BY JAMES W. COLE, CPA
According to Wikipedia, Darwinism is the
theory of biological evolution stating that all
species arise and develop through the natural
selection of small inherited variations that
increase the organism’s ability to compete,
survive and reproduce. In nature this plays
out over long periods, often with small incremental
changes.
In today’s business and tax world, these
changes happen rapidly and “natural selection”
is driven by innovation, global competition,
the political process and, ideally, by
well-informed conscious choice rather than
transmutation.
Most businesses today are no longer bound
by small geographical constraints. You can
invent the better mousetrap in your garage
today and be selling it across the country and
possibly the world next month thanks to the
internet and global shipping. And it is even
easier for many IT based businesses that can
avoid shipping altogether. This provides both
opportunity for success, as well as competitive
risk to be beaten by someone, somewhere who
can build it faster and/or cheaper.
So how does all of this “evolution” play out
in the business tax world?
It starts with how a business is structured
for tax purposes. Most businesses operate
either as a taxable C corporation, an S corporation,
or as a limited liability company (LLC).
The latter two entities are often referred to
as “flow-through” entities meaning the company
does not pay income taxes but rather
the owner(s) pays the tax individually. In
fiscal 2014 just over 2.2 million C corporate
returns were filed, whereas over 8.4 million
flow-through entities’ returns were filed (split
between S corporations and partnerships).
Thus it appears that natural selection has
favored the flow through entities in large part
to avoid the potential “double taxation” that
can exist with taxable corporations (1st level)
and on the taxable distributions to the shareholders
(2nd level). However, the conclusion is
much more nuanced and the decision should
be reached after evaluating all options and
various scenarios. In fact many businesses operate
with a combination of entities designed
for legal protection and tax minimization.
Then while operating the business, the
owner is faced with a myriad of decisions most
of which have tax implication; capital investments,
financing, compensation, retirement
plans and other benefits just to name a few.
And because the tax consequences can
be so high (at times at a total rate in excess
of 50 percent), the decisions can be unduly
influenced by the expected tax impact. (For
example – buying new equipment to grab
“bonus” depreciation when the owner would
have otherwise deferred the purchase.)
While the business owner is sorting through
their own selection tree for their growth
and “survival”, governments are doing the
same albeit on the other side of the ledger.
At the Federal level, serious debate over the
corporate tax rates is undertaken in part as a
response to the issue of corporate inversions
(a U.S. multi-national company merging with
a foreign company to avoid U.S. tax on oversea
earnings – often generated in part through
development and technology in the United
States). The U.S. will be forced to compete in
the global market as more and more barriers
come down for businesses to structure their
operations. Unfortunately broad based tax
reform is a prisoner of the political process.
New York state has also had to respond to
competition over the years – primarily with
other states. Historically known for its heavy
tax load, the state has made various moves to
encourage business to stay (or move) here.
This includes lowering the corporate tax
rate to 0 percent for qualified manufacturing
companies, switching to a single sales factor
for apportioning income to the state (which
benefits companies located here and selling
elsewhere), and adopting the controversial
“economic nexus” standard to attempt to collect
taxes from businesses located outside of
New York and selling to New York customers.
The state has made the economic determination
that it is better to have businesses
located within the state generating income
taxes through its employees rather than taxing
the business entity heavily. In addition to
the income tax shift, keeping businesses here
drives property and sales taxes as well as the
compounding economic benefit of employees
spending their wages locally. How this plays
out over time will be vital to the health of the
state and will continue to require adjustments.
Comprehensive tax reform (call it evolution)
is needed for the benefit of the society
as a whole. In the past 75 years the U.S. government
has shown a surplus 12 times. Restated
as a won-loss record we would be 12-63 (with
no wins since 2001) and clearly looking for a
new approach.
Where the theory of evolution breaks down
in the tax world is the insertion of conscious
choice that can supersede natural selection.
Left to their own inclinations, business owners
generally want to pay as little tax as possible
while governments try to appease various interest
groups – favoring some over others. The
combination can be unhealthy and requires a
different approach and more than a few individuals
with a longer and broader perspective.
Cole is a tax partner with SaxBST, an accounting,
tax, and financial services consulting
firm.