Health Care Reform and S Corporations
President Obama released a list of proposed changes to the Senate-passed health care reform bill on Monday, and while there is plenty to interest any American, one item in particular should catch the attention of S corporation owners:
The President’s proposal adopts the Senate bill approach and adds a 2.9 percent assessment (equal to the combined employer and employee share of the existing HI tax) on income from interest, dividends, annuities, royalties and rents, other than such income which is derived in the ordinary course of a trade or business which is not a passive activity (e.g., income from active participation in S corporations) on taxpayers with respect to income above $200,000 for singles and $250,000 for married couples filing jointly. The additional revenues from the tax on earned income would be credited to the HI trust fund and the revenues from the tax on unearned income would be credited to the Supplemental Medical Insurance (SMI) trust fund.
By all appearances, the Administration has decided to apply a new 2.9 percent tax to all forms of “unearned” income, including S corporation income earned by shareholders not active in the business. [That is our take at this time -- we are reaching out to taxwriters to make certain that is what the Administration intends]. This tax would be imposed on top of other applicable taxes and would be used to offset the cost of health care reform. CongressDaily reported on this provision yesterday:
President Obama's $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed. But critics charge it could open the floodgates to a raft of companies re-structuring their businesses as subchapter S corporations in order to avoid the tax.
That is the glass half full version. The half empty view is the Administration just proposed to raise marginal tax rates on S corporation shareholders with day jobs. Here’s how we see it applying:
- Taxpayer A works at his S corporation, earns a salary above $200,000 and receives a distribution of S corporation earnings. He would now pay an extra .9 percent on his salary, but not pay more on any earnings from the S corporation.
- Taxpayer B makes more than $200,000 at another job and is a shareholder of an S corporation. She would now pay an extra .9 percent on her salary as well as an extra 2.9 percent on any earnings from the S corporation.
This proposal raises all sorts of alarm bells. First, as we have pointed out, it takes the notion of the “payroll” tax and throws it in the trashcan. Second, it continues the illusion of the Medicare and SMI Trust Funds; revenue raised by this tax pays for health care reform, not Medicare benefits. Third, it raises the cost of capital (especially if it is combined with next year’s scheduled increase in the capital gains and dividend rates) at a time when our financial institutions are capital-starved. The whole point of TARP was to recapitalize our financial system, remember?
Beyond those broad policy concerns, the mechanics of this tax are particularly challenging. Does Taxpayer B pay a total Medicare tax of 3.8 percent on her salary above $200,000, but only 2.9 percent on any passive income, including S corporation earnings? And what about Taxpayer A? He already faces the challenge of making certain he pays himself a “reasonable” wage or he risks being accused of tax avoidance. This proposal would increase that temptation and the broader policy challenge.
Finally, how does the Administration plan to distinguish between passive and active shareholders? Here is how IRS Publication 925 (Passive Activity and At-Risk Rules) defines “Active Participation”:
Active participation depends on all the facts and circumstances. Factors that indicate active participation include making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees. Factors that indicate a lack of active participation include lack of control in managing and operating the activity, having authority only to discharge the manager of the activity, and having a manager of the activity who is an independent contractor rather than an employee.
It’s pretty sketchy. So now will all those non-active S Corp shareholders try to become active so they can avoid the new “payroll” tax? Sounds like another enforcement headache for the IRS. Expect to hear lots more on this issue in coming weeks.
More Intel on Estate Taxes
Two ideas are being floated in the Senate on the estate tax. A while back, Dow Jones reported on a proposal to allow taxpayers to prepay their estate taxes. As Martin Vaughn wrote:
A proposal to allow wealthy people to prepay estate taxes while they are still alive, in exchange for a lower tax rate, has caught the attention of Senate staff trying to craft a bipartisan, permanent compromise on the estate tax…. The plan would allow wealthy people to place assets in a prepayment trust while they are still alive. Those assets would be subject to a 35% tax, which the estate owner would have five years to pay, according to a document describing the plan, obtained by Dow Jones Newswires.
The value of this option for taxpayers is obvious: you get a lower rate. For the government, the value is that it would be scored as a revenue raiser. Congress operates on a finite budget window, so the prepayments would be scored as new revenues while some of the estate taxes foregone would fall outside the budget window and wouldn’t count. Not exactly kosher, but the point is this idea could, just like the old Roth IRA concept, fit the needs of Congress and help them move towards a resolution of the estate tax dilemma.
The other idea to break the current impasse is to impose a “toll charge” on family foundations as a means of offsetting the cost of lowering the estate tax below 2009 levels. The Hill reported earlier this week:
The Gates Family Foundation – arguably the biggest charity in the world with assets over $35 billion according to 2008 records – is in the crosshairs of Sens. Jon Kyl (R-Ariz.) and Blanche Lincoln (D-Ark.), who see it as a money pot to help pay for a legislative fix for the estate tax. Well-placed sources say the senators might create a “toll charge” on charitable foundations that would sock Democratic heavyweights like Bill Gates and Warren Buffet.
During last year’s budget debate, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) offered an amendment to reduce the top estate tax rate from 45 to 35 percent while increasing the exclusion from $3.5 million to $5 million. That amendment garnered majority support but less than the 60 votes needed to clear the Senate. Moreover, it left unresolved how the sponsors would make up the revenue difference between their amendment and 2009 estate tax rules. That’s where the toll charge on foundations might come in.
In terms of timing, the clock is ticking. We are now two months into the year of repeal and more estates are finding themselves in estate tax limbo. Senator Kyl addressed this concern yesterday, suggesting he would begin blocking other Senate business in order to force an agreement to take up an estate tax fix. As the Hill quoted Reid yesterday:
Very soon we’re going to have a process on how estate tax reform is going to move forward. I will insist on an agreement on how to proceed, if we’re going to have unanimous consent on how to proceed with any of these subsequent bills.
At the end of this process, it is possible no permanent fix can get 60 votes, the estate tax stays repealed for the rest of the year with the old 55 percent and $1 million exclusion coming back in 2011. All this recent activity suggests some sort of effort is just around the corner, however, and we may know the outcome soon.
Washington Wire
Thursday, February 18, 2010
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.
Washington Wire
Friday, February 05, 2010
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.
Washington Wire
Tuesday, February 02, 2010
President Releases 2011 Budget
The president released his FY2011 budget yesterday. According to the Office of Management and Budget (OMB), the administration begins with a ten year baseline deficit of $5.5 trillion dollars. Simply put, if Congress and the administration left current laws in place, the deficit would average over $500 billion per year for the next decade.
The president’s proposed policies would raise this deficit to $8.5 trillion. As a result, debt held by the public would increase from $5.8 trillion (41 percent of GDP) in 2008 to $17.5 trillion (76 percent of GDP) in 2019.
It always helps to look at the really big numbers -- there aren’t any bigger than when you’re discussing federal budgeting -- to put things in perspective. Under the president’s proposed budget:
- Total spending over ten years would be $45.8 trillion. Spending is scheduled to move from 24.7 percent of GDP in 2009 to 23.7 percent of GDP in 2020. The historical average is around 21 percent.
- Meanwhile, total revenue collections would be $37.3 trillion. Taxes are scheduled to rise from 14.8 percent of GDP in 2009 to 19.6 percent by 2020. The historical average is 18 percent.
On the revenue front, the president proposes just over $4 trillion in tax relief -- most of which comes in the form of extending the 2001 and 2003 tax relief packages which targeted folks making less than $250,000. On the other side of the ledger, the president proposes a large “grab bag” of tax increases -- LIFO repeal, carried interest, black liquor, etc. With the odd baseline the administration is using (see below), we’re not sure exactly what the tax increases total, but it’s somewhere in the neighborhood of $1 to $1.5 trillion.
As expected, the budget calls for allowing taxes on upper-income families (and businesses) to rise back to their pre-2001 levels. As the Wall Street Journal reports this morning,
The two top income-tax brackets would rise to 36% and 39.6%, from 33% and 35% respectively. For families earning at least $250,000, capital gains and dividend tax rates would rise to 20% from 15%. All told, upper-income families would face $969 billion in higher taxes between 2011 and 2020.
For other big ticket items -- health care reform and cap-and-trade -- the budget includes only cursory references. These placeholders are consistent with the administration’s approach to date of delegating these policy decisions to Congressional leadership.
As we have observed in previous posts, the president’s budget is always an odd duck. The president has no tangible authority to tax or spend -- the Constitution reserves that right for Congress, after all -- yet there is a leadership quality to any presidential budget that can effectively set the tone for the budget decisions to be litigated through the legislative process.
In the case of this budget, that leadership appears wholly absent. No details on his biggest policy priorities. No meaningful proposals for holding down spending or bringing down the deficit No hints at entitlement reform. There is a proposed deficit reduction commission, but it has no teeth.
Congress this year will face as difficult a budgeting challenge as any in recent memory. The economy has stabilized and a continued financial meltdown is no longer imminent. The biggest threat to economic growth now is the federal deficit and its impact on interest rates and prices. As this budget release makes clear, Congress will be addressing these challenges alone.
Estate Tax Update
On the estate tax front, the president continues to call for making permanent the estate tax rules from 2009 -- a 45 percent top rate and a $3.5 million exemption -- but you’d be hard-pressed to find much discussion of this policy in the budget. That’s because the administration is using something other than the usual “Current Law” baseline. As Treasury’s Green Book notes:
The Administration’s primary policy proposals reflect changes from a tax baseline that modifies current law by “patching” the alternative minimum tax, freezing the estate tax at 2009 levels, and making permanent a number of the tax cuts enacted in 2001 and 2003. The baseline changes to current law are described in the Appendix. In some cases, the policy descriptions in the body of this report make note of the baseline (e.g., descriptions of upper-income tax provisions), but elsewhere the baseline is implicit.
In other words, they have taken a projection of current policy and modified that baseline to accommodate changes to AMT, Medicare Physician Payment policy and the estate tax. In budget world, no mention of the estate tax in the budget means an extension of current policy. A footnote on page 158 of the budget makes clear the “current” policy they’re referring to for the estate tax is the 2009 policy, not the 2010 policy currently in place. Not exactly a strident endorsement for the 2009 rules, but it’s there nonetheless.
The second set of estate tax proposals in the budget looks similar to last year’s budget proposals. There are three, the headings are the same, and the revenue estimates are similar:
1. Require consistent valuation for transfer and income tax purposes: Ten Year Estimate -- $1.8 billion (2010 budget); $2.1 billion (2011 budget);
2. Modify rules on valuation discounts: Ten Year Estimate -- $19.0 billion (2010 budget); $18.7 billion (2011 budget);
3. Require a minimum term for grantor-retained annuity trusts (GRATS): Ten Year Estimate -- $3.3 billion (2010 budget); $3.0 billion (2011 budget).
We spent the past year working on issues related to provision 2 -- the valuation discounts. While the write-up of the administration’s proposal refers to “estate freezes” rather than the “family attribution”, we remain wary that restoration of the old “family attribution” approach is part of the policy mix being discussed at Treasury and on Capitol Hill. With that in mind, we will continue our work to educate policymakers on why family attribution is a really bad idea.
Regarding work on an estate tax compromise, the Finance Committee has been working with key offices to come up with some sort of process to move a compromise forward in the next couple months. They appear to be still working on what that compromise might look like, even at this late date. Possible policies range from restoring 2009 rules to implementing a more business-friendly compromise centered around a 35 percent top rate and $5 million exemption.
The bottom line question for everyone involved remains the same -- is there a proposal out there that can garner 60 votes? If not, expect to see the current repeal stay in place through the rest of the year, followed by the restoration of the old pre-2001 rules. The longer this process takes, the more likely that is the final outcome.
Washington Wire
Friday, January 29, 2010
S Corporations and Payroll Taxes are Back in the News
A couple weeks ago, House-Senate health care negotiators raised the idea of paying for health care reform by expanding the types of income subject to the Medicare payroll tax. Payroll taxes are limited to wages at the moment, but this proposal would also tax cap gains, dividends, interest, rents, and limited partners. Oh, and S corporation income.
S-CORP has a long history of advocacy on these issues and, while the future of health care reform is wholly uncertain following the special election in Massachusetts, we felt it was important for the business community to weigh in on this issue with strong opposition. The result is a letter signed by 20 trade associations opposing this concept. As the letter notes:
Expanding the application of the Medicare payroll tax to non-wage income is an unprecedented policy that would undermine the principle that Medicare is an earned entitlement, damage the integrity of the Medicare Trust Fund, and hurt Main Street businesses and jobs. We strongly urge you to reject this misguided policy.
This morning, a CongressDaily article makes clear that this idea continues to be actively discussed between House and Senate negotiators. While the prospects for health care reform are dim, leadership continues to press for some sort of resolution and apparently this payroll tax item is part of those talks. Peter Cohn reports that the House and Senate are divided on how to expand the Medicare tax:
Senate negotiators want to keep active S corporation income -- other than income from passive investments -- exempt from the payroll tax, fearing their chamber's fragile voting math can ill afford what could be seen as a new small business tax, aides said. House lawmakers disagree, citing the revenue loss, relatively few actual small-business employers that would be affected, and potential to game the system -- such as opting for S corporation status simply to avoid the tax.
We’ll keep you apprised on any new developments on this front. As we’ve mentioned before, our assessment is health care reform will be talked about for the next month or so and then just fade away as other priorities take center stage. There won’t be a funeral or closure, but the votes simply do no exist to move forward right now. That said, no bad idea ever goes away and we fully expect to see this payroll tax expansion to be raised on other bills.
Washington Wire
Wednesday, January 27, 2010
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.
Washington Wire
Tuesday, January 26, 2010
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.
Washington Wire
Friday, January 15, 2010
Tax Outlook for 2010 -- Starting in a Hole
The economic fear that gripped folks in the Fall of 2008 has resulted in a historic collapse of federal revenues.
Revenue collections since 1960 have stayed in a relatively tight pattern centered around 18 percent of our GNP. Considering the range of tax policies we’ve imposed on taxpayers during that time, the steadiness of the 18 percent mean is remarkable and suggests some sort of political or economic boundary is in effect.
That steadiness was broken last year when federal collections fell to their lowest level since 1950. Meanwhile, Washington’s response to the crisis has driven federal spending to levels not seen since World War II. Record low revenues and record high spending means record high deficits.
While record high deficits are obviously a negative, what your S-CORP team finds most troubling is the long-term outlook. For the next decade, the trend is definitely not our friend.
Once we get past the immediate effects of the “fear” and revenues move back to their historic mean, deficits of 4 or 5 percent GNP will persist. And when revenues move well above their historic mean? Deficits of 4 or 5 percent will persist.
And this is the baseline! It doesn’t include expensive policies that are either set to expire or those that are simply politically unsustainable.
Obama 2009 Tax Proposals vs. CBO Baseline Deficit
The chart above takes CBO’s September deficit estimates and superimposes CBO’s June estimates of President Obama’s 2009 tax proposals. Not exactly kosher, but the underlying point is undiminished: even the President’s modest policies to extend just part of the Bush tax relief would add hundreds of billions to the deficit each year.
“Unsustainable” is the word that comes to mind. Herb Stein once observed that unsustainable trends will not be sustained, which suggests these projected deficits are unlikely to become a reality, but that just means something has to give. Stuck between a rock (record deficits) and a hard place (a weak economy), there are simply no easy answers.
For S corporations, the challenge is to spend the next year demonstrating to taxwriters the economic importance of our community, especially as Congress grapples with the “too big to fail” concept for financial services.
S corporations were created to fight economic consolidation. They move economic power and decision-making away from Wall Street and on to Main Street. If policymakers want proactive policies that reduce the incidence of systemic risk, empowering closely-held businesses is a sure-fire means of doing so.
Health Care Pay-Fors
Health care reform is in the final stages of its legislative journey -- last half of the fourth quarter perhaps? -- and while the pro-reform team has plenty of momentum, exactly what tax items make it into the final package remain undecided.
Of most concern to S corporations are the marginal rate increases included in both bills. In the House, it is the 5.4 surtax applied to individual incomes above $500,000, while in the Senate it is the 0.9 percent HI tax increase applied to individual incomes over $200,000.
Moreover, recent stories on possible compromises should raise S corporation eyebrows. As first reported in CongressDaily, negotiators are considering expanding the Medicare HI tax beyond wages to include all types of income, including S corporation income.
According to JCT, applying the existing 1.45 percent payroll tax to investment income, including capital gains, taxable interest, dividends, estate and trust income and income from rents, royalties, S corporations and passive partnership income, to those earning above the $200,000/$250,000 thresholds would raise $111 billion over a decade.
S-CORP has a long history of fighting efforts to expand payroll taxes beyond, well, payrolls. Payroll taxes like the HI tax were designed to resemble private insurance premiums on the premise that Medicare and Social Security were “earned” benefits. This proposal would blur the line beyond taxes on labor and taxes on capital, undermine the notion that Medicare is an “earned” benefit, and should be of considerable concern to the business community.
GAO Releases S Corporation Report
In response to a request by Senators Max Baucus (D-MT) and Charles Grassley (R-IA), the Government Accountability Office spent the last year looking into tax compliance by the S corporation community. The GAO presented its findings in a report released yesterday.
Reports like this always carry with them a large degree of headline risk. Words like “noncompliance” and “misreported” jump off the first few pages. Look beyond the first couple pages, however, and the GAO has compiled a comprehensive review of the challenges S corporation face when calculating their taxes.
Questions covered by the GAO include why some businesses choose to be S corporations, what are the types of S corporation non-compliance, and what are the options for improving S corporation compliance. To answers these questions, the GAO interviewed numerous stakeholders, including the S Corporation Association, and, in their just-released report, came to the following conclusions:
o Congress should require S corporations to calculate and report the basis for their shareholders’ ownership shares;
o The IRS should research options for improving the performance of professional tax preparers;
o The IRS should provide additional guidance to new S corporations on calculating basis and compensation; and
o The IRS should require examiners to document analysis of compensation, and provide more guidance on compensation.
Having given the report a first read, what is our reaction? First, the S corporation was created to encourage private enterprise, not avoid lawfully-owed taxes. We don’t support or help those taxpayers who knowingly avoid paying their taxes.
Second, the legislative recommendation included in the report is for Congress to require an entity-level basis calculation. According to the GAO, this proposal would help address the problem of shareholders claiming losses beyond their basis in the firm. This recommendation is new to S-CORP and we have asked our advisors to weigh-in on its merits.
Third, we’re glad to see the GAO agrees with us that the IRS has tools to address one of the larger areas of non-compliance. Some S corporation owners who work in their business underpay their salaries in order to reduce their payroll tax obligations. As the GAO notes, the IRS needs to do a better job of both defining the existing “reasonable compensation” standard in its guidance, and applying the standard in its examinations.
As to the headline risk, last summer the IRS reported that tax compliance by S corporations likely was as good, and possibly better, than taxpayers’ compliance in general. Meanwhile, the SBA reported last year that S corporations shoulder the highest effective tax burden of any business type. As an investor, as an employer, and as a taxpayer, S corporations are a valuable component of America’s business community. The GAO has given us some suggestions on how we can do better.
Washington Wire
Wednesday, January 13, 2010
Welcome to 2010!
Dear S-CORP Member:
As we begin a new year and gear-up for all the hopes and challenges that 2010 will bring, I wanted to take a moment to thank you for your support and highlight the efforts and priorities of your S-CORP team.
2009 started off with a bang when we successfully secured temporary relief from the built-in gains (BIG) tax as part of the economic stimulus package adopted in February. With the enactment of that bill, firms that converted to S corporation status or existing S corporations that acquired other businesses between the years 2000 through 2003 are now able to dispose of their built-in gains assets without paying a punitive level of tax.
Built-in gains relief was a great win for S-CORP and we plan to build on that success by pushing for permanent BIG tax relief in 2010, as well as a broad range of other tax reforms important to the S-CORP community. Many of these items are included in the S Corporation Modernization Act (S. 996, H.R. 2910) introduced in both the House and the Senate in record time last year. This legislation forms the core of our S-CORP advocacy and 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.
Congress is expected to consider multiple tax bills in 2010 and we will continue to push to get these and other reforms included. Based on our success in 2009, I am confident our S-CORP team and its allies on the Hill are well poised to deliver.
As we move into 2010, however, to say there is significant “policy risk” facing the S-CORP community is a true understatement. Never have the rules and rates that govern our community been under more pressure. For a community whose existence is defined by the tax code, we plan to step up our efforts to defend those rules and make certain policymakers in Washington understand the economic importance of closely-held businesses.
One challenge we face in 2010 is ensuring that closely-held businesses are treated fairly when subject to the estate tax. We expect the estate tax to return in 2011, if not sooner, and some influential members of Congress would like to charge family-owned businesses a premium when they are part of an estate. This idea is simply un-American and wrong, and S-CORP took the lead in 2009 and put together a coalition of 15 major trade associations to educate lawmakers on the need to protect family-owned businesses from arbitrary valuation rules. Estate valuation issues will be front and center in 2010, and S-CORP will continue to fight the good fight.
Pressure on marginal rates is another challenge in the coming year. Rates are set to increase in 2011 without congressional action. Meanwhile, all of the proposals on the table to date would raise them even further. S-CORP has spent years educating policymakers on the massive amount of economic activity currently being taxed at individual rates -- closely-held businesses create more jobs and produce more income than public firms -- and raising their taxes at a time of economic stress is a recipe for a double-dip recession. We are currently working on new options, and policies, to get this message heard.
Finally, for the growing ranks of exporters in the S corporation community, we plan to continue our efforts to block tax increases on closely-held exporters. S-CORP led the charge to block such an increase in 2007, and with dividend and capital gains tax rates in play in 2010, we expect another effort to single out exporters for higher tax rates.
Now more than ever, it is imperative that policymakers on Capitol Hill and at the White House are reminded of the important role the S corporation plays in our nation’s economy. Through our Washington Wires, recruitment of trade associations and other allies, shoe-leather advocacy, and media outreach, the S Corporation Association continues to do just that.
To assist in these efforts, your S-CORP team relies on a long list of Hill allies with a history of supporting closely-held businesses. Members like Senators Blanche Lincoln (D-AR), Orrin Hatch (R-UT), Chuck Grassley (R-IA), Olympia Snowe (R-ME), Mike Enzi (R-WY) and Ben Cardin (D-MD) and Representatives Ron Kind (D-WI), David Reichert (R-WA), Nydia Velazquez (D-NY), Allyson Schwartz (D-PA), Wally Herger (R-CA) and Danny Davis (D-IL) and others have supported our efforts in the past, and we plan to rely on their support and expertise in the coming year as well.
The S Corporation Association is the only organization in Washington D.C. exclusively devoted to promoting and protecting the interests of America’s 4.5 million S corporation owners. To carry on with this important work, we need your continued participation and support. Let us know of the tax issues most important to you and spread the word to other closely-held businesses. Your increased participation can make an important difference to our continued success.
Now is the time to act. We look forward to representing your interests for another year.
Sincerely,
Dick Roderick
Washington Wire
Tuesday, December 15, 2009
Items Remaining on the Congressional “To-Do” List
Friends of ours who follow Congress have begun quoting the old country and western song, “How Can I Miss You If You Won’t Go Away?”
With Christmas less than two weeks away, Members of Congress would like to leave soon, but a long list of to-do items still stands in the way:
o Health Care Reform: Majority Leader Reid is still pressing to get the Senate bill finished before Congress leaves for the New Year. He still might make it, but the odds against him are climbing rapidly.
o Government Funding: Congress passed a batch of spending bills -- termed the “minibus” -- this weekend, leaving just the Department of Defense (DoD) Appropriations bill to be done. DoD was held back to carry other items with it, potentially including a debt ceiling increase, extension of unemployment benefits, short term estate tax extension, and tax extenders. The DoD bill is definitely a “must-pass,” but that’s a long and heavy list. Look for DoD to pass with less on board rather than more. The House Rules Committee could move to this legislation as early as today.
o Debt Limit: The government will run out of room under the debt ceiling to continue borrowing in the next couple of weeks. Treasury has the ability to make additional room available, but it is an ugly process that undermines our financial credibility. With the government borrowing record amounts each week, the debt ceiling will have to be raised, possibly with a small increase that would be revisited later next year.
o Deficit Reduction Commission: Senate Budget Committee Chairman Kent Conrad (D-ND) and 10 colleagues have indicated they would oppose a debt ceiling increase unless it’s accompanied by the creation of a bipartisan deficit reduction commission whose recommendations would be brought straight to the Senate floor. Senate Finance Committee Chairman Max Baucus vehemently opposes this idea. Speaker Pelosi does too.
o COBRA & Unemployment: Funding for extended benefits runs out soon, as do extended COBRA benefits.
o Tax Extenders: Numerous tax benefits expire at the end of the year, such as the R&D tax credit and the S corp charitable deduction. The Majority would like to move them this week, perhaps on the DoD bill, but not everyone agrees, and extenders could end up being retroactively extended – yet again – early next year.
o Estate Tax: See below. Very unlikely anything moves this year.
The Washington Post reported this morning that the House “will move the year's final must-pass piece of legislation without a long-term increase to the national debt and without a large boost in infrastructure funding that was aimed at creating jobs.” Meanwhile, Politico reports that UI and a one-year extension of 2009 estate tax rules now look like they are part of the bill.
Bottom Line: It’s a long list and just how it all gets resolved is anybody’s guess.
More on Estate Tax
The image of a train wreck comes to mind when viewing the prospects for moving some sort of estate tax solution in the next couple weeks.
Absent legislation, the estate tax disappears next year and is replaced with a capital gains tax imposed on appreciated property when the assets are actually sold. It’s more humane and workable than the current estate tax -- no valuation issues, no liquidity issues, no taxes imposed when somebody dies -- but it’s also not long for this world.
Estate tax repeal is only good for one year and then the estate tax returns in full force in 2011 with a 55 percent top rate and a $1 million exemption.
This makes the current delay and stalemate over some sort of permanent solution all the more inexplicable and troubling. Everybody knew it was coming. Everybody knew Congress would need to take action if they wanted to do something permanent. And yet, here we are with just three weeks left in the year and no real plan for action.
The current approach would attach the estate tax and several other process orphans onto to the last remaining spending bill that needs to get done this year -- the DoD Appropriations bill. Also riding on DoD Appropriations will be an increase in the debt ceiling and several other “must pass” items. At some point, all those items could weigh the bill down and prevent its adoption.
Another option being considered is a temporary extension in the current estate tax rules. As Dow Jones reports:
"Obviously, the defense bill is the one remaining appropriation bill and one remaining conference report that will need to be passed before we adjourn for the year," Hoyer said in a Friday press conference. Adding a temporary estate-tax measure to the bill "is an option," he said.
“Temporary” could mean several things here, but it’s possible that it might mean a multi-month -- not multi-year -- extension of the current rules, kicking this issue into 2010. Just how that would appease folks, including Senators Lincoln (D-AR) and Kyl (R-AZ) who would like to see something better than the current rules, is unclear.
Some advocates in the estate tax world argued for having the tax expire next year, arguing that anti-tax members would have more leverage with the tax repealed than otherwise. We’re not sure we agree, but it looks increasingly likely that we’re about to find out.
Rep. Hare Introduces S Corporation Donation Legislation
Companies that donate excess inventory or equipment to charity are allowed to deduct up to twice the basis of the item (not more than the retail value) -- but only if they are a C corporation. S corporations need not apply.
Congressman Phil Hare (D-IL) has introduced legislation to fix this disparity. The bill (H.R. 4069) would extend section 170 tax benefits to S corporations, ensuring they also have an incentive to donate items to schools and charities. As your S-CORP team wrote to Congressman Hare:
Now, more than ever, America’s charities are in need of assistance. They are being asked to serve more individuals with fewer resources. In 2008, the United Way saw a 68 percent increase in demand for basic needs such as food, shelter, and clothing. Your legislation would help fill this gap by making S corporations eligible for section 170.
The 111th Congress is half over, but the tax-writing community understands there are numerous tax bills on the horizon that Congress will need to debate and send to the President. Legislation like H.R. 4069 is an excellent candidate to be part of those bills, and we will be working to make sure it is.
Washington Wire
Friday, November 13, 2009
Business Community Supports Estate Tax Relief
Last week, the S Corporation Association joined a group of nearly 50 small business organizations to support estate tax legislation (H.R. 3905) to make permanent rates and exclusion levels more favorable than those in place in 2009. In a letter to family business allies on the Ways and Means Committee, the Family Business Estate Tax Coalition stated:
The cost of the estate tax falls heavily on family businesses and farms. The cost comes not only from paying the tax itself, but also from estate tax planning costs. Resources diverted from businesses to pay for estate tax planning would be better invested in business operations and expansion.
The goal of the FBETC continues to be repeal of the estate tax, but this legislation will provide much needed additional relief above the current law. The higher exemption level and reduced rate will lessen the burden of the estate tax and provide family businesses and farms with more capital to reinvest in their business.
As S-CORP readers know, there are three key questions to any estate tax solution -- what is the rate, what is the exclusion, and what is the base? Earlier this month, your S-CORP team was joined by fifteen other business groups to make sure Congress doesn’t increase the estate tax base for family owned businesses. This legislation would lock in the other two and help set the stage for continued estate tax relief in the future.
Taxes Are Going Up
The consensus in Washington is that taxes are going up. Just how high is debatable, but higher tax rates appear to be baked in whatever policy cake we are eventually served. So what does the Obama Administration think about higher rates? Obama economist Austan Goolsbee was on CNBC the other day and has this exchange on health care reform after CNBC Squawk Box host Joe Kernen pointed out marginal rates in his home state of New Jersey would soon approach 60 percent:
Goolsbee: We need health care reform so that small business can thrive. You know very well in every small business survey the unaffordability of health care is the thing that small business says is the number one barrier to their growth.
Kernen: But is there a marginal rate were you would say this is a disincentive for small businesses. Is there somewhere where you’re willing, where the administration is willing to draw the line?
Goolsbee: I don’t like high marginal rates, Joe, I agree with you. But to say the marginal rate is going to be 60 percent is totally nuts.
But Joe is right. Marginal rates are going much higher than what they were under Clinton if the House health care reform is adopted. Here’s a rough summary of tax rates in 2011 if the House health care bill is adopted:
|
Rates in 2011*
|
|
Top Rate
|
39.6
|
|
Health Reform Surtax
|
5.4
|
|
Medicare
|
2.9
|
|
State Average
|
6
|
|
Pease
|
1.2
|
|
Total
|
55.1
|
Dr. Goolsbee took pains to point out that state taxes are deductible at the federal level. Fair enough. That would reduce the average state rate from around 6 percent to maybe 4 percent and the total effective rates to around 53 percent. But Pease reduces the value of that deduction, and the surtax applies to “modified” AGI thus it actually has a bigger impact that a regular rate increase. In other words, worrying that the top effective marginal rate may approach 60 percent in high tax states is not so nuts after all. Go Joe.
(S-CORP ally Bob Carroll at the Tax Foundation issued a nice paper last summer summarizing these concerns and pointing out that high marginal rates are an extremely inefficient means of raising tax revenue.)
The good news is that it is still just 50/50 that the House surtax will survive in health care reform and make it to the President’s desk. The bad news is that won’t matter much, since the fiscal pressures facing Congress are almost unprecedented. As former CBO Director Doug Holtz-Eakin testified before the Senate Budget Committee earlier this week:
Any attempt to keep taxes at their post-war norm of 18 percent of GDP will generate an unmanageable federal debt spiral. In contrast, a strategy of ratcheting up taxes to match the federal spending appetite would be self-defeating and result in a crushing blow to economic growth.
In other words, we’re stuck between the proverbial rock and the hard place. Federal spending levels far exceed their post-war averages and unless taxes are raised to match them, the resulting deficits will be enormous. On the other hand, raising taxes by the necessary amount will, at best, retard economic growth and job creation for years to come.
And what is team Obama doing about this? Downplaying valid concerns about higher marginal rates and supporting legislation that will add more than $1 trillion to our spending obligations over the next ten years.
Update on Healthcare Reform in the Senate
Senate Majority Leader Harry Reid (D-NV) is still working to combine the two health care packages passed by the Senate Finance Committee and the Health, Education, Pensions and Labor Committee. Word is the cost of the plan may be going up. He also is reportedly looking at raising the threshold for the “high cost” plan from $21,000 to $25,000, resulting in lower tax collections from the excise tax. As a result, the Majority Leader is apparently looking into a new way to help pay for the cost of the package by applying Medicare taxes to non-wage income earned by couples making over $250,000. As Bloomberg News reports:
Reid’s proposal would apply Medicare taxes to non-wage income earned from capital gains, dividends, interest, royalties and partnerships for U.S. couples earning more than $250,000, the aides said. He’s also considering an alternative that would simply increase the 1.45 percent Medicare tax on salaries of couples who earn more than $250,000, one of the aides said.
The
Wall Street Journal this morning has a bit more on the item, suggesting the proposal could include raising the HI tax to 1.75 percent for individuals starting at $200,000 and couples starting at $250,000.
This new pay-for is an attempt to scale back the previously proposed tax on so-called “Cadillac” health plans.
So what does this mean for S corps?
More pressure on rates, higher taxes on business income, and less capital to invest and hire new workers.
And these hikes would take place during the worst economy since at least 1980 and maybe before.
What are they thinking?
Washington Wire
Monday, November 02, 2009
S-Corp Organizes Defense of Family Business
Led by S-CORP, a coalition of fifteen small business trade associations sent letters last week to the Senate Finance and House Ways and Means Committees urging policymakers to protect the interests of family-owned businesses during the upcoming estate tax debate.
“Penalizing businesses simply because they are family-owned is inconsistent with good tax policy, it creates an unworkable framework with two conflicting definitions of fair market value, it makes it more difficult for these family businesses to be passed on from one generation to the next, and should be rejected by Congress,” the letter states.
Under consideration is the issue of Family Attribution, which has the effect of dramatically raising the estate tax burden on family-owned businesses relative to those not owned by family members. Family Attribution was originally embraced by the IRS in the 1980s, and despite being rejected by the courts in several prominent cases, the idea continues to be put forward. Earlier this year Congressman Earl Pomeroy (D-ND) introduced the “Certain Estate Tax Relief Act of 2009” (H.R. 436), which, among other items, would create an alternative and more punitive definition of fair market value for business assets that are transferred to members of the same family.
S Corporation Association Chairman Dick Roderick applauded the efforts of the coalition and those members of Congress who have a history of supporting family enterprise. “Family businesses play a vital role in our economy, and it is important to ensure their continued success” he noted. “Imposing a higher estate tax on businesses simply because they are owned by a family does not make sense. We look forward to working with our friends on the Hill to ensure this idea does not become law.”
The letter was signed by the following organizations: American Hotel & Lodging Association, AMT - The Association For Manufacturing Technology, Associated Builders and Contractors, Independent Community Bankers Of America, National Association of Manufacturers, National Association of Wholesalers-Distributors, National Beer Wholesalers of America, National Funeral Directors Association, National Lumber and Building Material Dealers Association, National Restaurant Association, National Roofing Contractors Association, Printing Industries of America, S Corporation Association of America, United States Chamber of Commerce, and the Wine & Spirits Wholesalers of America.
House Health Care Bill Surtax
S corporations should be paying strict attention to the health care bill offered up by House leadership last week. The new bill imposes a 5.4 percent surtax on income above $500,000 for individuals and $1 million for families. Like most taxes applied to personal income, this surtax applies to flow-through business income as well as wages. It also applies to capital gains, dividends, rents, etc. (It may also apply to trusts and other structures -- we’re checking.)
Revenue offsets for health care reform need to accomplish at least two goals: raise enough money to cover expanded coverage over the next ten years, and grow at least as fast as health care costs to fully cover expanded coverage costs in years eleven and beyond. The surtax before the House raises $461 billion over the next decade, covering about half the cost of expanding health insurance coverage; the other half is offset with provider payment cuts to Medicare and an assortment of other revenue raisers.
Perhaps just as important, the thresholds for the surtax are not indexed, so the threshold for individuals paying the tax would remain at $500,000 while the threshold for families would stay at $1 million over time. This imbedded bracket creep is necessary for the bill’s authors, since it’s the only way an income tax can be constructed to grow at about the same rate as health care costs.
The Congressional Budget Office indicates that the overall bill - spending minus savings and taxes - results in a surplus for years one through ten, while “in the subsequent decade, the collective effect of its provisions would probably be slight reductions in federal budget deficits. Those estimates are all subject to substantial uncertainty.”
So, the House health care reform bill apparently lives up to the promise not to increase the federal budget deficit in the long term, but only at the cost of drastically raising marginal taxes on a significant portion of business income and reversing a quarter-century of tax policy committed to indexing thresholds to ensure the federal government doesn’t profit from inflation. By all accounts, the surtax will face rough sledding in the Senate. We hope so. We also hope policymakers have a chance to fully explore the implications of an un-indexed marginal rate increase of this size.
Marginal Tax Rate Outlook
Economists Barro and Redlick put together the
chart below showing the average marginal rates faced by Americans over the past century.
As you can see, it has been a consistent upward trend interrupted primarily by the cumulative effects of the Reagan tax relief of 1981 and 1986 and the Bush tax cuts in 2001 and 2003.
What’s concerning your S-CORP team is where that little blue line is headed in coming years. Add 5.4 percent (health care reform) to 4.6 percent (expiring tax relief) to 35 percent (current top rate), and the top federal tax rate on regular income could be 45 percent in just fourteen months. That rate applies to wages and business income alike.
And where will Congress be in fourteen months with top marginal rates at 45 percent? It will be looking at a federal deficit that exceeds one trillion dollars, a Social Security system that is now operating under a cash flow deficit (i.e. its taking money from the general treasury rather than contributing to it), and a Federal Reserve and Treasury working overtime to unwind several trillion dollars worth of balance sheet buildup incurred during the recent financial crisis.
No wonder the markets are spooked. Happy belated Halloween.
Washington Wire
Tuesday, October 27, 2009
Update on Estate Tax
We’ve been visiting Capitol Hill offices over the past couple weeks to talk about the estate tax and its impact on family businesses and now have a clearer idea of where the issue is headed. Here’s our latest intelligence.
As Ways and Means Committee Chairman Charles Rangel (D-NY) announced the other day, he intends to move separate legislation next week making permanent the 2009 estate tax rules, including an exemption amount of $3.5 million per spouse and top tax rate of 45 percent. Having the House move a permanent fix to the estate tax, at least initially, was not what we expected earlier in the year. We were under the impression that House leadership preferred to do something temporary and wait for the big tax bill next year to make any lasting decisions.
We also thought the Senate would be more proactive in pursuing a permanent fix. Wrong again. We continue to hear from Finance Committee staff that Chairman Baucus would like to move a one year extension of 2009 rules and kick this can down the road. Just how that sits with the Republican minority and pro-business Democrats remains to be seen. Why trade one year of repeal for one year of higher taxes? It’s entirely possible that neither side is able to muster the 60 votes needed to move their position along, resulting in a stalemate that allows the currently-planned one year repeal of the estate tax to take place.
Meanwhile, Representative Shelley Berkley (D-NV) introduced the business-friendly Estate Tax Relief Act of 2009 (H.R. 3905) late last week, a bipartisan compromise estate tax bill that would begin with 2009 parameters and then phase in increases in the exemption and reductions in the rate. Under H.R. 3905, each year from 2010 through 2019, the estate tax applicable exclusion amount would increase by $150,000 and the top rate would decrease by 1 percent. Thus, the exemption would start at $3.5 million in 2009, and by 2019, the exemption and rate would be $5 million and 35 percent. This legislation is consistent with the Senate compromise offered by Senators Lincoln (D-AR) and Kyl (R-AZ) and is co-sponsored by fellow Ways and Means Committee members Representatives Kevin Brady (R-TX), Devin Nunes (R-CA), and Artur Davis (D-AL).
Finally, on our Family Enterprise Coalition efforts, we’re making excellent progress educating policymakers on the perils of taxing estates with family-owned businesses more than non-family businesses as well as signing up allies in the business association world. With everybody focused on the rate and exclusion, our point is simple -- the tax base matters too, especially to closely held businesses attempting to survive from one generation to the next. We’re up to fifteen trade associations on our letter opposing this so-called “family attribution” concept and expect to send it to the tax writers later this week.
Washington Wire
Tuesday, October 06, 2009
Health Care Update
The Senate should take up the health care reform bill next week, while the House plans to wait and see what the upper body produces. While there are lots of moving parts, the one that piqued our interest is the Senate’s proposed excise tax on high cost health insurance plans.
We have discussed the House plan to impose a surtax on incomes over $280,000 already, and its impact on S corporations is pretty clear. But how would the Senate excise tax affect our community?
The idea of taxing high cost plans is relatively new, and there are many outstanding questions about how it would work. For example, how exactly how would this excise tax raise revenue? The Senate plan imposes a 40 percent excise tax on high value plans with a cumulative cost of more than $21,000. But medical loss ratios for private health insurance plans easily exceed 60 percent of premiums, so insurance companies confronted with a 40 percent excise tax will simply stop issuing those plans.
At the employer level, that means if an employer used to offer his employees a $30,000 package of health benefits, he will now offer them a $21,000 plan and pay the remaining $9,000 to them in the form of wages and non-health benefits. These extra wages, in turn, are subject to income and payroll taxes, resulting in higher tax collections by the federal government. The revenues raised from the excise tax come from higher income and payroll taxes on employees, not from excise taxes on insurance companies.
It’s this aspect of the Senate plan that has unions united in opposition. The excise tax is coupled with a refundable tax credit available to families making less than 400 percent of the federal poverty level (about $88,000 for a family of four). But many union members make more than that while most union members enjoy health insurance benefits that exceed the Baucus threshold. So for many union members, the Baucus plan would reduce their health benefits and raise their income and payroll taxes, but exclude them from the refundable tax credit.
What about S Corporations? How would they be impacted? Here’s chart we put together:
|
|
Earns More than 400% FPL
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Earns Less Than 400% FPL
|
|
Has High Cost Plan
|
Taxes Are Higher
|
Mixed
|
|
Has Low Cost Plan
|
Not Affected*
|
Taxes Are Lower*
|
We put an asterisk by the “low cost plan” results because of another quirk in the excise tax that deserves review, the indexing for its thresholds. As we mentioned, the Baucus bill sets the initial threshold for a family’s high cost plan at $21,000. This threshold includes all forms of health care spending -- premiums, preventive care, flexible spending accounts -- and is indexed not to health care inflation (about 8 percent), but to regular inflation plus one percent (about 3-4 percent). That means over time, the value of your low cost insurance plan is going to catch up to the threshold and become subject to the tax.
This aspect of the Baucus plan would have been fixed had it not been essential to the procedural challenges facing health care reform. Simply put, both the House and the Senate are attempting to offset health care spending, which grows at 8 percent per year, with tax increases, which rise at five percent per year. The costs of the plans grow faster than the offsetting taxes, resulting in deficits in the out years.
By comparison, the Baucus tax, because of the indexing details, grows faster than health care spending and produces surplus revenues in the out years. As much as the unions complain, coming up with an offset that keeps the President’s and congressional leadership’s promise not to make the deficit picture worse is going to be hard to find.
Thus, the friction between the House and Senate tax offsets, and yet another obstacle between healthcare reform and a signing ceremony. The House surtax targets closely held businesses while the excise tax targets union workers. Nobody said raising taxes by half a trillion dollars would be easy.
Estate Tax Update
We expect Round 1 in the great estate tax battle to take place this fall/winter. The tax goes away in 2010, and then returns in full form in 2011, giving just about everybody a reason to come to the table.
In preparation for this debate, forty-six trade associations, including your S Corporation Association, the Chamber of Commerce, NIFB, and the National Association of Manufacturers sent a letter to Congress urging them to support a permanent estate tax fix that includes a 35 percent top rate and a $5 million per spouse exclusion.
As Martin Vaughn of Dow Jones reported:
The groups said they will support a permanent rate of 35%, with the first $5 million of wealth exempted, and up to $10 million in the case of married couples. Those are the terms that are being pushed in the Senate by Sens. Jon Kyl, R-Ariz., and Blanche Lincoln, D-Ark.
On timing, the expectation continues to be that Congress will take up legislation to extend certain expiring tax provisions before the end of the year, and that the estate tax fix will be made part of that bill.
Tax Reform Panel Report Update
Remember the President’s Economic Recovery Board headed by Paul Volcker? The President announced its creation at the beginning of the year but it’s been quiet since then. The principle reasons for this silence are federal sunshine laws that require any gathering to be open to the public. It is hard to provide the President with critical insights into how to fix the economy when the whole world’s watching.
One offshoot of the Board that has been active is the White House Tax Reform Panel. They had their first (and last?) public meeting last week, chaired by CEA Member Austan Goolsbee. During the meeting, Goolsbee made clear that the Panel was not seeking to create a new tax system but rather would focus its recommendations on three specific areas -- tax simplification, enforcement and corporate tax reform. The panel is accepting public comments through October 15th and then will make its own recommendations known to Treasury Secretary Geithner by December 4th.
In the past, it has been easy to dismiss the work of presidential or congressional tax reform panels. They tend to come and go, after all, with little to show for their efforts. This time, however, the combination of huge deficits and an expiring tax code make some sort of dramatic changes to the tax code almost a certainty. Given the landscape, we intend to follow the efforts of this group closely.
Washington Wire
Monday, August 31, 2009
Estate Tax Update
Where to start? The August break is nearly over and Congress is scheduled to return after Labor Day with a full agenda that includes finishing (or finishing off) health care reform, wrapping up all the spending bills, increasing the debt ceiling, doing something on the energy front, and adopting a package extending expiring tax provisions, including a possible estate tax compromise.
Earlier this month, Martin Vaughan of the AP had a nice piece outlining the current state of play on the estate tax. While the House is poised to enact a simple extension of 2009 rules into 2010, we don’t expect the Senate to follow suit quickly or easily for the simple reason that it would surrender any leverage Senate Republicans have to negotiate a deal beyond 2011. The only thing bringing Democratic leadership to the table is their wish to avoid next year’s repeal.
For that reason, the staffs of Senate Finance Committee members are using the August break to finalize the outline of a possible compromise, including provisions to reduce the overall cost of the package. The budget resolution allows for an estate tax fix that extends 2009 rules into 2010 and beyond to be adopted without needed offsets. Negotiators in the Senate would like to go beyond the 2009 rules, so they would need offsets for any additional relief.
S-CORP members are worried that the old IRS “family attribution” concept for valuing family business assets at a premium might make an appearance during these talks. The IRS unsuccessfully pushed this idea back in the 70s and 80s and lost repeatedly in court. They gave up in 1993, but as we all know, no bad idea ever dies in Washington D.C.
Legislation to resurrect the concept has been introduced in the House, the concept is part of the Obama budget this year, and the Treasury Department has been looking into promoting it administratively. All of this activity should be troubling to family businesses. Our S-CORP team continues to work with friendly members of Congress to educate them on the harmful impact this would have on family businesses across the country.
SOI on S Corporations
After a multi-year year hiatus, the Statistics of Income folks over at the IRS have issued a new update on their S Corporation analysis, this time for 2006. The report is along the same lines as previous efforts, outlining the general size and nature of the S corporation community, but a few items stand out.
First, “Sting Tax” collections -- the tax applied to excess passive income -- took a big 108 percent jump from 2005 to 2006. Not sure why, but we’re hoping that the Sting Tax relief enacted in 2007 helps ensure that fewer S corporations get stung by this unreasonable tax.
Second, the Bulletin reminds us that S corporations have been the predominant business form (excluding sole proprietorships), eclipsing C corporations back in 1996 and widening the gap ever since. This chart does a nice job of reflecting the trend.
Bottom Line:
S corporations are an important segment of the economy, a key contributor to job creation, and their success is important to economic recovery.
Deficit Implications for Closely-Held Businesses
The Obama Administration released its mid-session budget review last week on the same day the Congressional Budget Office updated its ten-year budget outlook. The headlines for both reports are the dramatic -- really dramatic -- deficit levels for the next ten years and beyond.
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Mid-Session Review Deficits and Debt
|
|
|
2008
|
2009
|
2010
|
2011
|
2012
|
2013
|
|
Deficits
|
459
|
1580
|
1502
|
1123
|
796
|
775
|
|
Debt Held by the Public
|
5803
|
7856
|
9575
|
10590
|
11443
|
12281
|
|
Source: Office of Management and Budget
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|
|
Consider what this means for managing the public debt. Over 2009 and 2010, deficits will exceed $3 trillion. Add to that Treasury’s need to roll over maturing existing debt and it means the Treasury will be auctioning around $50 to $75 billion in new bonds, bills and notes every week for 100 weeks in a row. Wow.
For closely-held businesses, our take away is that taxes are going to rise in the next few years. This chart from the CBO is instructive. Historically, federal revenues have been around 18 percent of national income, while federal spending has been in the 20 percent range. The growth of entitlements in the next decade will take federal spending to 23 percent of national income and beyond. Meanwhile, tax receipts are expected to rise to above 20 percent, largely reflecting the growth of the Alternative Minimum Tax and the expiration of the Bush tax cuts.
So even if Congress allows all the Bush tax cuts to expire -- including repealing the lower marginal rates, the $100 child credit, and the marriage penalty relief -- the gap between revenues and spending will still grow. To shrink this gap and get deficits under control, Congress will need to raise taxes even further, reducing spending by a large amount, or some combination of the two.
Given that the current health care plans before Congress would expand federal health care spending, not reduce it, we doubt the ability of Congress to effectively reduce spending and expect the policy bias will be towards higher taxes instead.
Washington Wire
Tuesday, July 21, 2009
Estate Tax & PAYGO
The House is scheduled to take up a Paygo bill -- short for “pay-as-you-go” -- this week that makes room for an estate tax fix.
Paygo was established back in 1990 as a means of controlling the Federal deficit. Under Paygo, any increase in the deficit, either by a reduction in revenues or an increase in mandatory spending, must either be fully offset or it will be added to the Paygo scorecard and possibly trigger an across-the-board spending cut (called sequestration) at the end of the fiscal year.
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.
Washington Wire
Wednesday, July 15, 2009
House Releases Health Care Legislation
As expected, House Leadership released its health care reform plan yesterday -- America’s Affordable Health Choices Act of 2009 (H.R. 3200). As you can imagine, there are any number of provisions to explore in a 1000-page health care bill, but for S corporations, the big four items appear to be:
- The new health insurance exchange;
- The surtax on high income individuals;
- The health insurance tax credit for smaller firms; and
- The payroll tax penalty for non-participating firms.
Supporters of the plan argue that the combination of the health care exchange and the small business tax credit will provide a net benefit to S corporations and other small businesses. Opponents point to the higher taxes and penalties for firms that choose not to offer health care plans to their employees.
They also question whether the overall plan will actually save money. The CBO estimates it will cost money after all – more than $1 trillion dollars. Of particular importance is the response of the moderate Democratic Blue Dog Coalition. As BNA reported this morning:
Rep. Mike Ross (D-Ark.), chairman of the Blue Dog Health Care Task Force, said his group was committed to passing health care reform. He also said that “reform that does not meet the president's goal of substantially bringing down costs is not an option.”
We are not in a position to judge how successful the exchange will be. The only example is the one in Massachusetts and that one has both supporters and detractors. As for the other three provisions, here’s our best summary:
Surtax: Starting in 2011, a surtax of 1, 1.5 and 5.4 percent will be applied on “modified” AGI exceeding $350,000, $500,000 and $1 million respectively (joint filers). Unless OMB certifies that the bill’s changes to Medicare and Medicaid result in an additional $150 billion in cost savings, the surtax will rise to 2, 3, and 5.4 percent starting in 2012. If OMB certifies these savings exceed $175 billion, then the lower two surtaxes go away.
Small Business Tax Credit: For employers with fewer than 25 employees and who offer them qualified coverage, they are eligible for a tax credit equal to a percentage of their health care costs. The credit starts at 50 percent for employers with fewer than 11 employees and average annual compensation of less than $20,000. It phases out for more employees and higher salaries. A firm with 25 employees and/or average compensation of more than $40,000 gets no credit.
Payroll Tax Penalty: Firms that do not pay for at least 65 percent of their employees’ qualified coverage are subject to a payroll tax penalty. The tax starts at 2 percent of payroll for firms whose payroll exceeds $250,000 and rises to 8 percent for firms with payrolls exceeding $400,000. It is unclear whether the payroll tax applies to all payroll or just the amount exceeding the threshold.
Suffice to say that the complexity of each provision is worth its own white paper. Trying to gauge the interaction between them is simply impossible. Here are some observations and questions:
- How does the payroll tax penalty work? If an employer does not offer qualified coverage to his/her employees, does the tax apply to all payroll or just the amount above the threshold? How does the bill define firm? By entity or by establishment?
- The plan penalizes employers for expanding their payroll. If the employer offers qualified coverage, raising wages would reduce their credit. If they don’t, increased wages will increase their penalty. Either way, the plan raises the marginal cost of hiring new employees and offering them higher wages.
- The higher surtax rates can be avoided if OMB finds additional savings from Division B in the bill. How is OMB supposed to measure these savings and attribute them to the Division B? If the CBO failed to measure these savings, how will OMB?
- The bill appears to add to the deficit, especially in later years. Is this the plan, or will additional cost savings be offered to make it budget neutral?
- What about the need to balance the budget, reform the Alternative Minimum Tax, extend some or all of the expiring tax relief, or make the corporate tax code more competitive? How will Congress accomplish all these things if it spends $1 trillion on health care reform?
The House Ways and Means, Labor, and Energy and Commerce committees will begin marking up their respective portions of the bill tomorrow. Expect these markups to be extremely contentious. The Speaker’s goal is to get the bill through the full House before the August recess. Given the primary importance both the Speaker and the President have placed on health care reform, we expect this goal will be met. Exactly what changes are necessary to get the plan through the House, however, remains to be seen.
The Surtax and Small Business
The fight over who will pay the surtax has begun. The Ways and Means Committee published its estimates that only 1.2 percent of all taxpayers will pay the tax, and only 4.1 percent of all small business owners.
Our immediate reaction was that small business owners are 3.5 times more likely than the average taxpayer to pay the tax, but even that observation misses the larger point. It’s not the number of taxpayers affected that counts, but rather the amount of economic activity subject to the higher rates.
As we’ve pointed out previously, about two thirds of all small business income is taxed at the top two rates, so any surtax applied to upper incomes is likely to tax a majority of small business income. Moreover, those rates are already scheduled to rise, resulting in a double hit on upper income business owners in 2011 and beyond.
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Marginal Tax Rates Under HR 3200 (Joint Filers)
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|
AGI
|
Marginal Rate (2009)
|
Marginal Rate (2011)
|
Marginal Rate (2012)
|
|
$350,000
|
33%
|
34.00%
|
35%
|
|
$500,000
|
35%
|
41.10%
|
42.60%
|
|
$1,000,000
|
35%
|
45%
|
45%
|
This chart requires several caveats, including pointing out that the surtax applies to “modified” AGI rather than taxable income, but the general point is valid -- HR 3200 will return marginal tax rates back to where they were before we started cutting rates in the 1980s.
In addition, this chart doesn’t include the HI tax that now applies to wage income, it doesn’t adjust for taxing “modified” AGI, which includes income from capital as well as labor, it doesn’t include the impact of restoring PEP and Pease, and it doesn’t include state and local taxes. All told, the effective marginal rates on higher incomes will easily exceed 50 percent under this plan.
One last point. When taxing the rich is debated, the discussion usually ignores the actual amount of taxes being paid. Your S-CORP team thinks that’s a mistake.
For example, the CBO reports that the top fifth of taxpayers pay, on average, $64,000 in federal taxes every year. The top one percent pay over half a million.
How much more will HR 3200 add to this burden? And at what level of tax do taxpayers, including small business owners, stop being productive and choose to do something else with their time?
Washington Wire
Thursday, July 09, 2009
S-Corp Priorities Included in Small Business Tax Relief Bill
Just prior to the July 4th break, Senator Chuck Grassley (R-IA) introduced a package of small-business friendly tax provisions, including one of our S-CORP priorities – built-in gains relief! Specifically, the legislation (S. 1381) includes:
- Reducing the BIG holding period from 10 to 5 years;
- Providing a 20 percent deduction for flow-through business income for businesses with less than $50 million in annual gross receipts; and
- Increasing Section 179 expensing, lowering corporate rates, exempting business credits from the AMT, and other items.
As Senator Grassley stated when introducing the bill, “My bill contains a number of provisions that will leave more money in the hands of these small businesses so that these businesses can hire more workers, continue to pay the salaries of their current employees, and make additional investments in these businesses.”
S-CORP is excited to see Senator Grassley include S corporations in this package and we will keep you apprised of any movement on this legislation. While much of the news coming from Capitol Hill lately has been cause for concern for S corporations (see below), it’s great to see that our S-CORP champions on the Hill continue to recognize the importance of our community to growth and job creation.
S Corporations Survive Scrutiny!
Our friends at BNA reported yesterday that the preliminary results of the IRS “tax gap” look into S corporations are in. For the past seven or eight years, the IRS has been conducting a National Research Program that seeks to get a better idea of how much Americans underpay their taxes. For reasons known only to the IRS, the agency has targeted S corporations for closer inspection while largely ignoring other business structures. Regarding the new numbers, BNA reported:
An Internal Revenue Service study preliminarily found that S corporations underreported $50 billion in 2003 and $56 billion in 2004, an IRS employee in the Research, Analysis, and Statistics Division said July 8 at the IRS Research Conference. Drew Johns, citing the 2003-2004 National Research Program S Corporation Underreporting Study, said the net misreporting percentages, or ratios of the net misreporting amounts to the sum of the absolute values of the amounts that should have been reported, for these years were 12 and 16 percent, respectively. The error rates for each year were 69 percent and 68 percent, respectively, he said.
So what’s your S-Corp team’s take on this? Pretty positive, actually. Total compliance by all US taxpayers is around 84 percent (best in the world), so the IRS is telling us that S corporations are better taxpayers than the population in general. Moreover, that 69 percent error rate is eye-catching only until you realize that he’s talking about any error, even small ones that are immaterial to the amount owed.
One question we do have is why the total noncompliance rate jumped from 12 to 16 percent between 2003 and 2004? A 33 percent increase in non-compliance from one year to the next would appear to be a statistical outlier and deserves a closer look.
So to sum up, the IRS spent the last three or four years diving into S corporation tax returns and what they found is that S corporations are solid taxpaying citizens. Combine that finding with the SBA’s report that S corporations shoulder the highest effective tax burden of any business form, and our conclusion is that S corporations should be praised by policymakers rather than targeted for increased enforcement and higher taxes.
Paying for Healthcare Reform
Speaking of higher taxes, July may be the month when taxpayers learn how Congress intends to pay for health care reform. As we’ve reported, the plans in both the House and the Senate have price tags around $1 trillion over ten years.
About $400 billion of that amount will be offset by spending cuts to Medicare and Medicaid, so the remaining $600 billion would need to come from higher taxes. Finance Committee Chairman Max Baucus (D-MT) stated yesterday he needs to identify about $320 billion in new taxes, so he’s apparently comfortable he’s got about $280 billion in revenue raisers ready to go.
Where will the revenues come from? Until this week, the Finance Committee was focused on raising the revenue within the health care world, creating the expectation that some sort of cap on the employer-provided health care exclusion would be part of the mix. It’s health care, after all, and it’s the largest tax expenditure out there. But, it’s losing favor. The Wall Street Journal reported yesterday:
Sen. Kent Conrad (D., N.D.) and others involved in talks on a health bill said Tuesday that the idea of taxing health benefits is unpopular with voters, though they stressed that it hasn't been completely swept off the bargaining table.
A proposal to cap the exclusion just above the cost of plans for federal employees would have raised $320 billion. It’s now apparently off the table, so that’s the revenue hole Senator Baucus was referring to in yesterday’s remarks.
Given the size of the tax expenditure, we still think some form of exclusion cap will make it into the final bill, maybe with a much higher cap of around $25,000. That “only” raises $90 billion (seriously, who knew that many health plans cost that much?) so other tax increases will have to be added.
What’s on the list? A proposal mentioned in both the House and the Senate would place a 2% surtax on families making more than $250,000. Bloomberg reported on Tuesday:
Two people familiar with closed-door talks by committee Democrats said a House bill probably will include a surtax on incomes exceeding $250,000, as Congress seeks ways to pay for changes to a health-care system that accounts for almost 18 percent of the U.S. economy. By targeting wealthier Americans, a surtax may hold more appeal for House Democrats than a Senate proposal to tax some employer-provided health benefits.
If this surtax is like the one proposed by Chairman Rangel in 2007, it would be assessed against AGI and it would apply to wages and investment income alike. As you can imagine, a surtax like that raises lots of revenue.
Another potential item would expand the Medicare payroll tax to income like capital gains and dividends -- and possibly S corporation income too. Like the surtax, the last time something similar was proposed was back in 2007 in Chairman Rangel’s “Mother” bill. That proposal targeted S corporations engaged in services only, though, and would have raised about $9 billion. The new proposal is much broader and raises a reported $100 billion. The S Corporation Association led the effort to educate policymakers why this was a bad idea back in 2007, and you can bet we’ll have something to say about this broader proposal in 2009.
Other items under consideration -- seriously or otherwise -- include increased taxes on drug companies and insurers, capping the value of charitable and other tax deductions (preferred by the Obama Administration), taxing sodas and other sugared beverages, and increasing reporting requirement by corporations.
When will all this be put forward? We were hearing the House might make its plans known as early as tomorrow with the Senate following next week. The most current word, however, is both releases are going to be pushed back, perhaps weeks in the Senate’s case. As to the question of what will be in the plan, if we had to guess today, we’d say the revenue package could include:
- A surtax on income;
- Caps on charitable and other deductions;
- The soda tax;
- An expansion of payroll taxes to new income; and
- Modest caps on the employer-provide health benefit exclusion (Senate).
Some mixture of these could easily raise $600 billion or more over ten years. Whether they could pass Congress, particularly the Senate, is another question entirely. The fact that several raise marginal tax rates on job creators in the middle of a recession is certain to be a central part of the debate.
Washington Wire
Thursday, June 25, 2009
S-Corp Modernization Bill Introduced in the House
Good news! Last week, S-CORP Champion Congressman Ron Kind (D-WI) introduced the “S Corporation Modernization Act of 2009.” Joining Congressman Kind in sponsoring the legislation were fellow Ways & Means Committee Members Wally Herger (R-CA), Allyson Schwartz (D-PA) and Dave Reichert (R-WA).
The legislation is the companion bill to legislation (S.996) introduced in the Senate earlier this year, and represents the priorities of the S Corporation Association for the 111th Congress, including a provision to make permanent the built-in gains reform enacted as part of the larger economic stimulus package adopted earlier this year.
In a statement accompanying the legislation, Congressman Kind noted, “This bill is a commonsense tax code change that will have huge returns in terms of growth and investment for S corporations. Especially in this tough economic time, my goal is to look out for the small and family-owned businesses which drive our economy. This bill speaks to that, reducing a penalty on S corporations, and thus encouraging them to reinvest the savings into growing their business and creating jobs.”
“At a time when small, family and closely-held businesses are struggling to survive, it is encouraging to see that these Members of Congress are dedicated to ensuring the long term viability of S corporations,” said S-CORP Chairman Dick Roderick. “S-CORP would like to congratulate our champions on the timely introduction of this legislation, and express our gratitude for their commitment to the nearly 4.5 million S corporations across the country.”
With legislation now introduced in both the House and Senate, your S-CORP team will be working hard to garner additional support for the legislation. Reforming the rules governing S corporations will allow countless S corporations to reinvest in their businesses and create jobs – something the economy desperately needs at this moment.
S-CORP wishes to thank Representatives Kind, Herger, Schwartz and Reichert for their commitment to closely-held businesses and looks forward to working with these advocates to move this legislation forward this Congress.
How to Pay for Health Care
Chairman Max Baucus today announced he now has a plan to cover the cost of reforming health care.
Past options to cover the cost put forward by the
President, the
Senate Finance Committee, and the
House Ways and Means Committee include:
- A value-added tax
- A rate increase on upper-income families
- A rate increase on Medicare payroll taxes
- Capping employer-provided health insurance benefits
- Capping itemized deductions
- A sin tax on alcohol and soda
None of these options is particularly attractive and, given the challenge of raising this much money, our expectation was that the overall scope of the House and Senate reforms would get smaller as the debate moves into July.
It appears that whittling down process is underway. According to his comments, the Finance Chairman now has in mind a $1 trillion expansion of health insurance coverage (down from previous drafts) to be paid for through an even split of spending cuts and tax increases, including a slimmed down version of capping the employer-provided health care exclusion.
“We are much closer on the scores for a health care reform package than we were at this point last week. We have options the Congressional Budget Office tells us would cost under $1 trillion and are fully paid for,” said Baucus. “Based on these developments, I’m even more confident in our ability to move forward. And as I’ve said before, we will not put out a mark until we are sure we have it right. I’ll continue to work with Senator Grassley and Senators on both sides of [the] aisle to turn these options into a package that can pass the Senate and become law this year.”
The reforms themselves seek to widen health insurance coverage by expanding Medicare and Medicaid while creating a new health insurance exchange for employers and families. The exchange would include both private insurance options as well as some sort of public alternative, and there would be carrots to encourage small employers and low-income families to participate as well as sticks for those who don’t.
The overall cost of these proposals is in the $100 to $200 billion range and would be added on to the $750 billion the federal government already spends on health care programs annually.
But even if Senator Baucus succeeds in offsetting half that cost through spending cuts elsewhere, there is simply no way to efficiently raise $50 billion a year by focusing on individuals making more than $250,000. To raise that kind of money, you need to reach down to the middle class, which is why options like capping the employer-provided health care exclusion are now part of the discussion.
For S corporations, the concern is that the new taxes (whatever form they take) are going to come on top of likely tax increases on income, capital gains and dividends, and estates. These taxes are already scheduled to go up, and with Congress operating at a deficit several times larger than average, they are unlikely to get pared back before they take effect in 2011. Congress simply can’t afford it. Whether Congress (and taxpayers) can afford an expensive expansion of health coverage too is certain to be part of the debate.
Obama LIFO Proposal and S Corps
Speaking of tax increases, the S Corporation Association has been fighting LIFO repeal ever since the issue first emerged as part of a 2006 bill to protect consumers from rising energy prices.
Over the years, we’ve made the case that LIFO is a perfectly legitimate inventory accounting method that can provide the IRS with a more accurate picture of a firm’s income, especially in an environment where prices are rising. (Has anybody looked at long-term Treasuries recently?)
And over the past three years, Ways and Means, Finance, the Joint Committee on Taxation, FASB, and the SEC have all taken positions that, to one degree or another, would undermine the ability of firms to use LIFO in the future.
The most recent shot in the LIFO wars was included in President Obama’s FY 2010 budget. The Obama proposal would repeal LIFO for tax purposes effective in 2012. This change would adversely affect LIFO firms in two respects. First, firms would no longer be able to use LIFO moving forward, likely resulting in higher reported income and higher taxes.
Second, firms would need to pay taxes on their so-called LIFO reserves -- an accounting entry that doesn’t reflect real wealth or income. As we’ve observed, for firms that have been on LIFO for any significant period of time, their LIFO reserves are going to be substantial. The Obama proposal recognizes this double hit by allowing LIFO firms to pay tax on their reserves over an eight year period.
Firms will still be hit with a double tax increase for the privilege of switching to FIFO, but at least the second tax will be spread out over eight years. Of course, they’ll also be paying for health care reform and shouldering the 2011 tax increase and paying down record federal deficit…
Washington Wire/News Flash Archive
