Another interesting week in our nation’s capital. The big news is the tax deal struck between Congressional Republicans and the White House. We expect this deal to pass, with few changes, either next week or when Congress returns the first couple weeks in January. Here are some useful summaries and the legislative text if you’re interested:
The Senate is going to take the package up on Monday and should pass it Tuesday night or Wednesday morning. It then goes to the House, where it faces an angry liberal caucus and its leadership. According to the Hill:
House Majority Leader Steny Hoyer (D-Md.) said earlier Thursday night that the House will probably take a vote but on what remains to be seen.
“Well, we’re going to see what comes from the Senate,” he said on MSNBC. “But we’re going to vote on something, I’m sure. Whether it’s exactly what the president made a deal with on the Republicans or not, that remains to be seen.”
For S corporations and the markets, though, the key was to get an agreement. It is less important that the deal is being temporarily blocked and more critical that we have a little clarity on tax policy for the next two years. Either this year or very early next year, Congress will pass a two year extension of most existing tax policies. The delay of a few weeks might matter to the IRS and short-term withholding tables, but not to real investment and hiring decisions.
In the meantime, the question for policymakers is whether to make concessions to the current House Democratic leadership in order to get them to bring up the bill next week. Knowing that they can pass the deal intact on January 3rd, Republicans are going to be reluctant to make substantive changes to the deal, especially on key items like the estate tax, so the leverage of House leadership should be limited. We’ll see.
Estate Tax Compromise
We know lots of folks care about the estate tax provisions in the deal so here is summary of those provisions. Considering the alternative — higher rates and lower exemptions from now on — the negotiators did a remarkable job getting this agreement:
Temporary estate, gift and generation skipping transfer tax relief. The EGTRRA phased-out the estate and generation-skipping transfer taxes so that they were fully repealed in 2010, and lowered the gift tax rate to 35 percent and increased the gift tax exemption to $1 million for 2010. The proposal sets the exemption at $5 million per person and $10 million per couple and a top tax rate of 35 percent for the estate, gift, and generation skipping transfer taxes for two years, through 2012. The exemption amount is indexed beginning in 2012. The proposal is effective January 1, 2010, but allows an election to choose no estate tax and modified carryover basis for estates arising on or after January 1, 2010 and before January 1, 2011. The proposal sets a $5 million generation-skipping transfer tax exemption and zero percent rate for the 2010 year.
Portability of unused exemption. Under current law, couples have to do complicated estate planning to claim their entire exemption (currently $7 million for a couple). The proposal allows the executor of a deceased spouse’s estate to transfer any unused exemption to the surviving spouse without such planning. The proposal is effective for estates of decedents dying after December 31, 2010.
Reunification. Prior to the EGTRRA, the estate and gift taxes were unified, creating a single graduated rate schedule for both. That single lifetime exemption could be used for gifts and/or bequests. The EGTRRA decoupled these systems. The proposal reunifies the estate and gift taxes. The proposal is effective for gifts made after December 31, 2010.
President Mentions Tax Reform
With the tax outlook for the next two years almost in place, we’re wondering what’s next? The current extension takes us right up to the President’s reelect in 2012 (and the reelect of 23 Democratic Senators) and we can’t imagine they’d welcome a reprise of this year’s battle over rates, etc.
So what’s the plan? The Hill’s On the Money Blog suggests it could be broad based tax reform. According to the Blog:
An administration official said the tax reform ideas are now being examined under the direction of Assistant Treasury Secretary Michael Mundaca and Treasury adviser Gene Sperling.
Treasury and the President’s Economic Recovery Advisory Board previously had examined reforming corporate tax rates, but had not considered eliminating individual tax breaks and lowering individual rates as part of a deficit reduction package until the commission raised the idea, the official said.
The administration official said a likely next step will be for placeholder language for tax reform to appear in the Obama 2012 budget, with the details of the tax reform to be worked out in the following months. The deficit commission report recommends putting the new tax code in place by 2012.
Lots of folks are skeptical that this President will be able to work with the incoming Republican House, especially on something like tax reform, but the tax deal just agreed to is evidence that the two sides can work together when circumstances force their hands. With massive deficits projected from now on, the circumstances should be there.
With Congress gone, we thought we might dust off the old S-CORP Crystal Ball and make some predictions. By all accounts, the seats in play this cycle are well above the norm and this could go down as an historic election, much like 1974 or 1994.
So what do we expect? We predict that Republicans will control the House next year, while Democrats will retain the majority in the Senate, albeit with just a one or two vote majority. We come to this conclusion after reviewing the following sources:
We recommend each, especially the RCP site. It’s an eye-opener. The RCP has Republicans winning 212 House seats, excluding the results of 44 toss up races. It takes 218 seats to control the House, so Republicans would only need to win 6 out of 44 to get there. No wonder Intrade predicts there’s an 88 percent chance they win the House.
Meanwhile, RCP has Republicans winning 46 seats (up from 41 now) with six seats in the toss up category (no, the Delaware seat is not one of them). Joe Biden is the Vice President and the President of the Senate, so Republicans would need to win five of six toss-up seats in order to control that body. It is possible, but highly unlikely.
So we predict the House flips while the Senate stays. What are the implications for tax policy and S corporations?
Rates: We’ve written extensively about this and our general view remains the same. Of the three possible broad outcomes – 1) nothing happens, 2) an extension of middle-class relief only, and 3) an extension of everything for one year — it’s a close race between nothing and everything, with the middle-class option nowhere to be seen.
For example, we can see how Congress comes back from the election and, despite an unusual number of seats switching parties, the stalemate over this issue continues. Speaker Pelosi will still control the House floor, after all, and the President would still be waiting with his veto pen. To date, they have yet to change their “middle-class only” position.
What might cause them to change? The size of Republican gains is one possible variable. If they win the bare minimum to claim the House — 40 to 50 — then we expect the Speaker and President to hold firm and nothing to happen. If Republicans win a huge number however — 60 to 70 — then there’s a chance the Speaker may step aside and allow the House to extend everything for one year. The President also may embrace an opportunity to kick this issue into next year.
The other key variable here is the economy. It continues to struggle, and it is hard to believe the President’s economic team would welcome a $230 billion one-year tax hike on families and businesses. We’ve made the case for extending the current top rates. It’s a question of jobs and investment. But what about the threat to the economy if nothing gets extended? The experts we listen to suggest it sharply raises the possibility of a Double-Dip Recession.
That has to be a concern for everybody, which is why we believe a one year extension of everything (rates, dividends, cap gains, credits) is now the slight favorite for the Lame Duck.
Estate Tax: How do you handicap a race that shouldn’t have happened? Congress should have passed something last year. Then it should have acted quickly early this year. People were leaving large estates in limbo as their attorneys waited to learn what the rules would be. Last summer, too, was a good time to provide clarity.
Now, almost a year later, they are still waiting. Ouch.
One explanation for this inaction is that Congress, or at least those folks running things, are happy with the status quo. They might not have the votes to reinstate the old estate tax proactively, but they can get to the same place through inaction. Just wait a couple months and you’ll see.
Another explanation is that no particular fix enjoys sufficient support to pass. They could make permanent 2009 rules. They might embrace the Kyl-Lincoln formula of 35 percent rats and $5 million exemptions. They could allow the old 2000 rules to rise from the dead with their 55 percent top rate and measly $1 million exemption. Or anything in-between. With so many options, no one option appears to have the 60 votes needed to pass the Senate.
So what is our prediction? We don’t have one, or more accurately, we don’t have a strong sense that one option will prevail. Which suggests that nothing happens and the status quo — a return to 55 percent and $1 million — has the best chance for next year. And if you passed away in 2010? Well, you were lucky, estate-tax-wise. You’re probably also not reading this. But we digress.
Meanwhile, careful S-Corp readers will remember we were particularly concerned with valuations. Congressman Earl Pomeroy (D-ND) introduced legislation this Congress that caught the attention of the valuation crowd. Among other things, the bill would disallow minority interest discounts for family-owned businesses. The argument is that related parties always act in concert, so if the broader family controls the business, minority discounts should not apply.
There are numerous problems with this approach– families don’t always act in concert, you can’t have two competing valuation systems, etc. With the [likely] pending flip in the House, and the possibility that Pomeroy loses his seat (he’s down), what are the odds that this issue lives?
Surprisingly good, unfortunately. Both President Obama and key tax folks on the Hill believe this approach is good tax policy and we expect to see some version of this policy in the President’s budget. Which means we need to keep after this issue, and not let it be described as a “tax loophole” or “tax evasion.” Even a Republican Congress will need to find new revenues. Punishing family businesses with higher estate taxes should not be the source.
Payroll Tax: A provision included in the House-passed tax extender package last summer included an $11 billion tax hike of S corporations in the form of higher payroll taxes for some service sector companies.
S-Corp led the charge to oppose this unjustified tax, convincing a bare minimum of forty-one Senators to oppose the package, including S-Corp champ Olympia Snowe (R-ME). It was close, but ultimately Finance Committee Chairman Max Baucus (D-MT) dropped the provision from the broader package.
But what about next year? This issue has been around as long as S corporations (more than fifty years) but it really gained notoriety when former Senator John Edwards used his S corporation to block paying payroll taxes on his law practice. Edwards is gone, but the issue lives on.
With Republicans taking the House, the pen for drafting tax policy will shift from Congressman Sander Levin’s (D-MI) hands to Congressman Dave Camp’s (R-MI). They are both from Michigan, but that’s where any similarity ends. We do not expect a payroll tax hike to emerge from a Camp-led Ways and Means Committee. Using an S corporation to block payroll taxes you legally owe is tax avoidance. It’s against the rules, and the IRS has the tools to go after you. The $11 billion tax hike passed by the House last year was about revenue, not tax enforcement.
The provision could emerge from the Senate and the Administration, however, so we’ll continue to work this issue and educate policymakers on the distinction between a tax loophole and tax avoidance.
So those are our S-CORP Crystal Ball predictions into the future. The predictions are based on a Republican House and Democratic Senate. That seems to be the most likely outcome this November, but things change. If they do, we’ll come back with some new assessments. It’ll give us something to write about while Congress is gone.
President Obama — Tax Cutter?
The New York Times ran a piece the other day entitled, “From Obama, the Tax Cut Nobody Heard Of.” What they are referring to is the $400 Making Work Pay credit adopted as part of the broader 2009 stimulus package. This credit was available in 2009 and 2010 and had a total price tag of $116 billion.
The point of the story is that the President, contrary to the popular perception, is actually a tax cutter. From our perspective on the front lines of many of these battles, we’re not sure we agree.
First, many of these credits went to families with no tax burden. Of the credit’s $116 billion cost, about $37 billion takes the form of transfer payments from one taxpayer to another and are not properly described as tax relief. For example, a family filing jointly with two kids and making $40,000 typically has no income tax liability and would receive an additional $800 refund under this credit. Not bad, but it’s not tax relief.
Second, the credits were — by design — temporary. The net tax relief from the credits took place in 2009 and 2010. So even if you could describe the President as a tax cutter because of this provision, it only was only temporary. Tellingly, the President’s most recent budget only calls for a one-year extension of the credit. Again, temporary.
Finally, the credit’s net tax relief is fully offset by tax hikes the President either has signed into law or has put forward as part of his two budgets. Unlike his tax cutting accomplishments, this list is long and permanent, and includes the $400 billion-plus tax increase enacted as part of health care reform, including the new 3.8 percent tax on all investment income.
Taken on balance, it is hard to make the case that this President is a tax cutter. He has proposed tax cuts in the past, and signed some of those into law. But he has signed into law or proposed many more tax hikes — including a $700 billion permanent tax hike about to take effect this January — and has made clear in his rhetoric and his budgets that he believes a significantly higher tax burden is both necessary and appropriate.
So what to make of the new effort to label the President a tax cutter? Could it be a trial balloon preceding a shift in his tax policies in the new Congress? We’ll see.
S-Corp Joins Panel on Tax Policy
Looking for a concise review of the tax issues facing private businesses? Look no more!
Last month the Heritage Foundation hosted a forum on “Pro-Growth Tax Policy for All Americans.” S-Corp Executive Director Brian Reardon joined several other tax experts, including the Tax Foundation’s Scott Hodge, in reviewing the state of tax policy and where it’s headed in 2011.
Members of Congress are back home and set to return mid-September for a final three week session before the November elections. Add in two or three weeks of possible “lame duck” session, and that’s the extent of time available to tax writers to address the numerous items on their honey-do list:
- Preventing the 2011 tax hikes (including AMT);
- Adopting the small business tax bill;
- Extending the extenders that expired last year;
- Extending the extenders that will expire this year; and
- Something on the estate tax.
Given that these issues have been before Congress the entire year, it’s difficult to conceive how Congress would suddenly jump into action on all these items before the clock runs out. And while recent statements by leadership suggest they will make a concerted effort to address most of these items before adjourning for good, the Senate continues to be hamstrung in its ability to move anything. Here’s our take on the where we go from here:
- Small Business Tax Bill: The bill itself is non-controversial and has bipartisan support. What’s holding it up is a fight over the process — will amendments be allowed and, if so, how many — and on-going debates over extraneous tax items like the future of the estate tax. Majority Leader Reid was very close to a deal with Minority Leader McConnell just prior to the break. We expect further progress and ultimate adoption of this package in September.
- Tax Hikes: Last week, Finance Committee Republicans issued a statement calling on the Committee to hold a markup on extending current rates “as soon as possible to bring certainty of continued tax relief…” Meanwhile, House Majority Leader Steny Hoyer is calling for extending only those provisions for taxpayers making less than $200,000. And several Senate Democrats — notably Senators Kent Conrad (D-ND) and Evan Bayh (D-IN) — have expressed support for a one-year extension of everything. No clear path out of this challenge, but we continue to believe a one-year extension of everything is most likely, followed by failure of Congress to pass anything. A one year extension of the middle-class relief is a close third.
- Extenders: Extenders will likely move as part of the small business tax bill in September, which is good news for manufacturers and families living in states with no state income tax. The bad news is the extension would last just until the end of this year, so another bill would have to follow soon.
- Estate Tax: We’re now four months away from seeing the estate tax rise from the dead (55 percent top rate and $1 million exemption) with no apparent solution in view. Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) are pressing for lower rates and a higher exemption (35 percent and $5 million) while others support adopting the rules in place in 2009 (45 percent and $3.5 million). Still a third camp is happy to see the estate tax return in full force. Time is short, and no side appears to have the 60 votes necessary to prevail, which means current law has the upper hand.
Regarding the floor situation, Senate Majority Leader Reid set up the small business bill to be pending business as soon as they get back on September 13th. He introduced yet another substitute before they left and filled the amendment tree to block other amendments. He then filed cloture on several democratic amendments to the bill as well as the underlying legislation, setting up a series of 60-vote threshold cloture votes in the first couple days when they return.
While it’s possible these votes take place and fail along party lines, it’s more likely the two leaders come to an agreement on allowing a limited number of amendments — including adding the extender package to the mix – for the bill to move forward. At least that’s what we hope, since there are some very good provisions in the small business bill that should help investment and job creation.
Regarding the other items, including Extenders v. 2011, we’re expecting the rest of the to-do list to get pushed into a lame duck, with some sort of omnibus bill that includes federal funding and tax provisions presented to members in November or December. No idea how that battle royale turns out, but we’ll be sitting in the front row to watch.
More on S Corporations and Employment
The ongoing battle over the pending tax hikes has a tendency to devolve into a debate over the definition of “small” business and other random characteristics a firm needs before it be considered “real” by some policymakers. For example, proponents of the tax hike appear to believe a manufacturer is more “real” than a law firm, even though both are taxed as flow-through entities and both might be defined by the SBA as small.
But this debate over which types of business activity are “real” is silly and misses the point. The point is that a large percentage of the pending tax hike will be imposed on employers and investment. One half of all business income is taxed at the individual tax rates. One quarter to one-third of all business income is subject to the top two rates. That’s a lot of economic activity subject to the pending tax hikes.
Consider this debate from the perspective of the employee: whether your job comes from a large S corporation or a small S corporation makes no difference to you; both are employers, and your job is your job. So why should policymakers care whether you work at a 500 employee manufacturing plant or a 12 person law firm? Why do some policymakers believe one job worth saving but the other not?
One challenge we face in this debate is that while the folks at the Statistics of Income break down firms by structure, they don’t include employment numbers, so it’s difficult to tell how many employees work for S corporations. One way to back out an estimate is to look at their payroll and executive compensation numbers. If we assume the average compensation of an American worker is $40,000 (admittedly a rough estimate) then it appears S corporations employed about 21 million workers back in 2007.
Moreover, S corporation employment gets bigger the more revenue and income a firm makes (as you’d expect). Firms with more than $50 million in revenues employed about 4.5 million workers, while firms with $10 to $50 million in revenues employed 4.4 million workers.
Firms that size have average business income per shareholder exceeding $335,000, which means more often than not, their business income is taxed at the top two rates. Are the nine million employees who work at these firms less deserving than the employees who work at the local coffee shop? Obviously not, but for some reason the other side of this debate spends an enormous amount of time trying to minimize the value of those employees and the firms they work for.
Again, these numbers are just rough estimates, but the point they make is valid nonetheless: flow-through businesses — including S corporations — represent the majority of employers in this country and raising their taxes is not going to help the economy or the job picture.
Joint Committee Estimates Tax Hikes
In response to a request from the Ways and Means Committee, the Joint Committee on Taxation released some estimates last week on who would benefit from foregoing the rate hikes and other tax increases next year. You may have seen related stories focusing on how much “millionaires” would benefit. A couple thoughts:
First, while the JCT estimates that taxpayers earning over $1 million would see an average tax break of $103,834, they also estimated this break would reduce their tax burden by only 11 percent, suggesting that these taxpayers will pay nearly $1 million in income taxes next year on average.
Second, the revenue “cost” of avoiding all the tax hikes next year is not substantially more than the cost of avoiding those for taxpayers making less than $200,000 — $227 billion versus $202 billion.
That’s not as much as we would have expected, and in our view raises the odds that Congress extends for one year all the 2001 and 2003 tax cuts. It’s not a done deal, of course, and total inaction by Congress is also possible, but with the weak job market and pending elections, the legislative equivalent of a punt — a one year extension of everything — is looking increasingly likely.
It’s July 14th, 2010. There are approximately 30 legislative days before the fall elections and less than six months before huge portions of the tax code expire, so it’s only appropriate that today, the Senate Finance Committee held the first substantive hearing on the implications of allowing the Bush tax cuts to expire. Some key points:
- Chairman Max Baucus (D-MT) clearly takes a dim view of flow-through taxation for certain firms and appears dismissive of arguments that higher rates will hurt the business community and employment. Washington Wire readers are encouraged to watch the hearing and see for themselves, but it’s obvious that we have lots of work to do in defending the basic S corporation structure.
- Dr. Doug Holtz-Eakin alone made the point that as long as federal spending was too high — well above historic norms already, with the explosion in entitlement spending still before us — and until it is addressed, tax policy is going to be an exercise in second-best options.
In one “laugh out loud” moment, Professor Len Burman pointed out that higher tax rates may increase entrepreneurship because business owners have access to more deductions. In other words, let’s raise taxes because that will encourage taxpayers to come up with novel ways to avoid paying them? Being entrepreneurial in your tax avoidance is not the sort of entrepreneurship we’re looking for here.
Perhaps the best point of the hearing was made by S-CORP ally Dr. Holtz-Eakin, who, in a back-and-forth with Chairman Baucus, made the case for flow-through taxation as cogently as anybody to date. Boiled down, his point is that because individuals pay all business taxes anyway, it makes good policy sense to tax business income at the individual rates directly.
So what to conclude? The list of witnesses and tone of the majority–especially the Chairman’s–suggest this hearing was designed to lay the policy predicate for higher rates next year. What’s unclear is exactly which taxes the Committee plans to raise. Despite what you might read, most of the Bush tax cuts enacted in 2001 and 2003 went to middle- and low-income Americans, not the rich. So the pending tax hike is going to impact regular families in a very real and harmful way. With just 30 days of legislative session left before the elections, even a well intentioned effort to extend those tax policies may fall short.
Perhaps more importantly, the hearing demonstrated the lack of a plan for what happens beyond 2010. Even if Congress extends some or all of the 2001 and 2003 tax cuts, something more comprehensive is needed if the United States is not to follow Greece down the path towards the third world. Senators Ron Wyden (D-OR) and Judd Gregg (R-NH) have introduced what they describe as a budget neutral tax reform plan. In the absence of any other ideas, it might be worth a look to see what they propose.
Estate Tax Fix Introduced in Senate
In more tax news, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) yesterday evening introduced an amendment to make permanent changes to the estate tax. As the entire tax world knows, the estate tax is taking a one-year hiatus in 2010 before returning in 2011 with a top rate of 55 percent and an exclusion of $1 million.
This dramatic shift, from a regime that applies a capital gains tax on inherited assets when they are sold to a very high 55 percent rate imposed at the death of the estate’s principal is possibly the largest marginal rate hike in history and is giving estates and estate planners alike a very real case of whiplash. Nobody predicted we would be in this situation a year ago, and the uncertainty is having a very real impact on how folks are behaving.
The Lincoln-Kyl proposal is designed to mitigate this harm and uncertainty by making permanent a middle ground on taxing estates. Key provisions in the bill include:
- Reducing the top estate tax rate to 35 percent;
- Increasing the exclusion from $1 million to $3.5 million; and
- Allowing the estates of deceased taxpayers to choose between no estate tax and limited “carryover basis” or the provisions included in this plan for 2010.
Missing from the proposal are any revenue increases or spending cuts to offset the revenue loss of the lower rates and higher exclusion. The selective pay-go rules adopted by Congress earlier this year allowed Congress to extend 2009 estate tax rules without offsets, but any reduction in the estate tax beyond that would have to be offset or face a 60 vote Budget Act point of order. Filling this revenue hole, which has been estimated in the $50-$75 billion range over ten years, has been a significant challenge for the Lincoln-Kyl team, and it appears it still is unresolved.
While the Lincoln-Kyl proposal is targeted at the pending small business bill, it is unclear whether they will get a clean vote on the issue. Majority Leader Reid has filled the so-called amendment tree and is taking other steps necessary to limiting changes to the underlying bill. Regardless, the introduction of this legislation is the first substantive effort in the Senate to enact a permanent estate tax fix, which is progress. The question now is whether there’s enough time in the legislative calendar for this debate to play out. Stay tuned.
Your S-CORP team has been busy hitting the Hill in opposition to this payroll tax provision in recent days. Late last week, the House Ways and Means Committee released its package of tax extenders, partially offset by an expansion of the S corporation payroll tax to firms in service industries.
While the S corporation community knew the payroll tax hike was under consideration, this was the first time we had seen an actual proposal and it took us a couple days to get a read on who would be affected.
The provision is much broader than advertised. It begins by defining the population of firms targeted — professional or personal services firms in the area of law, engineering, architecture, performing arts, etc. The Committee’s choice to create a new definition for “Professional Services Business” was, we believe, predicated on the desire to target financial services firms as well as athletes, movie stars and other highly compensated individuals who might use an S corporation to block payroll tax obligations.
Once you fall into the “Professional Services Business” pool of S corporations, the provision asks, is your firm the partner in a service partnership and does that partnership consume substantially all of the activities of the S corporation? This test is targeted directly at the “John Edwards case” where a successful lawyer used the S corporation to block payroll taxes on his legal fees. Our members have raised few concerns about this test.
The second test, however, is more troubling. It would apply to “any other S corporation which is engaged in a professional services business if the principal asset of such business is the reputation and skill of 3 or fewer employees.” It took us a couple reads to realize this provision is not nearly as narrow as it first appears.
First, the test is not limited to firms with three or fewer employees. Firms with numerous employees could be affected, as long as only three are “key.”
Second, “principal asset” does not mean their skill and reputation comprises the majority of the value of the firm. Instead, that asset just has to be bigger than all the other assets of the firm. So, a business at which the largest asset is equal to 10 percent of the firm’s value would be affected if the “skill and reputation” of three employees are worth 11 percent.
With that as background, here is a list of concerns we’ve shared with the Committee over their new, never-before-seen provision to tax service S corporations:
- The provision would require a “disqualified” small business to determine whether its principal asset is the “skill and reputation” of fewer than three employees. This would require every “disqualified” small business to get a valuation of each of its significant assets every year in order to determine which asset is its “principal” asset.
- The provision arbitrarily discriminates against small businesses. It taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except they have four key employees.
- The provision tests for highly-skilled “employees” rather than shareholders. Why? Is there evidence that indicates that highly-skilled employees are underpaid by S corporations?
- The provision requires difficult legal conclusions about uncertain areas, such as whose asset is an employee’s “skill and reputation”– the employee’s? Or the company for which the employee works?
- The provision provides no definition of “asset”– it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single “asset” for purposes of determining the “principal asset” of a company.
- The provision would discriminate against family-owned S corporations by applying payroll taxes to family members not active in the business. This provision would reduce the ability of S corporations to raise capital from family members.
- And finally, how exactly does one go about establishing the value of “skill and reputation” of employees on a widespread basis? This, and the other undefined terms used in this provision are simply inviting litigation.
All of these technical challenges beg the question: What problem is the second test designed to solve? The first test, after all, captures the “John Edwards case” that everybody, including S-CORP, would like to address. What is the magic value of “three or fewer” employees? 60 90 percent of S corporations are owned by three or fewer shareholders. Is it just a money grab?
Beyond the policy, the lack of process or public review should be enough to bring about this provision’s defeat. No specific hearings on the proposal, no markups, no floor debate, not even a draft bill to comment on, and yet this $11 billion tax hike is supposed to be considered by the House and the Senate before the Memorial Day recess.
The IRS already has the tools to go after John Edwards and others like him. It has successfully litigated cases where taxpayers have taken compensation that was less than reasonable. Spicer Accounting Inc. v. US, 918 F2d 90 (9th Cir. 1990); Dunn & Clark, PA v. US, 853 F. Supp. 365 (D. Idaho 1994); Radtke v. US, 712 F. Supp. 143 (ED Wis. 1989) , aff’d per curiam, 895 F2d 1196 (7th Cir. 1990) Veterinary Servs. Corp., PC, 117 TC 141 (2001) . Veterinary Surgical Consultants, P.C., 117 TC 141 (2001) , aff’d, 54 Fed. Appx. 100, 2003-1 USTC ¶ 50,141 (3d Cir. 2002).
We’re not in the business of proposing tax hikes on our members, but if the problem resides with single shareholder S corporations in the service sector, why not start with that population and whittle it down from there? And what about an employee threshold? Who is going to hire lots of people at market salaries in order to reduce their personal tax rate by a little more than 2 percent?
We understand Congress needs revenue to offset its priorities, but to try to raise $11 billion on the backs of closely-held businesses without having one public review of the policy strikes us as a little much. Take a little time, engage the public, and you might get a better product.
Extender Package Stalls in the House
On a related note, timing for consideration of the “extender plus” package is very much up in the air. It was supposed to go to Rules earlier this week with floor consideration today or tomorrow, but that might not happen.
Although members are concerned with the offsets in the package, it is the number of extraneous items and their cost to taxpayers that is slowing any progress at this point. In addition to extenders, the package includes a UI extension, Cobra benefits, the Doc Fix, and other expensive items. The size of the package is causing moderate members concern:
“I’m concerned about it,” said Sen. Ben Nelson, D-Neb. When combined with “emergency”-designated extensions of unemployment insurance and COBRA health benefits for laid-off workers, Medicaid assistance to states and perhaps Temporary Assistance for Needy Families funds, the unpaid-for cost of the bill could top $170 billion. “Obviously, my preference is to have offsets, and look hard at nonemergency issues. Everything can’t be called an emergency to avoid having offset requirements,” Nelson said.
Sen. Kent Conrad, chairman of the Senate Budget Committee, said Tuesday he has concerns with the size of a large tax and benefit bill Democratic leaders hope to pass this week, casting doubt on the chances of the legislation being approved. Mr. Conrad (D., N.D.) said the current net cost of the measure to public finances—$141 billion over a five-year period—was too high.
So the package is getting larger, but only those provisions extending tax benefits for families and employers are going to be offset, and those provisions will be offset with tax hikes on families and employers.
To put this discussion into perspective, the current extender package extends provisions that expired last year. The extension is only twelve months, which means Congress will have to come back later — most likely in a Lame Duck session — and pass another extension if all these tax provisions are not to expire at the end of 2010. The tax hikes, on the other hand, are permanent.
Groups targeted for tax hikes in this bill need to be wary. Taxwriters will be on the hunt for another $30 billion in just a few months, so any deal cut today will be revisited tomorrow.
Estate Tax Update
The inability of any estate tax proposal to garner 60 votes in the Senate is becoming increasingly apparent. There’s still a chance for a breakthrough, but time is getting short and opposition is getting more vocal.
As reported in numerous publications, estate tax negotiators have hit a wall in crafting a compromise plan that can pass. As Dow Jones reported last week:
Senators that want to reduce estate tax rates even further have in the past two weeks closed in on a compromise that would not add any more to the deficit, at least in the short-term, than Obama’s plan. The plan would start at Obama’s proposed levels in 2011, but gradually phase down to a 35% rate and a $5 million exemption level.
But Tuesday they said that a proposed compromise is in limbo. “Nothing is clear about how the estate tax will be considered,” said Sen. Jon Kyl (R., Ariz.), the lead Republican in the negotiations. “Last week I believed there was an agreement on what the details were going to be. That may not be the case now.”
“There’s no agreement on estate tax, neither on substance nor on process. None whatsoever,” said Senate Finance Committee Chairman Max Baucus (D., Mont.), who is one of two Democrats involved in the talks, the other being Sen. Blanche Lincoln (D., Ark.).
Meanwhile, the lack of progress and the short calendar is emboldening the opposition. According to CongressDaily:
That would be fine with Sen. Bernie Sanders, I-Vt., who said reverting to pre-2001 law would only affect about 2 percent of the nation’s estates. When asked about a plan to reduce the tax to 35 percent and lift the exemption to $5 million, Sanders replied: “I will do everything I can to stop that.”
CongressDaily goes on to quote another Senator as estimating that up to 80 percent of the Democratic conference is opposed to any sort of estate tax compromise. While he quickly backed off that estimate, anywhere near that level of opposition would doom an estate tax compromise this year and allow the pre-2001 rules to take effect beginning in 2011.
This stalemate also is blocking the Senate small business tax package, including built-in gains relief, from moving forward. The package has been negotiated between Finance Committee Democrats and Republicans and was ready to be marked-up last week until the estate tax roadblock emerged.
At this point, the path forward is unclear. Taxwriters could resolve their differences on the estate tax or they could agree to set that issue aside and let the small business package proceed (perhaps directly on the Senate floor). A third option would be to resolve nothing and let both estate tax relief and the small business package die. Let’s hope it’s not option three.
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.
With the Senate back in town this week, here’s a quick recap on the status of the S Corp reform tax title we’ve been advocating in Congress:
- First, on January 10th, the House passed a clean minimum wage increase and sent the legislation to the Senate.
- Second, on January 31st, the Senate added by voice vote $8 billion worth of small business tax provisions to the House wage increase, including an S Corporation Reform tax title incorporating several S Corp priorities.
- Third, on February 16th, the House adopted its own $1 billion small business tax relief alternative to the Senate package. This package failed to include any S Corporation provisions.
- Fourth, Senate Republicans insisted that the House meet them to “pre-conference” the differences between the Senate and House small business tax packages before they would allow the two bills to go to a conference committee for negotiation.
- Fifth, on March 23rd, the House added its $1 billion small business tax package to the Iraq War supplemental spending bill, despite the fact that a veto threat currently hangs over that bill’s future.
- Sixth, on March 27th, the Senate added its own, larger $12 billion small business package, including the S Corporation Reform tax title, to its version of the Iraq War supplemental spending bill.
- Seventh, on March 29th, Senate Majority Leader Harry Reid appointed members of the Appropriations Committee to the House/Senate conference and did NOT appoint Senate Finance Committee Chairman Max Baucus signaling the potential for conference negotiators to drop the tax bill from the supplemental bill to deal with it separately, at a later date.
And that’s where things stand, awaiting the return of the House from recess next week and the appointment of House conferees to work out the differences between the House and the Senate on these bills.
It almost goes without saying that the S Corporation Association is continuing to press our friends on the Hill to end this stalemate and pass these much needed reforms to the rules governing S corporations. We remain confident that these provisions will be enacted, it’s just a question of how long the process will take.
S Corp Gets Some Ink in INC.
S Corp President Stephanie Silverman is quoted this month in INC. Magazine as part of a story on the new congressional leadership, “Learning to Love Nancy Pelosi.” As the story notes, business groups like the S Corporation Association are having to reconfigure their approach and expectations to reflect the new Democratically-controlled Congress. Here’s Stephanie:
- In the last Congress, there was a serious effort to abolish the estate tax. Today, Congress is considering bolstering the Internal Revenue Service’s budget for business audits and levying new payroll taxes on S corps. Stephanie Silverman, the president of the… S Corporation Association, says the group’s members are nervous about the payroll tax idea. The group is currently scheduling meetings with members of the House Ways and Means Committee to discuss the plan. “We’re trying to make them aware of how many S corporations there are in their states,” Silverman adds.
A recent Washington Times article by Mike Whalen, chief executive of Heart of America Restaurants and Inns, should give policymakers pause as they worry about weak job growth while simultaneously piling one tax on top of another onto job-creating companies. Using 2008 numbers, Whalen runs through all the taxes a single 100-room limited service hotel located in Iowa pays:
For starters, we pay property taxes to the tune of about $199,000 annually. Next, there is a 7 percent “pillow tax” that generates about $162,000 annually. Then we pay a 6 percent sales tax on revenue that yields about $124,000 annually. Then we also pay sales tax on things like toilet paper, shampoo, soap, continental breakfast food and amenities and other items that the state of Iowa says are not really part of the product we sell because it says we are selling space. It may come as a surprise to you that toilet paper is not part of what you are buying when you rent a hotel room in Iowa, but the state considers it a gift. Those extra sales taxes come to about $1,800 per year.
Now on to Round 2. This little hotel also pays about $3,000 a year in various licenses and fees. Payroll taxes come to about $60,000. The federal government says the depreciable life of a hotel is 39.5 years, but we refurbish the hotel on a constant basis and pay sales tax on related purchases, such as new carpet, mattresses and bedding, and even paint. Anyone who doesn’t believe we already have a partial value-added tax (VAT) like Europe, isn’t in business. Now, between Round 1 and Round 2, we’re at $548,000 in taxes annually.
So, even if we don’t make a dime of profit, and before we pay the mortgage to the bank or buy new stuff, we pay $548,000 in various taxes, licenses and fees.
As Whalen points out, this tax burden doesn’t include state or federal income taxes. Those taxes are going up. And the alternatives aren’t pretty either:
…if I sell the hotel, I’ll pay a hefty capital gains tax of 25 percent, and it’s probably going up. Alternatively, when my wife and I die, I’ll pay another 45 percent if the estate tax returns in 2010. But don’t worry: We have diverted money from productive investments to pay for life insurance to partially pay this bill.
A central question to any economy is, “Where are tomorrow’s jobs going to come from?” A small hotel in the Midwest may not immediately come to mind as part of the answer, but ask folks in Iowa whether those jobs are important. And then ask yourself whether the tax changes just enacted, coupled with those on the horizon, are going to make it easier or harder for Mike and other entrepreneurs to take risks, invest in properties like a limited service hotel, and create jobs. The answer is pretty obvious.
Whither Tax Rates?
Following the release of the S Corporation Association letter on the new 3.8 percent tax and its impact on future tax rates, we got into a back and forth with a reporter over what is the appropriate baseline for measuring future rates.
We used a current law baseline, which is the same baseline the Congressional Budget Office and the Joint Committee on Taxation use when making their estimates. Under current law, for example, the tax rate on dividends is scheduled to rise from 15 percent today to 39.6 percent next year to nearly 45 percent in 2013 when the new 3.8 percent tax kicks in. That’s three times the current tax!
The reporter, on the other hand, suggested it would be more appropriate to use President Obama’s proposals as the correct baseline. Under the President’s plan, the top rate on dividends would rise to 25 percent in 2013 based on his proposal to tax capital gains and dividends at a 20 percent base rate. Here’s a comparison of the two baselines and their respective rates:
|Top Marginal Tax Rates in Future Years|
|* Current Law and Obama Budget include the phase-out of itemized deductions (Pease)|
Unless you’re actually working for the White House or OMB, using the President’s budget proposals as the baseline requires a certain amount of faith — faith he will press for those proposals, faith the Congress will pay attention, faith other priorities will not get in the way. The President’s budget does call for a statutory rate of 20 percent for 2010 and beyond, but most observers are betting rates of 28 percent or higher are more likely.
But that’s all beside the point. As the chart demonstrates, tax rates on investment are going up sharply regardless of which baseline you use.
More on the Investment Tax and S Corporations
Our Google Alert did its job and alerted us to another website devoted to S corporations – www.scorporationsexplained.com. It appears they too are concerned about the new 3.8 percent tax on investment income and S corporations. As web author Stephen Nelson explains, even S corporation shareholders active in the business may end up paying this tax on some of their S corporation income:
Once a taxpayer’s income exceeds the threshold amount, investment income gets hit with the tax. But it’s important to note that investment income earned inside an S corporation retains its character as the income flows through to investors. This means that even working shareholders may pay the new Medicare tax on the chunk of the S corporation’s profit that occurs because of interest, dividends, capital gains, or rental income earned by the S corporation.
Example: Your share of an S corporation’s profit is $100,000 but only $80,000 of this $100,000 represents profits from the business operation. The remaining $20,000 of profit comes from dividends, interest and capital gains earned on investments held by the S corporation. In this case, no matter whether you’re a working shareholder or a passive shareholder, you’ll pay the Obamacare Medicare tax on the $20,000 of investment income that flows through to you if your income exceeds the threshold amounts.
This result suggests the new tax may be more expansive than it appeared at first glance, especially for mature S corporations that control more than one entity.
President Obama released a list of proposed changes to the Senate-passed health care reform bill on Monday, and while there is plenty to interest any American, one item in particular should catch the attention of S corporation owners:
The President’s proposal adopts the Senate bill approach and adds a 2.9 percent assessment (equal to the combined employer and employee share of the existing HI tax) on income from interest, dividends, annuities, royalties and rents, other than such income which is derived in the ordinary course of a trade or business which is not a passive activity (e.g., income from active participation in S corporations) on taxpayers with respect to income above $200,000 for singles and $250,000 for married couples filing jointly. The additional revenues from the tax on earned income would be credited to the HI trust fund and the revenues from the tax on unearned income would be credited to the Supplemental Medical Insurance (SMI) trust fund.
By all appearances, the Administration has decided to apply a new 2.9 percent tax to all forms of “unearned” income, including S corporation income earned by shareholders not active in the business. [That is our take at this time -- we are reaching out to taxwriters to make certain that is what the Administration intends]. This tax would be imposed on top of other applicable taxes and would be used to offset the cost of health care reform. CongressDaily reported on this provision yesterday:
President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed. But critics charge it could open the floodgates to a raft of companies re-structuring their businesses as subchapter S corporations in order to avoid the tax.
That is the glass half full version. The half empty view is the Administration just proposed to raise marginal tax rates on S corporation shareholders with day jobs. Here’s how we see it applying:
- Taxpayer A works at his S corporation, earns a salary above $200,000 and receives a distribution of S corporation earnings. He would now pay an extra .9 percent on his salary, but not pay more on any earnings from the S corporation.
- Taxpayer B makes more than $200,000 at another job and is a shareholder of an S corporation. She would now pay an extra .9 percent on her salary as well as an extra 2.9 percent on any earnings from the S corporation.
This proposal raises all sorts of alarm bells. First, as we have pointed out, it takes the notion of the “payroll” tax and throws it in the trashcan. Second, it continues the illusion of the Medicare and SMI Trust Funds; revenue raised by this tax pays for health care reform, not Medicare benefits. Third, it raises the cost of capital (especially if it is combined with next year’s scheduled increase in the capital gains and dividend rates) at a time when our financial institutions are capital-starved. The whole point of TARP was to recapitalize our financial system, remember?
Beyond those broad policy concerns, the mechanics of this tax are particularly challenging. Does Taxpayer B pay a total Medicare tax of 3.8 percent on her salary above $200,000, but only 2.9 percent on any passive income, including S corporation earnings? And what about Taxpayer A? He already faces the challenge of making certain he pays himself a “reasonable” wage or he risks being accused of tax avoidance. This proposal would increase that temptation and the broader policy challenge.
Finally, how does the Administration plan to distinguish between passive and active shareholders? Here is how IRS Publication 925 (Passive Activity and At-Risk Rules) defines “Active Participation”:
Active participation depends on all the facts and circumstances. Factors that indicate active participation include making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees. Factors that indicate a lack of active participation include lack of control in managing and operating the activity, having authority only to discharge the manager of the activity, and having a manager of the activity who is an independent contractor rather than an employee.
It’s pretty sketchy. So now will all those non-active S Corp shareholders try to become active so they can avoid the new “payroll” tax? Sounds like another enforcement headache for the IRS. Expect to hear lots more on this issue in coming weeks.
More Intel on Estate Taxes
Two ideas are being floated in the Senate on the estate tax. A while back, Dow Jones reported on a proposal to allow taxpayers to prepay their estate taxes. As Martin Vaughn wrote:
A proposal to allow wealthy people to prepay estate taxes while they are still alive, in exchange for a lower tax rate, has caught the attention of Senate staff trying to craft a bipartisan, permanent compromise on the estate tax…. The plan would allow wealthy people to place assets in a prepayment trust while they are still alive. Those assets would be subject to a 35% tax, which the estate owner would have five years to pay, according to a document describing the plan, obtained by Dow Jones Newswires.
The value of this option for taxpayers is obvious: you get a lower rate. For the government, the value is that it would be scored as a revenue raiser. Congress operates on a finite budget window, so the prepayments would be scored as new revenues while some of the estate taxes foregone would fall outside the budget window and wouldn’t count. Not exactly kosher, but the point is this idea could, just like the old Roth IRA concept, fit the needs of Congress and help them move towards a resolution of the estate tax dilemma.
The other idea to break the current impasse is to impose a “toll charge” on family foundations as a means of offsetting the cost of lowering the estate tax below 2009 levels. The Hill reported earlier this week:
The Gates Family Foundation – arguably the biggest charity in the world with assets over $35 billion according to 2008 records – is in the crosshairs of Sens. Jon Kyl (R-Ariz.) and Blanche Lincoln (D-Ark.), who see it as a money pot to help pay for a legislative fix for the estate tax. Well-placed sources say the senators might create a “toll charge” on charitable foundations that would sock Democratic heavyweights like Bill Gates and Warren Buffet.
During last year’s budget debate, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) offered an amendment to reduce the top estate tax rate from 45 to 35 percent while increasing the exclusion from $3.5 million to $5 million. That amendment garnered majority support but less than the 60 votes needed to clear the Senate. Moreover, it left unresolved how the sponsors would make up the revenue difference between their amendment and 2009 estate tax rules. That’s where the toll charge on foundations might come in.
In terms of timing, the clock is ticking. We are now two months into the year of repeal and more estates are finding themselves in estate tax limbo. Senator Kyl addressed this concern yesterday, suggesting he would begin blocking other Senate business in order to force an agreement to take up an estate tax fix. As the Hill quoted Reid yesterday:
Very soon we’re going to have a process on how estate tax reform is going to move forward. I will insist on an agreement on how to proceed, if we’re going to have unanimous consent on how to proceed with any of these subsequent bills.
At the end of this process, it is possible no permanent fix can get 60 votes, the estate tax stays repealed for the rest of the year with the old 55 percent and $1 million exclusion coming back in 2011. All this recent activity suggests some sort of effort is just around the corner, however, and we may know the outcome soon.
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.