The tax community is still waiting for the third version of the Baucus substitute to be released. A “trial balloon” draft circulated yesterday made certain changes, but failed to address many of the sticking points holding up the overall bill.
Meanwhile, Senators Baucus and Reid spent most of yesterday negotiating with swing Republican votes — at this point, just Maine Republican Senators Olympia Snowe and Susan Collins — to identify what changes are necessary in order to gain the 59th and 60th votes needed. As CongressDaily reports:
The chief target appears to be $24 billion to extend higher Medicaid matching funds for six months, first authorized in the stimulus last year. Options floated Tuesday included phasing down the percentage boost and using untapped funds elsewhere in the Recovery Act for offsets. Snowe and Collins were noncommittal, having not seen details. Senior Democrats appeared resigned that the net cost of the Medicaid assistance would be scaled back. “They’re having to cut it back to try to get Republican votes, and it affects my state; it really affects Harry Reid’s state,” said Sen. John (Jay) Rockefeller, D-W.Va., who with Reid was an original lead Senate sponsor of the six-month Medicaid boost. “But it looks like the best we can get.”
The challenge for Senator Baucus is that the deficit spending in the package represents only half the opposition. There is a lot of opposition to the tax increases as well, including the payroll tax hike on S corporations and partnerships. Senator Snowe of Maine has led the fight to strike this provision from the bill. As The Hill notes:
Kyl said he isn’t sure winding down FMAP is the elixir Democrats think it is in garnering Republican support for the bill.“Whether that will satisfy more Republicans remains to be seen,” he said. “There are other issues with the bill as well, including issues related to the tax provisions.”
The current “K Street” rumor is that Chairman Baucus has been given a limited amount of time to round up the 60th vote. If he’s unable to do so, Majority Leader Reid would set the extender package aside and move on to other items. Whether the rumor is true or not (K Street rumors typically run about 50/50 on the accuracy dial), the clock is ticking.
In addition to Senate consideration, this bill would need to return to the House, where its adoption is by no means assured. If the House makes any changes, it would come back to the Senate. And then, since most of the spending and all the tax items expire before the end of 2010, we’d have to do it all over again before January.
We’ve observed previously that getting the entire business community to oppose a bill centered on extending business-friendly tax breaks is fairly remarkable. The current bill before the Senate is anti-business, and would need to be changed significantly before businesses could support it. It appears that several determined senators share those concerns.
Budget’s Impact on Employers
S-Corp allies over at the Manufacturer’s Alliance commissioned a new study on next year’s tax policy and what it means for S corporations and other business forms. Specifically, the study looked at the tax policies in President Obama’s 2011 budget and asked how these policies would impact economic growth and job creation. The verdict?
In terms of macroeconomic effects, the tax proposals in the 2011 budget are forecast to shave an average of 0.2 percent from annual GDP growth through the middle of the decade, resulting in $200 billion of foregone output and a net job loss of almost 500,000 relative to the baseline. Because taxable business revenues are highly concentrated in manufacturing firms, they will account for a disproportionate share of these output and employment gaps.
So despite much of the rhetoric coming from Washington these days, the rules of economics have not been turned on their figurative heads — the tax forecast for next year is higher tax rates imposed on a larger tax base, which means less investment and less job creation over time. Who will get hit the hardest?
The tax provisions of the 2011 budget will affect S corporations and other pass-through manufacturing firms much more heavily than both firms outside of manufacturing and C corporations within manufacturing. Pass-through businesses in the manufacturing sector will see their tax bills increase by an average of 14 percent. Given the growing importance of S corporations and partnerships to economic growth and job creation over the past 25 years, it is important to understand that tax increases intended to help contain deficits will exact a high price in terms of the competitive posture of U.S. manufacturing and the growth of the economy as a whole.
The study’s authors calculate that S corporations and other “pass through” firms will see their aggregate tax burden rise by $177 billion over the next ten years. Ouch.
Earlier today, the Senate voted earlier on its version of the “extenders plus” bill passed by the House a few weeks back. The vote, on a motion to waive a Budget Act point of order, failed miserably (45-52), indicating the Senate Leadership has a long way to go before they gather the sixty votes necessary to move forward.
With this morning’s vote behind us, the process moving forward is becoming clearer–Finance Chairman Max Baucus (D-MT) is expected to introduce a new substitute today. According to BNA:
Baucus is expected to draw up a new substitute amendment that will be a slimmed-down version of what the Senate defeated. That plan would have added $84 billion to the federal deficit, a figure that Republicans, and some Democrats, said was too high to stomach. Baucus has previously said that he would continue to work with senators of both parties to find 60 votes. Issues that could be modified to secure votes include Medicare reimbursement rates for physicians, unemployment insurance benefits, Medicaid funding to states, and possibly language making it more difficult for S corporations to avoid paying employment taxes.
As BNA indicates, the new effort will likely include a modified payroll tax hike. As with the House-passed provision, however, the new tax has been written behind closed doors and without the benefit of public scrutiny. It might be better than the flawed House effort, but we simply won’t know until it’s offered.
The next key vote will take place tomorrow, when the Senate considers Senator John Thune’s (R-SD) alternative “extender plus” package. This package includes all the tax extenders the business community wants, but strikes all the tax hikes the business community opposes (including striking the $11 billion payroll tax hike). Instead, all the tax relief and spending in the package are offset with spending cuts. As with today’s vote, Senator Thune is not expected to get 60 votes tomorrow, but we’re betting he does better than the 45 votes Senator Baucus got today.
Meanwhile, Senator Olympia Snowe (R-ME) continues her fight on behalf of S corporations. As CongressDaily reported this morning:
Snowe is upset about an $11 billion tax increase on small services firms organized as S corporations; Baucus is preparing some tweaks to that provision, and the chamber’s 63-33 adoption of an amendment she co-sponsored to establish an office within the Treasury Department to help homeowners struggling with mortgage payments can’t hurt. Democratic aides said they still have some work to do on their side of the aisle before working to assuage GOP holdouts.
The S corporation community owes Senator Snowe a big debt. Meanwhile, with the first Baucus substitute gone and the second version “to be introduced,” we will just have to wait to see what they have in mind.
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)|
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?
Just prior to the July 4th break, Senator Chuck Grassley (R-IA) introduced a package of small-business friendly tax provisions, including one of our S-CORP priorities – built-in gains relief! Specifically, the legislation (S. 1381) includes:
- Reducing the BIG holding period from 10 to 5 years;
- Providing a 20 percent deduction for flow-through business income for businesses with less than $50 million in annual gross receipts; and
- Increasing Section 179 expensing, lowering corporate rates, exempting business credits from the AMT, and other items.
As Senator Grassley stated when introducing the bill, “My bill contains a number of provisions that will leave more money in the hands of these small businesses so that these businesses can hire more workers, continue to pay the salaries of their current employees, and make additional investments in these businesses.”
S-CORP is excited to see Senator Grassley include S corporations in this package and we will keep you apprised of any movement on this legislation. While much of the news coming from Capitol Hill lately has been cause for concern for S corporations (see below), it’s great to see that our S-CORP champions on the Hill continue to recognize the importance of our community to growth and job creation.
S Corporations Survive Scrutiny!
Our friends at BNA reported yesterday that the preliminary results of the IRS “tax gap” look into S corporations are in. For the past seven or eight years, the IRS has been conducting a National Research Program that seeks to get a better idea of how much Americans underpay their taxes. For reasons known only to the IRS, the agency has targeted S corporations for closer inspection while largely ignoring other business structures. Regarding the new numbers, BNA reported:
An Internal Revenue Service study preliminarily found that S corporations underreported $50 billion in 2003 and $56 billion in 2004, an IRS employee in the Research, Analysis, and Statistics Division said July 8 at the IRS Research Conference. Drew Johns, citing the 2003-2004 National Research Program S Corporation Underreporting Study, said the net misreporting percentages, or ratios of the net misreporting amounts to the sum of the absolute values of the amounts that should have been reported, for these years were 12 and 16 percent, respectively. The error rates for each year were 69 percent and 68 percent, respectively, he said.
So what’s your S-Corp team’s take on this? Pretty positive, actually. Total compliance by all US taxpayers is around 84 percent (best in the world), so the IRS is telling us that S corporations are better taxpayers than the population in general. Moreover, that 69 percent error rate is eye-catching only until you realize that he’s talking about any error, even small ones that are immaterial to the amount owed.
One question we do have is why the total noncompliance rate jumped from 12 to 16 percent between 2003 and 2004? A 33 percent increase in non-compliance from one year to the next would appear to be a statistical outlier and deserves a closer look.
So to sum up, the IRS spent the last three or four years diving into S corporation tax returns and what they found is that S corporations are solid taxpaying citizens. Combine that finding with the SBA’s report that S corporations shoulder the highest effective tax burden of any business form, and our conclusion is that S corporations should be praised by policymakers rather than targeted for increased enforcement and higher taxes.
Paying for Healthcare Reform
Speaking of higher taxes, July may be the month when taxpayers learn how Congress intends to pay for health care reform. As we’ve reported, the plans in both the House and the Senate have price tags around $1 trillion over ten years.
About $400 billion of that amount will be offset by spending cuts to Medicare and Medicaid, so the remaining $600 billion would need to come from higher taxes. Finance Committee Chairman Max Baucus (D-MT) stated yesterday he needs to identify about $320 billion in new taxes, so he’s apparently comfortable he’s got about $280 billion in revenue raisers ready to go.
Where will the revenues come from? Until this week, the Finance Committee was focused on raising the revenue within the health care world, creating the expectation that some sort of cap on the employer-provided health care exclusion would be part of the mix. It’s health care, after all, and it’s the largest tax expenditure out there. But, it’s losing favor. The Wall Street Journal reported yesterday:
Sen. Kent Conrad (D., N.D.) and others involved in talks on a health bill said Tuesday that the idea of taxing health benefits is unpopular with voters, though they stressed that it hasn’t been completely swept off the bargaining table.
A proposal to cap the exclusion just above the cost of plans for federal employees would have raised $320 billion. It’s now apparently off the table, so that’s the revenue hole Senator Baucus was referring to in yesterday’s remarks.
Given the size of the tax expenditure, we still think some form of exclusion cap will make it into the final bill, maybe with a much higher cap of around $25,000. That “only” raises $90 billion (seriously, who knew that many health plans cost that much?) so other tax increases will have to be added.
What’s on the list? A proposal mentioned in both the House and the Senate would place a 2% surtax on families making more than $250,000. Bloomberg reported on Tuesday:
Two people familiar with closed-door talks by committee Democrats said a House bill probably will include a surtax on incomes exceeding $250,000, as Congress seeks ways to pay for changes to a health-care system that accounts for almost 18 percent of the U.S. economy. By targeting wealthier Americans, a surtax may hold more appeal for House Democrats than a Senate proposal to tax some employer-provided health benefits.
If this surtax is like the one proposed by Chairman Rangel in 2007, it would be assessed against AGI and it would apply to wages and investment income alike. As you can imagine, a surtax like that raises lots of revenue.
Another potential item would expand the Medicare payroll tax to income like capital gains and dividends — and possibly S corporation income too. Like the surtax, the last time something similar was proposed was back in 2007 in Chairman Rangel’s “Mother” bill. That proposal targeted S corporations engaged in services only, though, and would have raised about $9 billion. The new proposal is much broader and raises a reported $100 billion. The S Corporation Association led the effort to educate policymakers why this was a bad idea back in 2007, and you can bet we’ll have something to say about this broader proposal in 2009.
Other items under consideration — seriously or otherwise — include increased taxes on drug companies and insurers, capping the value of charitable and other tax deductions (preferred by the Obama Administration), taxing sodas and other sugared beverages, and increasing reporting requirement by corporations.
When will all this be put forward? We were hearing the House might make its plans known as early as tomorrow with the Senate following next week. The most current word, however, is both releases are going to be pushed back, perhaps weeks in the Senate’s case. As to the question of what will be in the plan, if we had to guess today, we’d say the revenue package could include:
- A surtax on income;
- Caps on charitable and other deductions;
- The soda tax;
- An expansion of payroll taxes to new income; and
- Modest caps on the employer-provide health benefit exclusion (Senate).
Some mixture of these could easily raise $600 billion or more over ten years. Whether they could pass Congress, particularly the Senate, is another question entirely. The fact that several raise marginal tax rates on job creators in the middle of a recession is certain to be a central part of the debate.
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…
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.
As we have noted, the stars appear to have aligned for a big estate tax compromise later this year, most likely to be focused on freezing the 2009 rules for at least a year. This means the current top tax rate of 45 percent and $3.5 million exclusion will stay the same for a while. But there’s lots of mischief that can take place under those broad levels.
As tax reformers will tell you, the base is just as important in determining your tax burden as the rates.
With that in mind, several S-Corp allies have pointed out legislation introduced by Congressman Pomeroy (D-ND) earlier this year — H.R. 436 — and asked us whether the base broadening included in this bill might get considered later this year. The answer is a definitive “Yes.” According to our quick read, H.R. 436 would do the following:
- Freeze the tax rate and exclusion at 45 percent and $3.5 million;
- Restore the step-up in basis;
- Restore the recapture of graduated rates; and
- Limit the use of minority discounts for family businesses.
To put the total impact of these provisions in perspective, here’s a simplified example of a family business where current rules would value the business at $7 million, but under H.R. 436 the value would be $10 million. For comparison’s sake, we included the tax burden on that estate under the rules in place in 2000, this year, in 2010 when the estate tax repeal takes place, and under the Pomeroy bill.
|Exclusion||$1 million||$3.5 million||NA||$3.5 million|
|Estate Tax Base/Basis||$7 million||$7 million||$650,000||$10 million|
|Estate/Capital Gains Tax||$2.9 million||$1.45 million||$1.4 million||$2.8 million|
As you can see, eliminating planning techniques used for closely-held businesses results in an estate tax under H.R. 436 that is nearly the same as the estate tax under the pre-2001 rules, and about twice as much as the current tax.
This is obviously a simplified example that doesn’t include many of the nuances associated with estate planning. Moreover, a smaller estate would experience less of an impact from changes to the valuation rules whereas larger estates would see a substantial increase.
For both, however, changing the rules under which estates are valued seriously threatens the ability of family-held businesses to survive one generation to the next, and should be treated very carefully by policymakers.
So while business groups are focused on the rates and exclusion, we should be just as worried about proposals that would affect the base. Be prepared to see this issue gather more ink in coming months.
So What’s Next?
With Washington focused like a laser on the stimulus package for the past few months, a natural question is: “What’s next?” Your S-CORP team has been asking around, and here’s what we’ve come up with:
Energy Bill: Both the House and the Senate will consider energy legislation this year that, among other items, will include a tax title extending and modifying expiring energy tax items like the Section 45 production tax credit. Many of these popular provisions are scheduled to expire at the end of the year and need to be extended. The Senate may move as early as March on a stand-alone bill, while the House looks like it will pair traditional energy issues — a renewable electricity standard, energy efficiency standards, and tax items — with a carbon cap-and-trade bill.
Housing & Financial Services: Congress is geared up to take up President Obama’s housing plan this spring together with a rewrite of the rules governing what’s left of Wall Street and the mortgage markets. The housing plan will cost money, so we expect a tax title to offset the revenue loss.
Rangel “Mother Bill”: Remember the “Mother of All Tax Bills” introduced in 2007? It swapped the AMT for higher income tax rates, cut the corporate rate while broadening the business tax base, and targeted benefits at low and middle-income families. Word is Mr. Rangel has been redrafting and could reintroduce the package sometime this spring. Once again, his goal would be to encourage an active discussion over the future of tax code. Actual action will likely wait until 2010 or later.
Middle-Class Tax Relief: Senator Baucus has made noises about moving legislation to provide permanent middle-class tax relief. Such relief could include an effort to permanently extend the middle-income tax rates, the child tax credit, and marriage penalty relief.
Estate Tax: An estate tax compromise is on the table and likely to be considered before the kids go back to school next fall. (See above)
Health Care Reform: We expect a push to provide Americans with more health insurance options at some point this summer. While most of the bill will be focused on Medicare, Medicaid, and an expansion of health coverage, we expect changes to the current tax treatment of health benefits to be included. Swapping the current health care deduction with a tax credit would not only balance the tax treatment of health care consumption, it would also raise lots of money that could be used to expand coverage.
As you can see, Congress’ plate is full. Even if only half of these items get addressed this year, it is a full agenda with lots of opportunities for mischief.
Moreover, with the deficit approaching $2 trillion and Congress done with the $800 billion stimulus package, its focus should shift to budget neutral reforms and deficit reduction, placing even more pressure on the tax code and taxpayers.
We’ll keep watch and make sure closely-held businesses are represented.
Congress is back for the week, but we do not expect much to get done. House and Senate Democrats support allocating $25 billion from the Troubled Asset Relief Program to bailout the Big Three automakers, while the White House, Treasury and Congressional Republicans oppose expanding the program.
The auto bailout could be considered as part of a set of a broader economic stimulus package introduced by Senate Majority Leader Harry Reid (D-NV). We expect the Senate to take up some or all of the Reid Economic Recovery Act in the next couple days, with the House of Representatives stepping aside to see how the Senate debate proceeds. Combined, the Reid package includes:
- An extension of unemployment benefits for seven weeks;
- $38 billion in Medicaid assistance to states;
- $25 billion in loans from the TARP to the Detroit Three;
- An above the line deduction for families who purchase new cars;
- Increased Food Stamp, WIC, and food bank funding;
- Weatherization assistance and subsidies for clean car technologies;
- $5 billion for environmental cleanup;
- $13 billion for highways and other transportation;
- $4 billion or so for housing programs;
- $250 million for military housing;
- $2.5 billion for education and job training;
- $2 billion for NIH, CDC, and pandemic preparedness;
- An expansion of the SBA small business loan program;
- $1 billion for border security and homeland security;
- $675 million for federal science programs;
- Disaster assistance for farmers and communities; and
- Increased funding for consumer protection.
In addition to this long list, Senate Finance Committee Chairman Max Baucus would like to add several tax provisions, including extending bonus depreciation, suspending required IRA dispersals for account holders over 70 ½ years old, and easing pension funding requirements for companies.
While there’s a small chance something might get passed, we believe the stalemate over the auto bailout as well as other funding items is unlikely to get resolved in the next couple days and, as a result, readers should view this broad package as a precursor to Congressional action early next year.
TARP and S Corp Banks
As readers know, Treasury has now officially focused the entire $700 billion TARP fund to be used to inject capital directly into financial institutions under its voluntary Capital Purchase Program. Secretary Paulson has made clear the previously announced Whole Loan and Distressed Asset purchase programs will not be pursued.
For financial institutions organized as S corporations, this new focus presents a particular challenge. As structured, S corporation banks do not qualify for the CPP. According to our friends at the Independent Community Bankers of America, the terms of the CPP require the bank to issue special “preferred” shares in exchange for Treasury’s direct investment. But S corporations are precluded by the tax code from issuing preferred shares and thus are unable to access the CCP.
The Treasury is aware of this issue and is working on new rules that would apply to S corporation and other non-public banks. Part of this failure is simply the result of Treasury’s need to move quickly to restore confidence in the banking system. With 2,500 S corporation banks out there, however, it is an oversight that needs to be fixed.
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.