Payroll Tax Hikes Back On The Agenda
Last week, the S corporation community was put on high alert when we received word that an S corporation payroll tax increase similar to the provision from the old Rangel “Mother” bill (H.R. 3970) was being discussed as an offset to the extender package. The “Mother” provision (see Sec. 1211) would apply payroll taxes to all the service-related income of active shareholders of S corporations primarily engaged in service businesses. While we anticipate that the language of any new provision will differ somewhat from its 2007 predecessor, the general concept remains the same. As CongressDaily noted:
Sources familiar with the House Ways and Means and Senate Finance discussions said applying payroll taxes to certain S corporation profits could raise anywhere from $10 billion to $15 billion, depending on how it is structured. Revenues in that ballpark would go a long way toward closing a $30 billion gap tax-writers need to fill to pay for extensions of numerous expired provisions.
An earlier proposal floated in 2007 was estimated to raise $9.4 billion over a decade by subjecting S corporation and partnership income earned from providing services to payroll taxes, although the new healthcare law would raise the Medicare portion of the tax beginning in 2013 for wealthier earners. The 2007 proposal was scaled back from an earlier option outlined by the Joint Committee on Taxation that would have applied the payroll tax to all S corporation income, estimated to raise $57.4 billion over a decade.
Team S-CORP has had to fight this battle in the past, and we have been in to discuss this provision with Ways and Means on several occasions to get a better idea what they have in mind. Letters sent back in 2007 on behalf of S-CORP as well as our allied trade associations should give you a better sense of the history of this issue.
The future of this particular effort is still very much up in the air. Our communications with the Hill suggest there continues to be strong interest in legislating on this issue — you could characterize this as just one more legacy item left to us by former Senator John Edwards and his law practice — albeit it may take place on a bill other than extenders.
We have pledged to work constructively with taxwriters on a resolution to this issue, but unless they are willing to dramatically pare back the “Mother” provision to target only bad actors, it is going to be very difficult for business groups to support yet another tax increase on their members.
Stay tuned. More to come.
Latest on Dividends
Whither Tax Rates? The Hill’s On the Money Finance & Economy Blog had an excellent discussion this month on the topic, focusing on the future of dividend rates.
As On the Money notes, “President Barack Obama has proposed that the current rate of 15 percent on dividends be extended for most taxpayers. He’d raise the tax on dividends for individuals making $200,000 or more and families making $250,000 or more to 20 percent. There are several reasons to think wealthier taxpayers will get hit with a much higher tax.”
Meanwhile, The Hill mentions that one possible outcome would be for the dividend tax to fall somewhere between the current 15 percent rate and the top rate on ordinary income. Any divergence from the baseline, however, would require positive action by Congress. As The Hill observes, that’s not something to be taken for granted:
Finally, the lesson of the expired estate tax also has dividend-tax watchers nervous. Congress was expected to extend the estate tax last year, but instead let it expire when Republican and Democratic senators could not reach a compromise. The estate tax is set to kick in again in 2011 at a much higher rate if no action is taken this year.
Also at play is a possible House-Senate dynamic. Our impression is Senate leadership would like to keep capital gains and dividends taxed at the same rates, while their House counterparts are more comfortable seeing the rate on dividends go back to 39.6 percent.
In the end, we believe process will dictate outcome here. The recently enacted “pay-go” rules require Congress to offset any reduction in the dividend tax rate below 39.6 percent for 2011. Exactly what tax increases would Congress use to offset dividend tax cuts for folks making more than $200,000? We don’t know either, and expect the tax hikes already imbedded in current law will take place as scheduled.
Long To-Do List
Tax policy is in danger of becoming that honey-do list that never gets done. The traditional tax extenders — R&E tax credit, state sales tax deduction, etc. — all expired at the end of last year and, almost five months later, are still expired. Legislation to extend them is stuck between the House and Senate without a pay-for, yet (see above).
Meanwhile, the estate tax fix that was supposed to be done last year — before the tax took its one-year sabbatical — remains stalled in the Senate. Efforts to negotiate some sort of permanent fix are actively taking place in the Senate, so there’s hope. As with the extender package, however, the hold-up is primarily over offsets.
There’s also the most recent in the growing line of “jobs” bills being considered by Congress this year. The latest one passed the House under the banner of a “small business jobs” bill, despite the fact that most of its benefits went to Build America Bonds. We expect the Senate to take up a bill that’s more small-business oriented soon.
Finally, there’s the burning issue of all those tax cuts expiring at the end of the year.
With that as background, reasonable folks might ask themselves “What’s the plan?” Ways and Means Committee Chairman Sander Levin (D-MI) addressed this question earlier this month, stating he hopes to complete work with the Senate on both tax extenders legislation and the House-passed small business bill by the end of May, telling reporters, “These bills are a critical priority for the leadership of this Congress and the president…These are jobs bills … and we need to get these done.”
According to BNA, Levin met with Senate Finance Committee Chairman Max Baucus (D-MT) to discuss the two bills, but the two “did not discuss efforts to address the estate tax, which expired at the start of 2010, and no detailed plans have been set for how lawmakers will deal with the middle-class tax cuts of 2001 and 2003 that are set to expire at the end of the year.”
Your S-CORP team has numerous member companies who are intently interested in Congress moving forward on both the estate tax and the expiring tax provisions. We are five months into 2010 already. It’s time for Congress to act.
Built-In Gains in Play
Team S-CORP spent the last couple weeks on the Hill, educating members and staff on the virtues of reducing the built-in gains (BIG) holding period.
When a company converts to an S corporation, it must hold onto any appreciated assets for 10 years or face a punitive level of tax. This tax effectively locks up these assets, preventing the company from selling them and putting the resources to better use. We’ve raised this issue before, but allowing private companies access to their own capital makes lots of sense in an economy where capital is scarce. It also reflects the reality of today’s shorter lifespan for key business investments.
Last year, Congress agreed and included a shorter, seven-year holding period in the stimulus package. That seven-year period expires at the end of 2010 and needs to be made permanent. A five-year period would work, too. Last summer, Senator Grassley (R-IA) introduced legislation to reduce the BIG tax holding period to five years which we view as tremendously valuable to S corporations struggling to raise capital.
With the Senate actively considering provisions to help small businesses grow and create jobs, a shorter BIG holding period is going to give you more job-creating umph than any other tax provision we know. It would benefit Main Street firms located in every state and every sector of the economy and should be included in the final package.
The Skinny on the Jobs Bill
So we’re still trying to figure out what happened between Thursday morning and Thursday afternoon last week.
On Thursday morning, the Senate Finance Committee released an $84 billion “Jobs” bill draft with all the expected items included — jobs provisions, tax extenders, unemployment and COBRA extensions, etc.
That same afternoon, Senator Reid rejected that approach and offered a “skinny” $15 billion bill instead. He called up the House-passed Jobs bill, offered his skinny package as an amendment, filled the amendment tree, and filed cloture on the new package. The skinny bill includes the Schumer-Hatch payroll tax credit, Section 179 expensing relief, Build America Bonds, and an extension of the Highway bill authority until the end of the year.
What happened? A couple of explanations are floating around town. The first version is Senator Reid got an earful over the contents of the Senate Finance bill and its “Christmas Tree” appearance and elected to go with a less costly approach. Version two is that Reid was unhappy with Senator McConnell’s willingness to allow the bipartisan bill to move forward and introduced the skinny package in response. Version three is that this has been the plan all along — to introduce and pass a series of more narrow, jobs oriented bills. Version two got a plug from the White House. As CongressDaily reported:
White House Press Secretary Robert Gibbs said the president is “eager to sign” the jobs bill as pared down by Reid, and he called its provisions “very akin to what the president had in mind,” adding there will be more bills to refine the jobs strategy.
Either way, the Senate is set to vote on closing out debate on the smaller bill next week when the Senate next reconvenes. As always, cloture requires 60 votes for adoption.
Current favorite topic of speculation: Does Senator Reid have the votes? There is a lot of pent up support for extenders, UI and COBRA extensions, and some of the other provisions dropped in the move to the skinny bill, after all, and the Leader’s move left lots of Senate offices scratching their heads. As The Hill reported this morning:
But since he announced his smaller jobs bill, it has been under siege by Republicans and Democrats alike. Absent political arm-twisting by Senate leaders to bring their rank-and-file in line, opposition to the bill is expected to be bipartisan, sources said.
All of which suggests the Senate will eventually return to the larger, bipartisan package and the votes early next week are merely a diversion. We’ll see.
Finance Hearing on Small Business Taxes and Trade
The Senate Finance Committee has announced it will hold hearings on “Trade and Tax Issues Relating to Small Business Job Creation” next Tuesday. The witness list is TBD, but we understand someone from the U.S. Treasury Representative will testify, in addition to a couple of think tank folks and a small business or two. The hearing’s focus on trade is consistent with the Obama Administration’s new focus on increasing exports. As the President outlined in his State of the Union address:
Third, we need to export more of our goods. Because the more products we make and sell to other countries, the more jobs we support right here in America. So tonight, we set a new goal: We will double our exports over the next five years, an increase that will support two million jobs in America. To help meet this goal, we’re launching a National Export Initiative that will help farmers and small businesses increase their exports, and reform export controls consistent with national security.
If Congress and the Obama Administration are looking for ways to promote small business exports, the first thing they should do is embrace the current tax treatment of IC-DISC dividends. Two years ago, taxwriters in the House and Senate tried to eliminate the IC-DISC under the guise of making technical corrections.
This effort came despite the fact that small business exporting has been an unmitigated “good news” story in the midst of all the recent financial and economic turmoil. Small business exports are up and the IC-DISC helps. Small and closely held businesses who invest in the United States, create jobs here, and export products overseas can use the IC-DISC to help manage their tax burden.
With a major debate over the correct tax treatment of dividends and capital gains on the horizon, we expect the tax treatment of IC-DISC dividends will once again be before Congress. As such, we’re revamping our efforts to ensure the IC-DISC remains in place to help the next crop of small business exporters break into new markets overseas. Let us know if you’d like to help.
Jobs Bill on Senate Floor Next Week
Senate leadership has committed to taking up a Jobs bill next week. The details of the package are still being worked out, but the list released by the Senate Democrats includes:
- Job Creation tax credit
- UI and Cobra Extensions
- Bonus depreciation and 179 expensing
- Highway funding
- Build America Bonds
- SBA loans
- Export Promotion
- Some energy related tax items
Although it’s not mentioned, we do expect the tax extenders to also be part on the mix. On the other hand, an estate tax fix is not likely to be included. Senator Reid told reporters that he still plans to move legislation restoring the estate tax, just not now. Meanwhile, policymakers are increasingly worried that time is slipping by. As BNA reported earlier:
Proponents of making the estate tax retroactive to Jan. 1 say case history is on their side, although they admit it will be more complicated because the longer they wait to enact legislation, the more people will attempt to game the tax system.
We are not exactly sure how one would “game” the current system. You have to pass away, after all, to take advantage of the current rules. Final jeopardy, indeed. Takeaway: more chatter about getting something done, but no clarity on when they would do it, what it would look like, whether the House is on board with the retroactive application, or whether they have better guidance on the constitutionality question.
Also, we are hearing from folks that a possible solution would be to offer estates the option of using the 2009 rules or the repeal rules. Point of this would be to protect those mid-sized estates (around $7 million) from paying more under repeal than they would have under last year’s rules. That would certainly get around the retroactive question, but it would also raise the cost of acting.
Rep. Paulsen Weighs in on Marginal Rates
The battle over tax rates is heating up. This week, Congressman Erik Paulsen (R-MN) sent the President a letter asking him to focus on proposals that would hold down marginal tax rates and spur small business growth.
The letter refers to a bill introduced by Rep. Paulsen (H.R. 2284) in May that would allow individual taxpayers an exclusion from gross income for certain items of partnership and S corporation pass-through income up to $250,000 ($500,000 for married couples filing joint returns). As Rep. Paulsen notes, this ability to defer taxes on reinvested income “ensures that small business owners are taxed only on the profits taken out of their business, and also allows for the deferment of taxes on income that was placed back into developing their business. By encouraging reinvestment and incentivizing job creation, we can reach our shared goal of economic growth.”
Paulsen also discusses the possibility of creating “an alternative rate schedule for income stemming from small business activity, including sole proprietor, partnership, and S corporation income” in order to “ensure that marginal tax rates would not rise for America’s job creators during a weak economy.”
Amen to that. America has a vibrant, active Main Street business sector because past Congresses have proactively adopted policies to encourage small business creation and growth. Creation of the S corporation was one of those policies. Now is not the time to reverse course.
John Edwards and S Corporations
One of our allies asked us, “How did John Edwards come to be the poster child for S corporations?” He’s featured prominently in a recent CongressDaily story and, frankly, it’s not an association we’re eager to continue.
The Edwards issue first emerged during the 2004 presidential campaign when we learned that, prior to be elected, Senator Edwards operated his law practice as an S corporation. According to reports — recapped by CongressDaily — Edwards took most of his earnings in the form of S corporation distributions which are not subject to payroll taxes.
As you can imagine, this use of the S corporation caught everybody’s attention and the “John Edwards Issue” was born. We still hear “Oh, is this that John Edwards thing?” when we talk to staff about payroll taxes.
While the payroll tax issue continues to be difficult for policymakers and tax collectors alike, the rules governing when S corporation shareholders pay payroll taxes have been in place for long time. Since the IRS released Revenue Ruling 59-221 back in 1959, S corporation shareholders have been required to pay payroll taxes, but only if they work at their business and only on the wages they pay themselves. Revenue Ruling 74-44 made clear that “dividends” paid to shareholders will be recharacterized as wages when the dividends are in lieu of reasonable compensation for services performed for the S corporation.
Despite these clear rules, when Congress lifted the cap on the Medicare payroll tax back in 1993, it created an arbitrage opportunity for business owners whose income exceeds the Social Security wage base. Organize as an S corporation, pay yourself little or no salary, and avoid paying the Medicare tax.
The S Corporation Association’s position on this is three-fold. First, people should pay the taxes they legally owe — we don’t support tax avoidance. Second, while it is admittedly time-consuming, the IRS has the tools necessary to deal with this issue and collect the money owed. As the IRS wrote one taxpayer back in 2003:
Generally, under the rules described above, if a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services. An S corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed.
Third, every legislative proposal we have seen to date to “fix” this issue has been overly broad and would raise taxes on shareholders already fully complying with the law.
As we mentioned, applying the “reasonable compensation” standard is difficult and time-consuming, but the standard is well established and ensures that payroll taxes only apply to shareholder income derived from their services, as opposed to income stemming from their investments in the business and its employees. As you can imagine, capital-intensive industries like manufacturers and others are keenly interested in making certain this line of demarcation is preserved.
The GAO spent the last year looking into S corporations and the tax policy challenges they present. On the payroll tax issue, the GAO recognized that the IRS has the tools in place to enforce current law. Its recommendation:
To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed.
We understand the current rules are not a perfect solution to the “John Edwards Issue.” But then, nothing else is either. We hope the IRS follows the GAO’s recommendation and works to improve its guidance and enforcement of reasonable compensation. Effective enforcement would take the pressure off policymakers to codify new rules, and remove from the S corporation community the threat that fifty years of tax policy will be turned on its head.
Business Community Rallies Around S Corporation Modernization
Last week, your S-CORP team sent a letter signed by 22 of our association allies to members of the House and Senate, urging them to cosponsor legislation to replace the dated rules that have governed S corporations for over fifty years. As the letter notes:
These outdated rules hurt the ability of S corporations to grow and create jobs. Many family-owned businesses would like to become S corporations, but the rules prevent them from doing so. Other S corporations are starved for capital, but find the rules limit their ability to attract investors or even utilize the value of their own appreciated property.
Well into the 21st century, America’s most popular form of small-business corporation deserves rules adapted to today, not fifty years ago. The S Corporation Modernization Act would ensure the continued success of these businesses.
Earlier this Congress, House Ways and Means Member Ron Kind (D-WI) and Senate Finance Committee Members Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) introduced the “S Corporation Modernization Act of 2009” (H.R. 2910 and S. 996) in their respective chambers.
The legislation, designed to update and simplify the rules governing S corporations, enhances the ability of S corporations to attract and raise capital, makes it easier for family-owned S corporations to stay in the family, and encourages additional charitable giving by S corporations and the trusts that hold them.
In the coming weeks, S-CORP will be ramping up its efforts to gather additional support for these bills. At a time when America’s job creators struggle through the difficult economy and the Federal government struggles with massive deficits, smaller, targeted reforms like these are an attractive means of helping Main Street without breaking the bank.
Health Care Reform Outlook & S Corporations
Just about everybody agrees the political landscape has shifted to the point where, while there were once 218 House votes in favor of a reform package, now there are nowhere near that many.
This lack of support is evidenced by the Rube Goldberg-nature of the current efforts to resurrect reform and move it through the Congress. One popular idea is for the House to pass the Senate bill, and then take up a reconciliation package of items to “fix” what’s wrong with the Senate bill.
We are skeptical anything like that happens. Health care reform is unpopular and members are nervous and tired. Moreover, this approach would require House members to “vote on faith” that the Senate would follow-through and adopt the fix. There is rarely a lot of trust between House members and the Senate under normal circumstances, and these are not normal circumstances.
Our expectation is for the hand-wringing to continue for a month or so and then for other pressing items like the jobs bill and the budget to push heath reform aside.
For S corporations, it is hard to regret the demise of this particular reform effort. We have refrained from weighing in on the merits of health care reform — it is a little outside our focus, after all — but the impact of paying for health care reform was clearly going to be a negative.
The House bill would have raised marginal rates on upper-income S corporation shareholders by 5.4 percentage points, while the Senate bill would have increased the Medicare HI tax from 1.45 percent to 2.35 percent — not a direct shot at S corporations, but it would have increased pressure on the IRS and others to change the payroll tax treatment of S corporation income.
And before talks broke down, House and Senate negotiators were seriously considering tossing out those items and expanding the tax base for payroll taxes to include capital gains, dividends, interest income, and S corporation income instead. As the Los Angeles Times wrote:
Democratic congressional leaders are considering a new strategy to help finance their ambitious healthcare plan — applying the Medicare payroll tax not just to wages but to capital gains, dividends and other forms of unearned income. The idea, discussed Wednesday in a marathon meeting at the White House, could placate labor leaders who bitterly oppose President Obama’s plan to tax high-end insurance policies that cover many union members. It could also help shore up Medicare’s shaky finances, and the burden of the new tax would fall primarily on affluent Americans, not the beleaguered middle class.
It would have fallen on the beleaguered S corporation community, too. Moreover, these increases were going to take place when taxes on S corporations (and other flow-through businesses) already were going up. Current law has the top income tax rate returning to 39.6 percent at the beginning of next year, and we anticipate the President will propose to keep these rate hikes in place, at the very least.
Finally, with health care reform out of the way, taxwriters on the Hill will have time to address some of the many tax items that were pushed aside last year, including tax extenders and a broader tax reform effort. As BNA noted this morning:
Last December, Rangel told a group of executives that he planned to press his case for tax reform at the conclusion of the health care debate.
It appears health care reform is over, so we expect Congress to refocus on tax policy this year.
S-Corp Organizes Defense of Family Business
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.
S-Corp Modernization Bill Introduced in the House
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…
Budget Process and Reconciliation
Both the House and the Senate completed their respective budget resolutions last week. The plan now is for the two bodies to get together to resolve any differences and produce a single budget in the form of a conference report. We expect most of those discussions to take place over the next couple of weeks.
One of the key questions for budget conferees is whether or not they will include reconciliation instructions for health care reform and climate change. As S-CORP readers know, the virtue of reconciliation is that it lowers the bar to pass something in the Senate from a 60 vote supermajority to just a basic majority (in this case, half of those present and voting plus Vice President Biden).
As has been noted, currently the Senate budget does not include reconciliation instructions at all while the House included them for health care and education only. This lack of instructions does not mean the Senate leadership had decided to forego reconciliation. Instead, most observers believe they were intent on pursuing a conference strategy whereby the House reconciliation instructions would be expanded to also include the Senate.
By adding the instructions at the last moment in conference, Senate leadership avoids an ugly floor battle on all of these issues. Instead, senators would be given one vote — up or down — on the conference report as a whole without the ability to make any changes.
Floor action last week, however, threw a big monkey wrench into that plan, at least as far as climate change is concerned. On Wednesday, the Senate voted 67-31 to support Senator Mike Johanns’ (R-NE) amendment. The amendment reads:
Section 202 is amended by inserting at the end the following: “(c) The Chairman of the Senate Committee on the Budget shall not revise the allocations in this resolution if the legislation provided for in subsections (a) or (b) is reported from any committee pursuant to section 310 of the Congressional Budget Act of 1974.”
In effect, the Johanns’ amendment is a statement that the Senate should not use reconciliation for climate change legislation. While the provision itself could easily be dropped in conference and reconciliation instructions added in its place, that change would still face the 67 senators who by all appearances are opposed to using this process to consider cap and trade, at least this year.
All the more reason for S-CORP readers to expect health care reform – rather than climate change – to be the first major reform item considered by Congress this year.
Estate Tax Votes
Lots of Senate activity on the estate tax front as well. The underlying budget resolution produced by the Budget Committee assumes Congress would extend 2009 estate tax rules for 2010 and beyond.
That means the top tax rate on estates would hold at 45 percent and the exclusion would be $3.5 million per spouse. That’s a definite improvement over where we started in 2001, with a top rate of 55 percent and an exclusion of $1 million per spouse, but its step back from the one-year repeal currently scheduled to take effect in 2010.
To make the pending compromise a little better, S-CORP ally Senator Blanche Lincoln (D-AR) offered an amendment to allow the Finance Committee to consider a deficit-neutral alternative with a 35 percent top rate and a $5 million per spouse exclusion. The S Corporation Association joined a long list of business groups in support of the effort. That amendment was adopted by the Senate, 51-48 with all Republicans and 10 Democrats voting in support, including Finance Chairman Max Baucus.
What followed then was a classic “what just happened?” moment when the Senate also adopted, 56-43, an amendment by Senator Dick Durbin (D-IL) to create a point of order against any additional estate tax relief (beyond the underlying resolution) that doesn’t include an equal amount of tax relief for families making less than $100,000.
It is possible to support both middle-class tax relief and estate tax relief, so exactly what the implications the Durbin amendment has for future estate tax legislation is unclear. For the moment, we’ll focus on the positive, which is that a majority of the United States Senate is now on record supporting an estate tax deal that is better than the 2009 rules. Given the current leadership in Congress, that may be as good as we’re going to do.
SBA on Effective Tax Rates
Anybody involved in tax policy for a reasonable period of time will pick up on the prejudice of some policymakers and folks at the IRS that S corporations tend to under-pay their taxes. Over the years, the S corporation has been described by some as “tax avoidance schemes” and worse.
Given that background, the findings from a new report commissioned by our friends at the Small Business Administration (SBA) might surprise you. Of the four core business types — C corporation, S corporation, Partnership, and Sole Proprietorship — which one pays the highest effective tax rate?
S corporations! By a lot.
The research, conducted by Quantria Strategies for the SBA, looked at a broad sample of firms with under $10 million in gross receipts and found that S corporations pay a significantly higher effective tax rate than C corporations, partnerships, or sole proprietorships.
Average Effective Federal Income
Tax Rates by Legal Form of Organization, 2004
Entity Type Rate (%)
Sole Proprietorship 13.3
Small Partnership 23.6
Small S Corporation 26.9
Small C Corporation 17.5
All Small Business 19.8
Source: Quantria Strategies LLC
To be fair, the effective tax rate for C corporations does not include taxes paid by shareholders on dividends and capital gains. As the researchers note:
… the effective tax rate analysis does not capture the taxes paid by C corporation owners on dividends and capital gains. This will tend to understate somewhat the total effective tax rate of small businesses organized as C corporations, but this bias will tend to be small, particularly because of the fairly low rates of tax currently applicable to individual dividends and capital gains.
So even with the shareholder level tax included, the research suggests that S corporations may shoulder the highest effective rate of any business type.
What’s the source of the higher tax burden? After all, the tax treatment of S corporations at the federal level is mirrored on the tax treatment of partnerships. One possibility is that S corporations may tend to be older, more mature companies that were organized before the emergence of the Limited Liability Company.
Whatever the underlying reason, if your operating premise is that S corporations have a significantly lower tax burden than comparable businesses structured as partnerships or C corporations, you might want to think again.
Jobs and Trade
Our friends at the Kaufman Foundation have a great site devoted to entrepreneurship called growthology that’s worth a look. The site is heavy on the high-tech side of growth, but it’s a great window into how the internet and entrepreneurship are combining to form an incredibly potent partnership.
What caught our eye this month was a new survey of economic bloggers on the best sources of job creation in the economy. “Economic Growth” was number one — no news there — while free trade was well down the list. Your S-CORP team finds that strangely disturbing. If anybody should understand the critical importance of open borders to continued economic growth, it’s economists who use the internet to circulate their writing. What is the internet, after all, but one big open border of products and ideas? Maybe it was just how the questions were worded, but this tepid response on the importance of free trade is one more reason to fear for the future of global commerce.
Second Stimulus on the Horizon
A second stimulus package is being formulated up on the Hill, but is by no means a done deal at this point. Just before adjourning for the election, the House passed a $61 billion bill containing infrastructure spending, aid to state governments and increased unemployment benefits, which will likely serve as a starting point for second stimulus discussion. That package included:
- $30 billion for infrastructure projects including highways, bridges, transit and water projects;
- $1 billion for public housing;
- $2.6 billion for food stamp program;
- A temporary increase in Federal Medicaid assistance to states; and
- An extension in unemployment benefits.
Other items that could be contained in a second stimulus package include the Columbia Free Trade Agreement, middle class tax relief, and changes to the TARP program. Emily Barrett from the Wall Street Journal reports that Treasury is “under pressure to broaden eligibility for assistance to smaller banks, as well as the cash-strapped autos sector.” Other actions related to the stimulus include:
- Speaker of the House Nancy Pelosi and Senate Majority Leader Harry Reid met with the CEO’s of America’s automakers last week to discuss billions of dollars of additional assistance to the industry. The two leaders subsequently asked Treasury to make relief to the automakers part of the $700 billion TARP plan.
- President-elect Obama made an economic stimulus his top priority at last week’s press conference. He indicated if one was not enacted during next week’s lame duck session, he would make it the first order of business in 2009. He also indicated that the package needed to focus on assisting the middle class with job creation and an extension of unemployment benefits.
- RollCall reports that Majority Leader Hoyer (D-MD) is suggesting that, absent an agreement with the Bush administration — which he described as “elusive” — the House might not ask rank-and-file members to come back next week.
All this activity suggests that, while the odds of a package getting enacted are extremely high, it will probably be early next year before anything moves.
Endangered Tax Species — LIFO
Your S-CORP staff is tempted to create an Endangered Species List for tax provisions. Deferral and Section 199 would top the list as the most likely to be extinct before the end of the next Congress.
LIFO accounting is another. A subset of accounting and tax professionals have been pursuing LIFO for years, and they are closing in. The Joint Committee on Taxation — the tax professionals that Congress uses to help them assess changes to the tax code — fired another shot last week.
In its annual “Tax Expenditures” report, the Committee has for the first time (to our knowledge) listed LIFO. For those of you who don’t follow such things, a tax expenditure is a congressional concept identifying tax provisions that divert from the basic approach to taxing income and measuring the revenue lost by those provisions — tax credits, certain deductions, and lower rates on investment income all qualify as tax expenditures. The concept was first introduced into budget speak in the 1960s and has been highly controversial ever since.
Conservatives especially dislike the idea since it implies that all your income is the government’s and if the government chooses not to take it from you, then that’s the equivalent of giving you a subsidy. Supporters argue that the point is to give policy makers better information on how much certain tax policies reduce revenues so they can make better decisions.
Either way, getting LIFO listed as a tax expenditure gives LIFO opponents one more argument to make in attempting to repeal it.
We will write more on this in the future, but suffice to say that LIFO does not belong on the tax expenditures list anymore than FIFO does. Moreover, while the JCT states its goal in revising the methodology of the expenditure report was to create a more neutral approach, we’re not sure they succeeded.
Capital Gains and Dividends
We’ve written about the likelihood that the capital gains rate is going up in the next couple years. Lots of our members would like to know just when that is going to occur so they can plan accordingly.
The economic distress of the last year and the rising deficit opens the possibility that Congress could enact a rate hike next year but make it effective January 1, 2010. The outcome of the prospective effective date would be to stimulate economic activity — and federal revenues — in 2009. A similar rate increase adopted in 1986 (made effective January 1, 1987) resulted in an enormous increase in federal tax revenues in 1986 as taxpayers rushed to sell their assets and qualify for the lower rates.
As S-CORP readers know, we favor lower rates over higher ones, especially when the higher rates only apply to S corporations and not C corporations. That said, encouraging asset sales at a time when many investors and companies are being forced into asset fire sales already might not be the best policy. Encouraging sales of appreciated property into a bear market may have the opposite of the intended economic effect by further driving down asset prices for everyone.
Obama and S Corporations
The Texas and Ohio presidential primaries are dominating the news today, so we thought we’d take a look at the candidates’ tax policies and see how they would affect S corporations. We’ll start with Illinois Senator Barack Obama.
So would an Obama presidency be good for S Corps? Here’s a quick summary of his positions and how they might affect Main Street.
Income Tax Rates: Obama supports letting the top tax rates revert to their pre-2001 levels. In other words, the top tax rate would rise from 35 back to 39.6 percent, the 33 percent bracket would rise to 36 percent, and the 28 percent bracket would likely rise to 31 percent.
Capital Gains and Dividends: While the Senator initially indicated he would like to see the tax rates on investment income rolled back all the way to their pre-2003 levels, some campaign advisors are now suggesting that he would support some middle ground rates of around 25 percent for both dividends and capital gains. Either way, he supports increasing rates on investment from current levels.
Estate Tax: Obama has called for a $3.5 million exemption per spouse, and while he has been quiet on what rate would be applied to the remainder, the impression we have is that the law as it exists for 2009 — a $3.5 million exemption coupled with a 45 percent top rate — is probably close.
Social Security Taxes: The Senator has come out in favor of raising the Social Security earning cap from its current $102,000 to an undisclosed amount to help make Social Security more solvent. Under current law, workers pay Social Security taxes (12.4 percent) on the first $102,000 they earn and Medicare taxes (2.9 percent) on the rest. The Obama plan apparently imposes the full combined tax (15.3 percent) on incomes above a certain level, perhaps $200,000.
Alternative Minimum Tax: We can’t find any indication of what he would do about the growth of the AMT.
S Corp readers know that payroll tax issues are of particular importance to our members. Some in Congress and the IRS would like to have payroll taxes apply to all S corporation income. Combine that desire with an increase in the payroll tax wage cap, and you’re looking at a truly historic tax rate increase on thousands of small and closely-held businesses.
Even without payroll tax convergence, the economic plan outlined above represents a large tax hike on S corporations. Right now, C corporations and S corporations pay a similar top marginal tax rate on their undistributed earnings — 35 percent. Under the Obama plan, the rate for S corporations would rise to nearly 40 percent, while the rate on C corporations would remain the same.
Meanwhile, while public corporations are immune to the estate tax, a family-owned S corporation worth more than a few million dollars would be subject to estate tax rates as high as 45 percent when the business is transferred from one generation to the next.
On the tax cut side, there’s little in the Obama plan to encourage S corporations. Rather than broad policies, he is offering instead a series of small tax credits for low-income workers, tuition expenses, a larger child tax credit, and a small savers tax credit. He would also allow seniors to earn up to $50,000 before they have to pay taxes.
On net, tax policy under a President Obama would mean higher taxes for S Corporations, but not on their larger C corporation competitors.
Alternative Minimum Tax & the Candidates
Senator McCain favors of repealing it. Senator Clinton wants to reform it. And Senator Obama has yet to mention it (as far as we can tell).
What is it? The alternative minimum tax, and together with the expiring Bush tax cuts, it presents Congress with the dominate tax policy challenge of the next three years. This chart from the Tax Policy Center does a better job of outlining the AMT challenge than any words we could write.
Simply put, absent change the AMT will take over the individual income tax, with most of the revenue collected by the federal government coming from the AMT. Taxpayers most likely to get hit by the AMT include those with children and those that live in high tax states like New York and California. Since S corporations pay their business tax as individuals, the growth of the AMT has particular importance to our members.
One interesting aspect of the current presidential run is that all three of the remaining viable candidates are members of the United States Senate and will have the opportunity to vote on many of these critical tax issues over the next few months. Repealing the AMT is a $1.5 trillion challenge, so just how the candidates reconcile their other tax priorities with possible Senate votes to protect taxpayers from the AMT this session will be very telling.
Peering into the Future of Tax Policy
We’ve been asked to gaze into our crystal ball and see what the future of tax policy looks like. For S Corporations, it looks a lot like when the Ghost of Christmas Future popped in to see Ebenezer Scrooge. Nothing has been etched in stone yet, but it’s still not a pretty picture of things to come.
On the macro level, three factors are going to frame the tax policy debate in the next Congress:
1. All the tax relief enacted in 2001 and 2003 expires at the end of 2010. Unless Congress takes action, tax rates on individuals and flow-through businesses, the child credit, estate tax, marriage penalty, small business expensing, etc all revert to their pre-2001 levels.
2. The Alternative Minimum Tax will continue to take over the tax code. In tax year 2007, about five million taxpayers will pay AMT. Absent action, that number will rise to 25 million in 2008 and grow from there.
3. The long term budget deficit picture is bleak. Over the next five years, the federal budget actually moves towards balance. Beyond five years, however, the growth of Social Security and Medicare will crowd out all other categories of federal spending, driving up deficits to unsustainable levels.
The combination of 1 & 2 also raises the projected federal tax burden on families and businesses to historic levels. As the CBO reports:
Under the assumption that current laws and policies will remain the same, total revenues reach 20.3 percent of GDP in 2018, a level not reached since 2000, and prior to that, not since World War II.
So the baseline is higher taxes on S corporations (and everybody else) together with growing deficits. With that as the backdrop, what is likely to happen? While much depends on who controls Congress and sits in the Oval Office next year, a couple things are clear.
First, the bias is for tax rates to rise. If Congress chooses to do nothing, or even if it’s deadlocked and unable to move meaningful tax bills that take the tax code in either direction, rates are going to go up.
Second, the current obsession with “pay-as-you-go” tax policy will pressure Congress to raise rates even higher. For example, Democrats and Republicans alike are eager to extend the $1000 child tax credit and marriage penalty relief. But extending this tax relief counts against the baseline and under PAYGO would require an offset.
That’s the dilemma for PAYGO advocates. They want to extend the tax relief for middle income families, but they want to offset the associated revenue loss too.
How high is the revenue loss? The President’s recent budget submission puts the ten-year revenue loss of the child credit and marriage penalty provisions at over $300 billion—more than the cost of extending the lower rates on dividends and capital gains.
Add to that the cost of eliminating the AMT and you get a sense of just how hungry Congress is going to be for tax revenues in the next three years.
As a result, we expect there to be a big push to enact tax reform next Congress. Ways and Means Chairman Charlie Rangel plans a series of hearings on the issue in coming months and use those hearings as the basis for moving a broad reform package next Congress.
What will it look like? His “Mother” bill introduced last fall is good place to start. We previously highlighted the particular dangers this legislation poses to S corporations. In fairness to Chairman Rangel’s staff, they’ve listened to our concerns and expressed a sincere desire to continue communications. Nonetheless, the factors highlighted above would tie the hands of even the most pro-S corporation Committee. The Mother bill reflects those challenges.
For starters, it assumes all the Bush tax relief expires in 2011. It then reduces taxes (or increases refunds) for lower income families, swaps the AMT for a four-percent surtax on families and businesses earning more than $150,000, and cuts the corporate tax rate while eliminating numerous deductions used by C and S corporations alike. The net result for S corporations is higher tax rates applied to a broader base of income.
The Christmas Carol had a happy ending because Ebenezer changed his behavior and thus his future. In that regard, he had an advantage over S corporations. Ebenezer, after all, was master of his own destiny. The S corporation community must work within the legislative process.
Nonetheless, we do have the ability to influence tax policy. As an Association, we intend to continue to work with our allies to ensure Congress understands the role S corporations play in job creation and economic growth. With a new President, Congress, and tax reform on the table for 2009, this education effort is more important than ever.
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