As Tax Reforms Trickle Through, Middle-Market Firms Find Them Bitter to the Taste

One month after the American Taxpayer Relief Act (ATRA) became law, business leader sentiment towards the new reforms is yet to thaw — especially inside the lower middle market, where the law’s impact arguably is being most deeply felt. Grant Thornton partner Mel Schwarz, director of tax legislative Affairs in the firm’s national tax office, recently gave us the scoop on why so many middle-market business leaders find the law little to smile about.

MME: We haven’t heard too many kind words about ATRA from middle-market business leaders. Can you help to boil this down for us? What’s their beef?

Schwarz: Well, when it comes to partnerships or LLCs, this can be a big deal. Under the Bush cuts, the situation was that the top marginal rate was the same for a regular corporation as it was for an individual, so there was no rate advantage or disadvantage to the structure that you chose. This has now changed, and as the rates are returned to the pre–Bush cuts levels, a business that does not pay its own taxes but passes through its income to its shareholders — as is the case with many lower-middle-market firms — the effective tax rate is now higher. Depending on whether the owner is active in the business or not, the rate has now gone to 39.6 percent. Add another 3.8 percent on top of that because of the Medicaid tax, and we’re at 43.4 percent, which is a significantly higher rate, at least in terms of current tax, than the regular corporate competitor is subject to.

MME: So, how do different corporate structures fare when it comes to the reforms?

Schwarz: We sort of have companies in two groups. There are the traditional corporations, the so-called C- corporations. In their case, the corporation is a separate taxpayer, and it pays its own tax, which right now caps out at 35 percent. Now, when that kind of corporation distributes earnings to its shareholders, then there’s a separate dividend tax that can apply, so there’s a double tax system. Then there are partnerships, the S-corps, the sole proprietorships. In these cases, the individual owner is taxed, and it’s only taxed once. You don’t have the double tax problem that corporations have. But by the same token, the current tax now is potentially as high as 43.4 percent, compared to the 35 percent that would be paid by the traditional C-corp. So at least in terms of that immediate taxation, there is a significantly higher burden on the pass-through companies — and in the lower middle market, there is a very high percentage of businesses that are organized as pass-throughs.

MME: Other than earn less money, what can businesses do to try to curtail their tax burden?

Schwarz: We don’t see tax shelters as a particularly active area right now. I think that most businesses are staying focused on the business. Certainly there are various tax benefits or tax preferences that reduce taxable income that can be taken advantage of. There’s accelerated depreciation or even the ability to deduct what would otherwise be depreciable property; bonus depreciation, the ability to deduct half of what would otherwise be taxable; and there are some credit mechanisms. But again: If you earn the money, you are going to pay the tax. Some companies have begun to say, Well, maybe I’ll just become a C-corporation. The problem with this idea is that if you don’t do it right, you can trigger some tax just on the transition. More important, a lot of companies in the lower middle market are actually in a position where they need to pay out a significant portion of their earnings to their owners on an annual basis. They’re not in a position to accumulate earnings in the way that a Fortune 500 company would. So while the downside to the traditional C-corporation is double tax — once when the company earns it and a second time when they pay the dividend — as long as you don’t have to pay that big a significant portion of your earnings out as a dividend, then you can defer that second tax potentially for a long time. However, I think that this is typically not the case for a lot of family-owned companies and other lower-middle-market companies. Because these companies can’t defer the double tax, they would bear a higher tax burden — even though the rates are the same — because of their greater need to distribute earnings. And it may not be feasible for them to switch from their current structure to a structure that would give them at least the lower immediate rate. They are sort of stuck here with these higher rates that have come about with the expiration of the Bush cuts for higher income and the imposition of the new Medicare taxes.

MME: So when it comes to ATRA, what should middle-market businesses be keeping an eye on?

Schwarz: ATRA had a few specific items that businesses will want to keep in view. Certainly the extension of bonus depreciation and the extension of the 179 expensing rules, because these do provide an opportunity for companies that are placing only a limited amount of depreciable property in service in the year to take some tax advantage of a current deduction of something that they would have otherwise had to depreciate. The provision that allows the “Rothification” — if you will — of existing 401(k) plans is one in which we’ve seen a significant amount of interest on the part of the lower middle market. So the essential difference here between a traditional 401(k) and a Roth IRA is that on a traditional 401(k), you get a deduction when you put the money in, but then you pay ordinary rates when it comes out. In the case of a Roth, you get no deduction when you put it in, but everything that you take out is tax-free.

The economists will tell you that these two are roughly equivalent, assuming a market rate of return on your investment. The difference is because we’ve got dollar limitations. If I put it in a traditional plan and, let’s say, I have a $20,000 limitation on my 401(k) contribution, that’s how much I’m able to put away. However, in the Roth plan, since I’m using after-tax money, effectively what I’m putting away in the advantage scheme is the $20,000 plus the tax on the $20,000, so figure that adds an additional $8,000, perhaps, at the 39.6 rate. I have effectively — for comparison purposes between the two — increased the amount that I have put into or I have been able to put into a tax advantage retirement scheme (using the word “scheme” as the British use it — it’s a process). Now, we’ve been able to do this for a number of years, but what’s new with ATRA is that I can take the balance that was in a traditional 401(k) plan, and if I pay tax on that balance and convert all of that into a Roth, I’m increasing the amount of money that I’m putting into a tax-benefited retirement scheme. Somewhere down the road, this rebounds to my advantage, and how much depends how far down the road I may get.

If I’m a young entrepreneur who can do this, I get a bigger advantage than if I’m guy planning to retire and go to Florida in a couple of years. But if you go through what was in ATRA, it essentially put the individual Alternative Minimum Tax on level footing, which was very important to a professional class that was earning between $250, 000 and $600,000, but not necessarily to the entrepreneurial class that sometimes pushes farther out and exceeds that. However, it didn’t have many specific new opportunities, and this was the one new opportunity that it created.