Payroll Tax Update
Congressional taxwriters, especially in the House, continue to express interest in raising payroll taxes on active S corporation shareholders as an offset to the tax extender package under consideration, and the business community has responded.
Nineteen groups penned letters to Chairmen Levin of Ways and Means and Baucus of Senate Finance, highlighting their concerns with the proposal. As BNA reported:
Small business groups urged in an April 28 letter that House Ways and Means Committee Chairman Sander Levin (D-Mich.) abandon a proposal that would raise payroll taxes paid by S corporation shareholders. The proposal is being considered as a possible way to raise additional revenues to pay for the annual tax extenders legislation (H.R. 4213) that includes $31 billion in extensions of popular tax cuts that expired at the end of 2009.
Setting aside the politics of raising taxes on small employers during an economic downturn, another significant challenge confronting tax-writers is the lack of an actual proposal. This idea has been around for years, yet the number of bills introduced with some form of this provision included is few — maybe only the Rangel “Mother” bill introduced in the fall of 2007. The association letters focused on that provision because it’s the only one out there.
A member of the American Institute of Architects had a chance to speak to this issue yesterday when he testified before the House Small Business Committee:
Although the details of the proposal currently under consideration are unclear, it is my understanding that the proposal would expand the application of payroll taxes to active shareholders of S corporations “primarily” engaged in “the performance of services.” I understand that there is concern that some S corporations misclassify salary compensation as earnings distributions in order to avoid paying payroll taxes. However, my fear is that the proposal will entrap millions of small business owners who are legitimately and correctly classifying salary and earnings distributions, with limited public policy benefit.
Yesterday’s hearing was unique in that, to the best of our knowledge, it was the first public testimony on this topic in years. The head of the Joint Committee on Taxation outlined a proposal to apply self-employment taxes to all partnership, LLC, and S corporation income before the Senate Finance Committee, but that was five years ago! We are unaware of any other legislative activity on this topic before last month, when the concept was floated to Ways and Means Members as a possible pay-for for extenders.
Overturning fifty years of tax policy should be a big deal and approached in an orderly fashion, not done at the last minute and on the run.
Payroll Taxes and the 3.8 Percent Investment Tax
With the S corporation payroll tax issue front and center, we’ve been revisiting the adoption of the 3.8 percent investment income tax as part of healthcare reform. There are a number parallels that deserve to be pointed out.
First, both taxes were introduced into the process at the eleventh hour. The 3.8 percent tax was introduced into the debate after both the House and Senate had passed their respective health reform bills and barely a few weeks before the whole package was signed into law. In terms of size and speed, the 3.8 percent investment tax is the LeBron James of the tax world. It’s likely nothing that size ($210 billion over ten years) has moved from introduction to law that quickly in the history of democracy.
Meanwhile, the S corporation tax is under consideration for the extender package. That package has already passed both the House and the Senate and the S corporation provision was not part of either bill. As with the 3.8 percent tax, it hasn’t actually been introduced in any legislation — it’s just a concept. And, like the 3.8 percent tax, this concept has never been subject to hearings or review.
Second, while both taxes are described generically as “payroll” taxes, they aren’t. The 3.8 percent tax is a tax on savings and investment only. It does not apply to wages or other forms of labor income. The same is true for the S corporation tax. For law-abiding shareholders, it’s a tax on returns from business investment.
Third, one of our arguments against the S corporation payroll tax is that it would, for the first time, fund Medicare with taxes on capital rather than labor. Some have suggested that the 3.8 percent tax broke that barrier already — not true.
There is no connection between the 3.8 percent investment tax and Medicare. The House struck the Medicare connection in the manager’s amendment filed the day before the package was adopted. So, while the tax still has “Medicare” in its title, none of the revenues raised by the tax go to the HI or related Medicare trust funds. Calling the 3.8 percent tax a “Medicare” tax, or even a payroll tax, is simply incorrect.
Finally, the 3.8 percent tax applies to just about all forms of investment income — rents, royalties, annuities, partnership income, etc. — except for business income earned by active shareholders of S corporations. Active shareholders of S corporations were explicitly exempted. Yet, the new S corporation payroll tax currently under consideration for the extenders package would effectively reverse this policy decision by applying a 3.8 percent tax to the business income of active shareholders!
Americans Love Small Business
The American economy’s reliance on small, closely-held businesses is unique in the developed world. Most other major economies focus their economic energies on large public corporations, but not the United States. Notwithstanding the financial crisis, the Jeffersonian concept of the yeoman farmer is alive and well and lives on Main Street.
As we’ve pointed out before, this emphasis on small and independent didn’t happen by accident. It was the result of conscious efforts by past Congresses — both Republican and Democratic — to empower Main Street business.
A recent poll by the Pew Research Center suggests this reliance on private enterprise is in synch with the American people. As reported in USA Today:
According to the just-released study by the highly respected Pew Research Center, small business is the most trusted institution in America. More than churches. More than colleges. More than technology companies. And certainly more than labor unions or large corporations.
The results were “striking,” according to Carroll Dougherty, Pew’s Associate Director. “At a time when a lot of institutions are viewed negatively, small business is viewed very positively. What’s really interesting is that large corporations are viewed almost as negatively as Wall Street. The contrast between large corporations and small business is enormous.”
“So much of this survey is partisan,” Dougherty continued. “In this case, it’s bipartisan. It crosses party lines.” 72% of Republicans, 70% of Democrats and 73% of independents say small businesses have a positive effect on the way things are going in the country.
Now if we could only translate those positive vibes into positive legislation.
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.
Senate Jobs Bill First Out of the Chute
With health care reform in a state of political limbo, Senate leadership is busy assembling a job-creation package that is likely to be the chamber’s next significant legislative effort.
Just before Christmas recess, the House hastily assembled and adopted a $154 billion spending package. In response, the Senate Finance Committee is working on a package that focuses more on tax relief than the House counterpart. As reported by Dow Jones:
The package would be paid for largely by re-directing funds that were available for the government’s bank bailout program, according to an outline dated Friday of possible measures being considered for inclusion in the bill.
The Senate document put the total cost of economic stimulus measures in the bill at $82.5 billion. A Senate Democratic aide cautioned that the document doesn’t reflect the most recent conversations among leaders about the plan, and some elements may change considerably.
A broad outline pitched to the Democratic conference today included pension relief, SBA lending provisions, energy efficiency tax credits, export promotion (IC-DISC users take note) and a proposal that would “provide a tax credit for between 10%-20% of increased payroll—to encompass both hiring of new workers and increasing part-time workers to full-time status.”
Tax policy veterans should recognize the employment tax credit idea from years past. Among others, Senator Kerry offered something similar as part of his Presidential platform in 2004. The proposal has been always been viewed skeptically, however, over concerns that it is poorly-targeted and only rewards those businesses that would hire new workers anyway.
Regarding timing, it’s still up in the air but we anticipate a Finance Committee markup in the next two weeks followed by floor consideration after the President’s Day holiday.
So what are your S-CORP takeaways? First, there’s an incredible amount of pent-up demand for tax policy in the Senate, and we expect this legislation to open the floodgates. It’s a tax vehicle, after all, so how can Chairman Max Baucus and Majority Harry Leader Reid keep extenders, energy tax incentives, and (perhaps less so) an estate tax fix on the sidelines once it starts moving?
Second, lots of other items are likely to catch a ride as well. Extended UI and Cobra benefits expire at the end of February, as does the temporary Doc Fix for Medicare payments. The timing of this package suggests those provisions stand a good chance of being included.
Finally, expect lots of message amendments regarding the expiring Bush tax relief. It all goes away at the end the year, after all, and none of the provisions listed above address this underlying policy challenge.
CBO Updates Budget Outlook
The CBO issued its outlook for 2010-20 today. Here’s the CBO on the short-term outlook:
CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest. Moreover, if legislation is enacted in the next several months that either boosts spending or reduces revenues, the 2010 deficit could equal or exceed last year’s shortfall.
And the longer term outlook:
Under current law, the federal fiscal outlook beyond this year is daunting: Projected deficits average about $600 billion per year over the 2011–2020 period. As a share of GDP, deficits drop markedly in the next few years but remain high—at 6.5 percent of GDP in 2011 and 4.1 percent in 2012, the first full fiscal year after certain tax provisions originally enacted in 2001, 2003, and 2009 are scheduled to expire. Thereafter, deficits are projected to range between 2.6 percent and 3.2 percent of GDP through 2020.
And the impact on debt:
Under current law, the federal fiscal outlook beyond this year is daunting: Projected deficits average about $600 billion per year over the 2011–2020 period. As a share of GDP, deficits drop markedly in the next few years but remain high—at 6.5 percent of GDP in 2011 and 4.1 percent in 2012, the first full fiscal year after certain tax provisions originally enacted in 2001, 2003, and 2009 are scheduled to expire. Thereafter, deficits are projected to range between 2.6 percent and 3.2 percent of GDP through 2020.
And none of this includes the cost of health care reform, the so-called Medicare Doc fix, extending some or all of the Bush tax relief, the new stimulus provisions, or any of the other expiring provisions. Ouch.
With a deficit outlook like this, the Obama Administration is being pushed in two directions these days. They face demands to increase federal spending in the short run to help the economy while also being told they need to cut spending in the long-term to address the deficit and debt.
One way to deal with this conflict is to substitute smaller, less expensive proposals for the broad, macro reforms that have characterized the Administration’s agenda. President Clinton adopted this approach for many of his State of the Union addresses. As CNN reported after his 1999 address:
President Bill Clinton’s 1999 State of the Union address was classic Clinton. It was another long laundry list of proposals, some conservative, some liberal… Clinton’s 77-minute speech was so overflowing with proposals that by the time it ended it was almost hard to remember that Social Security was the first and most important proposal of the evening. In previous years, commentators criticized Clinton for this approach, complaining that the State of the Union should be more focused. But this year, most commentators simply gushed.
So did viewers, who typically gave Clinton’s annual State of the Union speeches higher marks than professional commentators.
President Obama’s proposal to increase the child credit is a worthy successor to the Clinton approach. The proposal would increase the value of the credit, but not as much as one might expect. It’s not going to be refundable, which means most families with children would not benefit until their incomes rise above $40,000 or so. And it’s capped, so families above a certain income level don’t get it either. Nonetheless, offering middle class families extra child care assistance sounds great in a speech.
Given the current economic and deficit picture, we expect tomorrow’s State of the Union address to place more emphasis on proposals like the child care credit expansion, and less on health care reform and cap and trade.
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.
Items Remaining on the Congressional “To-Do” List
With Christmas less than two weeks away, Members of Congress would like to leave soon, but a long list of to-do items still stands in the way:
- Health Care Reform: Majority Leader Reid is still pressing to get the Senate bill finished before Congress leaves for the New Year. He still might make it, but the odds against him are climbing rapidly.
- Government Funding: Congress passed a batch of spending bills — termed the “minibus” – this weekend, leaving just the Department of Defense (DoD) Appropriations bill to be done. DoD was held back to carry other items with it, potentially including a debt ceiling increase, extension of unemployment benefits, short term estate tax extension, and tax extenders. The DoD bill is definitely a “must-pass,” but that’s a long and heavy list. Look for DoD to pass with less on board rather than more. The House Rules Committee could move to this legislation as early as today.
- Debt Limit: The government will run out of room under the debt ceiling to continue borrowing in the next couple of weeks. Treasury has the ability to make additional room available, but it is an ugly process that undermines our financial credibility. With the government borrowing record amounts each week, the debt ceiling will have to be raised, possibly with a small increase that would be revisited later next year.
- Deficit Reduction Commission: Senate Budget Committee Chairman Kent Conrad (D-ND) and 10 colleagues have indicated they would oppose a debt ceiling increase unless it’s accompanied by the creation of a bipartisan deficit reduction commission whose recommendations would be brought straight to the Senate floor. Senate Finance Committee Chairman Max Baucus vehemently opposes this idea. Speaker Pelosi does too.
- COBRA & Unemployment: Funding for extended benefits runs out soon, as do extended COBRA benefits.
- Tax Extenders: Numerous tax benefits expire at the end of the year, such as the R&D tax credit and the S corp charitable deduction. The Majority would like to move them this week, perhaps on the DoD bill, but not everyone agrees, and extenders could end up being retroactively extended – yet again – early next year.
- Estate Tax: See below. Very unlikely anything moves this year.
The Washington Post reported this morning that the House “will move the year’s final must-pass piece of legislation without a long-term increase to the national debt and without a large boost in infrastructure funding that was aimed at creating jobs.” Meanwhile, Politico reports that UI and a one-year extension of 2009 estate tax rules now look like they are part of the bill.
Bottom Line: It’s a long list and just how it all gets resolved is anybody’s guess.
More on Estate Tax
The image of a train wreck comes to mind when viewing the prospects for moving some sort of estate tax solution in the next couple weeks.
Absent legislation, the estate tax disappears next year and is replaced with a capital gains tax imposed on appreciated property when the assets are actually sold. It’s more humane and workable than the current estate tax — no valuation issues, no liquidity issues, no taxes imposed when somebody dies — but it’s also not long for this world.
Estate tax repeal is only good for one year and then the estate tax returns in full force in 2011 with a 55 percent top rate and a $1 million exemption.
This makes the current delay and stalemate over some sort of permanent solution all the more inexplicable and troubling. Everybody knew it was coming. Everybody knew Congress would need to take action if they wanted to do something permanent. And yet, here we are with just three weeks left in the year and no real plan for action.
The current approach would attach the estate tax and several other process orphans onto to the last remaining spending bill that needs to get done this year — the DoD Appropriations bill. Also riding on DoD Appropriations will be an increase in the debt ceiling and several other “must pass” items. At some point, all those items could weigh the bill down and prevent its adoption.
Another option being considered is a temporary extension in the current estate tax rules. As Dow Jones reports:
“Obviously, the defense bill is the one remaining appropriation bill and one remaining conference report that will need to be passed before we adjourn for the year,” Hoyer said in a Friday press conference. Adding a temporary estate-tax measure to the bill “is an option,” he said.
“Temporary” could mean several things here, but it’s possible that it might mean a multi-month — not multi-year — extension of the current rules, kicking this issue into 2010. Just how that would appease folks, including Senators Lincoln (D-AR) and Kyl (R-AZ) who would like to see something better than the current rules, is unclear.
Some advocates in the estate tax world argued for having the tax expire next year, arguing that anti-tax members would have more leverage with the tax repealed than otherwise. We’re not sure we agree, but it looks increasingly likely that we’re about to find out.
Rep. Hare Introduces S Corporation Donation Legislation
Companies that donate excess inventory or equipment to charity are allowed to deduct up to twice the basis of the item (not more than the retail value) — but only if they are a C corporation. S corporations need not apply.
Congressman Phil Hare (D-IL) has introduced legislation to fix this disparity. The bill (H.R. 4069) would extend section 170 tax benefits to S corporations, ensuring they also have an incentive to donate items to schools and charities. As your S-CORP team wrote to Congressman Hare:
Now, more than ever, America’s charities are in need of assistance. They are being asked to serve more individuals with fewer resources. In 2008, the United Way saw a 68 percent increase in demand for basic needs such as food, shelter, and clothing. Your legislation would help fill this gap by making S corporations eligible for section 170.
The 111th Congress is half over, but the tax-writing community understands there are numerous tax bills on the horizon that Congress will need to debate and send to the President. Legislation like H.R. 4069 is an excellent candidate to be part of those bills, and we will be working to make sure it is.
Business Community Supports Estate Tax Relief
The cost of the estate tax falls heavily on family businesses and farms. The cost comes not only from paying the tax itself, but also from estate tax planning costs. Resources diverted from businesses to pay for estate tax planning would be better invested in business operations and expansion.
The goal of the FBETC continues to be repeal of the estate tax, but this legislation will provide much needed additional relief above the current law. The higher exemption level and reduced rate will lessen the burden of the estate tax and provide family businesses and farms with more capital to reinvest in their business.
As S-CORP readers know, there are three key questions to any estate tax solution — what is the rate, what is the exclusion, and what is the base? Earlier this month, your S-CORP team was joined by fifteen other business groups to make sure Congress doesn’t increase the estate tax base for family owned businesses. This legislation would lock in the other two and help set the stage for continued estate tax relief in the future.
Taxes Are Going Up
The consensus in Washington is that taxes are going up. Just how high is debatable, but higher tax rates appear to be baked in whatever policy cake we are eventually served. So what does the Obama Administration think about higher rates? Obama economist Austan Goolsbee was on CNBC the other day and has this exchange on health care reform after CNBC Squawk Box host Joe Kernen pointed out marginal rates in his home state of New Jersey would soon approach 60 percent:
Goolsbee: We need health care reform so that small business can thrive. You know very well in every small business survey the unaffordability of health care is the thing that small business says is the number one barrier to their growth.
Kernen: But is there a marginal rate were you would say this is a disincentive for small businesses. Is there somewhere where you’re willing, where the administration is willing to draw the line?
Goolsbee: I don’t like high marginal rates, Joe, I agree with you. But to say the marginal rate is going to be 60 percent is totally nuts.
But Joe is right. Marginal rates are going much higher than what they were under Clinton if the House health care reform is adopted. Here’s a rough summary of tax rates in 2011 if the House health care bill is adopted:
| Rates in 2011* | |
| Top Rate | 39.6 |
| Health Reform Surtax | 5.4 |
| Medicare | 2.9 |
| State Average | 6 |
| Pease | 1.2 |
| Total | 55.1 |
(S-CORP ally Bob Carroll at the Tax Foundation issued a nice paper last summer summarizing these concerns and pointing out that high marginal rates are an extremely inefficient means of raising tax revenue.)
The good news is that it is still just 50/50 that the House surtax will survive in health care reform and make it to the President’s desk. The bad news is that won’t matter much, since the fiscal pressures facing Congress are almost unprecedented. As former CBO Director Doug Holtz-Eakin testified before the Senate Budget Committee earlier this week:
Any attempt to keep taxes at their post-war norm of 18 percent of GDP will generate an unmanageable federal debt spiral. In contrast, a strategy of ratcheting up taxes to match the federal spending appetite would be self-defeating and result in a crushing blow to economic growth.
In other words, we’re stuck between the proverbial rock and the hard place. Federal spending levels far exceed their post-war averages and unless taxes are raised to match them, the resulting deficits will be enormous. On the other hand, raising taxes by the necessary amount will, at best, retard economic growth and job creation for years to come.
And what is team Obama doing about this? Downplaying valid concerns about higher marginal rates and supporting legislation that will add more than $1 trillion to our spending obligations over the next ten years.
Update on Healthcare Reform in the Senate
Senate Majority Leader Harry Reid (D-NV) is still working to combine the two health care packages passed by the Senate Finance Committee and the Health, Education, Pensions and Labor Committee. Word is the cost of the plan may be going up. He also is reportedly looking at raising the threshold for the “high cost” plan from $21,000 to $25,000, resulting in lower tax collections from the excise tax. As a result, the Majority Leader is apparently looking into a new way to help pay for the cost of the package by applying Medicare taxes to non-wage income earned by couples making over $250,000. As Bloomberg News reports:
Reid’s proposal would apply Medicare taxes to non-wage income earned from capital gains, dividends, interest, royalties and partnerships for U.S. couples earning more than $250,000, the aides said. He’s also considering an alternative that would simply increase the 1.45 percent Medicare tax on salaries of couples who earn more than $250,000, one of the aides said.
This new pay-for is an attempt to scale back the previously proposed tax on so-called “Cadillac” health plans. So what does this mean for S corps? More pressure on rates, higher taxes on business income, and less capital to invest and hire new workers. And these hikes would take place during the worst economy since at least 1980 and maybe before. What are they thinking?
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.
House Releases Health Care Legislation
As expected, House Leadership released its health care reform plan yesterday — America’s Affordable Health Choices Act of 2009 (H.R. 3200). As you can imagine, there are any number of provisions to explore in a 1000-page health care bill, but for S corporations, the big four items appear to be:
- The new health insurance exchange;
- The surtax on high income individuals;
- The health insurance tax credit for smaller firms; and
- The payroll tax penalty for non-participating firms.
Supporters of the plan argue that the combination of the health care exchange and the small business tax credit will provide a net benefit to S corporations and other small businesses. Opponents point to the higher taxes and penalties for firms that choose not to offer health care plans to their employees.
They also question whether the overall plan will actually save money. The CBO estimates it will cost money after all – more than $1 trillion dollars. Of particular importance is the response of the moderate Democratic Blue Dog Coalition. As BNA reported this morning:
Rep. Mike Ross (D-Ark.), chairman of the Blue Dog Health Care Task Force, said his group was committed to passing health care reform. He also said that “reform that does not meet the president’s goal of substantially bringing down costs is not an option.”
We are not in a position to judge how successful the exchange will be. The only example is the one in Massachusetts and that one has both supporters and detractors. As for the other three provisions, here’s our best summary:
Surtax: Starting in 2011, a surtax of 1, 1.5 and 5.4 percent will be applied on “modified” AGI exceeding $350,000, $500,000 and $1 million respectively (joint filers). Unless OMB certifies that the bill’s changes to Medicare and Medicaid result in an additional $150 billion in cost savings, the surtax will rise to 2, 3, and 5.4 percent starting in 2012. If OMB certifies these savings exceed $175 billion, then the lower two surtaxes go away.
Small Business Tax Credit: For employers with fewer than 25 employees and who offer them qualified coverage, they are eligible for a tax credit equal to a percentage of their health care costs. The credit starts at 50 percent for employers with fewer than 11 employees and average annual compensation of less than $20,000. It phases out for more employees and higher salaries. A firm with 25 employees and/or average compensation of more than $40,000 gets no credit.
Payroll Tax Penalty: Firms that do not pay for at least 65 percent of their employees’ qualified coverage are subject to a payroll tax penalty. The tax starts at 2 percent of payroll for firms whose payroll exceeds $250,000 and rises to 8 percent for firms with payrolls exceeding $400,000. It is unclear whether the payroll tax applies to all payroll or just the amount exceeding the threshold.
Suffice to say that the complexity of each provision is worth its own white paper. Trying to gauge the interaction between them is simply impossible. Here are some observations and questions:
- How does the payroll tax penalty work? If an employer does not offer qualified coverage to his/her employees, does the tax apply to all payroll or just the amount above the threshold? How does the bill define firm? By entity or by establishment?
- The plan penalizes employers for expanding their payroll. If the employer offers qualified coverage, raising wages would reduce their credit. If they don’t, increased wages will increase their penalty. Either way, the plan raises the marginal cost of hiring new employees and offering them higher wages.
- The higher surtax rates can be avoided if OMB finds additional savings from Division B in the bill. How is OMB supposed to measure these savings and attribute them to the Division B? If the CBO failed to measure these savings, how will OMB?
- The bill appears to add to the deficit, especially in later years. Is this the plan, or will additional cost savings be offered to make it budget neutral?
- What about the need to balance the budget, reform the Alternative Minimum Tax, extend some or all of the expiring tax relief, or make the corporate tax code more competitive? How will Congress accomplish all these things if it spends $1 trillion on health care reform?
The House Ways and Means, Labor, and Energy and Commerce committees will begin marking up their respective portions of the bill tomorrow. Expect these markups to be extremely contentious. The Speaker’s goal is to get the bill through the full House before the August recess. Given the primary importance both the Speaker and the President have placed on health care reform, we expect this goal will be met. Exactly what changes are necessary to get the plan through the House, however, remains to be seen.
The Surtax and Small Business
The fight over who will pay the surtax has begun. The Ways and Means Committee published its estimates that only 1.2 percent of all taxpayers will pay the tax, and only 4.1 percent of all small business owners.
Our immediate reaction was that small business owners are 3.5 times more likely than the average taxpayer to pay the tax, but even that observation misses the larger point. It’s not the number of taxpayers affected that counts, but rather the amount of economic activity subject to the higher rates.
As we’ve pointed out previously, about two thirds of all small business income is taxed at the top two rates, so any surtax applied to upper incomes is likely to tax a majority of small business income. Moreover, those rates are already scheduled to rise, resulting in a double hit on upper income business owners in 2011 and beyond.
| Marginal Tax Rates Under HR 3200 (Joint Filers) | |||
| AGI | Marginal Rate (2009) | Marginal Rate (2011) | Marginal Rate (2012) |
| $350,000 | 33% | 34.00% | 35% |
| $500,000 | 35% | 41.10% | 42.60% |
| $1,000,000 | 35% | 45% | 45% |
This chart requires several caveats, including pointing out that the surtax applies to “modified” AGI rather than taxable income, but the general point is valid — HR 3200 will return marginal tax rates back to where they were before we started cutting rates in the 1980s.
In addition, this chart doesn’t include the HI tax that now applies to wage income, it doesn’t adjust for taxing “modified” AGI, which includes income from capital as well as labor, it doesn’t include the impact of restoring PEP and Pease, and it doesn’t include state and local taxes. All told, the effective marginal rates on higher incomes will easily exceed 50 percent under this plan.
One last point. When taxing the rich is debated, the discussion usually ignores the actual amount of taxes being paid. Your S-CORP team thinks that’s a mistake.
For example, the CBO reports that the top fifth of taxpayers pay, on average, $64,000 in federal taxes every year. The top one percent pay over half a million.
How much more will HR 3200 add to this burden? And at what level of tax do taxpayers, including small business owners, stop being productive and choose to do something else with their time?
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