We’ve seen it all before. It’s like a remake of a lousy movie. The Bush tax cuts are set to go up in smoke at year end. Tax rates will be hiked across the board. No one really wants this to happen because the economy is stalled, chronic unemployment has become unbearable, and higher rates will just add to and prolong the misery. The thought of doing anything permanent to fix our tax mess is off the table – politically impossible in an election year. So, once again, the solution is a short-term fix, coupled with another promise that our elected representatives will get serious about real tax reform next year. This time it would be a one-year extension of the rates that we have now lived with for eleven years.
But the old hiccup remains. Obama and his Democratic colleagues want the extension only for the non-rich, defined as married couples who make less than $250,000 and single taxpayers who make less than $200,000. Republicans want the existing rates to continue for everyone. Destructive uncertainty abounds, but the old rerun still makes for great election-year politics. It fuels Obama’s class warfare campaign, with a powerful argument that leaders on the right are holding ordinary folks hostage to leverage tax breaks for the rich. And Republicans easily point to our chronic sick economy and no plan for the unsustainable, escalating debt chaos in claiming that tax hikes on job creators will hurt the economy, employment, government revenues, and just about everything else.
The hostage argument is strong, particularly when packaged with Obama’s reasonable plea for lawmakers to act now on what is not in dispute. This plea deserves a much better response than the worn out threat “Do it for all or do it for none.” Many non-rich Americans have a hard time connecting the dots between tax rates on those making more than $250,000 and the health of the economy, even though the dots are as clear as a bell. They shiver at the thought of their own rates ballooning, but figure that big-buck players ought to be fair game.
The most crucial element of this hostage standoff is the debilitating impacts that higher rates will have on successful privately owned businesses that are taxed as S corporations and limited liability companies. The earnings of these businesses are passed through and taxed to the owners. The pass-through character of these enterprises put personal tax rates on high earners at center stage. If rates go up, the owner of a successful business has less after-tax earnings to grow the business and create new jobs. And higher rates instantly become a compelling disincentive for risking capital to create new businesses.
There are roughly one million business owners who own successful pass-though entities and qualify as part of the Obama-defined rich. Although they represent only a small fraction of all business owners, they provide the lion’s share (some estimate as much as 97 percent) of all small business jobs. We badly need these businesses creating more jobs, along with powerful incentives that will fuel and fund the creation of many more such successful businesses. It’s a key element of any real recovery.
The solution for these businesses is a smart package of permanent tax provisions that decouples small businesses from the Buffett-Wall Street crowd for tax purposes and provides some tax certainty and powerful growth incentives. The package could be developed and implemented right now on an expedited basis without derailing the election-year political tax theatrics. With such a decoupling, Obama and the Democrats could continue to rail for tax increases on the Buffett-Wall Street crowd, as Romney and the Republicans continue their push for lower across-the-board rates and a broader base. The prospect of comprehensive tax reform could still be debated and promised. Meanwhile (and this is the key), America’s privately owned businesses would be off and running and would no longer be the pawn in a hostage stalemate that promises only more chaos and uncertainty.
What might such a tax package look like? Here’s my dream list of the seven key elements.
1. A privately owned C corporation with assets of less than $50 million (a “Small C Corp”) would pay a flat income tax rate of 20 percent on the first $10 million of its annual earnings. Regular corporate rates would apply to any excess earnings.
2. Tax-free stock sales treatment would be available to any new investor in a Small C Corp who holds his or her investment for at least five years. It would be a permanent extension of the temporary section 1202 perk that expired at the end of 2011.
3. Dividends paid by a Small C Corp would be tax deductible by the corporation and would be taxed to the shareholders at a flat 20 percent rate.
5. Taxable earnings retained and reinvested by a Small C Corp would increase the shareholders’ basis in their stock.
6. The first $500,000 of losses realized by an investor in a Small C Corp would be entitled to ordinary tax loss treatment. This would be a ten-fold increase of the existing, peanut $50,000 limitation that we’ve had for decades.
7. Existing S corporations and partnership-taxed entities, such as LLCs, would be allowed to easily convert to Small C Corp status on a tax-free basis.
A package along these lines would provide immediate, powerful new incentives to invest and grow privately owned businesses and put people to work. A much higher percentage of a company’s taxable earnings (80 percent) could be reinvested for growth. Higher reinvestment amounts, when compounded over years and adjusted for leveraging impacts, dramatically improve a business’ capacity to finance growth.
There would be strong incentives for investors to fuel existing companies and start new enterprises. Investors who stay in for five years could exit completely tax free. Unlike public companies and larger C corporations, double tax burdens on dividends would be eliminated for Small C Corps. And if an investment turns bad, ordinary tax loss treatment up to $500,000 would be available.
Beyond the growth incentives, the package would create a much simpler tax world for small businesses. The Small C Corp would be the hot ticket. Choice of entity complexities would completely disappear for most. The rule-laden S corporation would quickly become extinct. Most profitable limited liability companies would shed the complicated partnership tax rules and opt for Small C Corp status. The K-1 form hassles, accounting challenges, and other burdens of pass-through entities would vanish for nearly all.
Perhaps best of all, the package would structurally decouple tax rates for the rich and small business growth incentives. This would create great flexibility for the future. Rate changes for the rich (up or down) would no longer impact business incentives. So too, changes in business rates would not automatically flow to the rich.
Is such a business tax package politically possible at this time? It could come from either side without dismantling that side’s broader core tax theme for the future. It would leverage and push the “let’s do now what we can agree upon” theme by focusing hard on America’s privately owned businesses and what is needed to get those businesses fired up right now. It would create a targeted, badly needed sense of urgency. The goal would be bold, permanent, pro-growth incentives, not another short-term quick fix.
A tax hostage rerun, standing alone, will keep America’s privately owned businesses indefinitely stalled in a haze of impossible tax uncertainty as everyone sweats out the prospects, good or bad, of a new cast of players in Washington. At this juncture, America and its small businesses deserve something much better from the existing cast. This would do it.