Private Enterprise and Jobs
A recent Washington Times article by Mike Whalen, chief executive of Heart of America Restaurants and Inns, should give policymakers pause as they worry about weak job growth while simultaneously piling one tax on top of another onto job-creating companies. Using 2008 numbers, Whalen runs through all the taxes a single 100-room limited service hotel located in Iowa pays:
For starters, we pay property taxes to the tune of about $199,000 annually. Next, there is a 7 percent “pillow tax” that generates about $162,000 annually. Then we pay a 6 percent sales tax on revenue that yields about $124,000 annually. Then we also pay sales tax on things like toilet paper, shampoo, soap, continental breakfast food and amenities and other items that the state of Iowa says are not really part of the product we sell because it says we are selling space. It may come as a surprise to you that toilet paper is not part of what you are buying when you rent a hotel room in Iowa, but the state considers it a gift. Those extra sales taxes come to about $1,800 per year.
Now on to Round 2. This little hotel also pays about $3,000 a year in various licenses and fees. Payroll taxes come to about $60,000. The federal government says the depreciable life of a hotel is 39.5 years, but we refurbish the hotel on a constant basis and pay sales tax on related purchases, such as new carpet, mattresses and bedding, and even paint. Anyone who doesn’t believe we already have a partial value-added tax (VAT) like Europe, isn’t in business. Now, between Round 1 and Round 2, we’re at $548,000 in taxes annually.
So, even if we don’t make a dime of profit, and before we pay the mortgage to the bank or buy new stuff, we pay $548,000 in various taxes, licenses and fees.
As Whalen points out, this tax burden doesn’t include state or federal income taxes. Those taxes are going up. And the alternatives aren’t pretty either:
…if I sell the hotel, I’ll pay a hefty capital gains tax of 25 percent, and it’s probably going up. Alternatively, when my wife and I die, I’ll pay another 45 percent if the estate tax returns in 2010. But don’t worry: We have diverted money from productive investments to pay for life insurance to partially pay this bill.
A central question to any economy is, “Where are tomorrow’s jobs going to come from?” A small hotel in the Midwest may not immediately come to mind as part of the answer, but ask folks in Iowa whether those jobs are important. And then ask yourself whether the tax changes just enacted, coupled with those on the horizon, are going to make it easier or harder for Mike and other entrepreneurs to take risks, invest in properties like a limited service hotel, and create jobs. The answer is pretty obvious.
Whither Tax Rates?
Following the release of the S Corporation Association letter on the new 3.8 percent tax and its impact on future tax rates, we got into a back and forth with a reporter over what is the appropriate baseline for measuring future rates.
We used a current law baseline, which is the same baseline the Congressional Budget Office and the Joint Committee on Taxation use when making their estimates. Under current law, for example, the tax rate on dividends is scheduled to rise from 15 percent today to 39.6 percent next year to nearly 45 percent in 2013 when the new 3.8 percent tax kicks in. That’s three times the current tax!
The reporter, on the other hand, suggested it would be more appropriate to use President Obama’s proposals as the correct baseline. Under the President’s plan, the top rate on dividends would rise to 25 percent in 2013 based on his proposal to tax capital gains and dividends at a 20 percent base rate. Here’s a comparison of the two baselines and their respective rates:
| Top Marginal Tax Rates in Future Years | ||||
| 2010 | 2011 | 2013 | ||
| Current Law* | ||||
| Capital Gains | 15% | 21% | 25% | |
| Dividends | 15% | 41% | 45% | |
| Interest Income | 35% | 41% | 45% | |
| Obama Budget | ||||
| Capital Gains | 15% | 21% | 25% | |
| Dividends | 15% | 21% | 25% | |
| Interest Income | 35% | 41% | 45% | |
| * Current Law and Obama Budget include the phase-out of itemized deductions (Pease) | ||||
Unless you’re actually working for the White House or OMB, using the President’s budget proposals as the baseline requires a certain amount of faith — faith he will press for those proposals, faith the Congress will pay attention, faith other priorities will not get in the way. The President’s budget does call for a statutory rate of 20 percent for 2010 and beyond, but most observers are betting rates of 28 percent or higher are more likely.
But that’s all beside the point. As the chart demonstrates, tax rates on investment are going up sharply regardless of which baseline you use.
More on the Investment Tax and S Corporations
Our Google Alert did its job and alerted us to another website devoted to S corporations – www.scorporationsexplained.com. It appears they too are concerned about the new 3.8 percent tax on investment income and S corporations. As web author Stephen Nelson explains, even S corporation shareholders active in the business may end up paying this tax on some of their S corporation income:
Once a taxpayer’s income exceeds the threshold amount, investment income gets hit with the tax. But it’s important to note that investment income earned inside an S corporation retains its character as the income flows through to investors. This means that even working shareholders may pay the new Medicare tax on the chunk of the S corporation’s profit that occurs because of interest, dividends, capital gains, or rental income earned by the S corporation.
Example: Your share of an S corporation’s profit is $100,000 but only $80,000 of this $100,000 represents profits from the business operation. The remaining $20,000 of profit comes from dividends, interest and capital gains earned on investments held by the S corporation. In this case, no matter whether you’re a working shareholder or a passive shareholder, you’ll pay the Obamacare Medicare tax on the $20,000 of investment income that flows through to you if your income exceeds the threshold amounts.
This result suggests the new tax may be more expansive than it appeared at first glance, especially for mature S corporations that control more than one entity.
The Skinny on the Jobs Bill
So we’re still trying to figure out what happened between Thursday morning and Thursday afternoon last week.
On Thursday morning, the Senate Finance Committee released an $84 billion “Jobs” bill draft with all the expected items included — jobs provisions, tax extenders, unemployment and COBRA extensions, etc.
That same afternoon, Senator Reid rejected that approach and offered a “skinny” $15 billion bill instead. He called up the House-passed Jobs bill, offered his skinny package as an amendment, filled the amendment tree, and filed cloture on the new package. The skinny bill includes the Schumer-Hatch payroll tax credit, Section 179 expensing relief, Build America Bonds, and an extension of the Highway bill authority until the end of the year.
What happened? A couple of explanations are floating around town. The first version is Senator Reid got an earful over the contents of the Senate Finance bill and its “Christmas Tree” appearance and elected to go with a less costly approach. Version two is that Reid was unhappy with Senator McConnell’s willingness to allow the bipartisan bill to move forward and introduced the skinny package in response. Version three is that this has been the plan all along — to introduce and pass a series of more narrow, jobs oriented bills. Version two got a plug from the White House. As CongressDaily reported:
White House Press Secretary Robert Gibbs said the president is “eager to sign” the jobs bill as pared down by Reid, and he called its provisions “very akin to what the president had in mind,” adding there will be more bills to refine the jobs strategy.
Either way, the Senate is set to vote on closing out debate on the smaller bill next week when the Senate next reconvenes. As always, cloture requires 60 votes for adoption.
Current favorite topic of speculation: Does Senator Reid have the votes? There is a lot of pent up support for extenders, UI and COBRA extensions, and some of the other provisions dropped in the move to the skinny bill, after all, and the Leader’s move left lots of Senate offices scratching their heads. As The Hill reported this morning:
But since he announced his smaller jobs bill, it has been under siege by Republicans and Democrats alike. Absent political arm-twisting by Senate leaders to bring their rank-and-file in line, opposition to the bill is expected to be bipartisan, sources said.
All of which suggests the Senate will eventually return to the larger, bipartisan package and the votes early next week are merely a diversion. We’ll see.
Finance Hearing on Small Business Taxes and Trade
The Senate Finance Committee has announced it will hold hearings on “Trade and Tax Issues Relating to Small Business Job Creation” next Tuesday. The witness list is TBD, but we understand someone from the U.S. Treasury Representative will testify, in addition to a couple of think tank folks and a small business or two. The hearing’s focus on trade is consistent with the Obama Administration’s new focus on increasing exports. As the President outlined in his State of the Union address:
Third, we need to export more of our goods. Because the more products we make and sell to other countries, the more jobs we support right here in America. So tonight, we set a new goal: We will double our exports over the next five years, an increase that will support two million jobs in America. To help meet this goal, we’re launching a National Export Initiative that will help farmers and small businesses increase their exports, and reform export controls consistent with national security.
If Congress and the Obama Administration are looking for ways to promote small business exports, the first thing they should do is embrace the current tax treatment of IC-DISC dividends. Two years ago, taxwriters in the House and Senate tried to eliminate the IC-DISC under the guise of making technical corrections.
This effort came despite the fact that small business exporting has been an unmitigated “good news” story in the midst of all the recent financial and economic turmoil. Small business exports are up and the IC-DISC helps. Small and closely held businesses who invest in the United States, create jobs here, and export products overseas can use the IC-DISC to help manage their tax burden.
With a major debate over the correct tax treatment of dividends and capital gains on the horizon, we expect the tax treatment of IC-DISC dividends will once again be before Congress. As such, we’re revamping our efforts to ensure the IC-DISC remains in place to help the next crop of small business exporters break into new markets overseas. Let us know if you’d like to help.
Jobs Bill on Senate Floor Next Week
Senate leadership has committed to taking up a Jobs bill next week. The details of the package are still being worked out, but the list released by the Senate Democrats includes:
- Job Creation tax credit
- UI and Cobra Extensions
- Bonus depreciation and 179 expensing
- Highway funding
- Build America Bonds
- SBA loans
- Export Promotion
- Some energy related tax items
Although it’s not mentioned, we do expect the tax extenders to also be part on the mix. On the other hand, an estate tax fix is not likely to be included. Senator Reid told reporters that he still plans to move legislation restoring the estate tax, just not now. Meanwhile, policymakers are increasingly worried that time is slipping by. As BNA reported earlier:
Proponents of making the estate tax retroactive to Jan. 1 say case history is on their side, although they admit it will be more complicated because the longer they wait to enact legislation, the more people will attempt to game the tax system.
We are not exactly sure how one would “game” the current system. You have to pass away, after all, to take advantage of the current rules. Final jeopardy, indeed. Takeaway: more chatter about getting something done, but no clarity on when they would do it, what it would look like, whether the House is on board with the retroactive application, or whether they have better guidance on the constitutionality question.
Also, we are hearing from folks that a possible solution would be to offer estates the option of using the 2009 rules or the repeal rules. Point of this would be to protect those mid-sized estates (around $7 million) from paying more under repeal than they would have under last year’s rules. That would certainly get around the retroactive question, but it would also raise the cost of acting.
Rep. Paulsen Weighs in on Marginal Rates
The battle over tax rates is heating up. This week, Congressman Erik Paulsen (R-MN) sent the President a letter asking him to focus on proposals that would hold down marginal tax rates and spur small business growth.
The letter refers to a bill introduced by Rep. Paulsen (H.R. 2284) in May that would allow individual taxpayers an exclusion from gross income for certain items of partnership and S corporation pass-through income up to $250,000 ($500,000 for married couples filing joint returns). As Rep. Paulsen notes, this ability to defer taxes on reinvested income “ensures that small business owners are taxed only on the profits taken out of their business, and also allows for the deferment of taxes on income that was placed back into developing their business. By encouraging reinvestment and incentivizing job creation, we can reach our shared goal of economic growth.”
Paulsen also discusses the possibility of creating “an alternative rate schedule for income stemming from small business activity, including sole proprietor, partnership, and S corporation income” in order to “ensure that marginal tax rates would not rise for America’s job creators during a weak economy.”
Amen to that. America has a vibrant, active Main Street business sector because past Congresses have proactively adopted policies to encourage small business creation and growth. Creation of the S corporation was one of those policies. Now is not the time to reverse course.
John Edwards and S Corporations
One of our allies asked us, “How did John Edwards come to be the poster child for S corporations?” He’s featured prominently in a recent CongressDaily story and, frankly, it’s not an association we’re eager to continue.
The Edwards issue first emerged during the 2004 presidential campaign when we learned that, prior to be elected, Senator Edwards operated his law practice as an S corporation. According to reports — recapped by CongressDaily — Edwards took most of his earnings in the form of S corporation distributions which are not subject to payroll taxes.
As you can imagine, this use of the S corporation caught everybody’s attention and the “John Edwards Issue” was born. We still hear “Oh, is this that John Edwards thing?” when we talk to staff about payroll taxes.
While the payroll tax issue continues to be difficult for policymakers and tax collectors alike, the rules governing when S corporation shareholders pay payroll taxes have been in place for long time. Since the IRS released Revenue Ruling 59-221 back in 1959, S corporation shareholders have been required to pay payroll taxes, but only if they work at their business and only on the wages they pay themselves. Revenue Ruling 74-44 made clear that “dividends” paid to shareholders will be recharacterized as wages when the dividends are in lieu of reasonable compensation for services performed for the S corporation.
Despite these clear rules, when Congress lifted the cap on the Medicare payroll tax back in 1993, it created an arbitrage opportunity for business owners whose income exceeds the Social Security wage base. Organize as an S corporation, pay yourself little or no salary, and avoid paying the Medicare tax.
The S Corporation Association’s position on this is three-fold. First, people should pay the taxes they legally owe — we don’t support tax avoidance. Second, while it is admittedly time-consuming, the IRS has the tools necessary to deal with this issue and collect the money owed. As the IRS wrote one taxpayer back in 2003:
Generally, under the rules described above, if a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services. An S corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed.
Third, every legislative proposal we have seen to date to “fix” this issue has been overly broad and would raise taxes on shareholders already fully complying with the law.
As we mentioned, applying the “reasonable compensation” standard is difficult and time-consuming, but the standard is well established and ensures that payroll taxes only apply to shareholder income derived from their services, as opposed to income stemming from their investments in the business and its employees. As you can imagine, capital-intensive industries like manufacturers and others are keenly interested in making certain this line of demarcation is preserved.
The GAO spent the last year looking into S corporations and the tax policy challenges they present. On the payroll tax issue, the GAO recognized that the IRS has the tools in place to enforce current law. Its recommendation:
To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed.
We understand the current rules are not a perfect solution to the “John Edwards Issue.” But then, nothing else is either. We hope the IRS follows the GAO’s recommendation and works to improve its guidance and enforcement of reasonable compensation. Effective enforcement would take the pressure off policymakers to codify new rules, and remove from the S corporation community the threat that fifty years of tax policy will be turned on its head.
Business Community Rallies Around S Corporation Modernization
Last week, your S-CORP team sent a letter signed by 22 of our association allies to members of the House and Senate, urging them to cosponsor legislation to replace the dated rules that have governed S corporations for over fifty years. As the letter notes:
These outdated rules hurt the ability of S corporations to grow and create jobs. Many family-owned businesses would like to become S corporations, but the rules prevent them from doing so. Other S corporations are starved for capital, but find the rules limit their ability to attract investors or even utilize the value of their own appreciated property.
Well into the 21st century, America’s most popular form of small-business corporation deserves rules adapted to today, not fifty years ago. The S Corporation Modernization Act would ensure the continued success of these businesses.
Earlier this Congress, House Ways and Means Member Ron Kind (D-WI) and Senate Finance Committee Members Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) introduced the “S Corporation Modernization Act of 2009” (H.R. 2910 and S. 996) in their respective chambers.
The legislation, designed to update and simplify the rules governing S corporations, enhances the ability of S corporations to attract and raise capital, makes it easier for family-owned S corporations to stay in the family, and encourages additional charitable giving by S corporations and the trusts that hold them.
In the coming weeks, S-CORP will be ramping up its efforts to gather additional support for these bills. At a time when America’s job creators struggle through the difficult economy and the Federal government struggles with massive deficits, smaller, targeted reforms like these are an attractive means of helping Main Street without breaking the bank.
Health Care Reform Outlook & S Corporations
Just about everybody agrees the political landscape has shifted to the point where, while there were once 218 House votes in favor of a reform package, now there are nowhere near that many.
This lack of support is evidenced by the Rube Goldberg-nature of the current efforts to resurrect reform and move it through the Congress. One popular idea is for the House to pass the Senate bill, and then take up a reconciliation package of items to “fix” what’s wrong with the Senate bill.
We are skeptical anything like that happens. Health care reform is unpopular and members are nervous and tired. Moreover, this approach would require House members to “vote on faith” that the Senate would follow-through and adopt the fix. There is rarely a lot of trust between House members and the Senate under normal circumstances, and these are not normal circumstances.
Our expectation is for the hand-wringing to continue for a month or so and then for other pressing items like the jobs bill and the budget to push heath reform aside.
For S corporations, it is hard to regret the demise of this particular reform effort. We have refrained from weighing in on the merits of health care reform — it is a little outside our focus, after all — but the impact of paying for health care reform was clearly going to be a negative.
The House bill would have raised marginal rates on upper-income S corporation shareholders by 5.4 percentage points, while the Senate bill would have increased the Medicare HI tax from 1.45 percent to 2.35 percent — not a direct shot at S corporations, but it would have increased pressure on the IRS and others to change the payroll tax treatment of S corporation income.
And before talks broke down, House and Senate negotiators were seriously considering tossing out those items and expanding the tax base for payroll taxes to include capital gains, dividends, interest income, and S corporation income instead. As the Los Angeles Times wrote:
Democratic congressional leaders are considering a new strategy to help finance their ambitious healthcare plan — applying the Medicare payroll tax not just to wages but to capital gains, dividends and other forms of unearned income. The idea, discussed Wednesday in a marathon meeting at the White House, could placate labor leaders who bitterly oppose President Obama’s plan to tax high-end insurance policies that cover many union members. It could also help shore up Medicare’s shaky finances, and the burden of the new tax would fall primarily on affluent Americans, not the beleaguered middle class.
It would have fallen on the beleaguered S corporation community, too. Moreover, these increases were going to take place when taxes on S corporations (and other flow-through businesses) already were going up. Current law has the top income tax rate returning to 39.6 percent at the beginning of next year, and we anticipate the President will propose to keep these rate hikes in place, at the very least.
Finally, with health care reform out of the way, taxwriters on the Hill will have time to address some of the many tax items that were pushed aside last year, including tax extenders and a broader tax reform effort. As BNA noted this morning:
Last December, Rangel told a group of executives that he planned to press his case for tax reform at the conclusion of the health care debate.
It appears health care reform is over, so we expect Congress to refocus on tax policy this year.
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.
Welcome to 2010!
2009 started off with a bang when we successfully secured temporary relief from the built-in gains (BIG) tax as part of the economic stimulus package adopted in February. With the enactment of that bill, firms that converted to S corporation status or existing S corporations that acquired other businesses between the years 2000 through 2003 are now able to dispose of their built-in gains assets without paying a punitive level of tax.
Built-in gains relief was a great win for S-CORP and we plan to build on that success by pushing for permanent BIG tax relief in 2010, as well as a broad range of other tax reforms important to the S-CORP community. Many of these items are included in the S Corporation Modernization Act (S. 996, H.R. 2910) introduced in both the House and the Senate in record time last year. This legislation forms the core of our S-CORP advocacy and would:
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Enhance the ability of S corporations to attract and raise capital;
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Make it easier for family-owned S corporations to stay in the family; and
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Encourage additional charitable giving by S corporations and the trusts that hold them.
Congress is expected to consider multiple tax bills in 2010 and we will continue to push to get these and other reforms included. Based on our success in 2009, I am confident our S-CORP team and its allies on the Hill are well poised to deliver.
As we move into 2010, however, to say there is significant “policy risk” facing the S-CORP community is a true understatement. Never have the rules and rates that govern our community been under more pressure. For a community whose existence is defined by the tax code, we plan to step up our efforts to defend those rules and make certain policymakers in Washington understand the economic importance of closely-held businesses.
One challenge we face in 2010 is ensuring that closely-held businesses are treated fairly when subject to the estate tax. We expect the estate tax to return in 2011, if not sooner, and some influential members of Congress would like to charge family-owned businesses a premium when they are part of an estate. This idea is simply un-American and wrong, and S-CORP took the lead in 2009 and put together a coalition of 15 major trade associations to educate lawmakers on the need to protect family-owned businesses from arbitrary valuation rules. Estate valuation issues will be front and center in 2010, and S-CORP will continue to fight the good fight.
Pressure on marginal rates is another challenge in the coming year. Rates are set to increase in 2011 without congressional action. Meanwhile, all of the proposals on the table to date would raise them even further. S-CORP has spent years educating policymakers on the massive amount of economic activity currently being taxed at individual rates — closely-held businesses create more jobs and produce more income than public firms — and raising their taxes at a time of economic stress is a recipe for a double-dip recession. We are currently working on new options, and policies, to get this message heard.
Finally, for the growing ranks of exporters in the S corporation community, we plan to continue our efforts to block tax increases on closely-held exporters. S-CORP led the charge to block such an increase in 2007, and with dividend and capital gains tax rates in play in 2010, we expect another effort to single out exporters for higher tax rates.
Now more than ever, it is imperative that policymakers on Capitol Hill and at the White House are reminded of the important role the S corporation plays in our nation’s economy. Through our Washington Wires, recruitment of trade associations and other allies, shoe-leather advocacy, and media outreach, the S Corporation Association continues to do just that.
To assist in these efforts, your S-CORP team relies on a long list of Hill allies with a history of supporting closely-held businesses. Members like Senators Blanche Lincoln (D-AR), Orrin Hatch (R-UT), Chuck Grassley (R-IA), Olympia Snowe (R-ME), Mike Enzi (R-WY) and Ben Cardin (D-MD) and Representatives Ron Kind (D-WI), David Reichert (R-WA), Nydia Velazquez (D-NY), Allyson Schwartz (D-PA), Wally Herger (R-CA) and Danny Davis (D-IL) and others have supported our efforts in the past, and we plan to rely on their support and expertise in the coming year as well.
The S Corporation Association is the only organization in Washington D.C. exclusively devoted to promoting and protecting the interests of America’s 4.5 million S corporation owners. To carry on with this important work, we need your continued participation and support. Let us know of the tax issues most important to you and spread the word to other closely-held businesses. Your increased participation can make an important difference to our continued success.
Dick Roderick
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…
S Corp Modernization Introduced in the Senate!
Good news for S corporations! S-CORP allies Senator Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) today introduced the “S Corporation Modernization Act of 2009.” This legislation is similar to bills offered in previous Congresses and includes many of our Association’s priorities for the year. In a statement accompanying the bill, Senator Lincoln noted:“A strong economic recovery will depend on the health and strength of our small business sector,” Lincoln said. “Over four million of our small businesses across the nation are organized as S corporations, including more than 40,000 in Arkansas, and at least 60 percent of the new jobs created over the last decade have come from small businesses. Congress has not updated many of the rules governing S corporations, and as a result many privately-held businesses are not ideally positioned to deal with the current downturn in the economy. We must modify our outdated rules so that these businesses that are starved for capital have the means to expand and create jobs.”
The bill is designed to update and simplify S corporation rules — some that date back 50 years — to make it easier for these small and closely-held businesses to raise capital and compete in a difficult economy. The “S Corporation Modernization Act” would:
• Enhance the ability of S corporations to attract and raise capital;
• Make it easier for family-owned S corporations to stay in the family; and
• Encourage additional charitable giving by S corporations and the trusts that hold them.
The whole S-Corp team thanks Senators Lincoln and Hatch for continuing their support of America’s small and closely-held businesses and we look forward to working with them to get these important reforms enacted into law this Congress!
More S Corps than Ever!
Just in time for our advocacy of the S Corporation Modernization Act, our friends at Statistics of Income have published their taxpayer Data Book for 2008 and guess what?
For 2008, there were nearly 4.4 million S corporations, an increase of more than 300,000 firms from 2007 and 1.7 million more than just 10 years ago.
Now if the SOI folks would only update their more in-depth “S Corporation Returns” study, we could dive into these numbers and get a better sense of the source of this growth. The most recent study is from 2003, and newer analysis is long overdue.
Obama Administration’s Tax Hikes
This week President Obama released the details of his proposals to raise taxes on multinational corporations. The two main components of the plan are new limits on deferral and the foreign tax credit and additional enforcement tools targeted at overseas “tax havens.”
Reaction on Capitol Hill was somewhat underwhelming. Senate Finance Committee Chairman Max Baucus (D-MT) referred to the proposals as “controversial,” and noted, “We’ll look at it. I don’t know how much is going to be enacted this year.” Despite this less than glowing review, we do expect some form of the President’s proposal to move through the Congress this year — their need for new revenues is just that strong.
What about S corporations? These proposals do not directly affect S corporations, but they are a worrisome indicator of the Obama Administration’s overall approach to business taxation. This Administration is looking to the business community to raise the tax revenues. During his press conference yesterday, Obama decried the “broken tax system, written by well-connected lobbyists on behalf of well-heeled interests and individuals. It’s a tax code full of corporate loopholes that makes it perfectly legal for companies to avoid paying their fair share.”
But businesses don’t pay taxes — people do — and the burden of raising taxes on corporations will fall primarily on the workers of those companies. Capital can and does move from one country to the next. For workers, it is just a little more difficult. It’s more difficult for S corporations too.
Middle-Class Tax Increases on the Horizon
Last Wednesday’s The Hill included a comprehensive overview of the exploding spending and deficit picture and calls into question President Obama’s ability to live up to his long-held promise not to raise middle class taxes. It’s worth a look.
For the past half-year, your S-CORP team has focused on President Obama’s long-stated goal to pay for health care reform and his other spending priorities by raising taxes on American families making more than $250,000 per year, all while cutting taxes for middle-class families.
With the Federal deficit approaching $2 trillion this year, however, just how does one expand government, reduce the deficit, and cut taxes for a large swath of taxpayers – all financed by less than five percent of the population? As The Hill reports, skepticism that the Administration can pull it off is on the rise:
“President Obama’s proposed changes to the tax code, combined with exploding entitlement costs, will lead to ever-growing debt, according to independent estimates. The big question for Obama and his economic team will be whether he can meet the rising costs with increased tax revenue only from small slices of the electorate…Many economists, including some who voted for Obama, do not believe that he can indefinitely avoid imposing tax increases much further down the income scale — on the middle class.”
It is becoming increasingly obvious that taxes on the middle class – not just the “wealthiest” – will need to go up to pay for the Obama Administration’s ambitious goals. Exactly what sort of taxes? Len Burman at the Tax Policy Center thinks a value-added tax is inevitable. Just like France. Great.
CBPP to States — Tax Your Way to Prosperity
If higher taxes at the Federal level weren’t enough, the folks over at the Center on Budget and Policy Priorities (CBPP) have a novel recommendation for states hurt by the current recession — balance your books by taxing job creators!
In a report entitled “Reforming the Tax Treatment of S-Corporations and Limited Liability Companies Can Help States Finance Public Services,” the CBPP provides a blueprint for and encourages states to “consider imposing meaningful levies on S-Corps and LLCs as a source of additional revenue to help close the major budget gaps many of them are facing.” Sure, gaps like those created by the extra unemployment checks for folks laid-off when their over-taxed business closes.
Enough said.
Private Enterprise and Job Creation
On a more positive note, our friends at the Kauffman Foundation have taken the new Business Dynamics Statistics series at the Census Bureau and crunched the numbers a bit.
What they have found is presented in a series of short papers that does a great job of demonstrating the critical importance of start-up businesses to job creation. Key findings include:
- More than 100 percent of all net new jobs in any particular year can be attributed to start-up businesses. Or put another way, absent new business creation every year, employment in the United States would shrink.
- Remaining net job growth comes from firms more than a quarter century old. Their job creation levels are low compared to younger firms, but unlike younger firms, surviving older firms create more jobs than are lost when older firms close.
- States differ substantially on the portion of employment attributed to younger companies (less than 3 years old). In the West and Southeast, it’s up to 12 percent, while in the Midwest and Northeast, it’s about 6 percent.
How does this add to our understanding of job creation and job creators? The important role of start-ups and entrepreneurs has been examined for hundreds of years, but who knew that older, more mature firms were a source of net job creation? Findings like this put the whole estate tax debate and the importance of transferring businesses from one generation to the next into a whole new light.
Your S-CORP team is often amazed at the gulf between the rhetoric over jobs and the actions of some policymakers. Everybody talks about the importance of jobs and job creators, but the policies supported by some folks make you wonder just how deep their understanding and commitment goes.
The work at the Kauffman Foundation gives us critical insight into the job creation process. We hope policymakers — especially those engaged in estate tax discussions — will pay attention.
Busy Week in Washington
Lots of activity on tax policy with implications for S corporations this week.
On Monday, the White House held a forum on the expiring tax relief and its potential to hurt the economy if it is not extended. In preparation for the forum, Treasury issued a collection of issue summaries that focus on the importance of keeping tax rates low, including the top two individual tax rates most in danger of going up in the next Congress.
As friends of S-Corp know, the debate over the top two rates has focused on their application to businesses like S corporations and partnerships. Advocates for the lower rates like President Bush argue that keeping these rates low helps small businesses grow and create jobs.
Opponents argue that most taxpayers in those brackets are inaccurately depicted as small business owners when in reality business income makes up little or no portion of their total income. For example, a recent witness at the Finance Committee argued:
“In the top two tax brackets, seventy-eight percent of tax units report some form of business income. However, many of those people are not “small business” people in the sense as you would normally think… Only 1.4 percent of tax units with some form of business income are in the top two brackets.”
Page six of the Treasury report provides a little clarity on this issue with a breakdown of taxpayers in the top two brackets and where they get their income. Perhaps the best statistic is:
- Nearly 540,000 of the 1.4 million tax returns that benefit from lowering the top two tax brackets are flow-through business owners who receive more than 30 percent of their income from flow-though businesses.
In other words, more than one-third of the taxpayers paying the top two rates have significant business income. Here at S-Corp, we would point out that 540,000 small business owners probably understates the impact on small businesses since S corporation shareholders and LLC members who participate in their businesses often derive a salary from their business as well. While that income shows up as wages rather than profits, it comes from the business nonetheless.
Finance Looks at Flow-Throughs
Today, the Finance Committee held a hearing entitled, “C, K, or S: Exploring the Alphabet Soup of Small Business Choices in Advance of Tax Reform.” As the title suggests, the hearing focused on the various options investors have when forming a business. Perhaps the best thing to come from the hearing is a really comprehensive report from the Joint Committee on Taxation summarizing the state of business in America and the major trends in business types over the past three decades.
The report makes clear that S corporations are an increasingly critical part of the business community. In the past thirty years, the number of S corporations has grown from less than half a million to more than four million—eight hundred percent growth! Our contribution to the income and employment base of the country has risen by a similar amount.
Another section in the report (Table 10) outlines the distinctions between S corporation rules and those that apply to LLCs and partnerships. As S-Corp readers know, much of our work here at S-Corp is dedicated to improving the rules that govern S corporations and level the playing field between S corporations and LLCs.
Unlike S Corporations, LLCs have no limitations on the number or type of shareholders and have more flexible ownership rules. Bills introduced by S-Corp champions Senator Lincoln and Representative Kind (S. 3063 and H.R. 4840) move the S corporation rules in the right direction and we are working hard to get them enacted.
S-Corp Board Meeting
Finally, the S Corporation Board met this week here in Washington, DC. Flying in from all over the country, the Board met with officials from the Administration, Treasury, and Capitol Hill. Continuously visiting policy-makers in Congress and the Administration is the only way we can ensure that the special challenges facing S Corporations are understood and the Board did a great job of advocating on your behalf.
One immediate result of our meetings was the addition of Senator Olympia Snowe as a cosponsor of Senator Lincoln’s “S Corporation Modernization Act” (S. 3063). Senator Snowe is the Ranking Member of the Small Business Committee as well as a senior member of the Senate Finance Committee. She has a long history of advocating on small business issues and we are extremely grateful for her support.
S Corporation Payroll Tax
A recurring theme in today’s Finance hearing was the disparate treatment of payroll taxes for S corporations and partnerships. The JCT report notes:
“Choice of entity also can affect the taxpayer’s flexibility to designate income as subject (or not subject) to payroll taxes. The evolution of present law with respect to limited liability companies, and the failure of the Code to clarify the payroll tax consequences for different contractual relationships made possible by these new forms, have created areas of significant uncertainty and potential planning opportunities with respect to payroll taxes. The situation is exacerbated by the fact that S corporations are subject to a different regime for determining labor income subject to payroll taxes than are partnerships, creating another potential planning option.”
Hearing witnesses also addressed this issue. When asked about changes they would recommend to simplify the tax code, three of four witnesses mentioned the differing treatment of payroll taxes between S corporations, partnerships, and LLCs.
The S Corporation Association has a long history of advocacy on this issue. Our core principle is to ensure that any changes enacted do not impose payroll taxes on S corporation income derived from capital investments. Payroll taxes should apply to wage income only — not returns on capital.
However, as last year’s bill introduced by Chairman Rangel revealed, maintaining that distinction is going to be a challenge. We expect this issue will be considered next Congress as a part of a broader tax reform effort and intend to continue to work with our friends in other associations and on the Hill to make sure Congress get this policy right.
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