Small companies such as Arc Abrasives Inc. in Troy, Ohio, may end up as a roadblock to President Barack Obama’s drive to revamp the corporate tax code.
A manufacturing business with 82 employees, Arc changed its tax status from a standard C corporation to a hybrid S corporation about a decade ago. The reason, says the company’s president, Anthony H. Stayman: to avoid paying taxes twice, at both the corporate and individual levels.
Now he is worried that his tax bill could grow if a corporate overhaul makes its way through Congress. Other companies structured like his are concerned, too. The Obama administration has “created a firestorm in the business community,” says Neal Weber, managing director of the Washington national tax office of RSM McGladrey Inc., a tax and consulting firm.
C corporations face what economists call double taxation. They pay taxes on profits at the corporate rate; those profits are taxed again at the individual level when they’re distributed to shareholders through dividends.
Unlike standard C corporations, S corporations — and entities including partnerships and limited-liability companies — aren’t subject to corporate taxes. They pay taxes once, at an individual rate, when profits flow to the owners of the business, earning them the name of flow-through or pass-through entities.
Reducing Corporate Rate
Obama has called for lowering the 35 percent top tax rate that applies to multinationals and other C corporations. Paying for that reduction, he has said, would require eliminating deductions for expenses such as interest costs that are available to all businesses, including S corporations.
Unlike C corporations, S corporations wouldn’t benefit from a corporate rate cut because they pay taxes at the individual rate.
By pitting small businesses against big corporations, Obama has put the goal of a corporate tax rewrite at risk, says Howard Gleckman, resident fellow at the Urban Institute in Washington and editor of the TaxVox blog. The politics of an overhaul along those lines are “exceedingly dicey,” he says.
Others also see problems with Obama’s approach. “We’re concerned about creating winners and losers,” says Dorothy Coleman, vice president of tax and domestic policy at the National Association of Manufacturers, a Washington-based trade group that counts C corporations and pass-through entities as members. Her group wants a tax code overhaul for individuals and companies, a move the president so far has resisted.
Pass-through entities have grown in popularity in recent years. More than 90 percent of U.S. businesses pay taxes this way, according to Robert Carroll, a principal in the accounting firm Ernst & Young LLP. Also, they account for about half of total U.S. business income, Treasury officials say.
Many Wall Street firms, including hedge funds and private- equity firms, are organized as pass-through entities. About 70 percent of manufacturing companies are as well, according to the manufacturers’ association. In total, such businesses employ almost 55 percent of the private workforce, says Carroll, a former deputy assistant secretary for tax analysis at Treasury.
Most are small outfits. Fewer than 1 percent of partnerships and S corporations had more than $50 million in assets in 2005, according to Donald Marron, director of the Urban-Brookings Tax Policy Center in Washington.
The pass-through structure doesn’t suit all types of businesses, even with the tax advantages. Almost all publicly traded companies are C corporations, for example. That’s because S corporations can’t have more than 100 shareholders.
Also, small technology businesses often choose to pay taxes through the corporate code because it’s then easier to seek investment from venture-capital companies, says Mitchell Kopelman, chairman of the tax group at Habif, Arogeti & Wynne LLP, an Atlanta-based accounting firm.
The S Corporation Association, a Washington-based trade group with more than 100 members, has begun lobbying lawmakers to get out ahead of overhaul plans.
“Our concern is that they’re going to use small and closely held businesses as the piggy bank to make it easier for the large multinationals,” said Brian Reardon, executive director of the association.
A study that Carroll and Ernst & Young’s Gerald Plante conducted for the association estimates that owners of flow- through organizations would face an average increase in their tax bills of 8 percent, or $27 billion annually, from 2010 to 2014 if all business tax breaks were eliminated in an overhaul.
Such firms might face what Weber called a “double hit” on the tax front. Obama doesn’t support extending the Bush-era tax cuts for wealthy individuals and households after they expire at the end of 2012. That would raise the top individual rate — which many smaller businesses pay — to 39.6 percent from 35 percent.
Tax experts including Gleckman say Obama likely has focused attention on a corporate overhaul because the administration thinks it would be easier to accomplish than rewriting the entire U.S. tax code.
That may have been a miscalculation.
“The business community is going to be deeply divided,” Gleckman says. “Obama may find it harder to reform corporate taxes on their own than he would trying to do broad-based tax reform.”