House Passes Health Care Reform and “Fix”
After a long legislative odyssey, the House passed the broad health care reform package on Sunday evening by a vote of 219-212. This legislation is identical to the Senate bill adopted on Christmas Eve and is now ready to go to the President. As CongressDaily noted:
The House took a historic vote late Sunday night to approve an overhaul of the nation’s healthcare system after more than a year of debate, a few near-deaths for the measure and an intense final week marked by loud and angry protests outside the Capitol.
The House also adopted 220-211 a package of “fixes” to the larger bill that will now go to the Senate for consideration. This narrower package makes numerous changes to the broader bill, including imposing a new 3.8 percent tax on unearned income that hits S corporations, and will be considered in the Senate under reconciliation rules that only require a simple majority vote.
The Senate vote is expected to occur later this week and, by all accounts, the Senate Democrats have the votes to prevail. (Note: There are two remaining bumps in the legislative road to look out for. First, there is a lot of talk about a possible Social Security point of order that would bring down the entire “fix” bill. Second, there are numerous so-called Byrd Rule violations in the “fix” bill that will need to be removed, which means the Senate “fix” bill will differ from the House version. That means a conference and a more protracted debate.)
About a month ago, we predicted that health care reform would stall and eventually be set aside by other legislative priorities. Its adoption yesterday demonstrates both the risk of trying to predict the future, and also the determination of the Obama Administration and Congressional Leadership to see this effort through. It’s an impressive legislative victory, albeit a costly one for private enterprise.
S-Corp Leads Response
Last week was a busy one for your S-Corp team. Early in the week, we learned that the House would consider, as part of the health care “fix” bill, a new 3.8 percent tax on certain types of income.
While the tax has been inflicted with various labels — in a nod to reality, the House dumped the original “Medicare Tax” title — the simplest description is that it’s a tax on investment income — just about any taxable investment — including S corporation and partnership income attributed to non-active shareholders and partners.
So, if your income is high enough and you invest in Microsoft, you’ll pay this tax on any dividends or capital gains Microsoft earns you. Similarly, if you invested in your daughter’s S corporation, you also pay the new tax.
In response, your S-Corp team quickly organized a business community letter opposing the new tax in the strongest terms. The letter, sent to Hill leadership and signed by 24 small business groups, makes the case that this new tax is going to hurt job creation and economic growth in future years. As the letter states:
Finally, while the tax has been described as applying to the “unearned” income of only a few taxpayers, it is actually a direct tax on the majority of taxable savings in this country. In 2007, households with incomes exceeding $200,000 accounted for 47 percent of all interest income, 60 percent of all dividends, and 84 percent of all capital gains reported on tax returns.
Businesses and workers rely on these savings to increase their productivity and wages. At a time when businesses are having a hard time accessing credit, millions of workers are unemployed, and the entire economy needs to recapitalize, raising taxes by this amount on that much capital is simply reckless.
Despite this harm, the House retained the provision. It now heads to the Senate. While we expect the Senate to adopt the tax as well, the tax itself doesn’t take effect until 2013, giving the S Corporation Association and our allies two years to educate policymakers on why this is a really bad idea.
The “3.8%” Tax and Future Tax Rates
Peter Cohn in CongressDaily has an interesting piece on where tax rates, especially the tax rate on dividends, are headed in the next couple years. Here’s the lead:
Democrats may be boxed in to letting the tax rate on dividends for upper-income earners top 40 percent in January — or coming up with tens of billions of dollars to pay for a lower rate — due to new budget rules signed into law in February.
The general assumption has been that Democrats will enact President Obama’s tax policies, averting that scheduled increase by capping it at 20 percent for wealthier earners. But the pay/go law only assumes the dividend rate will stay at its current 15 percent for middle-class taxpayers. For the wealthy, the rate would revert to its pre-2003 levels corresponding to ordinary income tax rates, unless Congress finds a way to pay for holding it to 20 percent.
With Federal deficits exceeding $1 trillion, we’re not holding our breath here that the same Congress that just imposed a new 3.8 percent tax on investment income would turn around and cut the base tax rates on that same category of income.
Which means, coupled with where the marginal tax rates are scheduled to go already, the new 3.8 percent tax has the potential to drive tax rates to their pre-1986 levels — capital gains rates would be 25 percent while the tax on interest, dividends, royalties, and other forms of investment income would be nearly 45 percent. More from Peter Cohn:
Observers outside the Beltway are baffled why the issue isn’t getting more attention. “I don’t think anyone is really focused on the dividend tax,” said Jeffrey Kwall, a professor of tax law at University of Loyola Chicago Law School. “And I don’t think people have really thought through what kind of impact it would have on the market” for the top rate on dividends to skyrocket by 165 percent.
Congress spent a year focused on expanding the Federal government’s obligations to health care while ignoring one of the most basic issues affecting the economy and job creation — the after- tax rate of return on investment. Outside observers should be baffled.
Health Care Reform and S Corporations
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.
S Corporations and Payroll Taxes are Back in the News
A couple weeks ago, House-Senate health care negotiators raised the idea of paying for health care reform by expanding the types of income subject to the Medicare payroll tax. Payroll taxes are limited to wages at the moment, but this proposal would also tax cap gains, dividends, interest, rents, and limited partners. Oh, and S corporation income.
S-CORP has a long history of advocacy on these issues and, while the future of health care reform is wholly uncertain following the special election in Massachusetts, we felt it was important for the business community to weigh in on this issue with strong opposition. The result is a letter signed by 20 trade associations opposing this concept. As the letter notes:
Expanding the application of the Medicare payroll tax to non-wage income is an unprecedented policy that would undermine the principle that Medicare is an earned entitlement, damage the integrity of the Medicare Trust Fund, and hurt Main Street businesses and jobs. We strongly urge you to reject this misguided policy.
This morning, a CongressDaily article makes clear that this idea continues to be actively discussed between House and Senate negotiators. While the prospects for health care reform are dim, leadership continues to press for some sort of resolution and apparently this payroll tax item is part of those talks. Peter Cohn reports that the House and Senate are divided on how to expand the Medicare tax:
Senate negotiators want to keep active S corporation income — other than income from passive investments — exempt from the payroll tax, fearing their chamber’s fragile voting math can ill afford what could be seen as a new small business tax, aides said. House lawmakers disagree, citing the revenue loss, relatively few actual small-business employers that would be affected, and potential to game the system — such as opting for S corporation status simply to avoid the tax.
We’ll keep you apprised on any new developments on this front. As we’ve mentioned before, our assessment is health care reform will be talked about for the next month or so and then just fade away as other priorities take center stage. There won’t be a funeral or closure, but the votes simply do no exist to move forward right now. That said, no bad idea ever goes away and we fully expect to see this payroll tax expansion to be raised on other bills.
Business Community Rallies Around S Corporation Modernization
Last week, your S-CORP team sent a letter signed by 22 of our association allies to members of the House and Senate, urging them to cosponsor legislation to replace the dated rules that have governed S corporations for over fifty years. As the letter notes:
These outdated rules hurt the ability of S corporations to grow and create jobs. Many family-owned businesses would like to become S corporations, but the rules prevent them from doing so. Other S corporations are starved for capital, but find the rules limit their ability to attract investors or even utilize the value of their own appreciated property.
Well into the 21st century, America’s most popular form of small-business corporation deserves rules adapted to today, not fifty years ago. The S Corporation Modernization Act would ensure the continued success of these businesses.
Earlier this Congress, House Ways and Means Member Ron Kind (D-WI) and Senate Finance Committee Members Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) introduced the “S Corporation Modernization Act of 2009” (H.R. 2910 and S. 996) in their respective chambers.
The legislation, designed to update and simplify the rules governing S corporations, enhances the ability of S corporations to attract and raise capital, makes it easier for family-owned S corporations to stay in the family, and encourages additional charitable giving by S corporations and the trusts that hold them.
In the coming weeks, S-CORP will be ramping up its efforts to gather additional support for these bills. At a time when America’s job creators struggle through the difficult economy and the Federal government struggles with massive deficits, smaller, targeted reforms like these are an attractive means of helping Main Street without breaking the bank.
Health Care Reform Outlook & S Corporations
Just about everybody agrees the political landscape has shifted to the point where, while there were once 218 House votes in favor of a reform package, now there are nowhere near that many.
This lack of support is evidenced by the Rube Goldberg-nature of the current efforts to resurrect reform and move it through the Congress. One popular idea is for the House to pass the Senate bill, and then take up a reconciliation package of items to “fix” what’s wrong with the Senate bill.
We are skeptical anything like that happens. Health care reform is unpopular and members are nervous and tired. Moreover, this approach would require House members to “vote on faith” that the Senate would follow-through and adopt the fix. There is rarely a lot of trust between House members and the Senate under normal circumstances, and these are not normal circumstances.
Our expectation is for the hand-wringing to continue for a month or so and then for other pressing items like the jobs bill and the budget to push heath reform aside.
For S corporations, it is hard to regret the demise of this particular reform effort. We have refrained from weighing in on the merits of health care reform — it is a little outside our focus, after all — but the impact of paying for health care reform was clearly going to be a negative.
The House bill would have raised marginal rates on upper-income S corporation shareholders by 5.4 percentage points, while the Senate bill would have increased the Medicare HI tax from 1.45 percent to 2.35 percent — not a direct shot at S corporations, but it would have increased pressure on the IRS and others to change the payroll tax treatment of S corporation income.
And before talks broke down, House and Senate negotiators were seriously considering tossing out those items and expanding the tax base for payroll taxes to include capital gains, dividends, interest income, and S corporation income instead. As the Los Angeles Times wrote:
Democratic congressional leaders are considering a new strategy to help finance their ambitious healthcare plan — applying the Medicare payroll tax not just to wages but to capital gains, dividends and other forms of unearned income. The idea, discussed Wednesday in a marathon meeting at the White House, could placate labor leaders who bitterly oppose President Obama’s plan to tax high-end insurance policies that cover many union members. It could also help shore up Medicare’s shaky finances, and the burden of the new tax would fall primarily on affluent Americans, not the beleaguered middle class.
It would have fallen on the beleaguered S corporation community, too. Moreover, these increases were going to take place when taxes on S corporations (and other flow-through businesses) already were going up. Current law has the top income tax rate returning to 39.6 percent at the beginning of next year, and we anticipate the President will propose to keep these rate hikes in place, at the very least.
Finally, with health care reform out of the way, taxwriters on the Hill will have time to address some of the many tax items that were pushed aside last year, including tax extenders and a broader tax reform effort. As BNA noted this morning:
Last December, Rangel told a group of executives that he planned to press his case for tax reform at the conclusion of the health care debate.
It appears health care reform is over, so we expect Congress to refocus on tax policy this year.
Tax Outlook for 2010 — Starting in a Hole
The economic fear that gripped folks in the Fall of 2008 has resulted in a historic collapse of federal revenues.
Revenue collections since 1960 have stayed in a relatively tight pattern centered around 18 percent of our GNP. Considering the range of tax policies we’ve imposed on taxpayers during that time, the steadiness of the 18 percent mean is remarkable and suggests some sort of political or economic boundary is in effect.
That steadiness was broken last year when federal collections fell to their lowest level since 1950. Meanwhile, Washington’s response to the crisis has driven federal spending to levels not seen since World War II. Record low revenues and record high spending means record high deficits.
While record high deficits are obviously a negative, what your S-CORP team finds most troubling is the long-term outlook. For the next decade, the trend is definitely not our friend.
Once we get past the immediate effects of the “fear” and revenues move back to their historic mean, deficits of 4 or 5 percent GNP will persist. And when revenues move well above their historic mean? Deficits of 4 or 5 percent will persist.
And this is the baseline! It doesn’t include expensive policies that are either set to expire or those that are simply politically unsustainable.
Obama 2009 Tax Proposals vs. CBO Baseline Deficit
The chart above takes CBO’s September deficit estimates and superimposes CBO’s June estimates of President Obama’s 2009 tax proposals. Not exactly kosher, but the underlying point is undiminished: even the President’s modest policies to extend just part of the Bush tax relief would add hundreds of billions to the deficit each year.
“Unsustainable” is the word that comes to mind. Herb Stein once observed that unsustainable trends will not be sustained, which suggests these projected deficits are unlikely to become a reality, but that just means something has to give. Stuck between a rock (record deficits) and a hard place (a weak economy), there are simply no easy answers.
For S corporations, the challenge is to spend the next year demonstrating to taxwriters the economic importance of our community, especially as Congress grapples with the “too big to fail” concept for financial services.
S corporations were created to fight economic consolidation. They move economic power and decision-making away from Wall Street and on to Main Street. If policymakers want proactive policies that reduce the incidence of systemic risk, empowering closely-held businesses is a sure-fire means of doing so.
Health Care Pay-Fors
Health care reform is in the final stages of its legislative journey — last half of the fourth quarter perhaps? — and while the pro-reform team has plenty of momentum, exactly what tax items make it into the final package remain undecided.
Of most concern to S corporations are the marginal rate increases included in both bills. In the House, it is the 5.4 surtax applied to individual incomes above $500,000, while in the Senate it is the 0.9 percent HI tax increase applied to individual incomes over $200,000.
Moreover, recent stories on possible compromises should raise S corporation eyebrows. As first reported in CongressDaily, negotiators are considering expanding the Medicare HI tax beyond wages to include all types of income, including S corporation income.
According to JCT, applying the existing 1.45 percent payroll tax to investment income, including capital gains, taxable interest, dividends, estate and trust income and income from rents, royalties, S corporations and passive partnership income, to those earning above the $200,000/$250,000 thresholds would raise $111 billion over a decade.
S-CORP has a long history of fighting efforts to expand payroll taxes beyond, well, payrolls. Payroll taxes like the HI tax were designed to resemble private insurance premiums on the premise that Medicare and Social Security were “earned” benefits. This proposal would blur the line beyond taxes on labor and taxes on capital, undermine the notion that Medicare is an “earned” benefit, and should be of considerable concern to the business community.
GAO Releases S Corporation Report
In response to a request by Senators Max Baucus (D-MT) and Charles Grassley (R-IA), the Government Accountability Office spent the last year looking into tax compliance by the S corporation community. The GAO presented its findings in a report released yesterday.
Reports like this always carry with them a large degree of headline risk. Words like “noncompliance” and “misreported” jump off the first few pages. Look beyond the first couple pages, however, and the GAO has compiled a comprehensive review of the challenges S corporation face when calculating their taxes.
Questions covered by the GAO include why some businesses choose to be S corporations, what are the types of S corporation non-compliance, and what are the options for improving S corporation compliance. To answers these questions, the GAO interviewed numerous stakeholders, including the S Corporation Association, and, in their just-released report, came to the following conclusions:
- Congress should require S corporations to calculate and report the basis for their shareholders’ ownership shares;
- The IRS should research options for improving the performance of professional tax preparers;
- The IRS should provide additional guidance to new S corporations on calculating basis and compensation; and
- The IRS should require examiners to document analysis of compensation, and provide more guidance on compensation.Having given the report a first read, what is our reaction? First, the S corporation was created to encourage private enterprise, not avoid lawfully-owed taxes. We don’t support or help those taxpayers who knowingly avoid paying their taxes.
Second, the legislative recommendation included in the report is for Congress to require an entity-level basis calculation. According to the GAO, this proposal would help address the problem of shareholders claiming losses beyond their basis in the firm. This recommendation is new to S-CORP and we have asked our advisors to weigh-in on its merits.
Third, we’re glad to see the GAO agrees with us that the IRS has tools to address one of the larger areas of non-compliance. Some S corporation owners who work in their business underpay their salaries in order to reduce their payroll tax obligations. As the GAO notes, the IRS needs to do a better job of both defining the existing “reasonable compensation” standard in its guidance, and applying the standard in its examinations.
As to the headline risk, last summer the IRS reported that tax compliance by S corporations likely was as good, and possibly better, than taxpayers’ compliance in general. Meanwhile, the SBA reported last year that S corporations shoulder the highest effective tax burden of any business type. As an investor, as an employer, and as a taxpayer, S corporations are a valuable component of America’s business community. The GAO has given us some suggestions on how we can do better.
S-Corp Organizes Defense of Family Business
Under consideration is the issue of Family Attribution, which has the effect of dramatically raising the estate tax burden on family-owned businesses relative to those not owned by family members. Family Attribution was originally embraced by the IRS in the 1980s, and despite being rejected by the courts in several prominent cases, the idea continues to be put forward. Earlier this year Congressman Earl Pomeroy (D-ND) introduced the “Certain Estate Tax Relief Act of 2009” (H.R. 436), which, among other items, would create an alternative and more punitive definition of fair market value for business assets that are transferred to members of the same family.
S Corporation Association Chairman Dick Roderick applauded the efforts of the coalition and those members of Congress who have a history of supporting family enterprise. “Family businesses play a vital role in our economy, and it is important to ensure their continued success” he noted. “Imposing a higher estate tax on businesses simply because they are owned by a family does not make sense. We look forward to working with our friends on the Hill to ensure this idea does not become law.”
The letter was signed by the following organizations: American Hotel & Lodging Association, AMT – The Association For Manufacturing Technology, Associated Builders and Contractors, Independent Community Bankers Of America, National Association of Manufacturers, National Association of Wholesalers-Distributors, National Beer Wholesalers of America, National Funeral Directors Association, National Lumber and Building Material Dealers Association, National Restaurant Association, National Roofing Contractors Association, Printing Industries of America, S Corporation Association of America, United States Chamber of Commerce, and the Wine & Spirits Wholesalers of America.
House Health Care Bill Surtax
S corporations should be paying strict attention to the health care bill offered up by House leadership last week. The new bill imposes a 5.4 percent surtax on income above $500,000 for individuals and $1 million for families. Like most taxes applied to personal income, this surtax applies to flow-through business income as well as wages. It also applies to capital gains, dividends, rents, etc. (It may also apply to trusts and other structures — we’re checking.)
Revenue offsets for health care reform need to accomplish at least two goals: raise enough money to cover expanded coverage over the next ten years, and grow at least as fast as health care costs to fully cover expanded coverage costs in years eleven and beyond. The surtax before the House raises $461 billion over the next decade, covering about half the cost of expanding health insurance coverage; the other half is offset with provider payment cuts to Medicare and an assortment of other revenue raisers.
Perhaps just as important, the thresholds for the surtax are not indexed, so the threshold for individuals paying the tax would remain at $500,000 while the threshold for families would stay at $1 million over time. This imbedded bracket creep is necessary for the bill’s authors, since it’s the only way an income tax can be constructed to grow at about the same rate as health care costs.
The Congressional Budget Office indicates that the overall bill – spending minus savings and taxes – results in a surplus for years one through ten, while “in the subsequent decade, the collective effect of its provisions would probably be slight reductions in federal budget deficits. Those estimates are all subject to substantial uncertainty.”
So, the House health care reform bill apparently lives up to the promise not to increase the federal budget deficit in the long term, but only at the cost of drastically raising marginal taxes on a significant portion of business income and reversing a quarter-century of tax policy committed to indexing thresholds to ensure the federal government doesn’t profit from inflation. By all accounts, the surtax will face rough sledding in the Senate. We hope so. We also hope policymakers have a chance to fully explore the implications of an un-indexed marginal rate increase of this size.
Marginal Tax Rate Outlook
And where will Congress be in fourteen months with top marginal rates at 45 percent? It will be looking at a federal deficit that exceeds one trillion dollars, a Social Security system that is now operating under a cash flow deficit (i.e. its taking money from the general treasury rather than contributing to it), and a Federal Reserve and Treasury working overtime to unwind several trillion dollars worth of balance sheet buildup incurred during the recent financial crisis.
No wonder the markets are spooked. Happy belated Halloween.
Health Care Update
At the employer level, that means if an employer used to offer his employees a $30,000 package of health benefits, he will now offer them a $21,000 plan and pay the remaining $9,000 to them in the form of wages and non-health benefits. These extra wages, in turn, are subject to income and payroll taxes, resulting in higher tax collections by the federal government. The revenues raised from the excise tax come from higher income and payroll taxes on employees, not from excise taxes on insurance companies.
It’s this aspect of the Senate plan that has unions united in opposition. The excise tax is coupled with a refundable tax credit available to families making less than 400 percent of the federal poverty level (about $88,000 for a family of four). But many union members make more than that while most union members enjoy health insurance benefits that exceed the Baucus threshold. So for many union members, the Baucus plan would reduce their health benefits and raise their income and payroll taxes, but exclude them from the refundable tax credit.
What about S Corporations? How would they be impacted? Here’s chart we put together:
| Earns More than 400% FPL | Earns Less Than 400% FPL | |
| Has High Cost Plan | Taxes Are Higher | Mixed |
| Has Low Cost Plan | Not Affected* | Taxes Are Lower* |
Estate Tax Update
We expect Round 1 in the great estate tax battle to take place this fall/winter. The tax goes away in 2010, and then returns in full form in 2011, giving just about everybody a reason to come to the table.
In preparation for this debate, forty-six trade associations, including your S Corporation Association, the Chamber of Commerce, NIFB, and the National Association of Manufacturers sent a letter to Congress urging them to support a permanent estate tax fix that includes a 35 percent top rate and a $5 million per spouse exclusion.
As Martin Vaughn of Dow Jones reported:
The groups said they will support a permanent rate of 35%, with the first $5 million of wealth exempted, and up to $10 million in the case of married couples. Those are the terms that are being pushed in the Senate by Sens. Jon Kyl, R-Ariz., and Blanche Lincoln, D-Ark.
On timing, the expectation continues to be that Congress will take up legislation to extend certain expiring tax provisions before the end of the year, and that the estate tax fix will be made part of that bill.
Tax Reform Panel Report Update
Remember the President’s Economic Recovery Board headed by Paul Volcker? The President announced its creation at the beginning of the year but it’s been quiet since then. The principle reasons for this silence are federal sunshine laws that require any gathering to be open to the public. It is hard to provide the President with critical insights into how to fix the economy when the whole world’s watching.
One offshoot of the Board that has been active is the White House Tax Reform Panel. They had their first (and last?) public meeting last week, chaired by CEA Member Austan Goolsbee. During the meeting, Goolsbee made clear that the Panel was not seeking to create a new tax system but rather would focus its recommendations on three specific areas — tax simplification, enforcement and corporate tax reform. The panel is accepting public comments through October 15th and then will make its own recommendations known to Treasury Secretary Geithner by December 4th.
In the past, it has been easy to dismiss the work of presidential or congressional tax reform panels. They tend to come and go, after all, with little to show for their efforts. This time, however, the combination of huge deficits and an expiring tax code make some sort of dramatic changes to the tax code almost a certainty. Given the landscape, we intend to follow the efforts of this group closely.
S-Corp Modernization Bill Introduced in the House
The legislation is the companion bill to legislation (S.996) introduced in the Senate earlier this year, and represents the priorities of the S Corporation Association for the 111th Congress, including a provision to make permanent the built-in gains reform enacted as part of the larger economic stimulus package adopted earlier this year.
In a statement accompanying the legislation, Congressman Kind noted, “This bill is a commonsense tax code change that will have huge returns in terms of growth and investment for S corporations. Especially in this tough economic time, my goal is to look out for the small and family-owned businesses which drive our economy. This bill speaks to that, reducing a penalty on S corporations, and thus encouraging them to reinvest the savings into growing their business and creating jobs.”
“At a time when small, family and closely-held businesses are struggling to survive, it is encouraging to see that these Members of Congress are dedicated to ensuring the long term viability of S corporations,” said S-CORP Chairman Dick Roderick. “S-CORP would like to congratulate our champions on the timely introduction of this legislation, and express our gratitude for their commitment to the nearly 4.5 million S corporations across the country.”
With legislation now introduced in both the House and Senate, your S-CORP team will be working hard to garner additional support for the legislation. Reforming the rules governing S corporations will allow countless S corporations to reinvest in their businesses and create jobs – something the economy desperately needs at this moment.
S-CORP wishes to thank Representatives Kind, Herger, Schwartz and Reichert for their commitment to closely-held businesses and looks forward to working with these advocates to move this legislation forward this Congress.
Chairman Max Baucus today announced he now has a plan to cover the cost of reforming health care. Past options to cover the cost put forward by the President, the Senate Finance Committee, and the House Ways and Means Committee include:
- A value-added tax
- A rate increase on upper-income families
- A rate increase on Medicare payroll taxes
- Capping employer-provided health insurance benefits
- Capping itemized deductions
- A sin tax on alcohol and soda
None of these options is particularly attractive and, given the challenge of raising this much money, our expectation was that the overall scope of the House and Senate reforms would get smaller as the debate moves into July.
It appears that whittling down process is underway. According to his comments, the Finance Chairman now has in mind a $1 trillion expansion of health insurance coverage (down from previous drafts) to be paid for through an even split of spending cuts and tax increases, including a slimmed down version of capping the employer-provided health care exclusion.
“We are much closer on the scores for a health care reform package than we were at this point last week. We have options the Congressional Budget Office tells us would cost under $1 trillion and are fully paid for,” said Baucus. “Based on these developments, I’m even more confident in our ability to move forward. And as I’ve said before, we will not put out a mark until we are sure we have it right. I’ll continue to work with Senator Grassley and Senators on both sides of [the] aisle to turn these options into a package that can pass the Senate and become law this year.”
The reforms themselves seek to widen health insurance coverage by expanding Medicare and Medicaid while creating a new health insurance exchange for employers and families. The exchange would include both private insurance options as well as some sort of public alternative, and there would be carrots to encourage small employers and low-income families to participate as well as sticks for those who don’t.
The overall cost of these proposals is in the $100 to $200 billion range and would be added on to the $750 billion the federal government already spends on health care programs annually.
But even if Senator Baucus succeeds in offsetting half that cost through spending cuts elsewhere, there is simply no way to efficiently raise $50 billion a year by focusing on individuals making more than $250,000. To raise that kind of money, you need to reach down to the middle class, which is why options like capping the employer-provided health care exclusion are now part of the discussion.
For S corporations, the concern is that the new taxes (whatever form they take) are going to come on top of likely tax increases on income, capital gains and dividends, and estates. These taxes are already scheduled to go up, and with Congress operating at a deficit several times larger than average, they are unlikely to get pared back before they take effect in 2011. Congress simply can’t afford it. Whether Congress (and taxpayers) can afford an expensive expansion of health coverage too is certain to be part of the debate.
Obama LIFO Proposal and S Corps
Speaking of tax increases, the S Corporation Association has been fighting LIFO repeal ever since the issue first emerged as part of a 2006 bill to protect consumers from rising energy prices.
Over the years, we’ve made the case that LIFO is a perfectly legitimate inventory accounting method that can provide the IRS with a more accurate picture of a firm’s income, especially in an environment where prices are rising. (Has anybody looked at long-term Treasuries recently?)
And over the past three years, Ways and Means, Finance, the Joint Committee on Taxation, FASB, and the SEC have all taken positions that, to one degree or another, would undermine the ability of firms to use LIFO in the future.
The most recent shot in the LIFO wars was included in President Obama’s FY 2010 budget. The Obama proposal would repeal LIFO for tax purposes effective in 2012. This change would adversely affect LIFO firms in two respects. First, firms would no longer be able to use LIFO moving forward, likely resulting in higher reported income and higher taxes.
Second, firms would need to pay taxes on their so-called LIFO reserves — an accounting entry that doesn’t reflect real wealth or income. As we’ve observed, for firms that have been on LIFO for any significant period of time, their LIFO reserves are going to be substantial. The Obama proposal recognizes this double hit by allowing LIFO firms to pay tax on their reserves over an eight year period.
Firms will still be hit with a double tax increase for the privilege of switching to FIFO, but at least the second tax will be spread out over eight years. Of course, they’ll also be paying for health care reform and shouldering the 2011 tax increase and paying down record federal deficit…
The Washington Post Discovers Small Employer
The Washington Post this week reported on an issue that shouldn’t come as a surprise for S-CORP readers: President Obama’s tax plans could hurt many of America’s small businesses. Small business owners who report their business profits on their personal income returns (like most small business owners do) are suddenly finding themselves classified as the “richest” Americans, and thereby subject to Obama’s tax increases. The Post explains:
Across the nation, many business owners are watching anxiously as the President undertakes expensive initiatives to overhaul health care and expand educational opportunities, while also reining in runaway budget deficits. Already, Obama has proposed an extra $1.3 trillion in taxes for business and high earners over the next decade. They include new limits on the ability of corporations to automatically defer U.S. taxes on income earned overseas, repeal of a form of inventory accounting that tends to reduce business taxes, and a mandate that investment partnerships pay the regular income tax rate instead of the lower capital gains rate.
The Washington Post is catching up to what S-CORP and its friends have been pointing out for a while now — if your goal is to reinvigorate the economy, placing additional burdens upon the very business that can help pull us out of this crisis is the wrong way to go. The example used by the Post — Gail Johnson of Richmond, Virginia — should give S corporation shareholders pause:
Johnson declined to say whether she voted for Obama. But she said she ignored his tax plans until her husband, who handles real estate and construction for the schools, mentioned it one day. “I’ve since talked to my accountant,” she said. “And, oh, my gosh!”
In a typical year, Johnson’s federal tax bill would be about $120,000. But starting in 2011, the higher marginal rates would add about $13,000 a year, Hurst said. Capping the value of itemized deductions at 28 percent would add another $10,000, for a total increase of $23,000.
And Johnson’s tax bill stands to grow dramatically if Obama were to revive a plan to apply Social Security tax to income over $250,000 instead of capping it at the current $106,800. Because Johnson is an employee and an employer, she would have to pay both portions of the tax, Hurst said, tacking another $30,000 onto her bill.
That’s a potential $50,000 tax increase for a small employer whose family earns about $500,000 a year, including the income from her business. It’s hard to see how increasing her federal tax bill (this does not include state and local taxes) from around $120,000 to $170,000 would not harm Gail’s plans to invest in her business and hire additional employees.
Budget Plan Finished
On that note, perhaps the most frustrating aspect of the tax increases outlined above is that they simply will not be enough. Federal deficits are going sky-high and higher taxes on the middle-class are all but inevitable. House and Senate negotiators this week put the final touches on the budget outline for next year. For S corporations, three major items stand out: total deficit estimates, the estate tax and the inclusion of reconciliation instructions for health care.
The Congressional Budget Office estimates that the Obama budget, if enacted, would result in deficits of $1.8 trillion, $1.4 trillion, $1 trillion, $658 billion, $672 billion, and $749 billion over the next five years. That’s a cumulative of $4.4 trillion over five years, or $1.7 trillion more than if we simply did nothing over the next five years and maintained current law.
The U.S. government has never run deficits of that magnitude and exactly how the debt will be financed is an open question. To put these five-year numbers in perspective, over eight years of President Bush — who is rightly criticized for not paying more attention to holding down spending – debt held by the public increased by $2.4 trillion. The budget offered up by conferees this week has deficit estimates that are smaller than the Obama budget, but not enough to address the question of who is going to finance all that debt.
Regarding the estate tax, the budget agreement calls for maintaining the 2009 rates and exemption levels of 45% and $3.5 million per spouse. While the Senate’s original budget allowed for higher exemption levels and a lower rate, the House ultimately prevailed and stuck with freezing the 2009 rules.
On the reform front, the resolution will include “reconciliation instructions” for health care reform. As S-CORP readers know, reconciliation is valuable to the majority in the Senate because it allows for controversial items to pass the Senate with a simple majority rather than the usual 60 votes.
There are limitations, however, because bills brought to the Senate floor under reconciliation may not increase the deficit outside of the budget window, which means whatever they enact under this budget would have to be sunset after five years.
S corporation shareholders know how these sunsets work — we have been dealing with the uncertainty of the estate tax repeal sunset for a decade now. How effective could broad-based health care reform be if it goes away in just five years?
Moreover, reconciliation bills may not include provisions with no or little impact on revenues and spending. The core provision in most health reform plans is to create a health insurance “exchange” similar to the Connector up in Massachusetts. This may or may not be a good idea, but it doesn’t have a significant impact on either revenues or spending and would likely fall outside of reconciliation. For a full review of these issues, we recommend reading the analysis of S-Corp ally Keith Hennessey.
Bottom line: Attempting to reconcile health care reform could cost the majority more than it’s worth, especially with Senator Specter now aligning himself with the Democratic Caucus.
Obama’s Tax Plans Take Shape
President Obama released a 140-page outline of his budget today that reflects his revenue and spending priorities for the next couple of years.
Chief among these is a major change in federal health care policies. As made clear in his speech to Congress the other day, health care reform is first among the several big reforms on the table and his budget sets aside $634 billion of the estimated $1 trillion he plans to spend on the plan.
To raise the $634 billion, Obama calls for: 1) limiting itemized deductions for families earning more than $250,000, starting in 2011; 2) cutting payments to Medicare Advantage plans; and 3) reducing Medicaid payments to hospitals and drug makers.
Other key proposals include:
- Beginning in 2011, increasing the top two income tax rates to 39.6 and 36 percent respectively while raising rates on capital gains and dividends to 20 percent, consistent with President Obama’s promise to raise taxes on families earning over $250,000.
- Raising $353 billion through the elimination of so-called business loopholes including limiting the ability of firms to defer tax payments on overseas income and LIFO repeal.
- Raising the tax rates applied to so-called “carried interest” earned by hedge fund managers and other professionals.
- Calling for a cap-and-trade program to limit carbon emissions with 100 percent of the credits auctioned off. The resulting revenue would be used to fund clean energy programs and be returned to families and small businesses.
- Locking into place the 2009 estate tax rate and exemption levels.
We will have more reports in coming days, but suffice it to say that the Obama outline, if enacted intact, would result in significantly higher tax rates for many S corporations that would be imposed on a significantly larger income base.
The one piece of good news is that the budget, reflecting the current economic climate, does not attempt to accelerate the rate increases on upper-income families, but rather allows the current rules to take effect whereby the lower rates expire beginning in 2011.
As students of government know, the President’s annual budget submission is required by Congress and is just the first step in the year-long process of establishing the government’s spending and revenue limits. Given the current make-up of Congress, however, we expect the plan outlined today to be the presumptive starting place for congressional deliberations — especially in the House. For S corporations, that means we will be playing a lot of defense for the next few months.
Do Marginal Rates Matter?
Perhaps the biggest tax debate in the next couple years will be over President Obama’s proposal to raise top tax rates back to their pre-2001 levels. Tax cutters argue that higher marginal tax rates will hurt small businesses and the economy as a whole.
Increasingly, we are hearing the counter argument that marginal rates don’t matter. Policymakers on the Hill have told us that and President Obama’s budget outline appears to endorse that notion as well. A back-and-forth on CNBC this morning does a nice job of outlining the debate.
Your intrepid S-CORP team was around in 1993, and we recall that the Clinton rate increases took place in an extremely positive economic and global climate — the Cold War was over, the Thrift Bailout had run its course, and much of the developed world was moving towards market-based policies. Attributing any effect of higher tax rates to economic performance in that climate is a stretch at best.
In many ways, the climate today is just the opposite of what Bill Clinton inherited in 1993, and we are not at all comfortable that higher tax rates applied to a broader tax base will have limited or minimal impacts on economic activity.
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