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Camp Opening Statement: Hearing on the Treatment of Closely-Held Businesses in the Context of Tax Reform

March 07, 2012

Good morning.  Before we begin, I want to say that I was saddened to learn that a former staff member of the Joint Committee on Taxation, Cyndi Lafuente, passed away earlier this week.  I know she was a valued colleague and friend to many people in this room.  I want to express my deepest condolences to her family and friends for their loss.  Cyndi will be missed.

Today, we are continuing our series of hearings on comprehensive tax reform and how a flatter, simpler, and fairer tax code can lead to economic growth and job creation.

Our last hearing focused on publicly-traded companies’ use of Generally Accepted Accounting Principles (GAAP) when compiling their SEC-required filings.  For these companies, both earnings results and cash flow are important to investment decisions and performance measurement.  

During today’s hearing we will shift gears to examine the other side of the coin – closely-held businesses.  The complexion of these businesses varies greatly.  They range from mid-size manufacturers to local law firms to the Main Street restaurants that sponsor the local Little League team.  

In this hearing, we will examine the rules that dictate how these entities should be organized for purposes of taxation, as well as 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.  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.  

This is the approach that Republicans have taken by calling for a top rate of 25 percent for both individuals and corporations.  It also mirrors one of the most important achievements of the 1986 Tax Reform Act – cementing the principle of closely aligning individual and corporate rates to eliminate abuse and economic distortions related to business structure.  

According to the Joint Committee on Taxation (JCT), in 2007, pass-through entities earned 56 percent of total net business income – which is taxed under the individual rate structure.  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.  And recent proposals have raised concerns from many in the pass-through community.  

For instance, under President Obama’s budget and other corporate reform proposals, the top statutory rate on individuals would rise to roughly 40 percent.  At the same time however, President Obama proposes to lower the corporate rate 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.  This will create more harm than good.  

As we continue to consider ways to transform the code from one that inhibits, to one that spurs, job growth, we must take steps to ensure that corporate reform is not 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.  

The Small Business Administration found that small businesses face a tax compliance burden – at $74.24 per hour – that is 67 percent higher than that faced by large businesses.  This burden results from reporting requirements such as 1099s, as well as complex tax accounting rules for inventories, depreciation, and other business activity.  

In addition to the many tax rules a business must contend with, it is the first tax-related decision that businesses make – the manner in which they should organize themselves – that will affect all other tax decisions they make from that day forward.  Whether a business organizes as a C corporation, an S corporation, a partnership, or some other form of business entity, that decision should not be driven by tax considerations.  Instead, it ought to be driven by what form of organization best suits that business and its needs.   

As we move forward on reform, this Committee should ask when it is appropriate to tax business income on a pass-through basis and when, if ever, it is appropriate to subject business income to entity-level taxation.

Given the importance of pass-through entities to the U.S. economy and the prevalence of closely-held businesses, the treatment of these job creators is critical to tax reform.  Our goal with comprehensive tax reform remains clear – to create an environment that is ripe for economic growth and job creation.  I look forward to hearing from our witnesses about how we can best achieve that goal.