent tax on net investment income of single taxpayers earning $200,000 and married couples earning $250,000, and mentioned the fact that capital gains and dividends will be subject to a 23.8 percent tax and 43.4 percent tax, respectively, in 2013 if the Bush era tax cuts expire at the end of this year. “The result would be a return to the classical system of taxing the earnings of a corporation with all the distortions that accompany such a system,” Hatch said.
Testimony
In his opening statement, Harrison LeFrak, Vice Chairman of the LeFrak Organization, stressed the need to maintain the current tax system to sustain the health of economy. Using his own organization as an example, LeFrak said that under the Obama Administration’s proposed corporate tax overhaul, half of corporate income would be taxed. He protested that the proposed tax changes would limit profits while inhibiting incentives to continue operations. LeFrak also warned that if implemented, the Administration’s proposal would increase offshore investment to countries that do not double tax partnership income. “My own family would have incentives to invest offshore, because we could avoid double taxation on our investments and benefit from foreign tax credits,” LeFrak said.
In his opening statement, Dana Trier, Adjunct Professor in Taxation at the University of Miami School of Law and Columbia Law School, argued the corporate tax rate should be decreased from the current 35 percent rate to increase U.S. competitiveness, but cautioned about a potential growing disparity between the maximum individual tax rate and the corporate tax rate. He also said the Committee should pay close attention to “the growing use of blockers and similar entities that cut off income.”Trier describes “blockers” in his testimony as “an entity inserted in a structure to change the character of the underlying income or assets, or both, to address entity qualification issues, to change the method of reporting, or otherwise to get a result that would not be available without the use of more than one entity.”
Trier went on to question whether the current tax system fully captures all of the taxable U.S. business income and advocated for the use of a one-level tax system for business income as a solution. Trier said he does not think that “we need to talk about treating big service companies as corporations subject to the two levels of tax” and expressed his satisfaction with the treatment of publicly-traded partnerships.
On dividend tax relief, Trier said “if the substantial reform effort fails, and no alternative integration mechanism is adopted, I would continue the experiment of partial dividend taxation relief into the future. In fact, I would extend the relief now pending further consideration of broader reform.” He added, “I also am somewhat influenced by what I perceive to be the possible behavioral responses of taxable investors like myself in the public markets if dividend relief is completely eliminated with respect to publicly traded stock in the context of a very low interest rate world with substantial uncertainty.”
In his testimony, Trier provided a historical overview of that taxation of business entities starting from the 1980s, before going on to provide his perspective on such taxation and contemporary issues pertaining to the taxation of business entities.
In his testimony, Alvin C. Warren, Professor of Law at Harvard University Law School, recommended reforming the “long standing” taxation of corporate entities in the US to reduce “distortions.” He said our current tax system results in a double tax on corporate incomes. These “distortions,” he said, have been exacerbated by the rise of “pass-through entities” like Limited Liability Companies (LLCs), and the growth of private equity. In closing, he said Congress must tax all business income “once, but only once. To the extent possible, the same tax rate should apply no matter how the business is organized or financed. The level of that rate is, of course, a separate question from how to structure the taxation of entities to advance the goal of neutrality.”
In his testimony, Fred C. De Hosson, Partner at Baker & McKenzie, outlined certain aspects of the European Union’s (EU) tax system. He said EU countries are making less use of pass-through entities and partnerships because lower tax rates on corporations make incorporating a cheaper and more appealing option. Since 1992, De Hosson said personal income rates have increased in the EU, while corporate tax rates have decreased significantly. Lastly, De Hosson said the double taxation of corporations is not a concern in the EU “as a result of a significant reduction of corporate income tax rates in almost all European countries.”
Question and Answer
Baucus asked Trier how business income allocable to a tax exempt or foreign investor “is able to set up a blocker or stopper to escape U.S. tax, and how this should be addressed.
Trier said a tax exempt or a foreign person could not directly invest in an ongoing business that is conducted in a passthrough. Trier said the “big issue” is “if the tax exempt gets its return from the blocker as debt, is there too big of interest deduction at the blocker level in effect pulling out income from the corporate sector and into the tax exempt sector.” More broadly, “we have so many different [blocker] entities that we’re not sure that things are working out correctly.”
Focusing on the “goal of simplicity,” Baucus asked Hatch asked what the panelists think about the Obama Administration’s proposal to double tax certain pass-through entities.
LeFrak harshly criticized the proposal saying it would cause job losses because it would increase tax complexity. Not only would employees at various partnerships be placed in a position “to work for the government more than nine months a year,” but the proposal would also cause pension funds to stop investing in domestic partnerships in favor of foreign partnerships, LeFrak said.
Trier said he had trouble fully understanding the proposal, calling it a “relatively sketchy document.” Trier said he is “not adverse to there being a single type of entity for business enterprises of all kinds. “What I am very adverse to,” he added, “is using that approach to move in a direction where there is more than one basic layer of tax. To the extent you’re talking about adding to that incremental one layer, I think it is a movement in the wrong direction.”
Hatch asked Warren whether he would recommend “one regime in which an entity level tax is imposed on all business entities and then a shareholder credit is used to eliminate the double tax on earnings, or would you establish two regimes in which a dividing line is created between taxable entities and pass-through entities and limit the shareholder credit system to the taxable entities?”
Warren said if “we’re going down the pathway to transform the corporate tax into some sort of withholding tax, my instinct would be to limit this to all business entities that were large, while letting smaller entities continue to pass-through.”
Sen. Mike Crapo (R-Idaho) asked the panelists whether they agreed that a single tax level for all business income “should be the objective of our efforts to reform the tax code.”
Warren said he agreed with the objective, but the question that remains, according to Warren, is what the level is going to be set at. “The fundamental choice the Committee needs to think about is are we going to try and tax investors on the income they earn through companies at the same rate they would earn on other income, or are we going to have a separate tax on entities that may be unrelated to what the individual taxes are?”
Pressed on how the level should be structured, Warren said he would start with the view that “however you earn your investment income, whether it is through a pass-through, a sole proprietorship, or through a company, in the end the same tax rate should apply. If we don’t do that, people are going to have all sorts of pressures to play all sorts of games.”
Crapo then asked whether the distinctions between capital gains income and ordinary income be maintained.
LeFrak said that distinction needs to be maintained, adding that one of the “most important reasons to have a lower capital gains rate is because it is not indexed for inflation. Without indexing… you’re just taxing people for doing a transaction, you’re not taxing their accession to wealth.”
Warren added that if inflation is the rationale for a lower rate for capital gains, “then you might want to rethink what the requirements are to get the lower rate. If inflation is really the problem, probably you don’t need to have a lower rate after an investment of six months or a year. Maybe the benefit should be on how long you held the asset.”
Trier said “if we’re not perfect in our integration system, the capital gains rate is having the effect of mitigating the second level of tax and therefore it is decreasing distortions.”
Sen. Ron Wyden (D-Ore.) cited a study from Ernst & Young which demonstrated that reforming the tax code for corporations alone would, in effect, raise income taxes for millions of small pass-through businesses. He asked the panel if tax reform should be comprehensive, including both the individual and corporate sides, to provide tax relief to the majority of Americans.
The panelists agreed with Wyden. Trier said he is not comfortable with a world that uses base broadening and rationalizes the corporate level rates applicable to public corporations, “but on the other hand you reintroduce the significant disparity between the pass-through world and individual world,” adding that in the end “me may have to live with some disparity.” LeFrak cautioned against hasty reform, noting the negative effects from the 1986 tax reforms on the real estate industry in the U.S.
Sen. Thomas Carper (D-Del.) asked the panel which type of integration system would be more effective to reduce any bias in favor of debt in the current tax code.
LeFrak said “if one is concerned with people receiving interest payments and inappropriately not paying tax on the receipt of those interest payments, then have a withholding tax on interest income. If one decides that the recipient is worthy of receiving that income without paying taxes, then credit back the withholding.”
Warren added that if there was a withholding tax on interest, “that would be an exact parallel to having a shareholder credit form of integration.” Warren cautioned the Committee against another pathway that would make dividends deductible as this would “eliminate the corporate tax for certain kinds of recipients, who themselves are not taxable.”
Sen. Ben Cardin (D-Md.) asked the panel whether it is a “good deal” to eliminate pass-through entities in order to lower the corporate tax rate.
Trier said he is skeptical that the U.S. can get to a 25 percent corporate tax rate. Trier said the Committee should accept “minor distortions” if it allows for the lowering of business income tax, at all levels, to a “modest level.” He added that the “last thing I want is for pass-throughs to be brought into the corporate world and then have a huge individual tax rate. I don’t think that is a forward movement. We have to keep the world that is inhabited by the LeFrak Organization, etc., relatively close to the corporate world; it doesn’t have to be identical.”
Cardin concluded by saying that while lawmakers support comprehensive reform, “we have to be realistic as to what is likely to happen here and we have got to be very careful if we’re going to go to double taxation as the solution to our problems. I for one am very concerned about movement away from or making it more difficult for pass-throughs.”
For more information on the hearing, please click here.