Finance Committee Chairman Max Baucus staked out unique turf yesterday, calling for keeping tax policy stable for middle class taxpayers, allowing rates to rise for taxpayers making more than $250,000, but for taxing capital gains and dividends at 20 percent. As BNA reports:
“I’m going for policy, and I think 20 percent for both capital gains and dividends is the right policy,” Baucus told reporters. Baucus acknowledged that the tax cut would specifically benefit the same $200,000 per year individuals that he has said should not expect to see their ordinary income tax rates cut again for 2011, but said the difference is that capital gains and dividends deserve to be treated the same under the tax code.
For wages and salary income for top-earning taxpayers, Baucus reiterated his position that Congress should focus on permanent tax cuts for only middle-class households and not entertain any temporary extensions of tax cuts for high-income individuals.
In effect, Senator Baucus is pressing for the tax policies outlined in President Obama’s budget. That budget called for taxing dividends at 20 percent, but the rhetorical battle over the past year has allowed that fact to slip aside. As your S corporation advocates, we feel compelled to observe the inconsistency of a policy that would keep (dividend) rates low for C corporation shareholders but would allow rates to go up for S corporation shareholders. Why is one better than the other?
Exactly how all this gets done also is unclear. There may be some effort in the Senate to bring up and pass a Baucus-like bill before the Senate adjourns (probably at the end of next week now), but that effort will likely be wrapped up with strict limits on debate and amendments, and the Republican minority has been successful this Congress blocking such requests.
If the Majority Leader wants to get anything done before the elections, he’ll need to set some time aside and let the Senate work its will. With time so short, we don’t expect that to happen.
S-CORP in Wall Street Journal
With the focus on flow-through businesses and the pending tax hikes, your S-CORP team is getting more press these days. The latest was earlier this week in the Wall Street Journal, where journalist John D. McKinnon quoted S-CORP Executive Director Brian Reardon on a story summarizing the rate debate. As the Journal writes:
Republicans cite studies showing roughly half of all such income would be affected by raising the top two rates. Democrats say only about 3% of households reporting such income account for that half. That suggests much of the income comes from big businesses operating under small-business structures, they say. Businesses affected by the top tax rates include all sorts of concerns, from farms and manufacturers to high-tech and professional firms.
That trend has been under way for years. Congress authorized Subchapter S corporations in 1958 to encourage the growth of small companies. The popularity of pass-through entities grew in the 1980s with the lowering of individual tax rates and other rule changes.
By now, “the vast majority of employers in this country are organized as flow-throughs,” said Brian Reardon, executive director of the S Corporation Association, which represents such companies.
Later, John gets to the heart of the matter:
But the new-found importance of such enterprises-regardless of their size-means raising individual tax rates could have significant economic impacts. This week, Moody’s Economy.com said raising taxes on higher earners would reduce GDP by 0.4 percentage point in 2011, while payroll employment would be 770,000 lower by mid-2012.
As we’ve pointed out before, the debate over tax rates is really a debate about jobs. The current obsession of policymakers over distinctions between small and large businesses or manufacturers verses professional services businesses is really beside the point. There are S corporations and partnerships in all business sectors, and they are all employers.
It’s July 14th, 2010. There are approximately 30 legislative days before the fall elections and less than six months before huge portions of the tax code expire, so it’s only appropriate that today, the Senate Finance Committee held the first substantive hearing on the implications of allowing the Bush tax cuts to expire. Some key points:
- Chairman Max Baucus (D-MT) clearly takes a dim view of flow-through taxation for certain firms and appears dismissive of arguments that higher rates will hurt the business community and employment. Washington Wire readers are encouraged to watch the hearing and see for themselves, but it’s obvious that we have lots of work to do in defending the basic S corporation structure.
- Dr. Doug Holtz-Eakin alone made the point that as long as federal spending was too high — well above historic norms already, with the explosion in entitlement spending still before us — and until it is addressed, tax policy is going to be an exercise in second-best options.
In one “laugh out loud” moment, Professor Len Burman pointed out that higher tax rates may increase entrepreneurship because business owners have access to more deductions. In other words, let’s raise taxes because that will encourage taxpayers to come up with novel ways to avoid paying them? Being entrepreneurial in your tax avoidance is not the sort of entrepreneurship we’re looking for here.
Perhaps the best point of the hearing was made by S-CORP ally Dr. Holtz-Eakin, who, in a back-and-forth with Chairman Baucus, made the case for flow-through taxation as cogently as anybody to date. Boiled down, his point is that because individuals pay all business taxes anyway, it makes good policy sense to tax business income at the individual rates directly.
So what to conclude? The list of witnesses and tone of the majority–especially the Chairman’s–suggest this hearing was designed to lay the policy predicate for higher rates next year. What’s unclear is exactly which taxes the Committee plans to raise. Despite what you might read, most of the Bush tax cuts enacted in 2001 and 2003 went to middle- and low-income Americans, not the rich. So the pending tax hike is going to impact regular families in a very real and harmful way. With just 30 days of legislative session left before the elections, even a well intentioned effort to extend those tax policies may fall short.
Perhaps more importantly, the hearing demonstrated the lack of a plan for what happens beyond 2010. Even if Congress extends some or all of the 2001 and 2003 tax cuts, something more comprehensive is needed if the United States is not to follow Greece down the path towards the third world. Senators Ron Wyden (D-OR) and Judd Gregg (R-NH) have introduced what they describe as a budget neutral tax reform plan. In the absence of any other ideas, it might be worth a look to see what they propose.
Estate Tax Fix Introduced in Senate
In more tax news, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) yesterday evening introduced an amendment to make permanent changes to the estate tax. As the entire tax world knows, the estate tax is taking a one-year hiatus in 2010 before returning in 2011 with a top rate of 55 percent and an exclusion of $1 million.
This dramatic shift, from a regime that applies a capital gains tax on inherited assets when they are sold to a very high 55 percent rate imposed at the death of the estate’s principal is possibly the largest marginal rate hike in history and is giving estates and estate planners alike a very real case of whiplash. Nobody predicted we would be in this situation a year ago, and the uncertainty is having a very real impact on how folks are behaving.
The Lincoln-Kyl proposal is designed to mitigate this harm and uncertainty by making permanent a middle ground on taxing estates. Key provisions in the bill include:
- Reducing the top estate tax rate to 35 percent;
- Increasing the exclusion from $1 million to $3.5 million; and
- Allowing the estates of deceased taxpayers to choose between no estate tax and limited “carryover basis” or the provisions included in this plan for 2010.
Missing from the proposal are any revenue increases or spending cuts to offset the revenue loss of the lower rates and higher exclusion. The selective pay-go rules adopted by Congress earlier this year allowed Congress to extend 2009 estate tax rules without offsets, but any reduction in the estate tax beyond that would have to be offset or face a 60 vote Budget Act point of order. Filling this revenue hole, which has been estimated in the $50-$75 billion range over ten years, has been a significant challenge for the Lincoln-Kyl team, and it appears it still is unresolved.
While the Lincoln-Kyl proposal is targeted at the pending small business bill, it is unclear whether they will get a clean vote on the issue. Majority Leader Reid has filled the so-called amendment tree and is taking other steps necessary to limiting changes to the underlying bill. Regardless, the introduction of this legislation is the first substantive effort in the Senate to enact a permanent estate tax fix, which is progress. The question now is whether there’s enough time in the legislative calendar for this debate to play out. Stay tuned.
A recent Washington Times article by Mike Whalen, chief executive of Heart of America Restaurants and Inns, should give policymakers pause as they worry about weak job growth while simultaneously piling one tax on top of another onto job-creating companies. Using 2008 numbers, Whalen runs through all the taxes a single 100-room limited service hotel located in Iowa pays:
For starters, we pay property taxes to the tune of about $199,000 annually. Next, there is a 7 percent “pillow tax” that generates about $162,000 annually. Then we pay a 6 percent sales tax on revenue that yields about $124,000 annually. Then we also pay sales tax on things like toilet paper, shampoo, soap, continental breakfast food and amenities and other items that the state of Iowa says are not really part of the product we sell because it says we are selling space. It may come as a surprise to you that toilet paper is not part of what you are buying when you rent a hotel room in Iowa, but the state considers it a gift. Those extra sales taxes come to about $1,800 per year.
Now on to Round 2. This little hotel also pays about $3,000 a year in various licenses and fees. Payroll taxes come to about $60,000. The federal government says the depreciable life of a hotel is 39.5 years, but we refurbish the hotel on a constant basis and pay sales tax on related purchases, such as new carpet, mattresses and bedding, and even paint. Anyone who doesn’t believe we already have a partial value-added tax (VAT) like Europe, isn’t in business. Now, between Round 1 and Round 2, we’re at $548,000 in taxes annually.
So, even if we don’t make a dime of profit, and before we pay the mortgage to the bank or buy new stuff, we pay $548,000 in various taxes, licenses and fees.
As Whalen points out, this tax burden doesn’t include state or federal income taxes. Those taxes are going up. And the alternatives aren’t pretty either:
…if I sell the hotel, I’ll pay a hefty capital gains tax of 25 percent, and it’s probably going up. Alternatively, when my wife and I die, I’ll pay another 45 percent if the estate tax returns in 2010. But don’t worry: We have diverted money from productive investments to pay for life insurance to partially pay this bill.
A central question to any economy is, “Where are tomorrow’s jobs going to come from?” A small hotel in the Midwest may not immediately come to mind as part of the answer, but ask folks in Iowa whether those jobs are important. And then ask yourself whether the tax changes just enacted, coupled with those on the horizon, are going to make it easier or harder for Mike and other entrepreneurs to take risks, invest in properties like a limited service hotel, and create jobs. The answer is pretty obvious.
Whither Tax Rates?
Following the release of the S Corporation Association letter on the new 3.8 percent tax and its impact on future tax rates, we got into a back and forth with a reporter over what is the appropriate baseline for measuring future rates.
We used a current law baseline, which is the same baseline the Congressional Budget Office and the Joint Committee on Taxation use when making their estimates. Under current law, for example, the tax rate on dividends is scheduled to rise from 15 percent today to 39.6 percent next year to nearly 45 percent in 2013 when the new 3.8 percent tax kicks in. That’s three times the current tax!
The reporter, on the other hand, suggested it would be more appropriate to use President Obama’s proposals as the correct baseline. Under the President’s plan, the top rate on dividends would rise to 25 percent in 2013 based on his proposal to tax capital gains and dividends at a 20 percent base rate. Here’s a comparison of the two baselines and their respective rates:
|Top Marginal Tax Rates in Future Years|
|* Current Law and Obama Budget include the phase-out of itemized deductions (Pease)|
Unless you’re actually working for the White House or OMB, using the President’s budget proposals as the baseline requires a certain amount of faith — faith he will press for those proposals, faith the Congress will pay attention, faith other priorities will not get in the way. The President’s budget does call for a statutory rate of 20 percent for 2010 and beyond, but most observers are betting rates of 28 percent or higher are more likely.
But that’s all beside the point. As the chart demonstrates, tax rates on investment are going up sharply regardless of which baseline you use.
More on the Investment Tax and S Corporations
Our Google Alert did its job and alerted us to another website devoted to S corporations – www.scorporationsexplained.com. It appears they too are concerned about the new 3.8 percent tax on investment income and S corporations. As web author Stephen Nelson explains, even S corporation shareholders active in the business may end up paying this tax on some of their S corporation income:
Once a taxpayer’s income exceeds the threshold amount, investment income gets hit with the tax. But it’s important to note that investment income earned inside an S corporation retains its character as the income flows through to investors. This means that even working shareholders may pay the new Medicare tax on the chunk of the S corporation’s profit that occurs because of interest, dividends, capital gains, or rental income earned by the S corporation.
Example: Your share of an S corporation’s profit is $100,000 but only $80,000 of this $100,000 represents profits from the business operation. The remaining $20,000 of profit comes from dividends, interest and capital gains earned on investments held by the S corporation. In this case, no matter whether you’re a working shareholder or a passive shareholder, you’ll pay the Obamacare Medicare tax on the $20,000 of investment income that flows through to you if your income exceeds the threshold amounts.
This result suggests the new tax may be more expansive than it appeared at first glance, especially for mature S corporations that control more than one entity.
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.
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.
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.
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.
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:
- 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.
- 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.
- 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.
- 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.
- COBRA & Unemployment: Funding for extended benefits runs out soon, as do extended COBRA benefits.
- 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.
- 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.
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
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.
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.
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…