Business Community Supports Estate Tax Relief
The cost of the estate tax falls heavily on family businesses and farms. The cost comes not only from paying the tax itself, but also from estate tax planning costs. Resources diverted from businesses to pay for estate tax planning would be better invested in business operations and expansion.
The goal of the FBETC continues to be repeal of the estate tax, but this legislation will provide much needed additional relief above the current law. The higher exemption level and reduced rate will lessen the burden of the estate tax and provide family businesses and farms with more capital to reinvest in their business.
As S-CORP readers know, there are three key questions to any estate tax solution — what is the rate, what is the exclusion, and what is the base? Earlier this month, your S-CORP team was joined by fifteen other business groups to make sure Congress doesn’t increase the estate tax base for family owned businesses. This legislation would lock in the other two and help set the stage for continued estate tax relief in the future.
Taxes Are Going Up
The consensus in Washington is that taxes are going up. Just how high is debatable, but higher tax rates appear to be baked in whatever policy cake we are eventually served. So what does the Obama Administration think about higher rates? Obama economist Austan Goolsbee was on CNBC the other day and has this exchange on health care reform after CNBC Squawk Box host Joe Kernen pointed out marginal rates in his home state of New Jersey would soon approach 60 percent:
Goolsbee: We need health care reform so that small business can thrive. You know very well in every small business survey the unaffordability of health care is the thing that small business says is the number one barrier to their growth.
Kernen: But is there a marginal rate were you would say this is a disincentive for small businesses. Is there somewhere where you’re willing, where the administration is willing to draw the line?
Goolsbee: I don’t like high marginal rates, Joe, I agree with you. But to say the marginal rate is going to be 60 percent is totally nuts.
But Joe is right. Marginal rates are going much higher than what they were under Clinton if the House health care reform is adopted. Here’s a rough summary of tax rates in 2011 if the House health care bill is adopted:
| Rates in 2011* | |
| Top Rate | 39.6 |
| Health Reform Surtax | 5.4 |
| Medicare | 2.9 |
| State Average | 6 |
| Pease | 1.2 |
| Total | 55.1 |
(S-CORP ally Bob Carroll at the Tax Foundation issued a nice paper last summer summarizing these concerns and pointing out that high marginal rates are an extremely inefficient means of raising tax revenue.)
The good news is that it is still just 50/50 that the House surtax will survive in health care reform and make it to the President’s desk. The bad news is that won’t matter much, since the fiscal pressures facing Congress are almost unprecedented. As former CBO Director Doug Holtz-Eakin testified before the Senate Budget Committee earlier this week:
Any attempt to keep taxes at their post-war norm of 18 percent of GDP will generate an unmanageable federal debt spiral. In contrast, a strategy of ratcheting up taxes to match the federal spending appetite would be self-defeating and result in a crushing blow to economic growth.
In other words, we’re stuck between the proverbial rock and the hard place. Federal spending levels far exceed their post-war averages and unless taxes are raised to match them, the resulting deficits will be enormous. On the other hand, raising taxes by the necessary amount will, at best, retard economic growth and job creation for years to come.
And what is team Obama doing about this? Downplaying valid concerns about higher marginal rates and supporting legislation that will add more than $1 trillion to our spending obligations over the next ten years.
Update on Healthcare Reform in the Senate
Senate Majority Leader Harry Reid (D-NV) is still working to combine the two health care packages passed by the Senate Finance Committee and the Health, Education, Pensions and Labor Committee. Word is the cost of the plan may be going up. He also is reportedly looking at raising the threshold for the “high cost” plan from $21,000 to $25,000, resulting in lower tax collections from the excise tax. As a result, the Majority Leader is apparently looking into a new way to help pay for the cost of the package by applying Medicare taxes to non-wage income earned by couples making over $250,000. As Bloomberg News reports:
Reid’s proposal would apply Medicare taxes to non-wage income earned from capital gains, dividends, interest, royalties and partnerships for U.S. couples earning more than $250,000, the aides said. He’s also considering an alternative that would simply increase the 1.45 percent Medicare tax on salaries of couples who earn more than $250,000, one of the aides said.
This new pay-for is an attempt to scale back the previously proposed tax on so-called “Cadillac” health plans. So what does this mean for S corps? More pressure on rates, higher taxes on business income, and less capital to invest and hire new workers. And these hikes would take place during the worst economy since at least 1980 and maybe before. What are they thinking?
Estate Tax & PAYGO
Of interest to S-CORP readers, the bill to be considered by the House (H.R. 2920) specifically exempts four policies from the Paygo rules:
- Adopting the doctor payment fix proposed to Medicare;
- Extending the higher exemption levels under the Alternative Minimum Tax;
- Extending select tax cuts from the 2001 and 2003 tax bills; and
- Extending the 2009 estate tax rules to 2010 and beyond.
In other words, Congress is seeking to ensure it pays for any tax cuts or spending increases, except for the four policies listed above. As the Congressional Budget Office reported, “In effect, that rule would allow the Congress to enact legislation that would increase deficits by an amount in the vicinity of $3 trillion over the 2010-2019 period without triggering a sequestration.”
The theory behind the exemption is to allow Congress room to continue “current policy” in each of these areas. The $1000 child tax credit, for example, expires at the end of 2010. Extending the credit would reduce revenues by $243 billion over ten years. H.R. 2920 shields this cost and the cost of other similar policies from Paygo.
What does this signal for estate taxes? The policy exempted in H.R. 2920 is an extension of estate tax rules for 2009. As the bill outlines:
(B) with respect to the estate and gift tax, assume that the tax rates, nominal exemption amounts, and related parameters in effect for tax year 2009 remain in effect thereafter without change;
The exempted policy is consistent with the Obama Administration’s budget proposal and was scored by the JCT to reduce revenues by $243 billion over ten years. What doesn’t get exempted is any further reduction in the estate tax beyond the 2009 rules.
For example, Members have been working on a compromise that would lower the estate tax rate to 35 percent and increase the exemption to $5 million per spouse. That’s certainly better than the 2009 levels of 45 percent and $3.5 million but, under H.R. 2920, the increased revenue reduction from the compromise would need to be offset with tax increases elsewhere.
Where would Congress find offsets to a potential estate tax compromise? Both the Obama Administration and Congressman Pomeroy (D-ND) have proposed targeting family businesses for higher taxes by inflating the value of their estates. Exactly how much revenue this would raise is unclear, but family businesses need to be on alert.
A package that lowers rates below 2009 levels while inflating the tax base has the potential to raise, not lower, estate taxes on family-owned enterprises and may be no compromise at all.
Do Small Businesses Really Create All Those Jobs?
A recent paper by Alan Viard at the American Enterprise Institute raises two fundamental questions: Are smaller firms responsible for creating a majority of new jobs in our economy and is there a bias towards smaller firms in the tax code? With small businesses at the epicenter of the debate on reforming our health care system, clearing the record on these questions is critical.
The “small businesses do not really create all those jobs” argument has been around for a long time. However, it is usually raised by folks with a history of supporting Big Government and Big Business. Thus, having someone with Alan’s background on the other side is a new twist.
Regardless of who asks the question, however, the answer is the same. Yes, small businesses really do create all those jobs. Here’s what the Small Business Administration’s (SBA) Office of Advocacy writes:
Since the mid-1990s, small businesses have created 60 to 80 percent of the net new jobs. In the most recent year with data (2005), employer firms with fewer than 500 employees created 979,102 net new jobs, or 78.9 percent. Meanwhile, large firms with 500 or more employees added 262,326 net new jobs or 21.1 percent.
Critics argue that this analysis suffers from several flaws, including how to best classify firms using longitudinal data. For example, if a firm begins at 450 employees and grows to 550, the SBA says that’s 100 jobs created by small business. But if the same firm shrinks from 550 to 450 employees the next year, it’s a loss of 100 jobs for big business. Classifying the firm based on its initial size biases the results in favor of smaller firms.
But seriously, how many firms “cross the threshold” each year? There simply are not that many firms with more than 500 employees. Adjusting for these instances may move some numbers around, but the basic tenet remains intact — businesses employing fewer folks create most of the new jobs and policymakers should pay attention.
A study from the Bureau of Labor Statistics adjusting for these statistical challenges found that firms with fewer than 500 employees created about 80 percent of net new jobs. Enough said.
The question of whether the tax code is biased towards small businesses is more difficult. The tax code, after all is incredibly complex and it does include numerous provisions — like Section 179 — targeted to help smaller enterprises. How do you tally up all the variables?
S-CORP readers may remember Dr. Viard from the LIFO debate. Alan pointed out that, if LIFO accounting is an undeserved tax windfall, why is the effective tax burden under LIFO similar to that tax burden shouldered by other forms of capital investment? How could it be a windfall if the tax burden is the same?
The same approach may work here as well. If the tax code is too small business friendly, then the effective tax burden on S corporations, partnerships, and sole proprietorships should be lower than for other taxpayers. But a study commissioned by the Small Business Administration found that the effective tax burden for small businesses (including small C corporations) in 2004 was 19.8 percent, or 3.5 points above the average for all taxpayers that year. S corporations, by the way, faced the highest effective rate of 26.9 percent.
Moreover, limiting the analysis to income and payroll taxes does small business a disservice. Home Depot doesn’t worry about the estate tax, the family-owned lumber yard down the street does. And studies show that the burden of federal regulations falls more heavily on smaller firms than larger ones.
Finally, we believe Alan’s argument misses a broader point. Your S-CORP team is not comprised of legal theorists, but we do recall that government grants corporations the same legal status as individuals in order to encourage their creation and economic growth. Corporations can enter into contracts and appear in court. Perhaps most importantly, the owners of corporations are shielded from liability.
The S corporation was created, in part, to counter the advantage the corporate structure gives to larger firms. The idea behind the S corporation was to allow smaller firms to thrive by extending some of the essentials of the corporate structure without the onerous tax rules. But S corporation rules also limit their ability to grow and raise capital. They limit the number and type of shareholder and they limit how the firm can be structured. How do these rules enter into the question of bias in the tax code?
The bottom line is that the effective tax rate on small businesses is higher than the rate for taxpayers in general. Given that reality, it’s difficult to see how small businesses are somehow advantaged. If Congress wants to help larger businesses by cutting the corporate rate, we’re all for it. But don’t forget who creates most of the jobs out there. It’s small business, and during economic downturns, the role they play is more important than ever.
S-Corp Priorities Included in Small Business Tax Relief Bill
Just prior to the July 4th break, Senator Chuck Grassley (R-IA) introduced a package of small-business friendly tax provisions, including one of our S-CORP priorities – built-in gains relief! Specifically, the legislation (S. 1381) includes:
- Reducing the BIG holding period from 10 to 5 years;
- Providing a 20 percent deduction for flow-through business income for businesses with less than $50 million in annual gross receipts; and
- Increasing Section 179 expensing, lowering corporate rates, exempting business credits from the AMT, and other items.
As Senator Grassley stated when introducing the bill, “My bill contains a number of provisions that will leave more money in the hands of these small businesses so that these businesses can hire more workers, continue to pay the salaries of their current employees, and make additional investments in these businesses.”
S-CORP is excited to see Senator Grassley include S corporations in this package and we will keep you apprised of any movement on this legislation. While much of the news coming from Capitol Hill lately has been cause for concern for S corporations (see below), it’s great to see that our S-CORP champions on the Hill continue to recognize the importance of our community to growth and job creation.
S Corporations Survive Scrutiny!
Our friends at BNA reported yesterday that the preliminary results of the IRS “tax gap” look into S corporations are in. For the past seven or eight years, the IRS has been conducting a National Research Program that seeks to get a better idea of how much Americans underpay their taxes. For reasons known only to the IRS, the agency has targeted S corporations for closer inspection while largely ignoring other business structures. Regarding the new numbers, BNA reported:
An Internal Revenue Service study preliminarily found that S corporations underreported $50 billion in 2003 and $56 billion in 2004, an IRS employee in the Research, Analysis, and Statistics Division said July 8 at the IRS Research Conference. Drew Johns, citing the 2003-2004 National Research Program S Corporation Underreporting Study, said the net misreporting percentages, or ratios of the net misreporting amounts to the sum of the absolute values of the amounts that should have been reported, for these years were 12 and 16 percent, respectively. The error rates for each year were 69 percent and 68 percent, respectively, he said.
So what’s your S-Corp team’s take on this? Pretty positive, actually. Total compliance by all US taxpayers is around 84 percent (best in the world), so the IRS is telling us that S corporations are better taxpayers than the population in general. Moreover, that 69 percent error rate is eye-catching only until you realize that he’s talking about any error, even small ones that are immaterial to the amount owed.
One question we do have is why the total noncompliance rate jumped from 12 to 16 percent between 2003 and 2004? A 33 percent increase in non-compliance from one year to the next would appear to be a statistical outlier and deserves a closer look.
So to sum up, the IRS spent the last three or four years diving into S corporation tax returns and what they found is that S corporations are solid taxpaying citizens. Combine that finding with the SBA’s report that S corporations shoulder the highest effective tax burden of any business form, and our conclusion is that S corporations should be praised by policymakers rather than targeted for increased enforcement and higher taxes.
Paying for Healthcare Reform
Speaking of higher taxes, July may be the month when taxpayers learn how Congress intends to pay for health care reform. As we’ve reported, the plans in both the House and the Senate have price tags around $1 trillion over ten years.
About $400 billion of that amount will be offset by spending cuts to Medicare and Medicaid, so the remaining $600 billion would need to come from higher taxes. Finance Committee Chairman Max Baucus (D-MT) stated yesterday he needs to identify about $320 billion in new taxes, so he’s apparently comfortable he’s got about $280 billion in revenue raisers ready to go.
Where will the revenues come from? Until this week, the Finance Committee was focused on raising the revenue within the health care world, creating the expectation that some sort of cap on the employer-provided health care exclusion would be part of the mix. It’s health care, after all, and it’s the largest tax expenditure out there. But, it’s losing favor. The Wall Street Journal reported yesterday:
Sen. Kent Conrad (D., N.D.) and others involved in talks on a health bill said Tuesday that the idea of taxing health benefits is unpopular with voters, though they stressed that it hasn’t been completely swept off the bargaining table.
A proposal to cap the exclusion just above the cost of plans for federal employees would have raised $320 billion. It’s now apparently off the table, so that’s the revenue hole Senator Baucus was referring to in yesterday’s remarks.
Given the size of the tax expenditure, we still think some form of exclusion cap will make it into the final bill, maybe with a much higher cap of around $25,000. That “only” raises $90 billion (seriously, who knew that many health plans cost that much?) so other tax increases will have to be added.
What’s on the list? A proposal mentioned in both the House and the Senate would place a 2% surtax on families making more than $250,000. Bloomberg reported on Tuesday:
Two people familiar with closed-door talks by committee Democrats said a House bill probably will include a surtax on incomes exceeding $250,000, as Congress seeks ways to pay for changes to a health-care system that accounts for almost 18 percent of the U.S. economy. By targeting wealthier Americans, a surtax may hold more appeal for House Democrats than a Senate proposal to tax some employer-provided health benefits.
If this surtax is like the one proposed by Chairman Rangel in 2007, it would be assessed against AGI and it would apply to wages and investment income alike. As you can imagine, a surtax like that raises lots of revenue.
Another potential item would expand the Medicare payroll tax to income like capital gains and dividends — and possibly S corporation income too. Like the surtax, the last time something similar was proposed was back in 2007 in Chairman Rangel’s “Mother” bill. That proposal targeted S corporations engaged in services only, though, and would have raised about $9 billion. The new proposal is much broader and raises a reported $100 billion. The S Corporation Association led the effort to educate policymakers why this was a bad idea back in 2007, and you can bet we’ll have something to say about this broader proposal in 2009.
Other items under consideration — seriously or otherwise — include increased taxes on drug companies and insurers, capping the value of charitable and other tax deductions (preferred by the Obama Administration), taxing sodas and other sugared beverages, and increasing reporting requirement by corporations.
When will all this be put forward? We were hearing the House might make its plans known as early as tomorrow with the Senate following next week. The most current word, however, is both releases are going to be pushed back, perhaps weeks in the Senate’s case. As to the question of what will be in the plan, if we had to guess today, we’d say the revenue package could include:
- A surtax on income;
- Caps on charitable and other deductions;
- The soda tax;
- An expansion of payroll taxes to new income; and
- Modest caps on the employer-provide health benefit exclusion (Senate).
Some mixture of these could easily raise $600 billion or more over ten years. Whether they could pass Congress, particularly the Senate, is another question entirely. The fact that several raise marginal tax rates on job creators in the middle of a recession is certain to be a central part of the debate.
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.
Election Impact on S Corporations
We’ll write more about the election in coming months, but wanted to send out a quick summary of how the elections yesterday affect the S corporation community.
We’ve noted several times that President-elect Obama’s tax policies are not friendly to flow-through businesses. The combination of higher tax rates and a broader base has the potential to significantly increase the marginal and effective tax rates paid by S corporations.
One factor that may retard the push towards higher rates is the weakening economy. Now that the credit crisis appears to be under control, investors and businesses are faced with a classic cyclical slowdown that is likely to extend well into next year. Several Obama advisors have noted that raising taxes in such an environment is unwise, suggesting that the expected broad increase in taxes may be put off for a year or two.
One area where we expect quick action will be the estate tax. Several highly placed tax experts have indicated they have little intention of allowing the scheduled repeal to take place in 2010 followed by the Lazarus-like reemergence of the tax in 2011. Action on the estate tax should take place next year, and may include extending the 2009 rules into 2010 or swapping the estate tax with an inheritance tax.
In the Senate, the Democratic majority has 56 seats, with an additional four seats very much up in the air. As of this writing, S-Corp ally Senator Gordon Smith (R-OR) leads his Democratic opponent, Oregon Speaker of the House Jeff Merkley. However, his lead has decreased over the course of the day with a sizable number of precincts in Democratic-leaning Portland remaining to be counted.
In Minnesota, Senator Norm Coleman leads his Democratic challenger Al Franken by 690 votes with 100% of the precincts reporting. This razor-thin margin sets the stage for a mandatory recount that could take up to a month.
In Georgia, Republican Senator Saxby Chambliss has not yet secured over 50% of the vote, which is necessary under law to avoid a runoff on December 2nd. Senator Chambliss is the likely favorite if there is a runoff, given his Democratic opponent likely benefited from high turnout for Obama voters.
Finally, in Alaska, incumbent Senator Ted Stevens beat Anchorage Mayer Mark Begich (D) by just over 3,000 votes despite being convicted of several felonies last week. Senator Stevens now has the difficult choice of resigning his seat or face possible expulsion. It takes 67 votes to expel a Senator. Unlike many other states, Alaska requires a special election, rather than give the governor the power, to fill a vacant Senate seat. Thus, despite rumors, Governor Sarah Palin cannot appoint herself to the Senate, but she could run if she was so inclined. This seat might be vacant for several months.
Depending on how these four states break, Democratic Majority Leader Harry Reid could control anywhere from 56 to 60 votes when Congress returns in January.
In the tax-writing Finance Committee, the three Democrats who were up for re-election won easily — Chairman Max Baucus (MT), John Rockefeller (WV), and John Kerry (MA). Of the three Senate Finance Committee Republicans who were up, Senator Pat Roberts (KS) was re-elected with a solid margin, Senator John Sununu (NH) was defeated, and Senator Smith’s race has not yet been called.
The current ratio on Finance is 11 to 10. Given the new make-up of the Senate, expect a new Committee ratio of 12-10 or 12-9, suggesting that one new Democrat will be appointed while the Republican ranks will hold steady or, if Smith loses, add one. Senators Claire McCaskill (D-MO), Ben Cardin (D-MD), George Voinovich (R-OH) and Mike Enzi (R-WY) lead the list of likely additions.
In the House, Speaker Nancy Pelosi has at least 255 votes in her party, with a handful of seats still undecided. If those seats split evenly, then the Democratic-controlled House will have around 40 votes more than the majority of 218, giving them a very strong majority from which to move legislation. For some issues, they may need those extra votes, as the number of moderate Democrats representing conservative districts has grown dramatically. The centrist Blue Dog coalition has 47 current members, and will likely grow to more than 50 before the new Congress arrives.
On the House Ways and Means Committee, all 22 House Democrats running for re-election won. Today, Committee member Rahm Emanuel (D-IL) accepted an offer to serve as President-elect Obama’s Chief of Staff. There are two other vacancies to fill on the Democratic side due to the retirement of Rep. Michael McNulty (NY) and the death of Rep. Stephanie Tubbs Jones (OH) earlier this year. Meanwhile, two Ways and Means Republicans were not re-elected: Reps. Phil English (PA) and Jon Porter (NV). Additionally, six Republican Members of the Committee are retiring at the end of this Congress.
As for the Committee’s makeup, expect the ratio to move from 24-17 to something closer to two-thirds/one-third. Any combination is possible, but 26-13 sounds about right. Despite losing three Committee seats with the new ratio, Republicans still would need to fill four seats while Democrats would have five seats to fill.
Quick Stimulus Update
More on the possible lame-duck stimulus package courtesy of CongressDaily:
House Speaker Pelosi said this afternoon that the economy will be the major topic of discussion when congressional leaders meet with President-elect Obama, but that “even before that we have an economic stimulus package on the table that I hope Republicans in the Senate will allow to be taken up in a lame-duck session.” Pelosi said “those conversations are still taking place with the White House.” When asked whether two separate stimulus packages may be passed, Pelosi said “it depends on what the White House is willing to do.”
Bailout and Extenders Combined
As equity markets continue their wild swings while the credit markets signal distress, Congress will make another run at the financial sector bailout this evening.
This time the Senate will try. The new package retains the core of the bailout — authority for Treasury to purchase hundreds of billions of dollars worth of troubled mortgages and other assets — while adding an increase in FDIC insurance levels from $100,000 to $250,000, hurricane relief, and the Senate-passed tax extender package.
The Senate will take up the package this evening, voting around 8:00 pm Eastern Time. If it passes, the House will take it up tomorrow. Here’s the new package plus the timeline for Senate action.
The goal is for the Senate to pass this package with a strong vote and put new pressure on House members of both parties to support the bailout. The House needs at least 12 members to change their vote and support the package.
We are hearing that a significant number of House Republicans are prepared to support the bailout this time around. Those votes will be needed. The Senate extender package that passed the Senate 93-2 has focused opposition on the House side, including the caucus of moderate Democrats known as the “Blue Dog” coalition.
Blue Dogs oppose passing tax provisions without offsets, but they voted 26-21 for the failed bailout on Monday. How many of those 26 will switch and vote against this expanded package? Will increased Republican support be sufficient to offset Blue Dog defections?
House Leadership thinks it will, but then, House Leadership thought they had the votes on Monday too.
Effective Tax Rates
The Tax Policy Center has a new study comparing the effective tax rates under the Obama and McCain tax plans. According to the Center, the effective tax rate for taxpayers making more than $1 million stays the same under McCain (34 percent) but rises dramatically under Obama (45 percent if you include his payroll tax proposal).
We have pointed out in the past that fully one-third of all business income in this country is subject to the top two individual tax rates. Raising the effective tax rate on that income from 34 to 45 percent is going to harm small business creation and growth.
As Economist Greg Mankiw points out in his blog, higher tax rates also mean more dead weight loss to the economy, even if lower income taxpayers see their effective tax burden decline.
The deadweight loss of taxation rises roughly with the square of the tax rate. As a result, if one person sees the marginal tax rate fall from 20 to 15, while another sees it rise from 30 to 35, the average marginal tax rate is unchanged, but the deadweight loss increases.
In non-economist speak, that means a revenue neutral plan to balance tax cuts and higher government payments for low-income families with rate hikes on upper income families will result in less economic activity overall. That means less capital for investment and fewer jobs for workers.
Signs of recession are every where right now. The last thing Congress should consider is a hike in tax rates.
Budget Debate and Taxes
Everyone in Washington knows Congress will have to address the growth of the Alternative Minimum Tax (AMT) and the expiration of popular tax provisions over the next three years. Just how they will go about it, however, is very much up in the air.
Both the House and the Senate are considering their respective budgets this week. Lots goes into a federal budget, as you can imagine, but nothing is more important for S corporations than how this budget will address the AMT and expiring tax provisions.
On this question, the House and Senate are moving in opposite directions. The House wants to offset the full revenue impact of extending the AMT patch and related expiring tax provisions while the Senate does not.
This difference is reflected in their budgets. The House budget calls for enacting a revenue neutral tax package with a simple majority vote in both the House and the Senate, while the Senate budget would require this package to gain 60 votes in order to pass.
As CongressDaily reported this morning, this fight is a replay of the challenge that confronted Congress last year:
On the tax side, Spratt said House Democrats would stand with the Blue Dog Coalition and insist that a one-year patch to the alternative minimum tax be fully offset. Last year, the Senate was unable to muster the votes for a fully offset AMT patch, and House Democrats were forced to allow an unfunded fix to be enacted. “We’re very insistent on seeing that this time, when we do the AMT extension, the AMT patch, it be offset,” Spratt said. “On the other hand,” he added, “Since Conrad has some problems mustering the votes for that in the Senate, we’ll have to wait and see how it comes out.”
Your S Corp team would point out that while this battle is very serious in its own right, it is merely a precursor to a much larger tax fight that will take place when an increasing share of the tax code expires in coming years.
How big is this impending challenge? The Congressional Budget Office has conveniently put together a table of all the expiring tax provisions between now and 2018 and how much revenue would be lost by their extension.
A few comments are in order. First, just extending the so-called family tax relief—the new 10-percent bracket, the marriage penalty relief, and the refundable $1,000 child credit—will reduce revenues by nearly $650 billion between now and 2018.
Second, the full scope of total expiring provisions is staggering—nearly 100 tax provisions expire between now and 2018. Measured by their revenue, that’s nearly $4 trillion in current tax benefits that will go away between now and then, or about 10 percent of total projected revenue.
Third, the expiration of these provisions is taking place within the context of a rising tax burden, as projected federal revenues take an increasing share of our total national income. According to the CBO, the total tax bite will rise from 17.9 percent this year to 20.3 percent in 2018.
If Congress lives up to its intention to use Pay-As-You-Go budgeting (Paygo), where the extension of any expiring tax provision must be offset with tax increases elsewhere, then we’re looking at an effective real tax increase on families and businesses of unprecedented proportions in coming years.
Paygo and Tax Increases
As you may have noticed, a real concern of the S corporation community these days is the combination of multiple expiring tax provisions and the application of Paygo budgeting.
Consider how this works in practice. In 2010, S corporation shareholder Jim is subject to the top tax rate of 35 percent on both his salary and his business income. In that business, he takes advantage of Section 179 expensing. He also uses LIFO (Last-In, First-Out) inventory accounting and has an IC-DISC (Interest Charge Domestic International Sales Corporation) for his growing export business.
Absent congressional action, in tax year 2011 Jim’s tax rate will rise to 39.6 percent and his ability to write-off new capital investments will decline from more than $125,000 per year to $25,000. In other words, Jim is facing a sharp increase in his federal taxes in 2011.
Under Paygo, Congress can extend Jim’s lower rate and preserve current levels of expensing only by raising taxes elsewhere. (Technically, Congress could cut spending as an offset too, but to date has refrained from using that option.)
So to comply with Paygo, Congress could temporarily extend the lower tax rates and higher expensing limit by, among other offsets, permanently repealing LIFO accounting and the IC-DISC. This being Congress, they would then send out a press release letting Jim know how they prevented his taxes from going up.
But Jim’s taxes did go up. Yes, he retains the lower 35 percent tax on his income and the ability to write-off $125,000 of his capital investments, but he no longer has the ability to use LIFO accounting nor the IC-DISC.
As this example demonstrates, the combination of expiring tax relief and Paygo budgeting has tag-teamed Jim into a significant tax increase.
What’s particularly pernicious about Paygo is Congress’ ongoing habit of making tax relief provisions temporary while making their offsetting tax increases permanent. This combination ensures that tax collections in the future will rise above current projections.
As we mentioned earlier, the total federal tax bite is estimated to increase to record levels in the next decade. The combination of expiring temporary tax relief, permanent offsets, and Paygo will only serve to raise that burden even higher.
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