Business Community Opposes Tax Hike
Following yesterday’s comments by President Obama, the S Corporation Association joined together with more than 30 other business associations to make the case for action by Congress to avoid the massive tax hike on private enterprise looming next year. As the letter states:
Main Street businesses are America’s job creators. They are responsible for 60 percent of the net new jobs created in the last decade. But uncertainty about the economy and looming tax hikes have kept this sector from hiring new workers, resulting in a weak economic recovery and slow to nonexistent job growth. Until Main Street begins to hire, we fear the unemployment rate will remain unacceptably high.
Congress returns next week and the first order of business will be the much-delayed package of small business tax provisions. This legislation is the perfect vehicle for extending the tax rates and Congress should jump at the chance. According to the Joint Committee on Taxation, failure to take action would mean that taxes next year will rise on families and businesses by $227 billion.
Despite the President’s opposition, momentum for extending all the expiring rates appears to be growing. In recent weeks, senators Ben Nelson (D-NE), Kent Conrad (D-ND) and Evan Bayh (D-IN) have all expressed support for extending all of the rates. Meanwhile, former OMB Director Peter Orzag wrote in the New York Times earlier that, given a choice between doing nothing and extending everything next year, Congress should extend everything.
Each of these Senate defections is significant since any effort to extend current tax policy will need 60 votes, and the Democrats only control 59 prior to the elections. As The Hill noted today:
Senate Democrats would need all 59 Democrats and at least one Republican to pass the Obama administration’s plan to extend tax cuts for the middle class while allowing the tax breaks for the highest-income tax brackets to expire. That plan could be a non-starter in the Senate without Nelson’s support, since another GOP vote would be needed for passage.
Moreover, the Democrat’s majority may shrink immediately after the November elections. Three states — Delaware, Illinois, and West Virginia — will immediately seat their new Senators after the elections in November rather than wait until January, which means if any of those seats change parties, support for a full extension would grow.
As before, we continue to believe the most likely outcome is continued stalemate on extending the rates and no action by Congress this year, followed closely by Congress choosing to extend all of the rates for at least a year. Each additional defection, combined with any Republican victories in Delaware, West Virginia, and Illinois, increases the odds that the latter option becomes law.
S-CORP on Fox Business News
S Corporation Association Executive Director Brian Reardon appeared on Fox Business News last week to discuss the Obama Administration’s newest stimulus proposals.
As discussed above, if the Obama Administration wants to see some real stimulus, it should seek to remove the policy uncertainty hanging over the private sector and support extending all of the current tax provisions that either expired last year or are scheduled to expire next year.
While some of the specific tax items offered up — particularly expensing and a permanent R&E tax credit — are attractive to members on both sides of the aisle, finishing the existing “honey-do” list of tax items is more important.
The amount of capital available to the private sector — and currently buried in money market funds and ridiculously low-interest Treasuries — completely dwarfs the $180 billion package proposed by the President, even without the offsetting tax hikes that are planned to accompany the package. Getting that capital off the sidelines is the first step towards helping the job market recover.
Baucus III
The tax community is still waiting for the third version of the Baucus substitute to be released. A “trial balloon” draft circulated yesterday made certain changes, but failed to address many of the sticking points holding up the overall bill.
Meanwhile, Senators Baucus and Reid spent most of yesterday negotiating with swing Republican votes — at this point, just Maine Republican Senators Olympia Snowe and Susan Collins — to identify what changes are necessary in order to gain the 59th and 60th votes needed. As CongressDaily reports:
The chief target appears to be $24 billion to extend higher Medicaid matching funds for six months, first authorized in the stimulus last year. Options floated Tuesday included phasing down the percentage boost and using untapped funds elsewhere in the Recovery Act for offsets. Snowe and Collins were noncommittal, having not seen details. Senior Democrats appeared resigned that the net cost of the Medicaid assistance would be scaled back. “They’re having to cut it back to try to get Republican votes, and it affects my state; it really affects Harry Reid’s state,” said Sen. John (Jay) Rockefeller, D-W.Va., who with Reid was an original lead Senate sponsor of the six-month Medicaid boost. “But it looks like the best we can get.”
The challenge for Senator Baucus is that the deficit spending in the package represents only half the opposition. There is a lot of opposition to the tax increases as well, including the payroll tax hike on S corporations and partnerships. Senator Snowe of Maine has led the fight to strike this provision from the bill. As The Hill notes:
Kyl said he isn’t sure winding down FMAP is the elixir Democrats think it is in garnering Republican support for the bill.“Whether that will satisfy more Republicans remains to be seen,” he said. “There are other issues with the bill as well, including issues related to the tax provisions.”
The current “K Street” rumor is that Chairman Baucus has been given a limited amount of time to round up the 60th vote. If he’s unable to do so, Majority Leader Reid would set the extender package aside and move on to other items. Whether the rumor is true or not (K Street rumors typically run about 50/50 on the accuracy dial), the clock is ticking.
In addition to Senate consideration, this bill would need to return to the House, where its adoption is by no means assured. If the House makes any changes, it would come back to the Senate. And then, since most of the spending and all the tax items expire before the end of 2010, we’d have to do it all over again before January.
We’ve observed previously that getting the entire business community to oppose a bill centered on extending business-friendly tax breaks is fairly remarkable. The current bill before the Senate is anti-business, and would need to be changed significantly before businesses could support it. It appears that several determined senators share those concerns.
Budget’s Impact on Employers
S-Corp allies over at the Manufacturer’s Alliance commissioned a new study on next year’s tax policy and what it means for S corporations and other business forms. Specifically, the study looked at the tax policies in President Obama’s 2011 budget and asked how these policies would impact economic growth and job creation. The verdict?
In terms of macroeconomic effects, the tax proposals in the 2011 budget are forecast to shave an average of 0.2 percent from annual GDP growth through the middle of the decade, resulting in $200 billion of foregone output and a net job loss of almost 500,000 relative to the baseline. Because taxable business revenues are highly concentrated in manufacturing firms, they will account for a disproportionate share of these output and employment gaps.
So despite much of the rhetoric coming from Washington these days, the rules of economics have not been turned on their figurative heads — the tax forecast for next year is higher tax rates imposed on a larger tax base, which means less investment and less job creation over time. Who will get hit the hardest?
The tax provisions of the 2011 budget will affect S corporations and other pass-through manufacturing firms much more heavily than both firms outside of manufacturing and C corporations within manufacturing. Pass-through businesses in the manufacturing sector will see their tax bills increase by an average of 14 percent. Given the growing importance of S corporations and partnerships to economic growth and job creation over the past 25 years, it is important to understand that tax increases intended to help contain deficits will exact a high price in terms of the competitive posture of U.S. manufacturing and the growth of the economy as a whole.
The study’s authors calculate that S corporations and other “pass through” firms will see their aggregate tax burden rise by $177 billion over the next ten years. Ouch.
Latest On Extenders and the Payroll Tax
So the Senate just adopted a stand-alone, six month Doc Fix. Adoption of this provision sends a couple signals for the broader extender package.
This action follows on last night’s failed 56-40 cloture vote on Baucus II. While this vote represented a significant improvement over the 45 votes in support of Baucus I, it still signaled to the Senate (and House for that matter) that the “extenders plus” package was not going to be completed this week. Hence the need for the stand-alone Doc Fix. Moreover, the adoption of this very large — and ultimately offset — spending item suggests that other non-tax parts of the “extender plus” package could get peeled off as well, calling into question the viability of the underlying tax parts.
As long as the majority insists on offsetting temporary extensions of current law with permanent, new tax hikes, this is going to be a problem and ultimately result in a much more burdensome tax code. Has anybody done a Net Present Value analysis of the relative values of the extenders and the tax hikes that offset them? Only in DC budget parlance are they at all equal.
Which brings us to the S corporation payroll tax hike envisioned by the Finance Committee. As we’ve mentioned, Baucus II is better than Baucus I, but it still fails the very basic test of being better targeted, less complicated and easier to enforce than current law.
Talks continue between the Finance Committee staff and those Senators concerned about raising taxes on small businesses in the middle of a recession — including S-Corp champions Snowe and Enzi. The trick is how to get at the tax avoiders without punishing compliant S corporations, because every dollar this provision takes from taxpayers already complying with the law is one less dollar they have to invest in their employees and businesses.
This debate will now spill into next week. We hope it gets resolved soon, because it’s almost time to take up the extension of the very tax provisions under consideration — they expire in six short months, after all.
Single Class of Stock and Payroll Tax Avoidance
Part of the frustration experienced by the S corporation community on the payroll tax issue is the lack of understanding of how S corporation rules effectively block payroll tax avoidance in multiple shareholder firms. It is extremely difficult if not impossible to effectively avoid payroll taxes year after year in an S corporation where no one shareholder controls the firm. Consider the following example:
A fictional John Edwards and his brother lawyer are both partners in a larger law practice. They agree to form an S corporation where each has a 50 percent share in the business and designate the S corporation as the partner in the law firm. John and his brother agree to pay themselves a nominal wage and take the rest as income on their K-1.
In year one, both John and his brother earn $1 million in legal fees. As the partner in the law firm, this money is paid to the S corporation. As agreed, they both pay themselves $200,000 in wages and take the rest as a distribution from the S corporation. By doing this, they successfully avoid HI payroll taxes on $1.6 million, or $46,400. [Editors Note: Here the IRS steps in, audits the brothers, applies a reasonable compensation test, and dings both of them for unpaid taxes and penalties.]
In year two, John wins a big case and has fees of $5 million, while his brother has legal fees of $1 million. Under their agreement, they would pay themselves $200,000 each and then distribute the rest as S corporation income. But S corporations can only have one class of stock, so any S corporation income would have to be divided up according to their ownership interest, or 50/50. This means John will have to share his $5 million legal fee with his brother. Both brothers would get $2.8 million in S corporation income, or total compensation of $3 million each, and avoid paying $81,200 in HI payroll taxes each.
So John Edwards’ clever scheme to avoid paying $81,200 in HI payroll taxes costs him $2 million in income.
Obviously, a real person would never enter into such an arrangement. And while the brothers could adjust their wages to get around the “single class of stock” limitation, those wages would be subject to payroll taxes and defeat the purpose of creating the S corporation in the first place.
This is an extreme example, but it makes clear the challenge of attempting to avoid payroll taxes in an S corporation with no one controlling shareholder. The HI tax is 2.9 percent, after all, so any effort by taxpayers to avoid this tax is going to be tempered by the cost of doing so. The simple rule is that, unless the earnings potential of all the active shareholders in the S corporation are remarkably stable over a number of years, it is next to impossible to structure an ownership agreement that can last.
Baucus Substitute, Part II
After falling 15 votes shy of the 60 needed to close debate and move forward on the “extender plus” package, Finance Chairman Max Baucus offered up a second substitute last evening and Senator Reid immediately filed a cloture motion to end debate. That motion requires 60 votes and the vote would take place on Friday.
The new Baucus substitute is “slimmer” than the previous effort and apparently was designed to mirror the deficit impact of the House-passed bill. As such, its goal is not only to attract 60 votes in the Senate, but also to pass the House as well. As CongressDaily noted:
The effort appears calculated to not only get 60 Senate votes — and at least one wavering Democrat, Sen. Evan Bayh of Indiana, signaled he plans to support the bill — but get though the House. The new version would add roughly the same amount to the deficit as the “extender” bill that passed the House on a 215-204 vote before Memorial Day.
On the payroll tax issue, the substitute makes significant changes that narrow the scope of the test while apparently expanding the base of S corporations that would be affected. The Committee summary reads like this:
A provision passed by the House and included in the original Baucus substitute would address this abuse in situations where (1) an S corporation is a partner in a professional service business or (2) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals. This provision does not change the ability of S corporations to use some income to make business investments or deduct those small business investments. To make the second alternative more administrable and more targeted, this amendment changes the language so that the policy applies only if 80 percent or more of the professional service income of the corporation is attributable to the services of 3 or fewer owners of the corporation. This proposal, as amended, is estimated to raise $9.15 billion over 10 years.
As the summary indicates, “Baucus II” would replace the flawed “principal asset test” with what might be described as a “principal rainmaker” test — if three or fewer shareholders bring in 80 percent or more of the firm’s gross income, then additional payroll taxes would apply. Here’s the section:
(ii) any other S corporation which is engaged in a professional service business if 80 percent or more of the gross income of such business is attributable to service of 3 or fewer shareholders of such corporation.
On the surface, that’s a big improvement over the “principal asset” test. Our advisors believe it would be easier to administer and less subject to litigation than the earlier version. That said, the key question for policymakers is not whether Baucus II is better than the untested House-passed version, but whether it’s an improvement over current law.
We convened our advisors last evening and their opinion was that it’s not an improvement over current law, especially for firms that don’t already track hours and directly attribute revenues to certain shareholders. Law firms and CPAs usually are set up that way; engineering consultants and architects often are not.
Keep in mind, the IRS can and does go after tax avoiders (its tax avoidance it’s illegal; it’s not “fraud” or “abuse” or a “loophole”) using the reasonable compensation test. They just won a big case out in Iowa using that standard. So how is having the IRS enforce a “principal rainmaker” test any easier?
Other changes, or lack of changes, are also troubling. The pool of S corporations affected by this new version appears to have expanded. The House-passed definition of “Professional Services Business” reads like this:
For purposes of this subsection, the term ‘professional service business’ means any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.
The new version reads the same, except they took out the words “substantially all of the activities of such a trade or business involve”, which begs the question, exactly how much lobbying or engineering or investment advice do you have to provide before you fall into the “Professional Services” pool?
The flawed “Family Attribution” paragraph remains intact. This provision discriminates against inactive family shareholders and sets the stage for further assaults on family-owned businesses in the future.
Finally, the provision continues to target firms with “3 or fewer” key shareholders. As we’ve noted, 94 percent of all S corporations have “3 or fewer” shareholders, but other than that threshold, we do not understand the significance of “3”. The GAO, TIGTA and others have identified single-shareholder S corporations as the predominant source of this problem.
Sharing our concerns, Senators Snowe and Enzi re-filed their amendment to strike this provision from the new substitute. We are continuing to work with those offices and others to highlight our concerns with this provision and get it struck or significantly amended.
If you are an S corporation and you provide any of the services listed above, now is the time to reach out to your Senators and let them know how this would affect you. The next key vote is scheduled for tomorrow, and the entire package could be finished and sent to the President by the end of next week, so now is the time to act.
Latest on Payroll Tax Hike and Extenders
Earlier today, the Senate voted earlier on its version of the “extenders plus” bill passed by the House a few weeks back. The vote, on a motion to waive a Budget Act point of order, failed miserably (45-52), indicating the Senate Leadership has a long way to go before they gather the sixty votes necessary to move forward.
With this morning’s vote behind us, the process moving forward is becoming clearer–Finance Chairman Max Baucus (D-MT) is expected to introduce a new substitute today. According to BNA:
Baucus is expected to draw up a new substitute amendment that will be a slimmed-down version of what the Senate defeated. That plan would have added $84 billion to the federal deficit, a figure that Republicans, and some Democrats, said was too high to stomach. Baucus has previously said that he would continue to work with senators of both parties to find 60 votes. Issues that could be modified to secure votes include Medicare reimbursement rates for physicians, unemployment insurance benefits, Medicaid funding to states, and possibly language making it more difficult for S corporations to avoid paying employment taxes.
As BNA indicates, the new effort will likely include a modified payroll tax hike. As with the House-passed provision, however, the new tax has been written behind closed doors and without the benefit of public scrutiny. It might be better than the flawed House effort, but we simply won’t know until it’s offered.
The next key vote will take place tomorrow, when the Senate considers Senator John Thune’s (R-SD) alternative “extender plus” package. This package includes all the tax extenders the business community wants, but strikes all the tax hikes the business community opposes (including striking the $11 billion payroll tax hike). Instead, all the tax relief and spending in the package are offset with spending cuts. As with today’s vote, Senator Thune is not expected to get 60 votes tomorrow, but we’re betting he does better than the 45 votes Senator Baucus got today.
Meanwhile, Senator Olympia Snowe (R-ME) continues her fight on behalf of S corporations. As CongressDaily reported this morning:
Snowe is upset about an $11 billion tax increase on small services firms organized as S corporations; Baucus is preparing some tweaks to that provision, and the chamber’s 63-33 adoption of an amendment she co-sponsored to establish an office within the Treasury Department to help homeowners struggling with mortgage payments can’t hurt. Democratic aides said they still have some work to do on their side of the aisle before working to assuage GOP holdouts.
The S corporation community owes Senator Snowe a big debt. Meanwhile, with the first Baucus substitute gone and the second version “to be introduced,” we will just have to wait to see what they have in mind.
Senators Snowe and Enzi Take On Small Business Tax Hike
The payroll tax hike in the House-passed extenders bill moves to the front burner in the Senate this week.
Senators Olympia Snowe (R-ME) and Mike Enzi (R-WY) introduced an amendment late last week to strike the provision from the bill. As a potential swing vote on the overall package, Snowe’s opposition in particular is sure to catch Leadership’s eye.
“At a time when Congress continues to dither on enacting a small business jobs bill, Section 413 is a poison pill in this tax bill, robbing American small businesses of the capital they need to create new, good-paying jobs,” Senator Snowe said in a release accompanying the amendment. “Indeed, this is a job-killing tax hike that will force entrepreneurs across the nation to retrench and reconsider any plans for hiring employees or expanding their business.”
Meanwhile, Senator Enzi raised this issue at a Finance Committee hearing last Thursday, first questioning Treasury Secretary Timothy Geithner about it and then entering into a colloquy with Chairman Max Baucus (D-MT). In response to Enzi’s concerns, Senator Baucus made clear his staff was working on an alternative.
The business community has come together as well, with twenty-seven business groups signing a letter spearheaded by the S Corporation Association highlighting the many flaws with the House-passed provision. In addition to focusing on the policy challenges, the letter notes the complete lack of legislative history accompanying this major new tax:
Finally, this new tax is an excellent example of what happens when the legislative process is short circuited. It was never the subject of hearings or public review, it was made public just a few short weeks ago, and it has been attached to legislation that already passed both the House and the Senate. It is an accident of the legislative calendar that we are in a position to offer our views at all.
If it were not for the deliberative nature of the Senate, this provision would have been enacted and signed into law before anybody in the business community—including legal and accounting professionals who advise them—knew it was even under consideration.
The Senate’s rules and the Memorial Day recess delay gave us time to get the message out, however, and we’re beginning to hear from practitioners and affected businesses from around the country. As a Dow Jones Newswire story makes clear, S corporations targeted by this provision extend well beyond the “lawyers and lobbyists” highlighted by the Ways and Means Committee:
Gabriel Durand-Hollis, owner of a San Antonio, Texas-based architecture and interior design firm, is no John Edwards. But he could nonetheless see his taxes rise as a result of a Senate measure that seeks to crack down on a technique Edwards, a former U.S. Senator from North Carolina, once used to avoid paying hundreds of thousands in payroll taxes…. Durand-Hollis, one of two owners of a firm that employees 25, said the provision, if enacted, would boost his federal tax bill by $30,000 or more. “If we had to send a big check like that to the IRS at the end of the year, we’d have to take a hard look at whether we can afford Christmas bonuses, or that new software purchase,” Durand-Hollis said in an interview.
On the process front, we expect Majority Leader Harry Reid (D-NV) to file cloture on the underlying bill (Baucus substitute, really, but we digress) sometime tomorrow or Wednesday. That would set up a key vote on closing debate as early as Thursday. Word is that Senator Reid is short of the 60 votes he needs right now and that changes to the underlying bill will be necessary for him to attract those key swing votes.
With the introduction of the Snowe-Enzi amendment, the odds of positive changes to the small business payroll tax hike shot up dramatically. That’s good for the small business community and good for good tax policy. The House-passed provision is clearly a step backward for taxpayers and the Tax Code. It would impose new costs on small businesses while asking the impossible of the IRS. With the leadership of Senators Snowe, Enzi, and others, we’re hopeful we can fix all that.
Payroll Tax Hike Taken Up in the Senate
The Senate began debate on the bloated tax extender package today. The House passed its version 215-204 shortly before leaving for the Memorial Day recess on May 28th.
That vote was supposed to take place earlier in May, leaving time for the Senate to take action, but opposition to the tax hikes and higher deficits called for in the bill delayed consideration until the Leadership was able to cobble together the votes. As a result, the Senate had already left town and is just now taking up the bill today.
Regarding the schedule, Senator Reid faces a tight window to get the bill done: he needs every Democrat plus at least one Republican to move this, but Senator Lincoln (D-AR) is back in Arkansas for today’s run-off tomorrow and won’t be available until tomorrow.
Meanwhile, there are no votes on Friday or next Monday and debate on Senator Murkowski’s Resolution of Disapproval (climate change) is set to consume much of Thursday.
That basically leaves Wednesday as the only day this week where Senator Reid might have the votes to move the process along, and it’s apparent from the news today that he’s not there yet. Senator Snowe (R-ME), a long-time S-CORP champion, indicated as much to CongressDaily:
Snowe said on Monday she was still waiting to see details. But she said the combination of deficit spending and tax increases, such as a new 15 percent payroll tax on small services-providers organized as “subchapter S” corporations, were giving her pause. “Pretty far from it at this point,” Snowe said, when asked about her comfort level with the bill, adding that it was unlikely to pass this week.
On the policy side, the delay in the House has been a boon for good tax policy, since the longer this payroll tax provision is out there, the worse it appears. Swapping a “reasonable compensation” standard for a “principal asset” test is not an improvement to the Tax Code. Exactly how is the IRS supposed to enforce an annual valuation of the “skill and reputation” of a firm’s three key employees?
Tom Nichols, a long-time S corporation attorney and head of the ABA’s Tax Section on S Corporations penned a letter to Congress making this point and many others. Meanwhile, the blogs of tax practitioners across the country are beginning to weigh in, raising numerous concerns that should have been dealt with through the normal legislative process — except there wasn’t one. The blog Tax Prof has links to a long list of critical commentators. As one observed:
But even assuming that you should hit service providers with self-employment tax on all of their K-1 income, you should do so in a way that is fair, understandable to taxpayers, and enforceable by the IRS. The S corporation provision in H.R. 4213 is none of these.
The Senate being the Senate, we expect this issue to be debated into the next week at least, and we plan to use that time to educate policymakers and improve the bill. There are taxpayers out there that use the S corporation to block payroll taxes they otherwise owe, and we support going after them, either through increased use of the “reasonable compensation” standard by the IRS or though a well-thought and well-targeted statutory provision. The provision before the Senate right now doesn’t meet that test.
Reasonable Compensation Standard in Action
Speaking of the “reasonable compensation” standard, the following post showed up in BNA this morning–as it makes clear, the IRS can and does go after payroll tax scofflaws using the “reasonable compensation” standard:
The U.S. District Court for the Southern District of Iowa May 27 held that David E. Watson P.C. must pay employment taxes on “all remuneration for employment.” David Watson incorporated an accounting firm as an Iowa professional corporation and chose to be taxed as an S corporation. Watson authorized himself a salary of $24,000 a year and he paid federal employment taxes on that amount. In addition to his salary, Watson received more than $200,000 in what he claimed were dividend payments. The Internal Revenue Service determined the dividend distributions should be recharacterized as wages, subject to employment taxes. (David E. Watson PC v. United States)
A fair reading of the House-passed bill is that the new, untested “principal asset” test for S corporations would be much more difficult for the IRS to enforce than the existing standard being used here. It would also be more costly for firms, as they would be required to value all their assets every year to determine if they are subject to the new tax. In order to enforce this new rule, the IRS would need to do the same.
The bill is now before the Senate, which has a reputation for debate and deliberation. We are hoping they expend a little deliberation on this provision. It could use it.
S-CORP Opposes Extender Pay-For
Your S-CORP team has been busy hitting the Hill in opposition to this payroll tax provision in recent days. Late last week, the House Ways and Means Committee released its package of tax extenders, partially offset by an expansion of the S corporation payroll tax to firms in service industries.
While the S corporation community knew the payroll tax hike was under consideration, this was the first time we had seen an actual proposal and it took us a couple days to get a read on who would be affected.
The provision is much broader than advertised. It begins by defining the population of firms targeted — professional or personal services firms in the area of law, engineering, architecture, performing arts, etc. The Committee’s choice to create a new definition for “Professional Services Business” was, we believe, predicated on the desire to target financial services firms as well as athletes, movie stars and other highly compensated individuals who might use an S corporation to block payroll tax obligations.
Once you fall into the “Professional Services Business” pool of S corporations, the provision asks, is your firm the partner in a service partnership and does that partnership consume substantially all of the activities of the S corporation? This test is targeted directly at the “John Edwards case” where a successful lawyer used the S corporation to block payroll taxes on his legal fees. Our members have raised few concerns about this test.
The second test, however, is more troubling. It would apply to “any other S corporation which is engaged in a professional services business if the principal asset of such business is the reputation and skill of 3 or fewer employees.” It took us a couple reads to realize this provision is not nearly as narrow as it first appears.
First, the test is not limited to firms with three or fewer employees. Firms with numerous employees could be affected, as long as only three are “key.”
Second, “principal asset” does not mean their skill and reputation comprises the majority of the value of the firm. Instead, that asset just has to be bigger than all the other assets of the firm. So, a business at which the largest asset is equal to 10 percent of the firm’s value would be affected if the “skill and reputation” of three employees are worth 11 percent.
With that as background, here is a list of concerns we’ve shared with the Committee over their new, never-before-seen provision to tax service S corporations:
- The provision would require a “disqualified” small business to determine whether its principal asset is the “skill and reputation” of fewer than three employees. This would require every “disqualified” small business to get a valuation of each of its significant assets every year in order to determine which asset is its “principal” asset.
- The provision arbitrarily discriminates against small businesses. It taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except they have four key employees.
- The provision tests for highly-skilled “employees” rather than shareholders. Why? Is there evidence that indicates that highly-skilled employees are underpaid by S corporations?
- The provision requires difficult legal conclusions about uncertain areas, such as whose asset is an employee’s “skill and reputation”– the employee’s? Or the company for which the employee works?
- The provision provides no definition of “asset”– it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single “asset” for purposes of determining the “principal asset” of a company.
- The provision would discriminate against family-owned S corporations by applying payroll taxes to family members not active in the business. This provision would reduce the ability of S corporations to raise capital from family members.
- And finally, how exactly does one go about establishing the value of “skill and reputation” of employees on a widespread basis? This, and the other undefined terms used in this provision are simply inviting litigation.
All of these technical challenges beg the question: What problem is the second test designed to solve? The first test, after all, captures the “John Edwards case” that everybody, including S-CORP, would like to address. What is the magic value of “three or fewer” employees? 60 90 percent of S corporations are owned by three or fewer shareholders. Is it just a money grab?
Beyond the policy, the lack of process or public review should be enough to bring about this provision’s defeat. No specific hearings on the proposal, no markups, no floor debate, not even a draft bill to comment on, and yet this $11 billion tax hike is supposed to be considered by the House and the Senate before the Memorial Day recess.
The IRS already has the tools to go after John Edwards and others like him. It has successfully litigated cases where taxpayers have taken compensation that was less than reasonable. Spicer Accounting Inc. v. US, 918 F2d 90 (9th Cir. 1990); Dunn & Clark, PA v. US, 853 F. Supp. 365 (D. Idaho 1994); Radtke v. US, 712 F. Supp. 143 (ED Wis. 1989) , aff’d per curiam, 895 F2d 1196 (7th Cir. 1990) Veterinary Servs. Corp., PC, 117 TC 141 (2001) . Veterinary Surgical Consultants, P.C., 117 TC 141 (2001) , aff’d, 54 Fed. Appx. 100, 2003-1 USTC ¶ 50,141 (3d Cir. 2002).
We’re not in the business of proposing tax hikes on our members, but if the problem resides with single shareholder S corporations in the service sector, why not start with that population and whittle it down from there? And what about an employee threshold? Who is going to hire lots of people at market salaries in order to reduce their personal tax rate by a little more than 2 percent?
We understand Congress needs revenue to offset its priorities, but to try to raise $11 billion on the backs of closely-held businesses without having one public review of the policy strikes us as a little much. Take a little time, engage the public, and you might get a better product.
Extender Package Stalls in the House
On a related note, timing for consideration of the “extender plus” package is very much up in the air. It was supposed to go to Rules earlier this week with floor consideration today or tomorrow, but that might not happen.
Although members are concerned with the offsets in the package, it is the number of extraneous items and their cost to taxpayers that is slowing any progress at this point. In addition to extenders, the package includes a UI extension, Cobra benefits, the Doc Fix, and other expensive items. The size of the package is causing moderate members concern:
“I’m concerned about it,” said Sen. Ben Nelson, D-Neb. When combined with “emergency”-designated extensions of unemployment insurance and COBRA health benefits for laid-off workers, Medicaid assistance to states and perhaps Temporary Assistance for Needy Families funds, the unpaid-for cost of the bill could top $170 billion. “Obviously, my preference is to have offsets, and look hard at nonemergency issues. Everything can’t be called an emergency to avoid having offset requirements,” Nelson said.
And:
Sen. Kent Conrad, chairman of the Senate Budget Committee, said Tuesday he has concerns with the size of a large tax and benefit bill Democratic leaders hope to pass this week, casting doubt on the chances of the legislation being approved. Mr. Conrad (D., N.D.) said the current net cost of the measure to public finances—$141 billion over a five-year period—was too high.
So the package is getting larger, but only those provisions extending tax benefits for families and employers are going to be offset, and those provisions will be offset with tax hikes on families and employers.
To put this discussion into perspective, the current extender package extends provisions that expired last year. The extension is only twelve months, which means Congress will have to come back later — most likely in a Lame Duck session — and pass another extension if all these tax provisions are not to expire at the end of 2010. The tax hikes, on the other hand, are permanent.
Groups targeted for tax hikes in this bill need to be wary. Taxwriters will be on the hunt for another $30 billion in just a few months, so any deal cut today will be revisited tomorrow.
Estate Tax Update
The inability of any estate tax proposal to garner 60 votes in the Senate is becoming increasingly apparent. There’s still a chance for a breakthrough, but time is getting short and opposition is getting more vocal.
As reported in numerous publications, estate tax negotiators have hit a wall in crafting a compromise plan that can pass. As Dow Jones reported last week:
Senators that want to reduce estate tax rates even further have in the past two weeks closed in on a compromise that would not add any more to the deficit, at least in the short-term, than Obama’s plan. The plan would start at Obama’s proposed levels in 2011, but gradually phase down to a 35% rate and a $5 million exemption level.
But Tuesday they said that a proposed compromise is in limbo. “Nothing is clear about how the estate tax will be considered,” said Sen. Jon Kyl (R., Ariz.), the lead Republican in the negotiations. “Last week I believed there was an agreement on what the details were going to be. That may not be the case now.”
“There’s no agreement on estate tax, neither on substance nor on process. None whatsoever,” said Senate Finance Committee Chairman Max Baucus (D., Mont.), who is one of two Democrats involved in the talks, the other being Sen. Blanche Lincoln (D., Ark.).
Meanwhile, the lack of progress and the short calendar is emboldening the opposition. According to CongressDaily:
That would be fine with Sen. Bernie Sanders, I-Vt., who said reverting to pre-2001 law would only affect about 2 percent of the nation’s estates. When asked about a plan to reduce the tax to 35 percent and lift the exemption to $5 million, Sanders replied: “I will do everything I can to stop that.”
CongressDaily goes on to quote another Senator as estimating that up to 80 percent of the Democratic conference is opposed to any sort of estate tax compromise. While he quickly backed off that estimate, anywhere near that level of opposition would doom an estate tax compromise this year and allow the pre-2001 rules to take effect beginning in 2011.
This stalemate also is blocking the Senate small business tax package, including built-in gains relief, from moving forward. The package has been negotiated between Finance Committee Democrats and Republicans and was ready to be marked-up last week until the estate tax roadblock emerged.
At this point, the path forward is unclear. Taxwriters could resolve their differences on the estate tax or they could agree to set that issue aside and let the small business package proceed (perhaps directly on the Senate floor). A third option would be to resolve nothing and let both estate tax relief and the small business package die. Let’s hope it’s not option three.
Payroll Tax Update
Congressional taxwriters, especially in the House, continue to express interest in raising payroll taxes on active S corporation shareholders as an offset to the tax extender package under consideration, and the business community has responded.
Nineteen groups penned letters to Chairmen Levin of Ways and Means and Baucus of Senate Finance, highlighting their concerns with the proposal. As BNA reported:
Small business groups urged in an April 28 letter that House Ways and Means Committee Chairman Sander Levin (D-Mich.) abandon a proposal that would raise payroll taxes paid by S corporation shareholders. The proposal is being considered as a possible way to raise additional revenues to pay for the annual tax extenders legislation (H.R. 4213) that includes $31 billion in extensions of popular tax cuts that expired at the end of 2009.
Setting aside the politics of raising taxes on small employers during an economic downturn, another significant challenge confronting tax-writers is the lack of an actual proposal. This idea has been around for years, yet the number of bills introduced with some form of this provision included is few — maybe only the Rangel “Mother” bill introduced in the fall of 2007. The association letters focused on that provision because it’s the only one out there.
A member of the American Institute of Architects had a chance to speak to this issue yesterday when he testified before the House Small Business Committee:
Although the details of the proposal currently under consideration are unclear, it is my understanding that the proposal would expand the application of payroll taxes to active shareholders of S corporations “primarily” engaged in “the performance of services.” I understand that there is concern that some S corporations misclassify salary compensation as earnings distributions in order to avoid paying payroll taxes. However, my fear is that the proposal will entrap millions of small business owners who are legitimately and correctly classifying salary and earnings distributions, with limited public policy benefit.
Yesterday’s hearing was unique in that, to the best of our knowledge, it was the first public testimony on this topic in years. The head of the Joint Committee on Taxation outlined a proposal to apply self-employment taxes to all partnership, LLC, and S corporation income before the Senate Finance Committee, but that was five years ago! We are unaware of any other legislative activity on this topic before last month, when the concept was floated to Ways and Means Members as a possible pay-for for extenders.
Overturning fifty years of tax policy should be a big deal and approached in an orderly fashion, not done at the last minute and on the run.
Payroll Taxes and the 3.8 Percent Investment Tax
With the S corporation payroll tax issue front and center, we’ve been revisiting the adoption of the 3.8 percent investment income tax as part of healthcare reform. There are a number parallels that deserve to be pointed out.
First, both taxes were introduced into the process at the eleventh hour. The 3.8 percent tax was introduced into the debate after both the House and Senate had passed their respective health reform bills and barely a few weeks before the whole package was signed into law. In terms of size and speed, the 3.8 percent investment tax is the LeBron James of the tax world. It’s likely nothing that size ($210 billion over ten years) has moved from introduction to law that quickly in the history of democracy.
Meanwhile, the S corporation tax is under consideration for the extender package. That package has already passed both the House and the Senate and the S corporation provision was not part of either bill. As with the 3.8 percent tax, it hasn’t actually been introduced in any legislation — it’s just a concept. And, like the 3.8 percent tax, this concept has never been subject to hearings or review.
Second, while both taxes are described generically as “payroll” taxes, they aren’t. The 3.8 percent tax is a tax on savings and investment only. It does not apply to wages or other forms of labor income. The same is true for the S corporation tax. For law-abiding shareholders, it’s a tax on returns from business investment.
Third, one of our arguments against the S corporation payroll tax is that it would, for the first time, fund Medicare with taxes on capital rather than labor. Some have suggested that the 3.8 percent tax broke that barrier already — not true.
There is no connection between the 3.8 percent investment tax and Medicare. The House struck the Medicare connection in the manager’s amendment filed the day before the package was adopted. So, while the tax still has “Medicare” in its title, none of the revenues raised by the tax go to the HI or related Medicare trust funds. Calling the 3.8 percent tax a “Medicare” tax, or even a payroll tax, is simply incorrect.
Finally, the 3.8 percent tax applies to just about all forms of investment income — rents, royalties, annuities, partnership income, etc. — except for business income earned by active shareholders of S corporations. Active shareholders of S corporations were explicitly exempted. Yet, the new S corporation payroll tax currently under consideration for the extenders package would effectively reverse this policy decision by applying a 3.8 percent tax to the business income of active shareholders!
Americans Love Small Business
The American economy’s reliance on small, closely-held businesses is unique in the developed world. Most other major economies focus their economic energies on large public corporations, but not the United States. Notwithstanding the financial crisis, the Jeffersonian concept of the yeoman farmer is alive and well and lives on Main Street.
As we’ve pointed out before, this emphasis on small and independent didn’t happen by accident. It was the result of conscious efforts by past Congresses — both Republican and Democratic — to empower Main Street business.
A recent poll by the Pew Research Center suggests this reliance on private enterprise is in synch with the American people. As reported in USA Today:
According to the just-released study by the highly respected Pew Research Center, small business is the most trusted institution in America. More than churches. More than colleges. More than technology companies. And certainly more than labor unions or large corporations.
The results were “striking,” according to Carroll Dougherty, Pew’s Associate Director. “At a time when a lot of institutions are viewed negatively, small business is viewed very positively. What’s really interesting is that large corporations are viewed almost as negatively as Wall Street. The contrast between large corporations and small business is enormous.”
“So much of this survey is partisan,” Dougherty continued. “In this case, it’s bipartisan. It crosses party lines.” 72% of Republicans, 70% of Democrats and 73% of independents say small businesses have a positive effect on the way things are going in the country.
Now if we could only translate those positive vibes into positive legislation.
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