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 Added on March 25, 2019  Marsha Chartrand

Whitmer plan to raise business tax a hard sell to Michigan Legislature

By Lindsay VanHulle (Bridge)

Gov. Gretchen Whitmer administration is proposing a tax hike on some Michigan companies to offset a tax break for some seniors on retirement income — in essence, reversing some of the tax policy signed into law by her Republican predecessor, Rick Snyder, in 2011.

The new Democratic administration has said the change could bring businesses federal tax relief to counteract higher state taxes, though that far from certain.

Bridge Magazine breaks down the policy points fueling the debate in Lansing over business taxes.

Whitmer proposal has drawn pushback from state business groups and Republicans who control the state House and Senate. Business and GOP leaders say the plan would harm the state economic competitiveness, while advocates say it would create a fairer tax system by helping residents who were asked to bear a larger financial burden eight years ago.

Next to a proposed 45-cent gas tax increase to fix the state roads, Whitmer business tax plan could be one of the toughest lifts in her first proposed state budget.

What is Whitmer proposing?

The state would levy a new 6 percent income tax on businesses that organize as partnerships, limited liability companies and S corporations. They’re commonly referred to as “pass-through entities” because their owners report their business income on their personal income tax returns. Currently, the companies’ owners pay the state individual income tax rate of 4.25 percent on their share of business income.

The new 6 percent rate would match Michigan 6 percent corporate income tax levied on C corporations, which often are larger than pass-through businesses.

The tax change would affect nearly 250,000 companies organized as partnerships and S corporations that currently pay the 4.25 personal income tax rate on their business income, according to the Michigan Department of Treasury, citing IRS data. By comparison, the number of C corporations that filed tax returns in Michigan in 2017 was just over 50,000.

The administration said pass-through business owners could reduce their state tax liability through a state tax credit claimed on their personal income tax returns that is worth 4.25 percent of the business income that was taxed. That effectively means these businesses would pay a state tax increase of 1.75 percent, rather than the full 6 percent, and would also prevent double taxation of their business income.

All pass-through companies also would be able to deduct the first $50,000 of business income from the new state tax, which the administration said also could exclude some of the smallest businesses from paying the higher tax.

The pass-through tax increase is estimated to raise roughly $203 million in total revenue in the 2020 fiscal year that starts Oct. 1, and $280 million in 2021. That revenue is expected to partially offset the revenue lost by unwinding the Snyder-era retirement tax, which is estimated to cost the state close to $355 million in 2021.

Using those estimates, that would mean the state general fund would take in $75 million less than under current tax policy.

Whitmer said the business tax is intended to pay for repealing the retirement tax, a promise she made to voters during her campaign. Republican legislators have introduced their own bills to reverse the tax on retirement income, though without identifying a way to recover the lost revenue.

“There no question, they’ve got to be able to pay for it,” Whitmer told reporters during a roundtable following her budget rollout this month.

She added that the Snyder administration originally attached the retirement tax to business tax cuts in 2011, a move she opposed as a state senator, and that restoring retirement income tax exemptions would relieve some financial pressure on taxpayers from her proposal to raise the gas tax by 45 cents a gallon over a year.

“This was a legitimate way to make sure that we paid for the relief,” Whitmer added, “but also to ensure that drivers are feeling some relief — our senior citizens in particular.”

The administration proposal would begin to restore balance to the state tax structure, which leaned heavily on individual taxpayers eight years ago, said Rachel Richards, legislative coordinator for the Michigan League for Public Policy, which advocates for policies to support vulnerable residents.

“We’ve at least started opening the door to a conversation on the adequacy of Michigan revenues, as well as taking a look at who paying them and whether we are all paying … our fair share,” Richards said.

How is Whitmer pitching this tax hike?

Rachael Eubanks, the state treasurer, has called the proposal “business tax parity” for leveling the tax rates different businesses pay.

She also says it should bring pass-through companies federal tax benefits that could offset much of what they pay in higher state taxes.

Eubanks and Jeff Guilfoyle, Michigan chief deputy treasurer, told Bridge that shifting the state tax paid on pass-through business income from the owner to the business itself would mean the owners would have a better chance at avoiding hitting a new $10,000 federal cap on state and local tax deductions.

That because, in theory, they would be able to deduct more of their state and local taxes on their federal returns that might have otherwise exceeded the $10,000 limit, Eubanks said.

“It allows these entities to be able to deduct more of their income on the federal tax level, which provides them a greater federal tax benefit,” she told Bridge this month.

“We’ve done it in a way that tries to mitigate the additional (state) tax as much as possible.”

What the risk?

The concept first has to get by the Internal Revenue Service, which has signaled it may try to challenge such efforts by states looking to work around the new $10,000 state and local tax deduction limits adopted in 2017 as part of broader federal tax reform.

Eubanks said the net tax increase to about 250,000 pass-through businesses and their owners in Michigan would be about $105 million, after accounting for federal tax benefits worth an estimated $175 million. The amount an individual company business taxes would increase would depend on its annual income.

It not entirely clear how much of pass-through business owners’ state taxable income comes from their business, since it included in owners’ personal income tax returns, which are themselves based on federal adjusted gross income, according to Treasury.

The Treasury Department estimated these business owners paid as much as $750 million in state income tax from pass-through companies for 2016, based on Michigan 4.25 percent individual income tax rate.

Would Washington be OK with allowing state taxpayers to pay less in federal taxes?

Possibly not.

More than one Michigan tax attorney told Bridge that the federal government may see proposals like Michigan as a workaround of the IRS’ state and local tax deduction cap and require that pass-through business income tax credited on a state personal income tax return is counted toward the $10,000 personal limit.

The new cap affected high-tax states like New York and Connecticut hardest, said Michael Indenbaum, a partner at Honigman LLP in Detroit. Those two states, in particular, have tried different ways to get around the limits, including creating new charitable contributions that could be written off.

Connecticut also tried a similar pass-through entity business tax and credit on owners’ personal income tax returns, which may be the target of new IRS regulations.

“This sort of proposal that the governor has is going to fall square within what the IRS is going to attack,” Indenbaum said.

The IRS guidance in the Connecticut case will be relevant to Michigan, said Greg Nowak, a principal and state tax services leader with Miller Canfield in Detroit.

“It remains vulnerable to … a strong likelihood that the IRS is going to challenge it,” Nowak said. “And it one of a number of reasons that the business community doesn’t like the idea. Obviously, no one wants to pay additional tax, but (Whitmer proposal represents) more complexity being introduced back into the Michigan tax structure.”

Instead of using a state personal income tax credit, the state could allow pass-through business owners to deduct their business income from their personal taxable income for state tax purposes, Nowak said. That could improve Michigan chances of defending the pass-through tax with the IRS.

Treasury spokesman Ron Leix said an exemption would be an alternative to a credit, but also more complicated to administer.

If the IRS comes down against Connecticut pass-through tax structure, which is similar to Michigan proposal, the Whitmer administration proposed tax rate hike on Michigan businesses would simply lead to higher business taxes without any federal relief, attorneys said.

That a nonstarter for the state business groups.

“The new small business tax is not negotiable from our perspective,” said Charlie Owens, state director of the National Federation of Independent Business in Michigan, which advocates for small businesses.

“I think the odds of (the IRS) kicking it back are very good, in which case now we’re stuck,” Owens said. “Those folks that think they’re only getting a 1.75 percent (tax) increase could be (on the hook for) substantially more than that.”

Last year, the Legislature passed a bill that would have created an optional, rather than mandatory, pass-through tax, only it would have kept the business tax rate at 4.25 percent.

Snyder vetoed it in December, citing the fact that the bill was introduced and passed in just over a month and “the risk of IRS action.”

The Michigan Chamber of Commerce supported the bill at the time, said Dan Papineau, the chamber director of tax policy and regulatory affairs, saying it could have helped small and medium-sized businesses without costing the state tax revenue.

The chamber opposes Whitmer proposal.

Papineau now says “it looking more and more likely that the federal government not going to allow it.”

If every state tried a SALT deduction workaround, “the feds would lose billions of dollars,” Papineau said.

State Treasury administrators tell Bridge they believe the proposal will hold up against IRS scrutiny.

“I don’t think we’ll have an IRS problem,” Guilfoyle said. “But until the IRS says it OK, that risk is out there.”

Businesses benefited from Snyder tax reforms. Would Republicans and business groups agree to scale them back?

Not so far.

Business taxation in Michigan has been a controversial subject since Snyder signed legislation in 2011 that repealed the state complicated and unpopular Michigan Business Tax.

Snyder and legislators replaced it with a 6 percent corporate income tax levied on the larger C corporations. The move cut business taxes received by the state by more than $1 billion, which Snyder made up in part by increasing taxes on some retirement income.

Business groups hailed the 2011 tax changes for their simplicity. The changes also ended the practice of double-taxing income of pass-through companies, on both the Michigan Business Tax and on their owners’ personal income tax returns.

“The assumption that we made back in 2011 was that Michigan needed jobs more than any other thing,” Brian Calley, president of the Small Business Association of Michigan and lieutenant governor under Snyder, said of the impetus for the business tax overhaul after the Great Recession.

Calley, a Republican from Ionia County, cast the tie-breaking vote in 2011 to pass the tax changes as president of the Senate.

“Our general tax code is working really well right now,” he told Bridge. “It competitive, and it simple. And while I’m not in office anymore, the income tax and the business tax are the sorts of things where you just don’t hear people complaining about them, that they’re too complex or they’re too difficult to deal with.”

But the 2011 overhaul didn’t sit well with Democrats — including Whitmer. They blasted the tax shift as asking seniors to bear a bigger tax burden so that businesses could lower theirs during the state economic recovery.

The corporate income tax itself is expected to generate more than $1 billion in state revenue this fiscal year, according to state revenue estimates from January. But the state only gets to pocket about $474 million, with the rest committed to tax credits to companies under the old business tax, an obligation worth billions of dollars that won’t expire until at least 2030.

Said Owens, of the National Federation of Independent Business, which opposes the proposed tax hike: “If they want tax parity, lower the corporate income tax to 4.25 (percent). Then they’re the same.”

Whitmer told Crain Detroit Business in an interview after unveiling her budget this month that she would be willing to trade the business tax increase in exchange for business leaders’ support in raising the gas tax 45 cents a gallon over a year to pay for road repairs. Some business groups, from the Michigan Chamber of Commerce to the Detroit Regional Chamber, have said they’re supportive of raising user fees to fix roads.

Whitmer spokeswoman Tiffany Brown told Bridge that Whitmer “stands behind her proposed budget as the best way to fix the roads, clean up drinking water, and make sure every Michigander has a path to a high wage career.”

Brown added that it “the first step in the budget negotiation process.” Whitmer has called on the Republican-majority Legislature to adopt the state 2020 budget before breaking for the summer.