The House Ways and Means Committee held a hearing to consider changing the tax treatment of closely held businesses in the context of overall tax reform efforts.

Dewey Martin

Wednesday’s hearing was the latest in a series of hearings that the Ways and Means Committee and the Senate Finance Committee have been holding on tax reform. Ways and Means Chairman Dave Camp, R-Mich., noted that closely held businesses can range from midsized manufacturers to local law firms to Main Street restaurants that sponsor the local Little League team. 

The hearing examined the rules that dictate how entities should be organized for purposes of taxation, along with the general burdens imposed on closely held businesses such as high compliance costs and tax rates.

“The difference between individual and corporate tax rates has an important effect on a business and how it is organized,” Camp said in his opening statement. “For example, if individual income tax rates are substantially higher than corporate income tax rates, there is a clear incentive for taxpayers to organize business activity in corporate form. In addition, businesses that are subject to the higher individual rates may face a competitive disadvantage. There is little doubt that economic distortions can be created by a tax code that tilts too much in any one direction. Naturally, one of the most effective ways to prevent that distortion is to create a neutral tax code in which the individual tax rates are similar to corporate rates.”

Camp noted that Republicans are calling for a top rate of 25 percent for both individuals and corporations, following the lead of the 1986 Tax Reform Act, which closely aligned individual and corporate rates to eliminate abuse and economic distortions related to business structure.

Accountant Dewey Martin testified before the committee on behalf of the National Federation of Independent Business. Martin owns a small accounting firm based in Hampden, Maine. In his testimony, he told the committee that major goals for small business tax reform should include keeping rates permanently low, reducing complexity, and avoiding disparity between corporate and individual tax rates. According to research from the NFIB, approximately 75 percent of small businesses pay taxes on business income at the individual rate.

“If Congress pursues a “corporate-only” reform that eliminates deductions and credits for a lower corporate rate, many small businesses could end up paying additional taxes without any corresponding benefit,” Martin said in his written testimony.

Martin took time out from tax season to travel to Washington to testify before the committee. He noted that taxes are a major issue for small businesses which affect decisions on whether to expand a business or not. Thoughtful, comprehensive reform to tax law could remove a major obstacle to small-business growth.

“One of the first organizational issues encountered when forming a business is its legal form,” said Martin. “The legal form chosen has implications for taxes, liability, startup costs, continuity, composition of ownership, and other matters of concern for the business owner. Critical to the business owner is the total cost to operate over the life of the business, including succession or termination. The owner cares about the variety of tax costs (income, payroll, return filing, etc.) that will be incurred as well as the cost of compliance with the related laws. A first meeting with a client would include all those topics.”

According to the Joint Committee on Taxation, in 2007, pass-through entities earned 56 percent of total net business income, which is taxed under the individual rate structure, Camp noted. Census data reveals that in 2008, pass-through entities employed more than 54 percent of the private sector workforce. “Both statistics point to the strong role pass-through entities play in our economy,” said Camp. “And recent proposals have raised concerns from many in the pass-through community.”

He criticized President Obama’s budget and other corporate reform proposals, which would lift the top statutory rate on individuals to roughly 40 percent, while the corporate rate would be lowered to 28 percent. “Corporate taxpayers would enjoy a tax rate that is 12 percentage points lower than the top rate faced by pass-through businesses,” said Camp. “This will create more harm than good.”

Camp argued that corporate tax reform should not be “financed on the backs of those who we have historically depended on the most to move us out of recessions—small businesses. Adding to the challenges posed by a disparate rate is the ever-increasing tax complexity facing closely held businesses. Unlike large, publicly held companies that have armies of accountants and lawyers, the complexity of the Tax Code disproportionately hits small businesses—which tend to be closely-held businesses.”

Rep. Sander Levin, D-Mich., the ranking Democratic member of the Ways and Means Committee, noted that pass-through businesses represented over a third of business receipts in 2008 and just under half of business income. “They are a major part of our economy and a major source of growth and jobs,” he said in his opening statement. “Because pass-through entities do not pay corporate income tax at the entity level, and because they range in size from very small businesses to very large businesses, they face a different set of issues with respect to tax reform than do C corporations.”

Levin noted that pass-through entities used to be a reasonable proxy for small businesses, but with the growth in both the number and size of S corporations and especially LLCs, this identity is breaking down. “This is vitally important as we debate the question of whether to continue the upper-income Bush tax cuts,” he added. “Some have sought to continue to draw a straight line between pass-throughs and small business to justify continuing the tax cuts for the highest earners. But pass-throughs are often quite large. For instance, in 2008, 64 percent of partnership income was earned by partnerships with more than $100 million in assets. “

Levin said that small business income also represents just a small fraction of the income that would be affected by an expiration of upper-income tax cuts, only about 8 percent.   

However, he added that as the committee contemplates the repeal of provisions that affect the cash flow of small businesses, such as accelerated depreciation or the domestic manufacturing deduction, in order to finance a corporate rate reduction, it would vitally affect pass-through entities benefiting from a reduction in the corporate rate. Pass-through entities also would not benefit from some of the international changes that the committee has discussed, he noted.

Mark Smetana, the CFO for family-owned and operated Eby-Brown Company and a member of Financial Executives International, also testified at the hearing on behalf of FEI.

“America's privately held businesses are the backbone to our economic success story,” he said in his prepared testimony. “Recognizing the importance of private companies is vital since any workable tax reform must address businesses regardless of their form of organization.”

"The recent framework for business tax reform released jointly by the Obama Administration and the Department of Treasury strongly implies that those [small and family-owned businesses] organized as pass-through entities are advantaged in the current Tax Code over corporations,” Smetana added. “This is simply not the case.”

Pass-through businesses reported 36 percent of all business net income, but paid 44 percent of all federal business income taxes, according to a report from Ernst and Young, he noted. Pass-through businesses include privately held firms organized as sole proprietorships, partnerships, C corporations, S corporations and limited liability companies.