Small Business and Tax Rates — The Debate Continues
The advocates over at the Center for Budget and Policy Priorities (CBPP) issued a new study last week demonstrating, once again, how few “real” small businesses would be adversely affected by raising the top two income tax rates back to their old 39.6 and 36 percent levels. As their study states:
“Some critics of the President’s budget charge that his proposals to roll back tax breaks for taxpayers with incomes over $250,000 would harm small businesses. In fact, only 8.9 percent of people with any small business income have incomes of over $250,000 and, thus, would even potentially be affected by these provisions.”
As S-Corp readers know, this is old ground. One side says only a tiny portion of small business owners pay the top two rates. The other side says that small business owners make up a large percentage of those affected. Back and forth, over and again.
Missing from the debate is a sense of scope. For example, there are only six million or so employers in the United States while there are about 30 million businesses. Under the CBPP’s approach, then, a policy to raise taxes on every single employer in America could be dismissed because it “only” affects twenty percent of all businesses. It’s not the number of taxpayers affected that matters, but rather the amount of total economic activity being taxed.
The reality is, as we’ve pointed out before, an enormous amount of business activity is subject to the top two rates. More than half of all business income is taxed at the individual rates (S corporations, partnership, and sole proprietorships), and more than two-thirds of that income is taxed at the top two rates, which means more than one-third of all business income earned in the United States will be subject to higher tax rates under the President’s plan. As the Tax Foundation points out, more than half the new revenues collected from the higher rates would come from business income.
Moreover, those higher rates are going to be applied to a larger tax base. Under proposals put forward by the President and/or the Chairman of the House Ways and Means Committee, the business tax base will be broadened by eliminating or restricting deferral, LIFO accounting, Section 199 deductions, and many other deductions used by business.
Finally, the President’s budget proposes to reinstate the old PEP and Pease rules. These rules phased out the personal exemptions and capped itemized deductions, respectively. Their net impact is to raise the base on which tax rates apply and would increase the number of taxpayers subject to the top two rates, including those who are small business owners.
So the cumulative result of these proposals would be to dramatically raise both the tax rate and tax base for a large percentage of business income earned in the United States. There’s no way to minimize the negative effect of that.
Obama Budget Limits LIFO
Speaking of base broadening, the budget outlined last week by the Obama Administration calls for repealing LIFO. Exactly how he would structure this repeal is unclear — the only reference to the policy is back in the revenue tables.
According to the revenue score, the proposal would increase tax collections by $61 billion beginning in 2012, or just about half of the projected tax increase from the provision included in the 2007 Rangel “Mother of All Tax Bills” legislation ($105 billion).
The Rangel provision applied to all businesses — large and small — using LIFO inventory accounting rules and gave them an eight year period to pay taxes on their accumulated LIFO reserves. (Keep in mind, repealing LIFO is a double whammy for LIFO businesses — their annual taxes go up moving forward but they are also on the hook to pay back-taxes on their accumulated LIFO reserves.)
Until the Treasury Department issues its “Blue Book” to describe all the tax provisions in the Administration’s budget, we won’t know for sure how the Obama repeal differs from the Rangel repeal. They might have limited the change to publicly-held companies, or eliminated the retroactive tax on LIFO reserves.
At this point, however, such differences are meaningless, since whatever President Obama proposes will have to go through Chairman Rangel’s committee anyway.
The headline here, which should be noted by every LIFO business and their accountants, is that the President of the United States, the Chairman of the Ways and Means Committee, the Securities and Exchange Commission, the Financial Standards Accounting Board, and the Joint Committee on Taxation have all weighed in recently against LIFO in one form or another.
The case against LIFO is a wholly contrived money-grab, but with that lineup against us, you might want to begin making contingency plans.
Obama’s Tax Plans Take Shape
President Obama released a 140-page outline of his budget today that reflects his revenue and spending priorities for the next couple of years.
Chief among these is a major change in federal health care policies. As made clear in his speech to Congress the other day, health care reform is first among the several big reforms on the table and his budget sets aside $634 billion of the estimated $1 trillion he plans to spend on the plan.
To raise the $634 billion, Obama calls for: 1) limiting itemized deductions for families earning more than $250,000, starting in 2011; 2) cutting payments to Medicare Advantage plans; and 3) reducing Medicaid payments to hospitals and drug makers.
Other key proposals include:
- Beginning in 2011, increasing the top two income tax rates to 39.6 and 36 percent respectively while raising rates on capital gains and dividends to 20 percent, consistent with President Obama’s promise to raise taxes on families earning over $250,000.
- Raising $353 billion through the elimination of so-called business loopholes including limiting the ability of firms to defer tax payments on overseas income and LIFO repeal.
- Raising the tax rates applied to so-called “carried interest” earned by hedge fund managers and other professionals.
- Calling for a cap-and-trade program to limit carbon emissions with 100 percent of the credits auctioned off. The resulting revenue would be used to fund clean energy programs and be returned to families and small businesses.
- Locking into place the 2009 estate tax rate and exemption levels.
We will have more reports in coming days, but suffice it to say that the Obama outline, if enacted intact, would result in significantly higher tax rates for many S corporations that would be imposed on a significantly larger income base.
The one piece of good news is that the budget, reflecting the current economic climate, does not attempt to accelerate the rate increases on upper-income families, but rather allows the current rules to take effect whereby the lower rates expire beginning in 2011.
As students of government know, the President’s annual budget submission is required by Congress and is just the first step in the year-long process of establishing the government’s spending and revenue limits. Given the current make-up of Congress, however, we expect the plan outlined today to be the presumptive starting place for congressional deliberations — especially in the House. For S corporations, that means we will be playing a lot of defense for the next few months.
Do Marginal Rates Matter?
Perhaps the biggest tax debate in the next couple years will be over President Obama’s proposal to raise top tax rates back to their pre-2001 levels. Tax cutters argue that higher marginal tax rates will hurt small businesses and the economy as a whole.
Increasingly, we are hearing the counter argument that marginal rates don’t matter. Policymakers on the Hill have told us that and President Obama’s budget outline appears to endorse that notion as well. A back-and-forth on CNBC this morning does a nice job of outlining the debate.
Your intrepid S-CORP team was around in 1993, and we recall that the Clinton rate increases took place in an extremely positive economic and global climate — the Cold War was over, the Thrift Bailout had run its course, and much of the developed world was moving towards market-based policies. Attributing any effect of higher tax rates to economic performance in that climate is a stretch at best.
In many ways, the climate today is just the opposite of what Bill Clinton inherited in 1993, and we are not at all comfortable that higher tax rates applied to a broader tax base will have limited or minimal impacts on economic activity.
Second Stimulus on the Horizon
A second stimulus package is being formulated up on the Hill, but is by no means a done deal at this point. Just before adjourning for the election, the House passed a $61 billion bill containing infrastructure spending, aid to state governments and increased unemployment benefits, which will likely serve as a starting point for second stimulus discussion. That package included:
- $30 billion for infrastructure projects including highways, bridges, transit and water projects;
- $1 billion for public housing;
- $2.6 billion for food stamp program;
- A temporary increase in Federal Medicaid assistance to states; and
- An extension in unemployment benefits.
Other items that could be contained in a second stimulus package include the Columbia Free Trade Agreement, middle class tax relief, and changes to the TARP program. Emily Barrett from the Wall Street Journal reports that Treasury is “under pressure to broaden eligibility for assistance to smaller banks, as well as the cash-strapped autos sector.” Other actions related to the stimulus include:
- Speaker of the House Nancy Pelosi and Senate Majority Leader Harry Reid met with the CEO’s of America’s automakers last week to discuss billions of dollars of additional assistance to the industry. The two leaders subsequently asked Treasury to make relief to the automakers part of the $700 billion TARP plan.
- President-elect Obama made an economic stimulus his top priority at last week’s press conference. He indicated if one was not enacted during next week’s lame duck session, he would make it the first order of business in 2009. He also indicated that the package needed to focus on assisting the middle class with job creation and an extension of unemployment benefits.
- RollCall reports that Majority Leader Hoyer (D-MD) is suggesting that, absent an agreement with the Bush administration — which he described as “elusive” — the House might not ask rank-and-file members to come back next week.
All this activity suggests that, while the odds of a package getting enacted are extremely high, it will probably be early next year before anything moves.
Endangered Tax Species — LIFO
Your S-CORP staff is tempted to create an Endangered Species List for tax provisions. Deferral and Section 199 would top the list as the most likely to be extinct before the end of the next Congress.
LIFO accounting is another. A subset of accounting and tax professionals have been pursuing LIFO for years, and they are closing in. The Joint Committee on Taxation — the tax professionals that Congress uses to help them assess changes to the tax code — fired another shot last week.
In its annual “Tax Expenditures” report, the Committee has for the first time (to our knowledge) listed LIFO. For those of you who don’t follow such things, a tax expenditure is a congressional concept identifying tax provisions that divert from the basic approach to taxing income and measuring the revenue lost by those provisions — tax credits, certain deductions, and lower rates on investment income all qualify as tax expenditures. The concept was first introduced into budget speak in the 1960s and has been highly controversial ever since.
Conservatives especially dislike the idea since it implies that all your income is the government’s and if the government chooses not to take it from you, then that’s the equivalent of giving you a subsidy. Supporters argue that the point is to give policy makers better information on how much certain tax policies reduce revenues so they can make better decisions.
Either way, getting LIFO listed as a tax expenditure gives LIFO opponents one more argument to make in attempting to repeal it.
We will write more on this in the future, but suffice to say that LIFO does not belong on the tax expenditures list anymore than FIFO does. Moreover, while the JCT states its goal in revising the methodology of the expenditure report was to create a more neutral approach, we’re not sure they succeeded.
Capital Gains and Dividends
We’ve written about the likelihood that the capital gains rate is going up in the next couple years. Lots of our members would like to know just when that is going to occur so they can plan accordingly.
The economic distress of the last year and the rising deficit opens the possibility that Congress could enact a rate hike next year but make it effective January 1, 2010. The outcome of the prospective effective date would be to stimulate economic activity — and federal revenues — in 2009. A similar rate increase adopted in 1986 (made effective January 1, 1987) resulted in an enormous increase in federal tax revenues in 1986 as taxpayers rushed to sell their assets and qualify for the lower rates.
As S-CORP readers know, we favor lower rates over higher ones, especially when the higher rates only apply to S corporations and not C corporations. That said, encouraging asset sales at a time when many investors and companies are being forced into asset fire sales already might not be the best policy. Encouraging sales of appreciated property into a bear market may have the opposite of the intended economic effect by further driving down asset prices for everyone.
Happy 50th, S Corps!
Today marks the 50th birthday of the S corporation! As you can imagine, here at the S Corporation Association we’ve got the cake and candles ready.
Perhaps more importantly, at a time of economic and political uncertainty, the story of the S corporation and its role in making the American economy more diverse and flexible is worth reviewing.
The S corporation was born at a time when the economy was slowing, Americans were losing their jobs, and an unpopular Republican President was being accused of practicing “trickle-down economics” by a Democratic Congress.
President Eisenhower embraced the S corporation — originally an idea proposed by the Truman Treasury Department — as a means of burnishing his Main Street credentials while addressing concerns of Republicans and Democrats alike that too much economic control was being consolidated into the hands of too few wealthy Americans.
Congress passed the provision as a small part of a much larger miscellaneous tax bill and the President signed on September 2, 1958 while on vacation up on Cape Cod.
Over the past fifty years, the S corporation has helped diversify the American economy while becoming an increasingly important player in the lives of millions of Americans.
While the S corporation has always been a successful vehicle for facilitating private enterprise and innovation, its growth accelerated dramatically in the last thirty years as marketing, communication, transportation and other transaction costs for small firms shrank along with the marginal tax rates they paid.
Lower transaction costs means smaller, more diversified firms and a stronger Middle America. Today, there are over four million S corporations, employing millions of workers and contributing significantly to our national income.
As Congress reconvenes next year and considers what to do with the tax code and how to address concerns of economic concentration, it should keep in mind that the S corporation was created by a Democratic Congress intent on countering economic concentration. It worked, as four million businesses spread throughout communities around the country can attest.
Happy 50th, S Corps and many returns!
The Game of LIFO
More movement on the LIFO front. Last week, the Securities and Exchange Commission approved for comment a roadmap to convert US accounting rules for public corporations over to EU rules.
The transition would take place over the next eight years and include numerous steps, including a decision by the SEC in 2011 on whether to proceed, but the bottom line is the accounting community and the people who regulate them are continuing to move away from rules that allow for LIFO accounting.
As S-Corp readers know, a move to eliminate LIFO for book accounting has implications for tax accounting as well, since the tax code requires companies to use the same broad inventory method for both.
While LIFO accounting debates may appear too technical to matter, this issue has the potential to impose a massive tax increase on manufacturers, retailers and wholesalers around the country. A recent revenue estimate for eliminating LIFO suggested it would raise taxes on these businesses by more than $100 billion over the next ten years.
A tax increase that size is bound to be noticed. It threatens a double hit on businesses that would be forced to pay back taxes on accumulated LIFO reserves while also being hit with higher tax levies in future years.
Tax issues were not a major part of the SEC discussion, although the Commissioners are aware of the tie between book and tax accounting on LIFO and suggested maybe the IRS could do something to fix it. Maybe. But, Congress still needs to find revenues over the next couple of years to offset a very expensive agenda of tax relief and spending increases. Whether the IRS comes to the rescue or not, we expect this issue to be debated in Congress beginning next year.
Extender Picture Muddy as Ever
With energy issues on the front lines, a group of 16 Senators has joined together to support a package of energy provisions that includes, well, just about everything — nuclear, drilling, renewables, and an extension of the production tax credit and other energy tax items.
Looking at the past votes on extenders, if you add the Republican members of the Group of Sixteen to the 55 or so Senators who supported the most recent extender package — the one with revenue offsets — Senate Majority Leader Harry Reid now has a roadmap to getting the necessary 60 votes and help take energy issues off the table before the elections.
What does this mean for the broader tax package, including the AMT relief, R&E tax credit and S corporation charitable deduction expansion? It is not entirely clear, but adoption of the very popular production tax credit and other energy tax provisions separately may ease pressure on Reid to move the larger extender bill.
Small Business Week 2008
Washington loves small businesses, at least in its rhetoric. April 20-26th was Small Business Week. The annual event is devoted to recognizing the “determination and ingenuity of America’s workers and entrepreneurs who play a vital role in building a more prosperous future for our country.”
Since 1963, every President has declared National Small Business Week to formally recognize the important role of small businesses in America.
In a discussion with small business owners, President Bush argued that “every day ought to be Small Business Day in America” and that government’s role should be “to create an environment in which the entrepreneurial spirit flourishes.”
In many ways, that is what the Congress accomplished when it created the S Corporation back in 1958. By combining liability protection with simple tax rules, Congress created a regulatory environment that allowed the S corporation community to thrive. Fifty years after its creation, more than four million S corporations are busy investing and creating jobs.
But not all is well. Many of those rules are outdated. And many favorable rules are set to expire, resulting in higher taxes on America’s job creators. The President addressed the difficulties of S corporations specifically when he pointed out that raising tax rates on individuals would not only affect wealthy taxpayers, but also S corporations and partnerships that pay tax at the individual rates.
More Sound and Fury (and Inaction) on Extenders
Speaking at the end of Tax Week in Washington, President Bush warned of the looming uncertainty of the tax code for small businesses. Lower individual rates, estate tax, and small business expensing provisions all expire at the end of 2010.
It is increasingly apparent that this uncertainty may last for a while. The budget passed by both the House and the Senate remains unfinished, evidently doomed by a disagreement on whether to offset the costs of extending expiring tax provisions like the higher Alternative Minimum Tax exemption and the R&E tax credit.
As we have written previously, the question is whether extending expiring tax policies need to be offset is a manner similar to a spending increase. Critics argue that the net effect of offsetting these provisions is a continuously higher tax burden on families and businesses.
Yesterday, forty-one Republican senators—including Republican Leader Mitch McConnell (R-KY) and Finance Committee Ranking Member Charles Grassley (R-IA)—weighed in on the issue, sending a letter to Majority Leader Harry Reid (D-NV) opposing any offsetting of extensions for these expiring provisions.
While the letter fails to outline what those forty-one senators would do if confronted with a “take-it-or-leave-it” vote that included offsets, on its face, forty-one senators is sufficient to block any tax bill that includes a tax increase from moving through the Senate.
The impasse between the House and the Senate on the budget (and tax extenders) just got more complicated.
You Bet Your LIFO
A group of concerned small business groups, including your intrepid S Corporation Association team, visited the SEC last week to discuss its plans regarding the financial accounting rules it imposes on publicly held companies and the effect any changes may have on private companies.
The SEC is currently reviewing these rules with an eye towards merging them with those used in the European Union. This January, SEC Chairman Chris Cox told the CPAs that he was “doing everything within our power to ensure that financial reporting information from different countries is comparable and reliable.”
The burning question is whose rules will prevail? The Europeans outlawed Last-In, First-Out valuation rules for their inventories several years ago, and if the SEC outlaws LIFO for large publicly held companies, it will be very difficult for FASB (the accounting oversight organization) to maintain LIFO for private companies.
S corporations that use LIFO need to pay attention. Repeal of LIFO by the accounting for book purposes means you cannot use LIFO for tax purposes either. That means higher taxes on your income going forward, as well as paying back taxes on your LIFO reserves. If your company has been on LIFO for a long time, your reserves may be more than your company’s net worth.
While the SEC is focused on large companies and their reporting requirements, it needs to take into account the impact any rule changes it mandates might have on closely-held businesses. LIFO repeal would be the single largest tax increase many of these companies have ever faced.
Budget Debate and Taxes
Everyone in Washington knows Congress will have to address the growth of the Alternative Minimum Tax (AMT) and the expiration of popular tax provisions over the next three years. Just how they will go about it, however, is very much up in the air.
Both the House and the Senate are considering their respective budgets this week. Lots goes into a federal budget, as you can imagine, but nothing is more important for S corporations than how this budget will address the AMT and expiring tax provisions.
On this question, the House and Senate are moving in opposite directions. The House wants to offset the full revenue impact of extending the AMT patch and related expiring tax provisions while the Senate does not.
This difference is reflected in their budgets. The House budget calls for enacting a revenue neutral tax package with a simple majority vote in both the House and the Senate, while the Senate budget would require this package to gain 60 votes in order to pass.
As CongressDaily reported this morning, this fight is a replay of the challenge that confronted Congress last year:
On the tax side, Spratt said House Democrats would stand with the Blue Dog Coalition and insist that a one-year patch to the alternative minimum tax be fully offset. Last year, the Senate was unable to muster the votes for a fully offset AMT patch, and House Democrats were forced to allow an unfunded fix to be enacted. “We’re very insistent on seeing that this time, when we do the AMT extension, the AMT patch, it be offset,” Spratt said. “On the other hand,” he added, “Since Conrad has some problems mustering the votes for that in the Senate, we’ll have to wait and see how it comes out.”
Your S Corp team would point out that while this battle is very serious in its own right, it is merely a precursor to a much larger tax fight that will take place when an increasing share of the tax code expires in coming years.
How big is this impending challenge? The Congressional Budget Office has conveniently put together a table of all the expiring tax provisions between now and 2018 and how much revenue would be lost by their extension.
A few comments are in order. First, just extending the so-called family tax relief—the new 10-percent bracket, the marriage penalty relief, and the refundable $1,000 child credit—will reduce revenues by nearly $650 billion between now and 2018.
Second, the full scope of total expiring provisions is staggering—nearly 100 tax provisions expire between now and 2018. Measured by their revenue, that’s nearly $4 trillion in current tax benefits that will go away between now and then, or about 10 percent of total projected revenue.
Third, the expiration of these provisions is taking place within the context of a rising tax burden, as projected federal revenues take an increasing share of our total national income. According to the CBO, the total tax bite will rise from 17.9 percent this year to 20.3 percent in 2018.
If Congress lives up to its intention to use Pay-As-You-Go budgeting (Paygo), where the extension of any expiring tax provision must be offset with tax increases elsewhere, then we’re looking at an effective real tax increase on families and businesses of unprecedented proportions in coming years.
Paygo and Tax Increases
As you may have noticed, a real concern of the S corporation community these days is the combination of multiple expiring tax provisions and the application of Paygo budgeting.
Consider how this works in practice. In 2010, S corporation shareholder Jim is subject to the top tax rate of 35 percent on both his salary and his business income. In that business, he takes advantage of Section 179 expensing. He also uses LIFO (Last-In, First-Out) inventory accounting and has an IC-DISC (Interest Charge Domestic International Sales Corporation) for his growing export business.
Absent congressional action, in tax year 2011 Jim’s tax rate will rise to 39.6 percent and his ability to write-off new capital investments will decline from more than $125,000 per year to $25,000. In other words, Jim is facing a sharp increase in his federal taxes in 2011.
Under Paygo, Congress can extend Jim’s lower rate and preserve current levels of expensing only by raising taxes elsewhere. (Technically, Congress could cut spending as an offset too, but to date has refrained from using that option.)
So to comply with Paygo, Congress could temporarily extend the lower tax rates and higher expensing limit by, among other offsets, permanently repealing LIFO accounting and the IC-DISC. This being Congress, they would then send out a press release letting Jim know how they prevented his taxes from going up.
But Jim’s taxes did go up. Yes, he retains the lower 35 percent tax on his income and the ability to write-off $125,000 of his capital investments, but he no longer has the ability to use LIFO accounting nor the IC-DISC.
As this example demonstrates, the combination of expiring tax relief and Paygo budgeting has tag-teamed Jim into a significant tax increase.
What’s particularly pernicious about Paygo is Congress’ ongoing habit of making tax relief provisions temporary while making their offsetting tax increases permanent. This combination ensures that tax collections in the future will rise above current projections.
As we mentioned earlier, the total federal tax bite is estimated to increase to record levels in the next decade. The combination of expiring temporary tax relief, permanent offsets, and Paygo will only serve to raise that burden even higher.
AMT and Other Updates
Just after Thanksgiving, we put together a list of the must-pass items that Congress would turn to in December, including the AMT/Extender package, omnibus spending bill, farm bill, S-CHIP, energy bill, and Medicare Doctors payment legislation.
With just a few hours to go in this congressional session, it looks like many of these items will clear the Congress—in one form or another—and be sent to the President. In just the last day, the two bodies dealt with the omnibus spending bill (including $70 billion to fund the war in Iraq), a six-month extension of doctors’ payments under Medicare and an 18 month extension of the State Children’s Health Insurance Program. Meanwhile, the President signed a slimmed-down energy bill this morning.
For S corporations, perhaps the biggest news is that the House adopted today a one-year extension of the higher exemption under the Alternative Minimum Tax. This higher exemption will apply to individual taxes due for tax-year 2007 (the current year) and it will protect 20 million-plus taxpayers from having to pay a higher tax bill under the AMT when they file this spring. As recently as Monday, there was some doubt whether this much needed extension would actually take place.
Just this morning, the cloud in this silver lining was that the House would include a new rule that will apply to next year’s tax bills. In effect, the rule would have required the House to “make up” the $50 billion revenue impact of extending the AMT patch before additional tax items can be adopted in 2008. This plan fell through, however, and the House has just adopted a clean one-year AMT extension.
That’s particularly good news for the package of extenders that were left undone this year, including the R&E tax credit, state and local sales tax deduction, and the S corporation charitable donation provision. It will also put less pressure on Congress next year to adopt tax increases on S corporation payroll taxes, LIFO repeal, or repeal of the IC-DISC.
Tax Victory for S Corp Exporters!
In case you missed it, the truncated 2-week comment period for the Tax Technical Correction Act of 2007 ended on December 3rd. Despite the tight window (that included the Thanksgiving holiday break), dozens of exporters and trade associations from around the country weighed in with the Finance and Ways and Means Committees to oppose the proposed tax increase.
Did the tax writers pay attention? You bet they did. Yesterday, the House adopted a technical corrections bill that did not include the rate increase on US exporters.
Many Senate and House offices weighed in with concerns about raising taxes on exporters. Special thanks go out to the offices of Senators Cantwell (D-WA), Smith (R-OR), Wyden (D-OR), Specter (R-PA), and Kohl (D-WI), whose letter to the Finance Committee raised the concern about this provision to the member level. On the House side, senior Ways and Means Member Jim McDermott (D-WA) weighed in directly with Chairman Rangel and let him know the adverse impact this provision would have on exporters in his district.
The net effect of all these communications was the House tax writers decided, earlier this week, to forego the IC-DISC technical correction, preserving this extremely important benefit for America’s small and closely held exporters.
This is a BIG victory for exporters and those whose jobs rely on the growth of American exporting. Congrats to those companies and trade associations who worked so hard together to block this harmful tax increase. Of course, now we have to prepare for next year…
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