This article, the second in our series on tax reform proposals, briefly reviews the issues the corporate tax presents for tax-qualified retirement savings plans and how corporate tax reform proposals may change the current retirement savings tax “deal.”
Why the corporate tax matters to retirement plans
Let’s begin by discussing why we’re talking about the corporate tax at all – why it would matter to retirement savings.
Generally (and oversimplifying), corporations pay taxes at the corporate level; dividends are not deductible; and shareholders pay taxes on (qualifying) dividends at capital gains rates. Thus there are two taxes on corporate earnings: (1) one at the corporate level; and (2) one at the shareholder level. This is sometimes called the double taxation of corporate earnings.
As tax-exempt entities, tax qualified retirement plans/trusts do not pay the shareholder level tax – tax (2) above. They do, however, indirectly pay the corporate level tax; that is, the earnings from their investment in a corporation are subject to tax, at the corporate level – tax (1) above. In his remarks at a recent conference on the issue, Professor Edward Kleinbard (USC Gould School of Law) described this feature of the current system vividly: “the corporation is … a wonderful place to collect tax on those investors who otherwise would be tax exempt without punching them in the nose with the fact that we’re now going to impose tax on them.” (US corporate tax reform in 2017: Exploring the options, American Enterprise Institute, June 7, 2016.)
The highest current US corporate-level tax rate is 35%; that rate is one of the highest in the world. There is broad and bipartisan sentiment that finding a way to lower it would be a good thing. There is not, however, agreement on how to lower it.
Corporate tax reform, revenue neutrality and taxing shareholders
With a Republican-controlled Congress and White House, revenue neutrality – making sure that revenues lost through reducing corporate tax rates are made up for by increased revenues from other tax law changes – may not be absolutely required for corporate tax reform. But both Republicans and Democrats are concerned about it. And many believe that simply eliminating corporate deductions will not adequately compensate for the kind of corporate tax rate reduction that is needed.
To solve this problem, many corporate tax reduction proposals are paired with a proposal for an offsetting increase in taxes on shareholders.
Corporate tax reform proposals
One such proposal, “corporate integration,” is being considered by Senate Finance Committee Chairman Hatch (R-UT). As reported (the proposal is still being evaluated by the Joint Committee on Taxation and has not been formally released), Senator Hatch’s corporate integration proposal would, generally, allow corporations to deduct any dividends they pay out. Then, a 35% nonrefundable withholding tax would be imposed on all dividends, shifting the tax on corporate earnings (to the extent of dividends paid) from the corporation to the shareholder.
Under this proposal, both tax-paying and tax-exempt entities would pay the 35% withholding tax and the current individual tax on dividends would be eliminated. This treatment would eliminate one significant current tax advantage retirement plan savers have over those who save outside a plan. Senator Hatch has indicated that he is considering ways to mitigate this effect.
Another proposal, advocated by Rosanne Altshuler (professor of economics at Rutgers University) and Harry Grubert (senior research economist in the Office of Tax Analysis at the US Department of the Treasury), would reduce the corporate level tax to 15% and increase the shareholder level tax to ordinary income tax rates. Under such a proposal (and similar reduce-the-corporate-rate/increase-the-shareholder-rate proposals), the corporate level tax that qualified plans do currently pay (tax (1) above) would go down, while the shareholder level tax that they do not pay (tax (2) above) would go up. That result would generally make qualified plan retirement savings (significantly) more attractive.
Thus, the effect of corporate tax reform on retirement plans could go either way – it could decrease, or increase, the value of the tax deal for retirement plans.
House Republicans’ and President-Elect Trump’s proposals
The House Republicans have published a comprehensive tax reform proposal that includes a (relatively) specific corporate tax reform proposal. For our purposes, the key features of that proposal are that it would lower the corporate tax rate to 20% and would reduce (to a top rate of 16.5%) the individual tax on investment income. President-Elect Trump would reduce the corporate tax rate to 15% and tax individual investment income at current rates (top rate 20%).
Thus, both the House Republicans and President-Elect Trump would, at the corporate level, lower taxes on investors generally, including retirement plans – tax (1) above. As we discussed in our article on income and investment taxes, however, the House Republicans’ proposal to reduce taxes on investment income (tax (2) above) would make in-plan savings marginally less attractive than currently.
These are very technical issues. Here are two rules-of-thumb to keep in mind:
Decreases in taxes at the corporate level (tax (1) above) will increase returns to all savers, regardless of whether they are saving inside a plan or outside of it.
Increases/decreases in taxes on individual savers (tax (2) above) will make saving inside a plan more/less attractive.
With respect to process, things are kind of a mess at the moment – we have several dueling proposals and no real consensus about which one is best.
Before they get to negotiations with Congressional Democrats, House Republicans (critically, House Speaker Ryan (R-WI)), Senate Republicans (critically, Senate Finance Chairman Hatch) and President-Elect Trump will need to come to some sort of agreement on a basic approach to corporate tax reform.
Once they do reach a consensus – and after any negotiations with Congressional Democrats – a final corporate tax reform proposal is likely to be bundled with a more general tax reform proposal and included in a Reconciliation Bill. We discuss that process briefly in our first article.