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.
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.
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.
|Mid-Session Review Deficits and Debt|
|Debt Held by the Public||5803||7856||9575||10590||11443||12281|
|Source: Office of Management and Budget|
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.
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.
As expected, House Leadership released its health care reform plan yesterday — America’s Affordable Health Choices Act of 2009 (H.R. 3200). As you can imagine, there are any number of provisions to explore in a 1000-page health care bill, but for S corporations, the big four items appear to be:
- The new health insurance exchange;
- The surtax on high income individuals;
- The health insurance tax credit for smaller firms; and
- The payroll tax penalty for non-participating firms.
Supporters of the plan argue that the combination of the health care exchange and the small business tax credit will provide a net benefit to S corporations and other small businesses. Opponents point to the higher taxes and penalties for firms that choose not to offer health care plans to their employees.
They also question whether the overall plan will actually save money. The CBO estimates it will cost money after all – more than $1 trillion dollars. Of particular importance is the response of the moderate Democratic Blue Dog Coalition. As BNA reported this morning:
Rep. Mike Ross (D-Ark.), chairman of the Blue Dog Health Care Task Force, said his group was committed to passing health care reform. He also said that “reform that does not meet the president’s goal of substantially bringing down costs is not an option.”
We are not in a position to judge how successful the exchange will be. The only example is the one in Massachusetts and that one has both supporters and detractors. As for the other three provisions, here’s our best summary:
Surtax: Starting in 2011, a surtax of 1, 1.5 and 5.4 percent will be applied on “modified” AGI exceeding $350,000, $500,000 and $1 million respectively (joint filers). Unless OMB certifies that the bill’s changes to Medicare and Medicaid result in an additional $150 billion in cost savings, the surtax will rise to 2, 3, and 5.4 percent starting in 2012. If OMB certifies these savings exceed $175 billion, then the lower two surtaxes go away.
Small Business Tax Credit: For employers with fewer than 25 employees and who offer them qualified coverage, they are eligible for a tax credit equal to a percentage of their health care costs. The credit starts at 50 percent for employers with fewer than 11 employees and average annual compensation of less than $20,000. It phases out for more employees and higher salaries. A firm with 25 employees and/or average compensation of more than $40,000 gets no credit.
Payroll Tax Penalty: Firms that do not pay for at least 65 percent of their employees’ qualified coverage are subject to a payroll tax penalty. The tax starts at 2 percent of payroll for firms whose payroll exceeds $250,000 and rises to 8 percent for firms with payrolls exceeding $400,000. It is unclear whether the payroll tax applies to all payroll or just the amount exceeding the threshold.
Suffice to say that the complexity of each provision is worth its own white paper. Trying to gauge the interaction between them is simply impossible. Here are some observations and questions:
- How does the payroll tax penalty work? If an employer does not offer qualified coverage to his/her employees, does the tax apply to all payroll or just the amount above the threshold? How does the bill define firm? By entity or by establishment?
- The plan penalizes employers for expanding their payroll. If the employer offers qualified coverage, raising wages would reduce their credit. If they don’t, increased wages will increase their penalty. Either way, the plan raises the marginal cost of hiring new employees and offering them higher wages.
- The higher surtax rates can be avoided if OMB finds additional savings from Division B in the bill. How is OMB supposed to measure these savings and attribute them to the Division B? If the CBO failed to measure these savings, how will OMB?
- The bill appears to add to the deficit, especially in later years. Is this the plan, or will additional cost savings be offered to make it budget neutral?
- What about the need to balance the budget, reform the Alternative Minimum Tax, extend some or all of the expiring tax relief, or make the corporate tax code more competitive? How will Congress accomplish all these things if it spends $1 trillion on health care reform?
The House Ways and Means, Labor, and Energy and Commerce committees will begin marking up their respective portions of the bill tomorrow. Expect these markups to be extremely contentious. The Speaker’s goal is to get the bill through the full House before the August recess. Given the primary importance both the Speaker and the President have placed on health care reform, we expect this goal will be met. Exactly what changes are necessary to get the plan through the House, however, remains to be seen.
The Surtax and Small Business
The fight over who will pay the surtax has begun. The Ways and Means Committee published its estimates that only 1.2 percent of all taxpayers will pay the tax, and only 4.1 percent of all small business owners.
Our immediate reaction was that small business owners are 3.5 times more likely than the average taxpayer to pay the tax, but even that observation misses the larger point. It’s not the number of taxpayers affected that counts, but rather the amount of economic activity subject to the higher rates.
As we’ve pointed out previously, about two thirds of all small business income is taxed at the top two rates, so any surtax applied to upper incomes is likely to tax a majority of small business income. Moreover, those rates are already scheduled to rise, resulting in a double hit on upper income business owners in 2011 and beyond.
|Marginal Tax Rates Under HR 3200 (Joint Filers)|
|AGI||Marginal Rate (2009)||Marginal Rate (2011)||Marginal Rate (2012)|
This chart requires several caveats, including pointing out that the surtax applies to “modified” AGI rather than taxable income, but the general point is valid — HR 3200 will return marginal tax rates back to where they were before we started cutting rates in the 1980s.
In addition, this chart doesn’t include the HI tax that now applies to wage income, it doesn’t adjust for taxing “modified” AGI, which includes income from capital as well as labor, it doesn’t include the impact of restoring PEP and Pease, and it doesn’t include state and local taxes. All told, the effective marginal rates on higher incomes will easily exceed 50 percent under this plan.
One last point. When taxing the rich is debated, the discussion usually ignores the actual amount of taxes being paid. Your S-CORP team thinks that’s a mistake.
For example, the CBO reports that the top fifth of taxpayers pay, on average, $64,000 in federal taxes every year. The top one percent pay over half a million.
How much more will HR 3200 add to this burden? And at what level of tax do taxpayers, including small business owners, stop being productive and choose to do something else with their time?
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.
As we have noted, the stars appear to have aligned for a big estate tax compromise later this year, most likely to be focused on freezing the 2009 rules for at least a year. This means the current top tax rate of 45 percent and $3.5 million exclusion will stay the same for a while. But there’s lots of mischief that can take place under those broad levels.
As tax reformers will tell you, the base is just as important in determining your tax burden as the rates.
With that in mind, several S-Corp allies have pointed out legislation introduced by Congressman Pomeroy (D-ND) earlier this year — H.R. 436 — and asked us whether the base broadening included in this bill might get considered later this year. The answer is a definitive “Yes.” According to our quick read, H.R. 436 would do the following:
- Freeze the tax rate and exclusion at 45 percent and $3.5 million;
- Restore the step-up in basis;
- Restore the recapture of graduated rates; and
- Limit the use of minority discounts for family businesses.
To put the total impact of these provisions in perspective, here’s a simplified example of a family business where current rules would value the business at $7 million, but under H.R. 436 the value would be $10 million. For comparison’s sake, we included the tax burden on that estate under the rules in place in 2000, this year, in 2010 when the estate tax repeal takes place, and under the Pomeroy bill.
|Exclusion||$1 million||$3.5 million||NA||$3.5 million|
|Estate Tax Base/Basis||$7 million||$7 million||$650,000||$10 million|
|Estate/Capital Gains Tax||$2.9 million||$1.45 million||$1.4 million||$2.8 million|
As you can see, eliminating planning techniques used for closely-held businesses results in an estate tax under H.R. 436 that is nearly the same as the estate tax under the pre-2001 rules, and about twice as much as the current tax.
This is obviously a simplified example that doesn’t include many of the nuances associated with estate planning. Moreover, a smaller estate would experience less of an impact from changes to the valuation rules whereas larger estates would see a substantial increase.
For both, however, changing the rules under which estates are valued seriously threatens the ability of family-held businesses to survive one generation to the next, and should be treated very carefully by policymakers.
So while business groups are focused on the rates and exclusion, we should be just as worried about proposals that would affect the base. Be prepared to see this issue gather more ink in coming months.
So What’s Next?
With Washington focused like a laser on the stimulus package for the past few months, a natural question is: “What’s next?” Your S-CORP team has been asking around, and here’s what we’ve come up with:
Energy Bill: Both the House and the Senate will consider energy legislation this year that, among other items, will include a tax title extending and modifying expiring energy tax items like the Section 45 production tax credit. Many of these popular provisions are scheduled to expire at the end of the year and need to be extended. The Senate may move as early as March on a stand-alone bill, while the House looks like it will pair traditional energy issues — a renewable electricity standard, energy efficiency standards, and tax items — with a carbon cap-and-trade bill.
Housing & Financial Services: Congress is geared up to take up President Obama’s housing plan this spring together with a rewrite of the rules governing what’s left of Wall Street and the mortgage markets. The housing plan will cost money, so we expect a tax title to offset the revenue loss.
Rangel “Mother Bill”: Remember the “Mother of All Tax Bills” introduced in 2007? It swapped the AMT for higher income tax rates, cut the corporate rate while broadening the business tax base, and targeted benefits at low and middle-income families. Word is Mr. Rangel has been redrafting and could reintroduce the package sometime this spring. Once again, his goal would be to encourage an active discussion over the future of tax code. Actual action will likely wait until 2010 or later.
Middle-Class Tax Relief: Senator Baucus has made noises about moving legislation to provide permanent middle-class tax relief. Such relief could include an effort to permanently extend the middle-income tax rates, the child tax credit, and marriage penalty relief.
Estate Tax: An estate tax compromise is on the table and likely to be considered before the kids go back to school next fall. (See above)
Health Care Reform: We expect a push to provide Americans with more health insurance options at some point this summer. While most of the bill will be focused on Medicare, Medicaid, and an expansion of health coverage, we expect changes to the current tax treatment of health benefits to be included. Swapping the current health care deduction with a tax credit would not only balance the tax treatment of health care consumption, it would also raise lots of money that could be used to expand coverage.
As you can see, Congress’ plate is full. Even if only half of these items get addressed this year, it is a full agenda with lots of opportunities for mischief.
Moreover, with the deficit approaching $2 trillion and Congress done with the $800 billion stimulus package, its focus should shift to budget neutral reforms and deficit reduction, placing even more pressure on the tax code and taxpayers.
We’ll keep watch and make sure closely-held businesses are represented.
Congress is back and ready to legislate. First out of the box will be the long-anticipated economic stimulus package. Unlike previous efforts, the current push has the benefit of support from leadership in the House, Senate, and the new Administration, so we expect a sizable package to reach the President’s desk prior to the February recess.
What exactly will the package include? Details are being negotiated right now but the broad outline remains the same — a large package of spending on infrastructure, relief to cash-strapped states in the form of increased federal Medicaid payments, and tax relief to businesses and families. What has changed is the relative size of the tax relief, which continues to grow as the economy shrinks.
According to our friends in the press, the Obama team is currently targeting a package of $775 billion, including approximately $300 billion in tax relief. On the tax side, contending provisions include:
- Relief to Working Taxpayers: Some variation of candidate Obama’s “Making Work Pay” proposal is likely to form the core of the tax/refund relief, perhaps as a permanent adjustment to employer withholding totaling $500 per taxpayer.
- Small Business Expensing: The higher $250,000 limit on small business expensing expired at the end of 2008. Package will likely include a two year extension of that higher limit.
- Other Business Provisions: In addition to expensing, other business breaks could include extending loss carry-backs, bonus depreciation, tax credits for firms that hire new workers, and other business incentives.
- Local Government Relief: This proposal would remove the applicable Alternative Minimum Tax on certain municipal bonds.
Also part of the mix is the S Corporation Association priority of Built-In Gains tax reform. As S-Corp readers know, such relief would help small businesses strapped for cash access much-needed capital by unlocking valuable assets they have had to hold for an overly restrictive time period.
As far as process goes, negotiators from the pertinent committees and the Obama team are meeting right now. The Senate Finance Committee had earlier indicated it might mark up a stimulus package this Thursday, January 8th. That target date appears to be pushed back to later in the month due to logistical as well as policy concerns, but the Committee has made clear to Senate Leadership and the Obama team that they intend to be part of the process of putting together this bill.
That’s good news for S corporations, since many of our champions on built-in gains and other reforms are Senate Finance Committee members. We’re continuing to reach out to them, our Ways and Means Committee friends, and the Obama economic team to make sure they understand the value to the economy and job creation of helping S corporations better access their capital.
Bottom line – the stimulus package is being actively developed and we expect it to move from proposal to law within the next six weeks.
The House is scheduled to vote on the financial sector bailout package later today. If it passes, the Senate will take it up on Wednesday.
The package itself retains the core Paulson proposal to give Treasury the authority to purchase $700 billion in problem mortgages held by banks and other financial institutions. The goal of the plan is to restore confidence in these institutions by eliminating this source of fear and uncertainty for the next two years. The ultimate cost of this plan to taxpayers will depend on how much further home prices fall. Some observers believe the taxpayer will be made whole when Treasury resells the securities.
In the past few months, we have seen the entire American investment banking industry disappear, the world’s largest insurance company fail, the largest failure of a bank in history, and Wachovia sold at a fire sale. Meanwhile, banks overseas are experiencing runs as well. Belgian giant Fortis was bailed out by European authorities this morning.
Opposition to the plan is now focused on questioning whether this plan will address the underlying problem — the lack of capital for our lending institutions and the pending run on our banks. One challenge for the plan as negotiated is it will take time for Treasury to begin buying these assets. Getting these assets off the banks’ books may help, but will it arrive in time?
Here’s some background material for those interested.
Observers expect the plan to pass both bodies, but it is going to be close. In the meantime, the world’s credit markets are watching very closely.
Extenders on Hold
At the beginning of the year, we would have bet money — serious money — that there is no way Congress would leave for the year without addressing the expiration of tax provisions like the AMT patch, R&E tax credits, and a long list of credits and deductions designed to encourage renewable energies.
The House is scheduled to take up yet another version of the energy extenders later today, and expects to adjourn for the elections shortly thereafter. The pending House action marks the six or seventh time this year that body has considered extender packages that include offsetting tax increases to cover the revenue loss.
The Senate has demonstrated repeatedly that it does not have the votes to adopt fully-offset extender packages, so why the House is taking yet another vote on this issue is unclear. Last week, the Senate passed a $150 billion package of extenders that included $25 billion in offsets. Both the Senate Leadership and the White House have communicated to the House that $25 billion is as high as they are willing or able to go.
The House action today suggests that if there is going to be an extension of these tax provisions before the end of the year, it’ll have to take place in a lame duck session. Now the question becomes, is there going to be a lame duck?
We are nearing the finish line for the 110th Congress with more on the table than when we started nearly two years ago.
None of the 12 bills to fund the government have been adopted. Tax provisions that expired at the end of 2007 remain to be extended. And the collapse of the subprime mortgage market that began a year ago with the failure of several hedge funds has grown into a full fledged credit crisis that, according to the Administration, threatens to harm the entire economy.
It appears Congress will stay in through next week and will have to address the following major items:
- A Continuing Resolution to fund the entire government through next March;
- A tax bill to extend expired and expiring provisions through 2009 and beyond; and
- Some form of relief to the credit markets, perhaps along the lines of what Secretary Paulson proposed last week.
Nothing like waiting until the last moment to start that really big term paper.
Some people believe you are not a real player in Washington tax circles until you have your own tax extender to worry over. If that’s the case, then your S Corporation Association has hit the big-time.
The S-Corp extender would extend for one year a provision that allows shareholders to deduct the full value of S corporation property they donate to charity. This provision, like all the other extenders, is caught in a battle of wills, with the House Democrats on one side and everybody else on the other.
Earlier this week, the Senate adopted a $150 billion package that included extensions of the AMT patch, the R&E tax credit, and the assorted energy tax provisions designed to encourage renewable energy. Over the last couple days, the House responded by passing separate bills to do the same thing.
The biggest difference in the two approaches is that the Senate package is offset with $25 billion in tax increases, while the House bills are offset by a total of $60 billion in tax increases. The horse traders in the room are probably thinking, “The Senate is at 25, the House is at 60. Let’s split the difference, pass the bill, and go home.”
But our intelligence is that both the Senate Republicans and the White House have made it clear that $25 billion in revenue raisers is as high as they are willing to go in this process — they would have preferred zero — and the House will have to take the Senate-passed bill or there will be no bill.
The Administration issued a veto threat against the House energy package, suggesting the House take up and pass the Senate bill instead. Whether House Democrats take the suggestion of a departing President remains to be seen.
Bailout Keeping Congress In D.C.
As we forecasted, the legislative wrangling over the bailout has been about as ugly as it gets. While we still expect a deal to get passed and sent to the President, there are several huge obstacles in the way and, while a deal this weekend is possible, action later next week is more likely.
The core of the plan being drafted in Congress is to give the Treasury the authority to purchase up to $700 billion in distressed assets over the next couple years. These assets are backed by subprime and Alt-A mortgages, are primarily held by banks and other financial institutions, and have undermined the ability of these institutions to continue their lending and other operations. Credit measures like Libor are signaling the threat Paulson outlined last week is becoming increasingly real.
If it works the way Paulson and Fed Chairman Bernanke suggest, the Treasury would purchase these assets at reverse auction for a competitive price, inject liquidity into the financial system while removing a considerable amount of risk and uncertainty, hold the assets until the housing market stabilizes, and then sell them back to the private sector. Observers much smarter than your intrepid S-Corp team — including Bill Gross and Warren Buffett — believe a properly executed plan would return a profit to the taxpayer.
The biggest obstacle to the bailout is the stand-off between Speaker Pelosi and House Republicans. The Speaker has made clear she will not move the bailout package unless a majority of House Republicans support it. But House Republicans — including their leadership and a substantial portion of their conference — have made it clear they oppose the current plan.
The solution is either that the plan changes enough to attract more House Republicans, or the Speaker moves the package without them.
- Here’s the latest Democratic draft reflecting the core proposal with numerous additions.
- Here’s the House Republican bailout principles released yesterday.
As you can see, there’s not a whole lot of common ground here. Republican Leader John Boehner just appointed the Republican Whip, Roy Blunt from , to represent House Republicans in future discussions, so talks will resume this afternoon and go into the weekend.
The question for S corporations is whether the dire predictions of the credit markets seizing up — affecting lines of credit, payrolls, etc — are realized before these talks result in some type of agreement.
Following a series of votes on alternatives, the Senate adopted a $150 billion package of tax extenders yesterday by a vote of 92-5. The key components of the package include:
- A one year extension of the higher exemption amount under the Alternative Minimum Tax. This provision will prevent about 20 million taxpayers from getting sucked into the AMT when they file their taxes this April.
- An extension of expired and expiring personal and business tax provisions, including the state sales tax deduction and R&E tax credit, though 2009.
- Several new provisions, including making the refundable child tax credit more valuable to low-income families and mental health parity provisions.
- Disaster relief for Hurricane Ike.
- A $17 billion package of energy extenders and new provisions, including an extension of the Section 45 production tax credit and a new credit for plug-in hybrid vehicles.
The big break-though was the decision by Senate leadership not to insist on offsetting the revenue impact of extending the AMT relief and other expired and expiring provisions. Of the total $150 billion revenue impact, only $42 billion is offset.
The package now moves to negotiations with the House, where its future is uncertain. The House today is expected to take up a smaller, $43 billion package of extenders fully offset with the same tax increases included in the Senate package.
All this action masks the fact that the underlying question remains the same — will House Democrats set aside their demand that all extensions of existing tax provisions be full offset, or will they accept the Senate compromise? With only a few days left before Congress leaves for the elections, we’ll know the answer in a couple of days.
Futures on Tax Rates
In the past, we have discussed how tax policy changes depending on who is the next President. Our assessment is that while there will be marginal differences, the final polices enacted under a McCain or Obama presidency will be more similar than not, with a strong bias for higher rates.
Greg Mankiw, former Chairman of the CEA, takes a more rigorous approach, but comes up with a similar conclusion. As posted on Greg’s blog:
What kind of tax policy will we get if John McCain is elected President? He says he wants to make the Bush tax cuts permanent. But is he likely to deliver that outcome in the face of a presumptively Democratic Congress? We can get some insight into this question using Intrade betting and some basic rules of conditional probability.
First, who knew the Intrade Prediction Markers tracked tax rates? Well they do, and using the current Intrade betting, Greg comes to the following conclusion:
That is, according to the Intrade betting, we are likely to see a significant hike in the top income tax rate even if McCain is elected President.
Estimating what will happen with the Treasury bailout plan is complicated by all the noise from Members of Congress expressing their opposition, advancing alternatives, and proposing additions like caps on executive compensation and changes to bankruptcy rules.
With a plan this large — and really, there’s nothing larger than giving Treasury $700 billion to save the economy – your S-CORP team prefers to step back and look at the forest.
Is the leadership in Congress willing to tell Treasury Secretary Paulson and Federal Reserve Chairman Bernanke “No” and take the risk — and responsibility — that the economy goes into free-fall? The answer is no, which means Congress will adopt some version of the Treasury plan with the core provisions intact.
The sausage making process will take a few days; it won’t be pretty, and many less than attractive provisions will be added to the legislation, but we believe it will get done.
By the way, Intrade agrees — the odds of Congress passing the package before the end of the month skyrocketed from yesterday’s close of 55 percent, to 80 percent this morning.