BY JAMES W. COLE, CPA
Accordingto 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.