Tax Policy on the Table for September
Members of Congress are back home and set to return mid-September for a final three week session before the November elections. Add in two or three weeks of possible “lame duck” session, and that’s the extent of time available to tax writers to address the numerous items on their honey-do list:
- Preventing the 2011 tax hikes (including AMT);
- Adopting the small business tax bill;
- Extending the extenders that expired last year;
- Extending the extenders that will expire this year; and
- Something on the estate tax.
Given that these issues have been before Congress the entire year, it’s difficult to conceive how Congress would suddenly jump into action on all these items before the clock runs out. And while recent statements by leadership suggest they will make a concerted effort to address most of these items before adjourning for good, the Senate continues to be hamstrung in its ability to move anything. Here’s our take on the where we go from here:
- Small Business Tax Bill: The bill itself is non-controversial and has bipartisan support. What’s holding it up is a fight over the process — will amendments be allowed and, if so, how many — and on-going debates over extraneous tax items like the future of the estate tax. Majority Leader Reid was very close to a deal with Minority Leader McConnell just prior to the break. We expect further progress and ultimate adoption of this package in September.
- Tax Hikes: Last week, Finance Committee Republicans issued a statement calling on the Committee to hold a markup on extending current rates “as soon as possible to bring certainty of continued tax relief…” Meanwhile, House Majority Leader Steny Hoyer is calling for extending only those provisions for taxpayers making less than $200,000. And several Senate Democrats — notably Senators Kent Conrad (D-ND) and Evan Bayh (D-IN) — have expressed support for a one-year extension of everything. No clear path out of this challenge, but we continue to believe a one-year extension of everything is most likely, followed by failure of Congress to pass anything. A one year extension of the middle-class relief is a close third.
- Extenders: Extenders will likely move as part of the small business tax bill in September, which is good news for manufacturers and families living in states with no state income tax. The bad news is the extension would last just until the end of this year, so another bill would have to follow soon.
- Estate Tax: We’re now four months away from seeing the estate tax rise from the dead (55 percent top rate and $1 million exemption) with no apparent solution in view. Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) are pressing for lower rates and a higher exemption (35 percent and $5 million) while others support adopting the rules in place in 2009 (45 percent and $3.5 million). Still a third camp is happy to see the estate tax return in full force. Time is short, and no side appears to have the 60 votes necessary to prevail, which means current law has the upper hand.
Regarding the floor situation, Senate Majority Leader Reid set up the small business bill to be pending business as soon as they get back on September 13th. He introduced yet another substitute before they left and filled the amendment tree to block other amendments. He then filed cloture on several democratic amendments to the bill as well as the underlying legislation, setting up a series of 60-vote threshold cloture votes in the first couple days when they return.
While it’s possible these votes take place and fail along party lines, it’s more likely the two leaders come to an agreement on allowing a limited number of amendments — including adding the extender package to the mix – for the bill to move forward. At least that’s what we hope, since there are some very good provisions in the small business bill that should help investment and job creation.
Regarding the other items, including Extenders v. 2011, we’re expecting the rest of the to-do list to get pushed into a lame duck, with some sort of omnibus bill that includes federal funding and tax provisions presented to members in November or December. No idea how that battle royale turns out, but we’ll be sitting in the front row to watch.
More on S Corporations and Employment
The ongoing battle over the pending tax hikes has a tendency to devolve into a debate over the definition of “small” business and other random characteristics a firm needs before it be considered “real” by some policymakers. For example, proponents of the tax hike appear to believe a manufacturer is more “real” than a law firm, even though both are taxed as flow-through entities and both might be defined by the SBA as small.
But this debate over which types of business activity are “real” is silly and misses the point. The point is that a large percentage of the pending tax hike will be imposed on employers and investment. One half of all business income is taxed at the individual tax rates. One quarter to one-third of all business income is subject to the top two rates. That’s a lot of economic activity subject to the pending tax hikes.
Consider this debate from the perspective of the employee: whether your job comes from a large S corporation or a small S corporation makes no difference to you; both are employers, and your job is your job. So why should policymakers care whether you work at a 500 employee manufacturing plant or a 12 person law firm? Why do some policymakers believe one job worth saving but the other not?
One challenge we face in this debate is that while the folks at the Statistics of Income break down firms by structure, they don’t include employment numbers, so it’s difficult to tell how many employees work for S corporations. One way to back out an estimate is to look at their payroll and executive compensation numbers. If we assume the average compensation of an American worker is $40,000 (admittedly a rough estimate) then it appears S corporations employed about 21 million workers back in 2007.
Moreover, S corporation employment gets bigger the more revenue and income a firm makes (as you’d expect). Firms with more than $50 million in revenues employed about 4.5 million workers, while firms with $10 to $50 million in revenues employed 4.4 million workers.
Firms that size have average business income per shareholder exceeding $335,000, which means more often than not, their business income is taxed at the top two rates. Are the nine million employees who work at these firms less deserving than the employees who work at the local coffee shop? Obviously not, but for some reason the other side of this debate spends an enormous amount of time trying to minimize the value of those employees and the firms they work for.
Again, these numbers are just rough estimates, but the point they make is valid nonetheless: flow-through businesses — including S corporations — represent the majority of employers in this country and raising their taxes is not going to help the economy or the job picture.
Joint Committee Estimates Tax Hikes
In response to a request from the Ways and Means Committee, the Joint Committee on Taxation released some estimates last week on who would benefit from foregoing the rate hikes and other tax increases next year. You may have seen related stories focusing on how much “millionaires” would benefit. A couple thoughts:
First, while the JCT estimates that taxpayers earning over $1 million would see an average tax break of $103,834, they also estimated this break would reduce their tax burden by only 11 percent, suggesting that these taxpayers will pay nearly $1 million in income taxes next year on average.
Second, the revenue “cost” of avoiding all the tax hikes next year is not substantially more than the cost of avoiding those for taxpayers making less than $200,000 — $227 billion versus $202 billion.
That’s not as much as we would have expected, and in our view raises the odds that Congress extends for one year all the 2001 and 2003 tax cuts. It’s not a done deal, of course, and total inaction by Congress is also possible, but with the weak job market and pending elections, the legislative equivalent of a punt — a one year extension of everything — is looking increasingly likely.
Private Enterprise and Jobs
A recent Washington Times article by Mike Whalen, chief executive of Heart of America Restaurants and Inns, should give policymakers pause as they worry about weak job growth while simultaneously piling one tax on top of another onto job-creating companies. Using 2008 numbers, Whalen runs through all the taxes a single 100-room limited service hotel located in Iowa pays:
For starters, we pay property taxes to the tune of about $199,000 annually. Next, there is a 7 percent “pillow tax” that generates about $162,000 annually. Then we pay a 6 percent sales tax on revenue that yields about $124,000 annually. Then we also pay sales tax on things like toilet paper, shampoo, soap, continental breakfast food and amenities and other items that the state of Iowa says are not really part of the product we sell because it says we are selling space. It may come as a surprise to you that toilet paper is not part of what you are buying when you rent a hotel room in Iowa, but the state considers it a gift. Those extra sales taxes come to about $1,800 per year.
Now on to Round 2. This little hotel also pays about $3,000 a year in various licenses and fees. Payroll taxes come to about $60,000. The federal government says the depreciable life of a hotel is 39.5 years, but we refurbish the hotel on a constant basis and pay sales tax on related purchases, such as new carpet, mattresses and bedding, and even paint. Anyone who doesn’t believe we already have a partial value-added tax (VAT) like Europe, isn’t in business. Now, between Round 1 and Round 2, we’re at $548,000 in taxes annually.
So, even if we don’t make a dime of profit, and before we pay the mortgage to the bank or buy new stuff, we pay $548,000 in various taxes, licenses and fees.
As Whalen points out, this tax burden doesn’t include state or federal income taxes. Those taxes are going up. And the alternatives aren’t pretty either:
…if I sell the hotel, I’ll pay a hefty capital gains tax of 25 percent, and it’s probably going up. Alternatively, when my wife and I die, I’ll pay another 45 percent if the estate tax returns in 2010. But don’t worry: We have diverted money from productive investments to pay for life insurance to partially pay this bill.
A central question to any economy is, “Where are tomorrow’s jobs going to come from?” A small hotel in the Midwest may not immediately come to mind as part of the answer, but ask folks in Iowa whether those jobs are important. And then ask yourself whether the tax changes just enacted, coupled with those on the horizon, are going to make it easier or harder for Mike and other entrepreneurs to take risks, invest in properties like a limited service hotel, and create jobs. The answer is pretty obvious.
Whither Tax Rates?
Following the release of the S Corporation Association letter on the new 3.8 percent tax and its impact on future tax rates, we got into a back and forth with a reporter over what is the appropriate baseline for measuring future rates.
We used a current law baseline, which is the same baseline the Congressional Budget Office and the Joint Committee on Taxation use when making their estimates. Under current law, for example, the tax rate on dividends is scheduled to rise from 15 percent today to 39.6 percent next year to nearly 45 percent in 2013 when the new 3.8 percent tax kicks in. That’s three times the current tax!
The reporter, on the other hand, suggested it would be more appropriate to use President Obama’s proposals as the correct baseline. Under the President’s plan, the top rate on dividends would rise to 25 percent in 2013 based on his proposal to tax capital gains and dividends at a 20 percent base rate. Here’s a comparison of the two baselines and their respective rates:
| Top Marginal Tax Rates in Future Years | ||||
| 2010 | 2011 | 2013 | ||
| Current Law* | ||||
| Capital Gains | 15% | 21% | 25% | |
| Dividends | 15% | 41% | 45% | |
| Interest Income | 35% | 41% | 45% | |
| Obama Budget | ||||
| Capital Gains | 15% | 21% | 25% | |
| Dividends | 15% | 21% | 25% | |
| Interest Income | 35% | 41% | 45% | |
| * Current Law and Obama Budget include the phase-out of itemized deductions (Pease) | ||||
Unless you’re actually working for the White House or OMB, using the President’s budget proposals as the baseline requires a certain amount of faith — faith he will press for those proposals, faith the Congress will pay attention, faith other priorities will not get in the way. The President’s budget does call for a statutory rate of 20 percent for 2010 and beyond, but most observers are betting rates of 28 percent or higher are more likely.
But that’s all beside the point. As the chart demonstrates, tax rates on investment are going up sharply regardless of which baseline you use.
More on the Investment Tax and S Corporations
Our Google Alert did its job and alerted us to another website devoted to S corporations – www.scorporationsexplained.com. It appears they too are concerned about the new 3.8 percent tax on investment income and S corporations. As web author Stephen Nelson explains, even S corporation shareholders active in the business may end up paying this tax on some of their S corporation income:
Once a taxpayer’s income exceeds the threshold amount, investment income gets hit with the tax. But it’s important to note that investment income earned inside an S corporation retains its character as the income flows through to investors. This means that even working shareholders may pay the new Medicare tax on the chunk of the S corporation’s profit that occurs because of interest, dividends, capital gains, or rental income earned by the S corporation.
Example: Your share of an S corporation’s profit is $100,000 but only $80,000 of this $100,000 represents profits from the business operation. The remaining $20,000 of profit comes from dividends, interest and capital gains earned on investments held by the S corporation. In this case, no matter whether you’re a working shareholder or a passive shareholder, you’ll pay the Obamacare Medicare tax on the $20,000 of investment income that flows through to you if your income exceeds the threshold amounts.
This result suggests the new tax may be more expansive than it appeared at first glance, especially for mature S corporations that control more than one entity.
The Skinny on the Jobs Bill
So we’re still trying to figure out what happened between Thursday morning and Thursday afternoon last week.
On Thursday morning, the Senate Finance Committee released an $84 billion “Jobs” bill draft with all the expected items included — jobs provisions, tax extenders, unemployment and COBRA extensions, etc.
That same afternoon, Senator Reid rejected that approach and offered a “skinny” $15 billion bill instead. He called up the House-passed Jobs bill, offered his skinny package as an amendment, filled the amendment tree, and filed cloture on the new package. The skinny bill includes the Schumer-Hatch payroll tax credit, Section 179 expensing relief, Build America Bonds, and an extension of the Highway bill authority until the end of the year.
What happened? A couple of explanations are floating around town. The first version is Senator Reid got an earful over the contents of the Senate Finance bill and its “Christmas Tree” appearance and elected to go with a less costly approach. Version two is that Reid was unhappy with Senator McConnell’s willingness to allow the bipartisan bill to move forward and introduced the skinny package in response. Version three is that this has been the plan all along — to introduce and pass a series of more narrow, jobs oriented bills. Version two got a plug from the White House. As CongressDaily reported:
White House Press Secretary Robert Gibbs said the president is “eager to sign” the jobs bill as pared down by Reid, and he called its provisions “very akin to what the president had in mind,” adding there will be more bills to refine the jobs strategy.
Either way, the Senate is set to vote on closing out debate on the smaller bill next week when the Senate next reconvenes. As always, cloture requires 60 votes for adoption.
Current favorite topic of speculation: Does Senator Reid have the votes? There is a lot of pent up support for extenders, UI and COBRA extensions, and some of the other provisions dropped in the move to the skinny bill, after all, and the Leader’s move left lots of Senate offices scratching their heads. As The Hill reported this morning:
But since he announced his smaller jobs bill, it has been under siege by Republicans and Democrats alike. Absent political arm-twisting by Senate leaders to bring their rank-and-file in line, opposition to the bill is expected to be bipartisan, sources said.
All of which suggests the Senate will eventually return to the larger, bipartisan package and the votes early next week are merely a diversion. We’ll see.
Finance Hearing on Small Business Taxes and Trade
The Senate Finance Committee has announced it will hold hearings on “Trade and Tax Issues Relating to Small Business Job Creation” next Tuesday. The witness list is TBD, but we understand someone from the U.S. Treasury Representative will testify, in addition to a couple of think tank folks and a small business or two. The hearing’s focus on trade is consistent with the Obama Administration’s new focus on increasing exports. As the President outlined in his State of the Union address:
Third, we need to export more of our goods. Because the more products we make and sell to other countries, the more jobs we support right here in America. So tonight, we set a new goal: We will double our exports over the next five years, an increase that will support two million jobs in America. To help meet this goal, we’re launching a National Export Initiative that will help farmers and small businesses increase their exports, and reform export controls consistent with national security.
If Congress and the Obama Administration are looking for ways to promote small business exports, the first thing they should do is embrace the current tax treatment of IC-DISC dividends. Two years ago, taxwriters in the House and Senate tried to eliminate the IC-DISC under the guise of making technical corrections.
This effort came despite the fact that small business exporting has been an unmitigated “good news” story in the midst of all the recent financial and economic turmoil. Small business exports are up and the IC-DISC helps. Small and closely held businesses who invest in the United States, create jobs here, and export products overseas can use the IC-DISC to help manage their tax burden.
With a major debate over the correct tax treatment of dividends and capital gains on the horizon, we expect the tax treatment of IC-DISC dividends will once again be before Congress. As such, we’re revamping our efforts to ensure the IC-DISC remains in place to help the next crop of small business exporters break into new markets overseas. Let us know if you’d like to help.
Jobs Bill on Senate Floor Next Week
Senate leadership has committed to taking up a Jobs bill next week. The details of the package are still being worked out, but the list released by the Senate Democrats includes:
- Job Creation tax credit
- UI and Cobra Extensions
- Bonus depreciation and 179 expensing
- Highway funding
- Build America Bonds
- SBA loans
- Export Promotion
- Some energy related tax items
Although it’s not mentioned, we do expect the tax extenders to also be part on the mix. On the other hand, an estate tax fix is not likely to be included. Senator Reid told reporters that he still plans to move legislation restoring the estate tax, just not now. Meanwhile, policymakers are increasingly worried that time is slipping by. As BNA reported earlier:
Proponents of making the estate tax retroactive to Jan. 1 say case history is on their side, although they admit it will be more complicated because the longer they wait to enact legislation, the more people will attempt to game the tax system.
We are not exactly sure how one would “game” the current system. You have to pass away, after all, to take advantage of the current rules. Final jeopardy, indeed. Takeaway: more chatter about getting something done, but no clarity on when they would do it, what it would look like, whether the House is on board with the retroactive application, or whether they have better guidance on the constitutionality question.
Also, we are hearing from folks that a possible solution would be to offer estates the option of using the 2009 rules or the repeal rules. Point of this would be to protect those mid-sized estates (around $7 million) from paying more under repeal than they would have under last year’s rules. That would certainly get around the retroactive question, but it would also raise the cost of acting.
Rep. Paulsen Weighs in on Marginal Rates
The battle over tax rates is heating up. This week, Congressman Erik Paulsen (R-MN) sent the President a letter asking him to focus on proposals that would hold down marginal tax rates and spur small business growth.
The letter refers to a bill introduced by Rep. Paulsen (H.R. 2284) in May that would allow individual taxpayers an exclusion from gross income for certain items of partnership and S corporation pass-through income up to $250,000 ($500,000 for married couples filing joint returns). As Rep. Paulsen notes, this ability to defer taxes on reinvested income “ensures that small business owners are taxed only on the profits taken out of their business, and also allows for the deferment of taxes on income that was placed back into developing their business. By encouraging reinvestment and incentivizing job creation, we can reach our shared goal of economic growth.”
Paulsen also discusses the possibility of creating “an alternative rate schedule for income stemming from small business activity, including sole proprietor, partnership, and S corporation income” in order to “ensure that marginal tax rates would not rise for America’s job creators during a weak economy.”
Amen to that. America has a vibrant, active Main Street business sector because past Congresses have proactively adopted policies to encourage small business creation and growth. Creation of the S corporation was one of those policies. Now is not the time to reverse course.
John Edwards and S Corporations
One of our allies asked us, “How did John Edwards come to be the poster child for S corporations?” He’s featured prominently in a recent CongressDaily story and, frankly, it’s not an association we’re eager to continue.
The Edwards issue first emerged during the 2004 presidential campaign when we learned that, prior to be elected, Senator Edwards operated his law practice as an S corporation. According to reports — recapped by CongressDaily — Edwards took most of his earnings in the form of S corporation distributions which are not subject to payroll taxes.
As you can imagine, this use of the S corporation caught everybody’s attention and the “John Edwards Issue” was born. We still hear “Oh, is this that John Edwards thing?” when we talk to staff about payroll taxes.
While the payroll tax issue continues to be difficult for policymakers and tax collectors alike, the rules governing when S corporation shareholders pay payroll taxes have been in place for long time. Since the IRS released Revenue Ruling 59-221 back in 1959, S corporation shareholders have been required to pay payroll taxes, but only if they work at their business and only on the wages they pay themselves. Revenue Ruling 74-44 made clear that “dividends” paid to shareholders will be recharacterized as wages when the dividends are in lieu of reasonable compensation for services performed for the S corporation.
Despite these clear rules, when Congress lifted the cap on the Medicare payroll tax back in 1993, it created an arbitrage opportunity for business owners whose income exceeds the Social Security wage base. Organize as an S corporation, pay yourself little or no salary, and avoid paying the Medicare tax.
The S Corporation Association’s position on this is three-fold. First, people should pay the taxes they legally owe — we don’t support tax avoidance. Second, while it is admittedly time-consuming, the IRS has the tools necessary to deal with this issue and collect the money owed. As the IRS wrote one taxpayer back in 2003:
Generally, under the rules described above, if a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services. An S corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed.
Third, every legislative proposal we have seen to date to “fix” this issue has been overly broad and would raise taxes on shareholders already fully complying with the law.
As we mentioned, applying the “reasonable compensation” standard is difficult and time-consuming, but the standard is well established and ensures that payroll taxes only apply to shareholder income derived from their services, as opposed to income stemming from their investments in the business and its employees. As you can imagine, capital-intensive industries like manufacturers and others are keenly interested in making certain this line of demarcation is preserved.
The GAO spent the last year looking into S corporations and the tax policy challenges they present. On the payroll tax issue, the GAO recognized that the IRS has the tools in place to enforce current law. Its recommendation:
To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed.
We understand the current rules are not a perfect solution to the “John Edwards Issue.” But then, nothing else is either. We hope the IRS follows the GAO’s recommendation and works to improve its guidance and enforcement of reasonable compensation. Effective enforcement would take the pressure off policymakers to codify new rules, and remove from the S corporation community the threat that fifty years of tax policy will be turned on its head.
Business Community Rallies Around S Corporation Modernization
Last week, your S-CORP team sent a letter signed by 22 of our association allies to members of the House and Senate, urging them to cosponsor legislation to replace the dated rules that have governed S corporations for over fifty years. As the letter notes:
These outdated rules hurt the ability of S corporations to grow and create jobs. Many family-owned businesses would like to become S corporations, but the rules prevent them from doing so. Other S corporations are starved for capital, but find the rules limit their ability to attract investors or even utilize the value of their own appreciated property.
Well into the 21st century, America’s most popular form of small-business corporation deserves rules adapted to today, not fifty years ago. The S Corporation Modernization Act would ensure the continued success of these businesses.
Earlier this Congress, House Ways and Means Member Ron Kind (D-WI) and Senate Finance Committee Members Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) introduced the “S Corporation Modernization Act of 2009” (H.R. 2910 and S. 996) in their respective chambers.
The legislation, designed to update and simplify the rules governing S corporations, enhances the ability of S corporations to attract and raise capital, makes it easier for family-owned S corporations to stay in the family, and encourages additional charitable giving by S corporations and the trusts that hold them.
In the coming weeks, S-CORP will be ramping up its efforts to gather additional support for these bills. At a time when America’s job creators struggle through the difficult economy and the Federal government struggles with massive deficits, smaller, targeted reforms like these are an attractive means of helping Main Street without breaking the bank.
Health Care Reform Outlook & S Corporations
Just about everybody agrees the political landscape has shifted to the point where, while there were once 218 House votes in favor of a reform package, now there are nowhere near that many.
This lack of support is evidenced by the Rube Goldberg-nature of the current efforts to resurrect reform and move it through the Congress. One popular idea is for the House to pass the Senate bill, and then take up a reconciliation package of items to “fix” what’s wrong with the Senate bill.
We are skeptical anything like that happens. Health care reform is unpopular and members are nervous and tired. Moreover, this approach would require House members to “vote on faith” that the Senate would follow-through and adopt the fix. There is rarely a lot of trust between House members and the Senate under normal circumstances, and these are not normal circumstances.
Our expectation is for the hand-wringing to continue for a month or so and then for other pressing items like the jobs bill and the budget to push heath reform aside.
For S corporations, it is hard to regret the demise of this particular reform effort. We have refrained from weighing in on the merits of health care reform — it is a little outside our focus, after all — but the impact of paying for health care reform was clearly going to be a negative.
The House bill would have raised marginal rates on upper-income S corporation shareholders by 5.4 percentage points, while the Senate bill would have increased the Medicare HI tax from 1.45 percent to 2.35 percent — not a direct shot at S corporations, but it would have increased pressure on the IRS and others to change the payroll tax treatment of S corporation income.
And before talks broke down, House and Senate negotiators were seriously considering tossing out those items and expanding the tax base for payroll taxes to include capital gains, dividends, interest income, and S corporation income instead. As the Los Angeles Times wrote:
Democratic congressional leaders are considering a new strategy to help finance their ambitious healthcare plan — applying the Medicare payroll tax not just to wages but to capital gains, dividends and other forms of unearned income. The idea, discussed Wednesday in a marathon meeting at the White House, could placate labor leaders who bitterly oppose President Obama’s plan to tax high-end insurance policies that cover many union members. It could also help shore up Medicare’s shaky finances, and the burden of the new tax would fall primarily on affluent Americans, not the beleaguered middle class.
It would have fallen on the beleaguered S corporation community, too. Moreover, these increases were going to take place when taxes on S corporations (and other flow-through businesses) already were going up. Current law has the top income tax rate returning to 39.6 percent at the beginning of next year, and we anticipate the President will propose to keep these rate hikes in place, at the very least.
Finally, with health care reform out of the way, taxwriters on the Hill will have time to address some of the many tax items that were pushed aside last year, including tax extenders and a broader tax reform effort. As BNA noted this morning:
Last December, Rangel told a group of executives that he planned to press his case for tax reform at the conclusion of the health care debate.
It appears health care reform is over, so we expect Congress to refocus on tax policy this year.
Senate Jobs Bill First Out of the Chute
With health care reform in a state of political limbo, Senate leadership is busy assembling a job-creation package that is likely to be the chamber’s next significant legislative effort.
Just before Christmas recess, the House hastily assembled and adopted a $154 billion spending package. In response, the Senate Finance Committee is working on a package that focuses more on tax relief than the House counterpart. As reported by Dow Jones:
The package would be paid for largely by re-directing funds that were available for the government’s bank bailout program, according to an outline dated Friday of possible measures being considered for inclusion in the bill.
The Senate document put the total cost of economic stimulus measures in the bill at $82.5 billion. A Senate Democratic aide cautioned that the document doesn’t reflect the most recent conversations among leaders about the plan, and some elements may change considerably.
A broad outline pitched to the Democratic conference today included pension relief, SBA lending provisions, energy efficiency tax credits, export promotion (IC-DISC users take note) and a proposal that would “provide a tax credit for between 10%-20% of increased payroll—to encompass both hiring of new workers and increasing part-time workers to full-time status.”
Tax policy veterans should recognize the employment tax credit idea from years past. Among others, Senator Kerry offered something similar as part of his Presidential platform in 2004. The proposal has been always been viewed skeptically, however, over concerns that it is poorly-targeted and only rewards those businesses that would hire new workers anyway.
Regarding timing, it’s still up in the air but we anticipate a Finance Committee markup in the next two weeks followed by floor consideration after the President’s Day holiday.
So what are your S-CORP takeaways? First, there’s an incredible amount of pent-up demand for tax policy in the Senate, and we expect this legislation to open the floodgates. It’s a tax vehicle, after all, so how can Chairman Max Baucus and Majority Harry Leader Reid keep extenders, energy tax incentives, and (perhaps less so) an estate tax fix on the sidelines once it starts moving?
Second, lots of other items are likely to catch a ride as well. Extended UI and Cobra benefits expire at the end of February, as does the temporary Doc Fix for Medicare payments. The timing of this package suggests those provisions stand a good chance of being included.
Finally, expect lots of message amendments regarding the expiring Bush tax relief. It all goes away at the end the year, after all, and none of the provisions listed above address this underlying policy challenge.
CBO Updates Budget Outlook
The CBO issued its outlook for 2010-20 today. Here’s the CBO on the short-term outlook:
CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest. Moreover, if legislation is enacted in the next several months that either boosts spending or reduces revenues, the 2010 deficit could equal or exceed last year’s shortfall.
And the longer term outlook:
Under current law, the federal fiscal outlook beyond this year is daunting: Projected deficits average about $600 billion per year over the 2011–2020 period. As a share of GDP, deficits drop markedly in the next few years but remain high—at 6.5 percent of GDP in 2011 and 4.1 percent in 2012, the first full fiscal year after certain tax provisions originally enacted in 2001, 2003, and 2009 are scheduled to expire. Thereafter, deficits are projected to range between 2.6 percent and 3.2 percent of GDP through 2020.
And the impact on debt:
Under current law, the federal fiscal outlook beyond this year is daunting: Projected deficits average about $600 billion per year over the 2011–2020 period. As a share of GDP, deficits drop markedly in the next few years but remain high—at 6.5 percent of GDP in 2011 and 4.1 percent in 2012, the first full fiscal year after certain tax provisions originally enacted in 2001, 2003, and 2009 are scheduled to expire. Thereafter, deficits are projected to range between 2.6 percent and 3.2 percent of GDP through 2020.
And none of this includes the cost of health care reform, the so-called Medicare Doc fix, extending some or all of the Bush tax relief, the new stimulus provisions, or any of the other expiring provisions. Ouch.
With a deficit outlook like this, the Obama Administration is being pushed in two directions these days. They face demands to increase federal spending in the short run to help the economy while also being told they need to cut spending in the long-term to address the deficit and debt.
One way to deal with this conflict is to substitute smaller, less expensive proposals for the broad, macro reforms that have characterized the Administration’s agenda. President Clinton adopted this approach for many of his State of the Union addresses. As CNN reported after his 1999 address:
President Bill Clinton’s 1999 State of the Union address was classic Clinton. It was another long laundry list of proposals, some conservative, some liberal… Clinton’s 77-minute speech was so overflowing with proposals that by the time it ended it was almost hard to remember that Social Security was the first and most important proposal of the evening. In previous years, commentators criticized Clinton for this approach, complaining that the State of the Union should be more focused. But this year, most commentators simply gushed.
So did viewers, who typically gave Clinton’s annual State of the Union speeches higher marks than professional commentators.
President Obama’s proposal to increase the child credit is a worthy successor to the Clinton approach. The proposal would increase the value of the credit, but not as much as one might expect. It’s not going to be refundable, which means most families with children would not benefit until their incomes rise above $40,000 or so. And it’s capped, so families above a certain income level don’t get it either. Nonetheless, offering middle class families extra child care assistance sounds great in a speech.
Given the current economic and deficit picture, we expect tomorrow’s State of the Union address to place more emphasis on proposals like the child care credit expansion, and less on health care reform and cap and trade.
Estate Tax & PAYGO
Of interest to S-CORP readers, the bill to be considered by the House (H.R. 2920) specifically exempts four policies from the Paygo rules:
- Adopting the doctor payment fix proposed to Medicare;
- Extending the higher exemption levels under the Alternative Minimum Tax;
- Extending select tax cuts from the 2001 and 2003 tax bills; and
- Extending the 2009 estate tax rules to 2010 and beyond.
In other words, Congress is seeking to ensure it pays for any tax cuts or spending increases, except for the four policies listed above. As the Congressional Budget Office reported, “In effect, that rule would allow the Congress to enact legislation that would increase deficits by an amount in the vicinity of $3 trillion over the 2010-2019 period without triggering a sequestration.”
The theory behind the exemption is to allow Congress room to continue “current policy” in each of these areas. The $1000 child tax credit, for example, expires at the end of 2010. Extending the credit would reduce revenues by $243 billion over ten years. H.R. 2920 shields this cost and the cost of other similar policies from Paygo.
What does this signal for estate taxes? The policy exempted in H.R. 2920 is an extension of estate tax rules for 2009. As the bill outlines:
(B) with respect to the estate and gift tax, assume that the tax rates, nominal exemption amounts, and related parameters in effect for tax year 2009 remain in effect thereafter without change;
The exempted policy is consistent with the Obama Administration’s budget proposal and was scored by the JCT to reduce revenues by $243 billion over ten years. What doesn’t get exempted is any further reduction in the estate tax beyond the 2009 rules.
For example, Members have been working on a compromise that would lower the estate tax rate to 35 percent and increase the exemption to $5 million per spouse. That’s certainly better than the 2009 levels of 45 percent and $3.5 million but, under H.R. 2920, the increased revenue reduction from the compromise would need to be offset with tax increases elsewhere.
Where would Congress find offsets to a potential estate tax compromise? Both the Obama Administration and Congressman Pomeroy (D-ND) have proposed targeting family businesses for higher taxes by inflating the value of their estates. Exactly how much revenue this would raise is unclear, but family businesses need to be on alert.
A package that lowers rates below 2009 levels while inflating the tax base has the potential to raise, not lower, estate taxes on family-owned enterprises and may be no compromise at all.
Do Small Businesses Really Create All Those Jobs?
A recent paper by Alan Viard at the American Enterprise Institute raises two fundamental questions: Are smaller firms responsible for creating a majority of new jobs in our economy and is there a bias towards smaller firms in the tax code? With small businesses at the epicenter of the debate on reforming our health care system, clearing the record on these questions is critical.
The “small businesses do not really create all those jobs” argument has been around for a long time. However, it is usually raised by folks with a history of supporting Big Government and Big Business. Thus, having someone with Alan’s background on the other side is a new twist.
Regardless of who asks the question, however, the answer is the same. Yes, small businesses really do create all those jobs. Here’s what the Small Business Administration’s (SBA) Office of Advocacy writes:
Since the mid-1990s, small businesses have created 60 to 80 percent of the net new jobs. In the most recent year with data (2005), employer firms with fewer than 500 employees created 979,102 net new jobs, or 78.9 percent. Meanwhile, large firms with 500 or more employees added 262,326 net new jobs or 21.1 percent.
Critics argue that this analysis suffers from several flaws, including how to best classify firms using longitudinal data. For example, if a firm begins at 450 employees and grows to 550, the SBA says that’s 100 jobs created by small business. But if the same firm shrinks from 550 to 450 employees the next year, it’s a loss of 100 jobs for big business. Classifying the firm based on its initial size biases the results in favor of smaller firms.
But seriously, how many firms “cross the threshold” each year? There simply are not that many firms with more than 500 employees. Adjusting for these instances may move some numbers around, but the basic tenet remains intact — businesses employing fewer folks create most of the new jobs and policymakers should pay attention.
A study from the Bureau of Labor Statistics adjusting for these statistical challenges found that firms with fewer than 500 employees created about 80 percent of net new jobs. Enough said.
The question of whether the tax code is biased towards small businesses is more difficult. The tax code, after all is incredibly complex and it does include numerous provisions — like Section 179 — targeted to help smaller enterprises. How do you tally up all the variables?
S-CORP readers may remember Dr. Viard from the LIFO debate. Alan pointed out that, if LIFO accounting is an undeserved tax windfall, why is the effective tax burden under LIFO similar to that tax burden shouldered by other forms of capital investment? How could it be a windfall if the tax burden is the same?
The same approach may work here as well. If the tax code is too small business friendly, then the effective tax burden on S corporations, partnerships, and sole proprietorships should be lower than for other taxpayers. But a study commissioned by the Small Business Administration found that the effective tax burden for small businesses (including small C corporations) in 2004 was 19.8 percent, or 3.5 points above the average for all taxpayers that year. S corporations, by the way, faced the highest effective rate of 26.9 percent.
Moreover, limiting the analysis to income and payroll taxes does small business a disservice. Home Depot doesn’t worry about the estate tax, the family-owned lumber yard down the street does. And studies show that the burden of federal regulations falls more heavily on smaller firms than larger ones.
Finally, we believe Alan’s argument misses a broader point. Your S-CORP team is not comprised of legal theorists, but we do recall that government grants corporations the same legal status as individuals in order to encourage their creation and economic growth. Corporations can enter into contracts and appear in court. Perhaps most importantly, the owners of corporations are shielded from liability.
The S corporation was created, in part, to counter the advantage the corporate structure gives to larger firms. The idea behind the S corporation was to allow smaller firms to thrive by extending some of the essentials of the corporate structure without the onerous tax rules. But S corporation rules also limit their ability to grow and raise capital. They limit the number and type of shareholder and they limit how the firm can be structured. How do these rules enter into the question of bias in the tax code?
The bottom line is that the effective tax rate on small businesses is higher than the rate for taxpayers in general. Given that reality, it’s difficult to see how small businesses are somehow advantaged. If Congress wants to help larger businesses by cutting the corporate rate, we’re all for it. But don’t forget who creates most of the jobs out there. It’s small business, and during economic downturns, the role they play is more important than ever.
S Corp Modernization Introduced in the Senate!
Good news for S corporations! S-CORP allies Senator Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) today introduced the “S Corporation Modernization Act of 2009.” This legislation is similar to bills offered in previous Congresses and includes many of our Association’s priorities for the year. In a statement accompanying the bill, Senator Lincoln noted:“A strong economic recovery will depend on the health and strength of our small business sector,” Lincoln said. “Over four million of our small businesses across the nation are organized as S corporations, including more than 40,000 in Arkansas, and at least 60 percent of the new jobs created over the last decade have come from small businesses. Congress has not updated many of the rules governing S corporations, and as a result many privately-held businesses are not ideally positioned to deal with the current downturn in the economy. We must modify our outdated rules so that these businesses that are starved for capital have the means to expand and create jobs.”
The bill is designed to update and simplify S corporation rules — some that date back 50 years — to make it easier for these small and closely-held businesses to raise capital and compete in a difficult economy. The “S Corporation Modernization Act” would:
• Enhance the ability of S corporations to attract and raise capital;
• Make it easier for family-owned S corporations to stay in the family; and
• Encourage additional charitable giving by S corporations and the trusts that hold them.
The whole S-Corp team thanks Senators Lincoln and Hatch for continuing their support of America’s small and closely-held businesses and we look forward to working with them to get these important reforms enacted into law this Congress!
More S Corps than Ever!
Just in time for our advocacy of the S Corporation Modernization Act, our friends at Statistics of Income have published their taxpayer Data Book for 2008 and guess what?
For 2008, there were nearly 4.4 million S corporations, an increase of more than 300,000 firms from 2007 and 1.7 million more than just 10 years ago.
Now if the SOI folks would only update their more in-depth “S Corporation Returns” study, we could dive into these numbers and get a better sense of the source of this growth. The most recent study is from 2003, and newer analysis is long overdue.
Obama Administration’s Tax Hikes
This week President Obama released the details of his proposals to raise taxes on multinational corporations. The two main components of the plan are new limits on deferral and the foreign tax credit and additional enforcement tools targeted at overseas “tax havens.”
Reaction on Capitol Hill was somewhat underwhelming. Senate Finance Committee Chairman Max Baucus (D-MT) referred to the proposals as “controversial,” and noted, “We’ll look at it. I don’t know how much is going to be enacted this year.” Despite this less than glowing review, we do expect some form of the President’s proposal to move through the Congress this year — their need for new revenues is just that strong.
What about S corporations? These proposals do not directly affect S corporations, but they are a worrisome indicator of the Obama Administration’s overall approach to business taxation. This Administration is looking to the business community to raise the tax revenues. During his press conference yesterday, Obama decried the “broken tax system, written by well-connected lobbyists on behalf of well-heeled interests and individuals. It’s a tax code full of corporate loopholes that makes it perfectly legal for companies to avoid paying their fair share.”
But businesses don’t pay taxes — people do — and the burden of raising taxes on corporations will fall primarily on the workers of those companies. Capital can and does move from one country to the next. For workers, it is just a little more difficult. It’s more difficult for S corporations too.
Small Business Exporters to the Rescue
In a bit of good news, the new trade numbers came in and are in line to add 1.8 percent to the GDP in the second quarter. That, and stronger than expected retail sales numbers, should result in GDP growth of more than 2 percent in the second quarter, putting another dent in public perception that we are in the midst of a recession.
The explosion of exports over the past couple of years is an under-reported story. Exports are up nearly 18 percent in just the last twelve months and almost single-handedly kept the economy from contracting in the past two quarters.
When your S Corporation Association team began working on small business issues two decades ago, the existence of small business exporters was widely doubted. Small businesses simply did not have the resources to access overseas markets.
Today, thanks to the information age small businesses make up the heart and soul of the exporting community. According to our allies over at the Small Business Exporters Association, 97 percent of exporters are small and medium-sized and their ranks have more than tripled since 1987.
In this environment and with exporters literally carrying the rest of the economy on their backs, it makes less sense than ever for Congress to raise tax rates on small exporters. The S Corporation Association and its allies continue to fight efforts to eliminate the IC-DISC and the assistance it provides to America’s exporting community. Today’s trade numbers are just a reminder of how important a fight it is.
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