The headline says it all. The long-awaited Volcker Tax Reform Commission report was released last Friday and was immediately put on a shelf someplace in the basement of the Ways and Means Committee. According to the Commission members:
The Board was asked to consider various options for achieving these goals but was asked to exclude options that would raise taxes for families with incomes less than $250,000 a year. We interpreted this mandate not to mean that every option we considered must avoid a tax increase on such families, but rather that the options taken together should be revenue neutral for each income class with annual incomes less than $250,000.
In general, the report’s authors sought to provide “helpful advice to the Administration” on “options for changes in the current tax system to achieve three broad goals: simplifying the tax system, improving taxpayer compliance with existing tax laws, and reforming the corporate tax system.” The Board was not asked to consider major tax reforms.
Just how helpful this advice is remains to be seen, but the low-key manner in which the report was released suggests the Administration does not see the report itself as a useful message vehicle. Proposals to raise taxes seldom are.
For S corporations, two recommendations stand out:
Payroll Tax Provision: The report suggests that payroll tax policy could be changed so that all active S corporation shareholders, LLC members and limited partners pay payroll taxes on all distributions from their businesses. Under the heading of “Disadvantages”, the report states:
The revenues raised from the proposal would come primarily from owners of small businesses. Moreover, it would impose employment taxes on income that is partially a return on capital rather than a return on labor.
Our point exactly.
Business Structure Neutrality: As a part of corporate tax reform, the report states that “a goal of reform in this area is tax neutrality with respect to organizational form” including these two options:
One option would be to require firms with certain “corporate” characteristics—publicly traded businesses, businesses satisfying certain income or asset thresholds, or businesses with a large number of shareholders—to pay the corporate income tax. In effect, this would broaden the corporate tax base by applying the corporate tax to more businesses….
An alternative option would eliminate the double taxation of corporate income and harmonize tax rates on corporate and non-corporate income through “integration” with the individual income tax. In one example of such a system, individual investors would be credited for all or part of the tax paid at the corporate level against their individual taxes.
In other words, you could harmonize the tax treatment of business income by either imposing the corporate tax on more entities or by reducing the double tax currently paid by C corporation shareholders. Again, the disadvantages of option one highlighted by the Commission speak volumes:
Achieving neutrality between corporate and non-corporate businesses by subjecting more businesses to the corporate tax would increase the cost of capital and thus decrease investment in those businesses.
More on Pending Tax Hikes
Our friends on the Hill pointed out a new survey of the National Association of Business Economists membership on the pending tax hikes. The survey found that more than half of NABE economists support extending all the marginal tax rates (including the upper brackets) while six out of ten support keeping the rates on capital gains and dividends at 15 percent. Other interesting results:
- Three quarters support promoting economic growth over reducing the deficit;
- Three quarters oppose further fiscal stimulus; and
- A large plurality support “clarity on future regulation and tax policy” over other ways in which the government can best “encourage increased employment.”
We are hearing this last point repeatedly these days — the best thing Congress can do is provide a little policy certainty to the markets. Congress is not doing the things it is supposed to (budgets, tax extenders, etc.) while it is considering and adopting dramatic changes to rules by which businesses relate to their employees, their customers, and their government. Markets do not like uncertainty, yet the current policy climate here in D.C. is rife with it. CNN points out that in the area of tax policy alone, more than 100 tax relief provisions affecting just about everybody are waiting to be extended.
Finally, on the National Commission on Fiscal Responsibility and Reform, four out of five respondents did not believe the Commission would produce a credible plan that could pass Congress. On that one, we’re not so sure. A growing number of smart folks around town are suggesting the Commission may be the best chance we have in the next couple years to get the federal deficit under control. Maybe; but either way, we’re guessing that report won’t be released on a Friday.
After reappearing briefly last week, the latest version of the tax extenders package (Baucus IV) has now disappeared. The plan was for the latest version to garner sufficient support and then be attached to the small business tax bill, but the small business bill was pulled, ending the chances of the extender package getting adopted before the August break.
That means all those tax provisions that expired at the end of last year, including the R&E tax credit and the state sales tax deduction, will have to wait until September at the earliest before getting another shot. That’s too bad, as it now appears the package has the votes to move through the Senate.
As we noted last week, one of the modifications Chairman Baucus made to the package was to eliminate the S corporation payroll tax provision. Dow Jones reported this on Friday:
Senate Finance Committee Chairman Max Baucus (D., Mont.) has removed a controversial proposal that would force lawyers, accountants and other professionals to pay more in payroll taxes from a broader bill to extend expired tax cuts. The payroll tax provision, which would have raised $9 billion to help pay for tax cut extensions, had drawn strong criticism from business advocacy groups and Republicans including Sen. Olympia Snowe (R., Maine).
Coupled with other changes, striking this provision should give Baucus the 60 votes he needs to move forward. We will find out in September.
On the small business bill, negotiations continued over the weekend and there’s a very slight chance the bill could come back up before the end of the week. As CongressDaily reported yesterday:
This week will determine if the chamber passes the small-business bill, which stalled last week in a dispute over amendments. Reid on Thursday urged members to “cool down” over the weekend as aides said they hoped for a deal that would set up a quick series of votes and passage of the bill by Wednesday. Republicans have sought votes on four amendments, while Reid last week offered three. Aides said completion could wait until September if they do not reach a deal, which will have to include Republican agreement to limit debate time.
Majority Leader Reid would also need to find extra time in a very crowded week. He intends to take up three other controversial matters before Friday — the Kagan nomination, extra money for states under FMAP, and competing energy bills designed to respond to the Gulf oil spill. All of these items will likely be debated at length, so fitting in yet another bill would be a challenge. With the tight calendar, we’re expecting this issue to get kicked into September as well.
Small Business and 1099 Reporting
Some good news on the small business paperwork front: a majority of House members support repealing from the health reform bill the 1099 reporting requirement that has the small business community up in arms. CNN Money has a nice summary of what’s at stake:
Right now, the IRS Form 1099 is used to document income for individual workers other than wages and salaries. Freelancers receive them each year from their clients, and businesses issue them to the independent contractors they hire.
But under the new rules, if a freelance designer buys a new iMac from the Apple Store, they’ll have to send Apple a 1099. A laundromat that buys soap each week from a local distributor will have to send the supplier a 1099 at the end of the year tallying up their purchases.
The bill makes two key changes to how 1099s are used. First, it expands their scope by using them to track payments not only for services but also for tangible goods. Plus, it requires that 1099s be issued not just to individuals, but also to corporations.
Taken together, the two seemingly small changes will require millions of additional forms to be sent out.
One item that caught our eye was the revenue estimate. The Joint Committee on Taxation believes repealing this paperwork mandate would reduce revenue collections by $2 billion per year! Since filing 1099s does not increase tax levies by itself, the JCT is assuming the IRS will be able to use the payment information to increase enforcement and collections. We’re skeptical. It’s just as likely that collecting, organizing, and putting to use the millions (billions?) of new 1099s would cost the federal government more than it saves.
But back to the good news. Last Thursday, House leadership pulled legislation from the House floor rather than lose a vote on repealing this 1099 requirement. Then on Friday, leadership attempted to adopt this provision with $20 billion in offsetting tax hikes, but failed again to garner the requisite votes. Apparently a sufficient number of House members recognized that trading a poorly-conceived paperwork mandate for higher taxes was not in fact a good bargain and should be rejected.
So there’s hope yet for the small business community. A majority of House members recognizes that imposing yet another paperwork requirement on Main Street businesses is a bad idea and should be repealed. Let’s hope House leadership listens to its members and lets them vote on a clean repeal.
More on Extending Tax Rates
The debate over extending tax rates also is getting kicked into September, but the rhetorical battle is heating up now. The Washington Post in particular is staking out the “let’s tax the rich” position. The paper’s online “Research Desk” feature highlighted the following question from reader Ross Cohen:
Republicans keep fighting for the Bush tax cuts with a talking point about small business owners filing as individuals. I’ve heard 50 and 75% quoted as the number of $250k filers that are actually small businesses. Any truth to this? It seems to be their strongest case against letting the cuts expire.
Post researcher Dylan Matthews responds:
As far as I can tell, this argument originated with Grover Norquist in this column. Norquist cites IRS data to say that two-thirds of income from sole proprietorships, partnerships and S corporations was reported by filers making over $250,000 a year. Although true, this is almost totally irrelevant. Norquist looks at the proportion of income, not filers, which inevitably results in a bigger portion for high-earners.
Really? The only source the Post researcher could find was Grover Norquist? We agree with Grover on this issue and many others, but he does tend to be a lightning rod. Had Ross asked S-CORP his question, here are a couple citations we would have provided him with:
The Joint Committee on Taxation projects that $1 trillion in business income will be reported on the individual income tax returns in 2011. Notably, of that $1 trillion, nearly one-half, $470 billion, will be reported on returns that will be subject to the top two rates of 36 percent and 39.6 percent if EGTRRA and JGTRRA are allowed to sunset.
Top bracket taxpayers received a disproportionate share of flow-through business income and paid an even larger share of the tax on it; taxpayers in the highest two tax brackets made up 8 percent of all taxpayers receiving any flow-through income or loss, but they received 72 percent of the net flow-through income and paid 82 percent of the taxes on this flow-through income (Table 3.3).
The Joint Committee on Taxation and the United States Treasury are good sources, no? Moreover, how many of our Washington Wire readers noticed that Dylan misread the question? The question asked what percentage of high-rate taxpayers own small businesses. There’s a lot of good data out there, too, including this one:
Because flow-through income is concentrated in the top tax brackets, the reductions enacted in 2001 and 2003 in the highest two marginal income tax rates have important consequences for the recipients of this income – typically owners of small and entrepreneurial businesses. For 2007, the Treasury Department estimates that about 75 percent of the taxpayers who will benefit from lowering the top rate from 39.6 percent to 35 percent are flow-through business owners, and that 84 percent of the tax reduction from the top rate reduction will go to flow-through business owners.
So, to summarize: yes, Ross, it is true that small businesses are overrepresented among taxpayers who pay the top two income tax rates, and those businesses will see their tax rates go up under the pending tax increases.
Finally, why is it irrelevant that a large percentage of business income — somewhere between one-quarter and one-third of all business income — is taxed at the top two rates? From our perspective, that is the heart of the issue. If a single taxpayer is responsible for a large amount of economic activity and employment, raising his or her taxes in the middle of a weak recovery makes little sense.
As the Tax Foundation noted several years ago:
So why should we pay attention to the way our tax code treats small businesses? They are an important source of innovation and risk-taking, creating between 60 and 80 percent of net new jobs, employing over half the labor force, and generating more than one half of the nation’s gross domestic product. Higher income tax rates reduce the investment spending of entrepreneurs and the likelihood that they invest at all, discouraging the growth or expansion of small businesses.
If you watched the Senate floor yesterday, you might be under the impression that nothing was happening. The Senate spent most of the day in a Quorum Call (Senate code for nothing happening), and when a member did take the floor, often it was to speak about something other than small business taxes.
Ah, but still waters run deep, don’t they. Behind the scenes, two efforts were taking place. First, Leaders Reid and McConnell were continuing their back-and-forth over whether Reid would allow any amendments to the underlying small business tax bill and, if he did, what those amendments would be. McConnell’s office sent around the list of eight amendments he was asking for, including amendments to:
- Repeal the new 1099 requirements starting in 2012;
- Extend for one year the R&D tax credit;
- Extend the expired biodiesel fuel tax credit; and
- Fix the current estate tax mess.
Later yesterday evening, Senator Reid offered a shorter list of both Republican and Democratic amendments — each side would get three so-called side-by-side amendments. McConnell objected to that request. Reid then objected to McConnell’s longer list, and we’re back at square one.
Meanwhile, Finance Chairman Max Baucus has spent the last couple weeks working with key members to revise his tax extenders package. His staff sent around a list of proposed changes yesterday evening, and he is expected to release Baucus IV sometime later today.
Good News Alert: We believe the S corporation payroll tax provision has been dropped!
So what’s going to happen? The Senate is scheduled to vote on ending debate on the small business tax package (Reid amendment #4519) — without Baucus IV or other amendments — this morning. As BNA is reporting:
Absent an agreement, Senate Majority Leader Harry Reid (D-Nev.) said the chamber would vote early July 29 on one cloture motion on a substitute amendment (S. Amdt. 4519) and one on the underlying bill. “We reached an impasse here,” Reid said late July 28 after he and Minority Leader Mitch McConnell (R-Ky.) traded potential agreements on the floor and then disagreed to both.
The motion to end debate would need 60 votes to prevail, and Democrats are telling folks they don’t expect to succeed. We’re not so sure, but we’ll find out shortly. If the vote does fall short, the whole issue will likely get kicked into September.
Last night, the Senate voted 60-39 to close debate on a Landrieu amendment to restore the $30 billion lending facility to the small business bill. This amendment was made necessary because earlier in the week, the leadership had dropped the lending facility due to staunch opposition from key swing votes.
The Senate is now on an unrelated bill, but we expect it to resume debate on the small business bill sometime next week – which will likely push House consideration of the bill into September. What’s the prognosis? Here’s the S-CORP Crystal Ball:
- Progress on the bill had been slowed by two points of contention: opposition to the lending facility, and demands (mainly by Republicans) to offer amendments on the estate tax and other tax items. The 60 votes in support of the lending provisions should put an end to that debate. The Senate has worked its will and members will likely move on, at least until negotiations take place between the House and the Senate.
- The next step will be a cloture vote on the Baucus Substitute. This is the tax portion of the bill that includes some very good provisions, including the bonus depreciation and built-in gains relief. There’s a good chance the first attempt to get cloture will fall short, with Republicans holding together in an effort to get votes on key amendments; they support the tax provisions, but want their amendments, too.
- At that point, our crystal ball gets fuzzy. We could end up with an agreement for one or two key votes and then final passage. Or the Leader could continue to block any additional amendments and try one last time to get cloture.
With two weeks left in the session, the Senate has two “must pass” items: the Kagan nomination and the small business bill. Getting both done is doable, but it’s going to require a concerted effort. With all of the bad policies on the horizon for small businesses, a friendly package of tax provisions would be a welcome respite. Here’s hoping the Senate succeeds in moving this bill.
Future of Expiring Tax Cuts: Update
Lots of conflicting news this week on future of the expiring tax cuts:
- “Democrats are considering a plan to delay tax hikes on the wealthy for two years because the economic recovery is slow and they fear getting crushed in November’s election.” The Hill, July 22nd.
- “In a speech on the economy and jobs, House Majority Leader Steny Hoyer (D-Md.) on Friday reiterated his party’s call to extend the Bush middle-class tax cuts and deemed Republicans’ call to extend breaks for the wealthy a ‘mistake [that] would be putting ourselves even deeper into debt.’” The Hill, July 22nd.
- “Senate Finance Committee Chairman Max Baucus (D., Mont.) is eyeing September for possible committee action on extending individual tax cuts that are scheduled to expire at the end of the year, according to Senate aides. Baucus held a meeting with Republicans and Democrats on his committee Thursday evening to begin discussing how to deal with the approaching expiration of the tax cuts. Baucus raised the possibility of a September committee vote, people present said. Aides cautioned that no conclusions about what to do or when to do it were reached at the meeting.” Dow Jones, July 21st.
- “Sen. Kent Conrad (D., N.D.), a senior Senate Democrat with influence over tax and budget policy, said Wednesday that Congress shouldn’t allow taxes on the wealthy to rise until the economy is on a more sound footing. Conrad told Dow Jones Newswires in an interview outside the Senate chamber that Democrats should cancel plans to let the top individual income-tax rates and capital-gains rates rise for the wealthy at the end of this year. He said a tax increase might imperil an economy already weakened by the effects of persistent unemployment and turmoil in European debt markets.” Dow Jones, July 21st.
So, the future of tax policy is clear as mud. What are the possible outcomes for the expiring tax cuts?
- Congress does nothing and all the tax cuts expire;
- Congress adopts a temporary (one- or two-year) extension of the middle class tax relief; or
- Congress adopts a temporary extension of all the tax relief.
It’s not intuitive, but we believe the second option — Congress extends the middle class tax cuts only — is the least likely outcome. It’s counterintuitive because that is the preferred policy of the leadership in Congress and the Obama Administration. It’s least likely because it will be hard for leadership, especially in the Senate, to cobble together the necessary votes. Republicans are likely to oppose en masse, and deficit hawk Democrats will object to the cost.
On the other hand, a one-year extension of all the tax cuts could carve out super majorities in both the House and the Senate, but that would require congressional leadership to move a bill over the objections of a significant portion of their conference. They might, but they haven’t been willing to do that to date.
Instead, faced with the no-win situation of dividing their base, leadership could choose to do nothing. With the legislative clock ticking, we see that as the most likely outcome. Congress does nothing, or makes a half hearted effort and falls short, and all the tax relief goes away.
Predicting is risky and we’ve been wrong many times. We hope we’re wrong this time too.
It’s July 14th, 2010. There are approximately 30 legislative days before the fall elections and less than six months before huge portions of the tax code expire, so it’s only appropriate that today, the Senate Finance Committee held the first substantive hearing on the implications of allowing the Bush tax cuts to expire. Some key points:
- Chairman Max Baucus (D-MT) clearly takes a dim view of flow-through taxation for certain firms and appears dismissive of arguments that higher rates will hurt the business community and employment. Washington Wire readers are encouraged to watch the hearing and see for themselves, but it’s obvious that we have lots of work to do in defending the basic S corporation structure.
- Dr. Doug Holtz-Eakin alone made the point that as long as federal spending was too high — well above historic norms already, with the explosion in entitlement spending still before us — and until it is addressed, tax policy is going to be an exercise in second-best options.
In one “laugh out loud” moment, Professor Len Burman pointed out that higher tax rates may increase entrepreneurship because business owners have access to more deductions. In other words, let’s raise taxes because that will encourage taxpayers to come up with novel ways to avoid paying them? Being entrepreneurial in your tax avoidance is not the sort of entrepreneurship we’re looking for here.
Perhaps the best point of the hearing was made by S-CORP ally Dr. Holtz-Eakin, who, in a back-and-forth with Chairman Baucus, made the case for flow-through taxation as cogently as anybody to date. Boiled down, his point is that because individuals pay all business taxes anyway, it makes good policy sense to tax business income at the individual rates directly.
So what to conclude? The list of witnesses and tone of the majority–especially the Chairman’s–suggest this hearing was designed to lay the policy predicate for higher rates next year. What’s unclear is exactly which taxes the Committee plans to raise. Despite what you might read, most of the Bush tax cuts enacted in 2001 and 2003 went to middle- and low-income Americans, not the rich. So the pending tax hike is going to impact regular families in a very real and harmful way. With just 30 days of legislative session left before the elections, even a well intentioned effort to extend those tax policies may fall short.
Perhaps more importantly, the hearing demonstrated the lack of a plan for what happens beyond 2010. Even if Congress extends some or all of the 2001 and 2003 tax cuts, something more comprehensive is needed if the United States is not to follow Greece down the path towards the third world. Senators Ron Wyden (D-OR) and Judd Gregg (R-NH) have introduced what they describe as a budget neutral tax reform plan. In the absence of any other ideas, it might be worth a look to see what they propose.
Estate Tax Fix Introduced in Senate
In more tax news, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) yesterday evening introduced an amendment to make permanent changes to the estate tax. As the entire tax world knows, the estate tax is taking a one-year hiatus in 2010 before returning in 2011 with a top rate of 55 percent and an exclusion of $1 million.
This dramatic shift, from a regime that applies a capital gains tax on inherited assets when they are sold to a very high 55 percent rate imposed at the death of the estate’s principal is possibly the largest marginal rate hike in history and is giving estates and estate planners alike a very real case of whiplash. Nobody predicted we would be in this situation a year ago, and the uncertainty is having a very real impact on how folks are behaving.
The Lincoln-Kyl proposal is designed to mitigate this harm and uncertainty by making permanent a middle ground on taxing estates. Key provisions in the bill include:
- Reducing the top estate tax rate to 35 percent;
- Increasing the exclusion from $1 million to $3.5 million; and
- Allowing the estates of deceased taxpayers to choose between no estate tax and limited “carryover basis” or the provisions included in this plan for 2010.
Missing from the proposal are any revenue increases or spending cuts to offset the revenue loss of the lower rates and higher exclusion. The selective pay-go rules adopted by Congress earlier this year allowed Congress to extend 2009 estate tax rules without offsets, but any reduction in the estate tax beyond that would have to be offset or face a 60 vote Budget Act point of order. Filling this revenue hole, which has been estimated in the $50-$75 billion range over ten years, has been a significant challenge for the Lincoln-Kyl team, and it appears it still is unresolved.
While the Lincoln-Kyl proposal is targeted at the pending small business bill, it is unclear whether they will get a clean vote on the issue. Majority Leader Reid has filled the so-called amendment tree and is taking other steps necessary to limiting changes to the underlying bill. Regardless, the introduction of this legislation is the first substantive effort in the Senate to enact a permanent estate tax fix, which is progress. The question now is whether there’s enough time in the legislative calendar for this debate to play out. Stay tuned.
Congress is back this week, and the pending business before the Senate is the small business tax bill that passed the House last month. Here’s BNA’s review of the plan:
The Senate is expected to resume consideration July 13 of a small business lending bill with the hope of completing floor debate in only a few days, although a Democratic leadership aide warned that it might depend on Republican cooperation… Currently awaiting consideration is a substitute amendment (S. Amdt. 4402) that carries roughly $12 billion in tax cuts aimed at small businesses, including a highly sought after provision to extend bonus depreciation tax incentives through the end of 2010…
“We know that the best way to create jobs, innovate, and help our economy recover is through the private sector and we know the engine that runs the private sector is made up of small businesses,” said Reid. The bill, Reid said, will put Americans back to work by providing tax incentives for small businesses, increasing Small Business Administration loan limits, making it easier for small businesses to export goods, and creating a small business lending fund.
The provisions included in the substitute are proven job creators, including expanded section 179 deductions and bonus depreciation, zero capital gains for certain small-business investments, and a shorter built-in gains holding period. With the short three week work period in July, small business advocates on the Hill and off are hoping to see the bill move through the Congress before August.
The biggest threats to quick adoption, ironically, are the other revenue items on the Senate’s “to-do” list — the extender package and the estate tax fix. CongressDaily is reporting that Senate Majority Reid is considering making another run at the tax extenders package in the next couple weeks:
Senate Majority Leader Reid has told senators he plans to bring up another tax extenders bill in coming weeks that would include billions of dollars in aid to states, despite repeated failures to pass versions of the measure, senators and aides said today. Sen. Amy Klobuchar, D-Minn. said today that Reid has promised to bring up the tax extenders bill once a successor to the late Sen. Robert Byrd, D-W.Va. is sworn in.
A Democratic leadership aide said the bill would include dozens of expiring tax breaks, known as extenders, and assistance to states to avoid layoffs of public employees. Democrats last month failed to line up 60 votes to pass several versions of the measure in the face of objections by Republicans and some Democrats about the bill’s cost.
The question your S-CORP team is asking is, why, with a tax bill on the Senate floor right now, would Senator Reid wait weeks to bring up yet another tax bill? Advocates for the extender package are likely asking themselves the same question. The small business package may be the last tax train leaving the station this session, which means everybody will be looking at it to carry their favorite provision. As a result, its adoption this month is by no means assured.
More on Extending the Bush Tax Cuts
Our friends at International Strategy & Investment (ISI) have an interesting write-up on tax policy for the remainder of this Congress. In general, their conclusions match ours, which is to say that time is short and Congress has yet to take any definitive steps to extending even those tax policies that benefit families making less than $200,000. As ISI notes:
We originally believed that Congress would resolve the tax issue this summer, but now we think it is at least as likely Congress will pass legislation this fall. At this point, neither of the tax committees in the House nor the Senate has passed a bill dealing with the 2001 and 2003 tax cuts (nor have the key people introduced a bill). What’s more, the Democrats in Congress have not been able to find 60 votes in the Senate for any kind of resolution of the estate tax (which temporarily has gone away) or for the “extender bill” dealing with mostly non-controversial tax credits that expired last December. There is no reason to predict smooth sailing for a bill addressing the Bush tax cuts.
Meanwhile, NFIB’s June Small Business Optimism Survey is a good measure of what happens when Congress doesn’t do its job. Simply put, this survey has never been this low for this long, with a large percentage of this month’s decline due to the sector’s pessimistic policy outlook. As The Atlantic reported:
Economic conditions remain the predominant reason why most firms think it’s not a good time to expand. The next most common reason given was the political climate. Small firms face still face a substantial amount of regulatory and other legal uncertainty.
Faced with record deficits, a massive pending tax hike, and increased regulatory burdens, the small business sector is pulling back. CNBC economic analyst Steve Liesman noted this morning that if the survey were made of chocolate, it would be very dark, dark chocolate.
This inaction and/or impasse is beginning to get the public’s attention. It’s starting to move markets and it’s harming job creation and growth. Congress needs to address this issue in a meaningful way, and soon.
S-CORP Member Weighs in on Tax Picture
Long-time S-CORP member Ron Bullock of Bison Gear & Engineering Corp. penned an op-ed for the Washington Times last week. The piece highlights the benefits of S corporations for American manufacturing and cautioned that the manufacturing sector— where our leadership is in danger of being overtaken by China in the next couple years — would be harmed by the policies outlined in President Obama’s 2011 budget proposal.
As Ron explains, electing S corporation status was integral part of him firm’s success over the past two decades:
By changing to a Subchapter S corporation taxed at the personal rate, I had 7 cents more from every profit dollar to reinvest into the company, which was key to growing the business. This led to growth rates that doubled our sales every five years ongoing and the hiring of an additional 200 employees, who enjoyed 14 percent higher wages than for other private-sector job.
…I was not alone in this type of thinking. Today, there are 4 million Subchapter S corporations and 3 million partnerships/LLCs with income passing directly through to their shareholders, who pay taxes at personal income tax rates. These are predominantly smaller, closely held American firms, averaging $12 million to $15 million in annual sales versus C corporations at an average size of $100 million.
Though “these businesses represent a full 80 percent of all corporations in the United States, accounting for one-third of gross domestic product,” the current landscape is tilted against them:
If Congress does nothing to change the tax provisions of the 2011 budget, those businesses face a 10 percent tax increase in 2011 at the top rate. These millions of American companies are the bedrock of our interconnected economy and, like my company, Bison Gear, are proven job creators, given the right investment incentives.
To highlight the challenge, Ron worked with the Manufacturers Alliance to produce their recent study on impact of President Obama’s tax policies and their impact on S corporations in the manufacturing sector. The study found that under this budget plan, S corporations in the manufacturing sector would see their tax bills go up 14 percent, while the nation’s economic output through 2015 would drop $200 billion on an annual basis and 500,000 fewer American would have jobs.
That’s the bad news. The worse news is that the Obama budget came out before Congress enacted the new, 3.8 percent tax on investment income and chose not to deal with the estate tax. As bad as the Obama budget is for private enterprise, current law is even worse.
Ron’s Bottom Line: America needs a bipartisan effort to ensure continued effective tax incentives to encourage export and manufacturing-sector investment. If not, the United State will lose its 110-year position as the world’s leading manufacturing economy to China—all because of a lack of effective tax and trade policies.
Armed with nothing more than the better policy argument, team S-CORP successfully rallied business groups and our friends on the Hill to defeat a proposed $9 billion payroll tax hike on S corporations last week.
The proposal, included in a larger package of so-called tax extenders, would have applied payroll taxes to all the income of service-oriented S corporations if they met a couple of tests. As your S-CORP allies observed, the new tests envisioned were more complicated and less enforceable than current law—meaning we would have taken a step backward had Congress enacted them.
The biggest ally we had in this fight was Senator Olympia Snowe (R) of Maine, who took the Senate floor shortly prior to the key vote last Thursday and made the following comments:
“Finally, I had suggested that the provision that imposed that $9 billion in additional taxes on our small businesses, or ‘Subchapter S’ corporations, be removed – while we work diligently on legislation to close existing loopholes in the law that have resulted in abuses. And last week, I was told these new taxes would, in fact, be removed. Yet, just last night, the tide turned once again, and I was informed they would in fact remain.
These are revenue provisions that had never been the subject of hearings, had never been seen by the public, and would significantly damage the business environment for businesses both large and small – just as we ought to be creating jobs, not curtailing them. This egregious provision would harm millions of small businesses and their ability to create jobs.
Under Section 413, a new, burdensome payroll tax of 15.3 percent is imposed on S corporations on the dividend distributions paid to employee-owners, to family members who are shareholders or partners, and – unbelievably – on retained earnings in the business when distributions are kept in the business for reinvestment. At a time of festering high unemployment, this is exactly the wrong prescription for job creation.”
In the end, Senator Snowe’s opposition—combined with the opposition several other swing votes—resulted in the failure of the overall bill and a respite for service sector S corporations. Exactly how long this respite lasts depends on many factors, and we do expect additional action on this front in the future.
As we’ve made clear, we don’t support using the S corporation structure to block payroll taxes. This practice is tax avoidance (not a loophole as is so often claimed) and the IRS already has the ability to go after shareholders using the S corporation in this manner. If the IRS needs new tools, then a simple rule is the new tools should be targeted at tax avoiders only, and they should be more effective and enforceable than current law. The tax hike defeated last week failed both tests.
Finally, Something on Expiring Tax Cuts
A friend of ours has taken to saying that “Congress has a secret plan to raise taxes on the middle-class.” What’s the plan? Do nothing.
Absent congressional action, the Bush tax cuts are set to expire at the end of the year, and a large majority of them are targeted directly at the middle class. Despite this looming tax hike, Congress has taken no concrete steps to extend them–no budget, no hearings, no markups, not even a whole lot of talk in the press.
This lack of action (or at least talk) appears to be ending this week. As CongressDaily reported earlier:
House Ways and Means Democrats are discussing a roughly $270 billion, one-year extension of the tax cuts enacted under President George W. Bush in 2001 and 2003 for everyone except households earning more than $250,000, or $200,000 for individuals, according to sources familiar with the discussions.
That cost includes a two-year “patch” for the alternative minimum tax, preventing more middle-class taxpayers from being ensnared when they file their 2010 and 2011 tax returns. Congress has not yet patched the AMT for 2010.
According to Democratic officials, House leaders have instructed Ways and Means Chairman Sander Levin to develop consensus among Democrats on the tax-writing panel, and based on early discussions, the one-year plan seems to be the most viable. But sources stressed that no decisions have been made, and that movement on the Bush tax cuts, which expire Dec. 31, could wait until September.
House Democratic tax-writers are discussing a one-year extension of tax cuts for middle-income Americans, which would prevent a tax increase for most but put off long-term decisions until next year.
The extension through the end of 2011 would avoid a tax increase for married couples with income of less than $250,000, or individuals with income of less than $200,000. Democrats would also include a provision shielding most taxpayers from the alternative minimum tax in 2010 and 2011 under the option discussed by House Ways and Means Committee Democrats in a Tuesday closed-door meeting.
Those items together would add $270 billion to the deficit, said a House aide with knowledge of discussions. The aide said the one-year option did not include any proposal on the estate tax, which, if Congress does not act, will return next year to tax estate wealth in excess of $1 million at 55%. Also discussed were a two-year option to extend the middle-class tax cuts through 2012, or an option to make those tax cuts permanent.
Meanwhile, The Hill is reporting that any middle-class tax cut extension will not be offset:
Rep. Chris Van Hollen (D-Md.), the Assistant to Speaker Nancy Pelosi (D-Calif.), on Wednesday said dire budget predictions by the Congressional Budget Office will not alter Democratic plans to extend middle-class tax cuts enacted under President George W. Bush and not pay for their cost.
“Our plan is to continue with that portion of the tax cuts that provide relief to people under $250,000,” he said, adding that “not at this time” was there a plan to offset the cost of extending these provisions.
Van Hollen also said there is currently no plan to offset the cost of protecting the middle-class from the alternative minimum tax and extending the 2009 estate tax law.
“The economy is still climbing out of a ditch,” he said, adding, “The problem is if you suck that much money out of the economy at the same time you get an anti-stimulative effect.”
So where there was nothing, at least now there is talk. But don’t get too excited. If there is an extension, it will be limited to taxpayers making less than $200,000, which means that Congress plans to raise taxes on everybody else. What impact would that have on the struggling economy? About one-third of all business income in the United States is taxed at the top two rates. A massive amount of other investment income is, too. You do the math.
Even a limited tax cut extension might not happen–Congress was supposed to deal with the estate tax last year, too. And what about the other chamber of Congress? All the talk this week has been limited to the House side.
Another S-CORP friend has repeatedly pointed out that the first approach House leaders take when addressing any policy challenge is pretending the Senate doesn’t exist. They then proceed from there. Just because the House may take action on stemming tax hikes in the next six months doesn’t mean they are coordinating with the Senate, or that the Senate can or will take similar action.
Even with a massive political football like middle-class tax hikes, with the current congressional leadership, you just never know…
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.
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.
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.