After a long legislative odyssey, the House passed the broad health care reform package on Sunday evening by a vote of 219-212. This legislation is identical to the Senate bill adopted on Christmas Eve and is now ready to go to the President. As CongressDaily noted:
The House took a historic vote late Sunday night to approve an overhaul of the nation’s healthcare system after more than a year of debate, a few near-deaths for the measure and an intense final week marked by loud and angry protests outside the Capitol.
The House also adopted 220-211 a package of “fixes” to the larger bill that will now go to the Senate for consideration. This narrower package makes numerous changes to the broader bill, including imposing a new 3.8 percent tax on unearned income that hits S corporations, and will be considered in the Senate under reconciliation rules that only require a simple majority vote.
The Senate vote is expected to occur later this week and, by all accounts, the Senate Democrats have the votes to prevail. (Note: There are two remaining bumps in the legislative road to look out for. First, there is a lot of talk about a possible Social Security point of order that would bring down the entire “fix” bill. Second, there are numerous so-called Byrd Rule violations in the “fix” bill that will need to be removed, which means the Senate “fix” bill will differ from the House version. That means a conference and a more protracted debate.)
About a month ago, we predicted that health care reform would stall and eventually be set aside by other legislative priorities. Its adoption yesterday demonstrates both the risk of trying to predict the future, and also the determination of the Obama Administration and Congressional Leadership to see this effort through. It’s an impressive legislative victory, albeit a costly one for private enterprise.
S-Corp Leads Response
Last week was a busy one for your S-Corp team. Early in the week, we learned that the House would consider, as part of the health care “fix” bill, a new 3.8 percent tax on certain types of income.
While the tax has been inflicted with various labels — in a nod to reality, the House dumped the original “Medicare Tax” title — the simplest description is that it’s a tax on investment income — just about any taxable investment — including S corporation and partnership income attributed to non-active shareholders and partners.
So, if your income is high enough and you invest in Microsoft, you’ll pay this tax on any dividends or capital gains Microsoft earns you. Similarly, if you invested in your daughter’s S corporation, you also pay the new tax.
In response, your S-Corp team quickly organized a business community letter opposing the new tax in the strongest terms. The letter, sent to Hill leadership and signed by 24 small business groups, makes the case that this new tax is going to hurt job creation and economic growth in future years. As the letter states:
Finally, while the tax has been described as applying to the “unearned” income of only a few taxpayers, it is actually a direct tax on the majority of taxable savings in this country. In 2007, households with incomes exceeding $200,000 accounted for 47 percent of all interest income, 60 percent of all dividends, and 84 percent of all capital gains reported on tax returns.
Businesses and workers rely on these savings to increase their productivity and wages. At a time when businesses are having a hard time accessing credit, millions of workers are unemployed, and the entire economy needs to recapitalize, raising taxes by this amount on that much capital is simply reckless.
Despite this harm, the House retained the provision. It now heads to the Senate. While we expect the Senate to adopt the tax as well, the tax itself doesn’t take effect until 2013, giving the S Corporation Association and our allies two years to educate policymakers on why this is a really bad idea.
The “3.8%” Tax and Future Tax Rates
Peter Cohn in CongressDaily has an interesting piece on where tax rates, especially the tax rate on dividends, are headed in the next couple years. Here’s the lead:
Democrats may be boxed in to letting the tax rate on dividends for upper-income earners top 40 percent in January — or coming up with tens of billions of dollars to pay for a lower rate — due to new budget rules signed into law in February.
The general assumption has been that Democrats will enact President Obama’s tax policies, averting that scheduled increase by capping it at 20 percent for wealthier earners. But the pay/go law only assumes the dividend rate will stay at its current 15 percent for middle-class taxpayers. For the wealthy, the rate would revert to its pre-2003 levels corresponding to ordinary income tax rates, unless Congress finds a way to pay for holding it to 20 percent.
With Federal deficits exceeding $1 trillion, we’re not holding our breath here that the same Congress that just imposed a new 3.8 percent tax on investment income would turn around and cut the base tax rates on that same category of income.
Which means, coupled with where the marginal tax rates are scheduled to go already, the new 3.8 percent tax has the potential to drive tax rates to their pre-1986 levels — capital gains rates would be 25 percent while the tax on interest, dividends, royalties, and other forms of investment income would be nearly 45 percent. More from Peter Cohn:
Observers outside the Beltway are baffled why the issue isn’t getting more attention. “I don’t think anyone is really focused on the dividend tax,” said Jeffrey Kwall, a professor of tax law at University of Loyola Chicago Law School. “And I don’t think people have really thought through what kind of impact it would have on the market” for the top rate on dividends to skyrocket by 165 percent.
Congress spent a year focused on expanding the Federal government’s obligations to health care while ignoring one of the most basic issues affecting the economy and job creation — the after- tax rate of return on investment. Outside observers should be baffled.
President Obama released a list of proposed changes to the Senate-passed health care reform bill on Monday, and while there is plenty to interest any American, one item in particular should catch the attention of S corporation owners:
The President’s proposal adopts the Senate bill approach and adds a 2.9 percent assessment (equal to the combined employer and employee share of the existing HI tax) on income from interest, dividends, annuities, royalties and rents, other than such income which is derived in the ordinary course of a trade or business which is not a passive activity (e.g., income from active participation in S corporations) on taxpayers with respect to income above $200,000 for singles and $250,000 for married couples filing jointly. The additional revenues from the tax on earned income would be credited to the HI trust fund and the revenues from the tax on unearned income would be credited to the Supplemental Medical Insurance (SMI) trust fund.
By all appearances, the Administration has decided to apply a new 2.9 percent tax to all forms of “unearned” income, including S corporation income earned by shareholders not active in the business. [That is our take at this time -- we are reaching out to taxwriters to make certain that is what the Administration intends]. This tax would be imposed on top of other applicable taxes and would be used to offset the cost of health care reform. CongressDaily reported on this provision yesterday:
President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed. But critics charge it could open the floodgates to a raft of companies re-structuring their businesses as subchapter S corporations in order to avoid the tax.
That is the glass half full version. The half empty view is the Administration just proposed to raise marginal tax rates on S corporation shareholders with day jobs. Here’s how we see it applying:
- Taxpayer A works at his S corporation, earns a salary above $200,000 and receives a distribution of S corporation earnings. He would now pay an extra .9 percent on his salary, but not pay more on any earnings from the S corporation.
- Taxpayer B makes more than $200,000 at another job and is a shareholder of an S corporation. She would now pay an extra .9 percent on her salary as well as an extra 2.9 percent on any earnings from the S corporation.
This proposal raises all sorts of alarm bells. First, as we have pointed out, it takes the notion of the “payroll” tax and throws it in the trashcan. Second, it continues the illusion of the Medicare and SMI Trust Funds; revenue raised by this tax pays for health care reform, not Medicare benefits. Third, it raises the cost of capital (especially if it is combined with next year’s scheduled increase in the capital gains and dividend rates) at a time when our financial institutions are capital-starved. The whole point of TARP was to recapitalize our financial system, remember?
Beyond those broad policy concerns, the mechanics of this tax are particularly challenging. Does Taxpayer B pay a total Medicare tax of 3.8 percent on her salary above $200,000, but only 2.9 percent on any passive income, including S corporation earnings? And what about Taxpayer A? He already faces the challenge of making certain he pays himself a “reasonable” wage or he risks being accused of tax avoidance. This proposal would increase that temptation and the broader policy challenge.
Finally, how does the Administration plan to distinguish between passive and active shareholders? Here is how IRS Publication 925 (Passive Activity and At-Risk Rules) defines “Active Participation”:
Active participation depends on all the facts and circumstances. Factors that indicate active participation include making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees. Factors that indicate a lack of active participation include lack of control in managing and operating the activity, having authority only to discharge the manager of the activity, and having a manager of the activity who is an independent contractor rather than an employee.
It’s pretty sketchy. So now will all those non-active S Corp shareholders try to become active so they can avoid the new “payroll” tax? Sounds like another enforcement headache for the IRS. Expect to hear lots more on this issue in coming weeks.
More Intel on Estate Taxes
Two ideas are being floated in the Senate on the estate tax. A while back, Dow Jones reported on a proposal to allow taxpayers to prepay their estate taxes. As Martin Vaughn wrote:
A proposal to allow wealthy people to prepay estate taxes while they are still alive, in exchange for a lower tax rate, has caught the attention of Senate staff trying to craft a bipartisan, permanent compromise on the estate tax…. The plan would allow wealthy people to place assets in a prepayment trust while they are still alive. Those assets would be subject to a 35% tax, which the estate owner would have five years to pay, according to a document describing the plan, obtained by Dow Jones Newswires.
The value of this option for taxpayers is obvious: you get a lower rate. For the government, the value is that it would be scored as a revenue raiser. Congress operates on a finite budget window, so the prepayments would be scored as new revenues while some of the estate taxes foregone would fall outside the budget window and wouldn’t count. Not exactly kosher, but the point is this idea could, just like the old Roth IRA concept, fit the needs of Congress and help them move towards a resolution of the estate tax dilemma.
The other idea to break the current impasse is to impose a “toll charge” on family foundations as a means of offsetting the cost of lowering the estate tax below 2009 levels. The Hill reported earlier this week:
The Gates Family Foundation – arguably the biggest charity in the world with assets over $35 billion according to 2008 records – is in the crosshairs of Sens. Jon Kyl (R-Ariz.) and Blanche Lincoln (D-Ark.), who see it as a money pot to help pay for a legislative fix for the estate tax. Well-placed sources say the senators might create a “toll charge” on charitable foundations that would sock Democratic heavyweights like Bill Gates and Warren Buffet.
During last year’s budget debate, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) offered an amendment to reduce the top estate tax rate from 45 to 35 percent while increasing the exclusion from $3.5 million to $5 million. That amendment garnered majority support but less than the 60 votes needed to clear the Senate. Moreover, it left unresolved how the sponsors would make up the revenue difference between their amendment and 2009 estate tax rules. That’s where the toll charge on foundations might come in.
In terms of timing, the clock is ticking. We are now two months into the year of repeal and more estates are finding themselves in estate tax limbo. Senator Kyl addressed this concern yesterday, suggesting he would begin blocking other Senate business in order to force an agreement to take up an estate tax fix. As the Hill quoted Reid yesterday:
Very soon we’re going to have a process on how estate tax reform is going to move forward. I will insist on an agreement on how to proceed, if we’re going to have unanimous consent on how to proceed with any of these subsequent bills.
At the end of this process, it is possible no permanent fix can get 60 votes, the estate tax stays repealed for the rest of the year with the old 55 percent and $1 million exclusion coming back in 2011. All this recent activity suggests some sort of effort is just around the corner, however, and we may know the outcome soon.
A couple weeks ago, House-Senate health care negotiators raised the idea of paying for health care reform by expanding the types of income subject to the Medicare payroll tax. Payroll taxes are limited to wages at the moment, but this proposal would also tax cap gains, dividends, interest, rents, and limited partners. Oh, and S corporation income.
S-CORP has a long history of advocacy on these issues and, while the future of health care reform is wholly uncertain following the special election in Massachusetts, we felt it was important for the business community to weigh in on this issue with strong opposition. The result is a letter signed by 20 trade associations opposing this concept. As the letter notes:
Expanding the application of the Medicare payroll tax to non-wage income is an unprecedented policy that would undermine the principle that Medicare is an earned entitlement, damage the integrity of the Medicare Trust Fund, and hurt Main Street businesses and jobs. We strongly urge you to reject this misguided policy.
This morning, a CongressDaily article makes clear that this idea continues to be actively discussed between House and Senate negotiators. While the prospects for health care reform are dim, leadership continues to press for some sort of resolution and apparently this payroll tax item is part of those talks. Peter Cohn reports that the House and Senate are divided on how to expand the Medicare tax:
Senate negotiators want to keep active S corporation income — other than income from passive investments — exempt from the payroll tax, fearing their chamber’s fragile voting math can ill afford what could be seen as a new small business tax, aides said. House lawmakers disagree, citing the revenue loss, relatively few actual small-business employers that would be affected, and potential to game the system — such as opting for S corporation status simply to avoid the tax.
We’ll keep you apprised on any new developments on this front. As we’ve mentioned before, our assessment is health care reform will be talked about for the next month or so and then just fade away as other priorities take center stage. There won’t be a funeral or closure, but the votes simply do no exist to move forward right now. That said, no bad idea ever goes away and we fully expect to see this payroll tax expansion to be raised on other bills.
As expected, House Leadership released its health care reform plan yesterday — America’s Affordable Health Choices Act of 2009 (H.R. 3200). As you can imagine, there are any number of provisions to explore in a 1000-page health care bill, but for S corporations, the big four items appear to be:
- The new health insurance exchange;
- The surtax on high income individuals;
- The health insurance tax credit for smaller firms; and
- The payroll tax penalty for non-participating firms.
Supporters of the plan argue that the combination of the health care exchange and the small business tax credit will provide a net benefit to S corporations and other small businesses. Opponents point to the higher taxes and penalties for firms that choose not to offer health care plans to their employees.
They also question whether the overall plan will actually save money. The CBO estimates it will cost money after all – more than $1 trillion dollars. Of particular importance is the response of the moderate Democratic Blue Dog Coalition. As BNA reported this morning:
Rep. Mike Ross (D-Ark.), chairman of the Blue Dog Health Care Task Force, said his group was committed to passing health care reform. He also said that “reform that does not meet the president’s goal of substantially bringing down costs is not an option.”
We are not in a position to judge how successful the exchange will be. The only example is the one in Massachusetts and that one has both supporters and detractors. As for the other three provisions, here’s our best summary:
Surtax: Starting in 2011, a surtax of 1, 1.5 and 5.4 percent will be applied on “modified” AGI exceeding $350,000, $500,000 and $1 million respectively (joint filers). Unless OMB certifies that the bill’s changes to Medicare and Medicaid result in an additional $150 billion in cost savings, the surtax will rise to 2, 3, and 5.4 percent starting in 2012. If OMB certifies these savings exceed $175 billion, then the lower two surtaxes go away.
Small Business Tax Credit: For employers with fewer than 25 employees and who offer them qualified coverage, they are eligible for a tax credit equal to a percentage of their health care costs. The credit starts at 50 percent for employers with fewer than 11 employees and average annual compensation of less than $20,000. It phases out for more employees and higher salaries. A firm with 25 employees and/or average compensation of more than $40,000 gets no credit.
Payroll Tax Penalty: Firms that do not pay for at least 65 percent of their employees’ qualified coverage are subject to a payroll tax penalty. The tax starts at 2 percent of payroll for firms whose payroll exceeds $250,000 and rises to 8 percent for firms with payrolls exceeding $400,000. It is unclear whether the payroll tax applies to all payroll or just the amount exceeding the threshold.
Suffice to say that the complexity of each provision is worth its own white paper. Trying to gauge the interaction between them is simply impossible. Here are some observations and questions:
- How does the payroll tax penalty work? If an employer does not offer qualified coverage to his/her employees, does the tax apply to all payroll or just the amount above the threshold? How does the bill define firm? By entity or by establishment?
- The plan penalizes employers for expanding their payroll. If the employer offers qualified coverage, raising wages would reduce their credit. If they don’t, increased wages will increase their penalty. Either way, the plan raises the marginal cost of hiring new employees and offering them higher wages.
- The higher surtax rates can be avoided if OMB finds additional savings from Division B in the bill. How is OMB supposed to measure these savings and attribute them to the Division B? If the CBO failed to measure these savings, how will OMB?
- The bill appears to add to the deficit, especially in later years. Is this the plan, or will additional cost savings be offered to make it budget neutral?
- What about the need to balance the budget, reform the Alternative Minimum Tax, extend some or all of the expiring tax relief, or make the corporate tax code more competitive? How will Congress accomplish all these things if it spends $1 trillion on health care reform?
The House Ways and Means, Labor, and Energy and Commerce committees will begin marking up their respective portions of the bill tomorrow. Expect these markups to be extremely contentious. The Speaker’s goal is to get the bill through the full House before the August recess. Given the primary importance both the Speaker and the President have placed on health care reform, we expect this goal will be met. Exactly what changes are necessary to get the plan through the House, however, remains to be seen.
The Surtax and Small Business
The fight over who will pay the surtax has begun. The Ways and Means Committee published its estimates that only 1.2 percent of all taxpayers will pay the tax, and only 4.1 percent of all small business owners.
Our immediate reaction was that small business owners are 3.5 times more likely than the average taxpayer to pay the tax, but even that observation misses the larger point. It’s not the number of taxpayers affected that counts, but rather the amount of economic activity subject to the higher rates.
As we’ve pointed out previously, about two thirds of all small business income is taxed at the top two rates, so any surtax applied to upper incomes is likely to tax a majority of small business income. Moreover, those rates are already scheduled to rise, resulting in a double hit on upper income business owners in 2011 and beyond.
|Marginal Tax Rates Under HR 3200 (Joint Filers)|
|AGI||Marginal Rate (2009)||Marginal Rate (2011)||Marginal Rate (2012)|
This chart requires several caveats, including pointing out that the surtax applies to “modified” AGI rather than taxable income, but the general point is valid — HR 3200 will return marginal tax rates back to where they were before we started cutting rates in the 1980s.
In addition, this chart doesn’t include the HI tax that now applies to wage income, it doesn’t adjust for taxing “modified” AGI, which includes income from capital as well as labor, it doesn’t include the impact of restoring PEP and Pease, and it doesn’t include state and local taxes. All told, the effective marginal rates on higher incomes will easily exceed 50 percent under this plan.
One last point. When taxing the rich is debated, the discussion usually ignores the actual amount of taxes being paid. Your S-CORP team thinks that’s a mistake.
For example, the CBO reports that the top fifth of taxpayers pay, on average, $64,000 in federal taxes every year. The top one percent pay over half a million.
How much more will HR 3200 add to this burden? And at what level of tax do taxpayers, including small business owners, stop being productive and choose to do something else with their time?