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.
To simplify tracking of the various tax bills under consideration by Congress, we’ve put together a chart of what’s moving and what’s being discussed, including separate tax bills on the AMT, energy production, education, housing, family tax relief, children’s health insurance, and international tax provisions.
As you can see, the total cost of the bills contemplated could exceed $1 trillion (!) over ten years. That’s a lot of offsets for Congress to generate, which suggests many of these bills will be delayed and/or scrapped as Congress weighs the benefits of action with the liability of the revenue raisers.
Another AMT Plan Floated
As you can see from the chart, the primary challenge in stemming the growth of the Alternative Minimum Tax is cost. Any change to the AMT reduces revenues by hundreds of billions over the 10-year budget window. That enormous cost is likely why the House has repeatedly delayed plans to produce a permanent fix to the alternative tax.
A recent plan proposes to offset this cost by imposing a new surtax on high income taxpayers. According to press accounts, the income threshold would be $500,000 and the surtax would be in the 4 to 5 percent range. That tax increase would offset a higher, permanent $250,000 AMT exemption ($125,000 for singles) that is indexed for inflation in future years.
If you are interested in the details, a similar plan has been outlined by Tax Policy Center here in town. The TPC plan would 1) raise the AMT exemption to $200,000 for families ($100,000 for singles) and 2) offset the cost of this increase with a new 4 percent surtax applied to a taxpayer’s Adjusted Gross Income above the $200,000 threshold.
The net effect of this plan on any particular taxpayer is complicated, as are all issues surrounding the AMT. Some taxpayers will pay more tax, some will pay less, and some will pay the same amount. But to date, all the AMT proposals floated in the House have embraced, to one extent or another, marginal rate increases for non-corporate taxpayers.
S corporations should pay attention. This new surtax would apply to all income above the $200,000 threshold, including your S corporation business income as well as any capital gains and dividends you receive. As a surcharge, this tax is applied on top of existing income taxes, resulting in a sizable increase in your effective marginal tax rates.
Big Four Weigh in on Tax Gap
In response to an IRS request for comments and suggestions in their on-going analysis of the tax gap, the large accounting firms have penned a 19-page white paper that outlines the issue as well as putting forward suggestions.
Perhaps an accurate summary of the paper would be: “Big business pays its fair share so the IRS should focus on small business instead.” Here’s the section related to S corporations and other pass-through businesses:
Mid-Size Corporations and Pass-Through Entities
Another potential area of high-risk involves taxpayers and entities that have been subjected to little or no enforcement in recent years. While larger corporations are examined with relatively high frequency (44 percent), mid-size corporations, S corporations, and partnerships are reviewed with much less frequency. The number of S corporations and partnerships has grown rapidly over the last several decades with very little enforcement activity occurring. IRS recently launched a new research project focused solely on S corporation returns. This is an important project to assess the level of compliance for S corporations, which should be completed as soon as possible. Gaining access to timely information from pass-through entities (e.g., partnership Forms K-1) remains a challenge to the ability of individuals, trusts, and estates (and their tax return preparers) to prepare an accurate income tax return on a timely basis. This issue should be considered as part of any effort to evaluate and improve compliance of pass-though entities.
As IRS continues to reengineer the examination process for larger corporations to provide close to real-time currency and streamlined examinations, and as IRS winds down a number of abusive tax shelter efforts, these resources should be redeployed to the task of assessing the level of compliance of mid-size corporations and pass-through entities and to identify noncompliance trends that should be addressed.
On a related note, the last time Treasury Secretary Hank Paulson appeared before the Senate Finance Committee to talk about the tax gap, he was asked to return in 90 days to let the Committee know what new approaches they were prepared to take. That 90 day window expires around July 18th — so expect some sort of hearing or meeting on the Tax Gap around that time. Exactly what new policies Treasury produces in the 90 days they were given remains to been seen.
S Corp Member Alert! Governor Blagojevich proposed last month to replace the Illinois state corporate income tax with a gross receipts tax (GRT). Under the current proposal, the state’s current 4.8% corporate income tax rate would be phased out over four years and the new GRT would be imposed on all revenues realized by IL businesses from the sale of good and services – .85% for goods and 1.95% for services. The change will increase projected annual revenue collections more than four-fold and has been characterized by the non-partisan Tax Foundation as the largest state tax increase this decade.
A massive tax increase is bad enough. But a gross receipts tax? These taxes are considered to be the most economically damaging of all taxes. As the Tax Foundation observed:
- The new tax would be problematic not only because of the additional tax burden it would impose, but also because of the way in which it would do so. Gross receipts taxes are one of the most economically damaging ways for states to extract revenue, and economists from all ends of the political spectrum are nearly unanimous in their opposition to them.
As bad as gross receipts tests are, the reasoning behind the increase is worse. Apparently, the Governor is concerned that corporate taxpayers in Illinois have seen their share of total tax burden decline over the past three decades, from about one dollar in five to one dollar in seven. Why? Because of the dramatic growth of pass-through businesses like S corporations. According to the Governor’s office, the reported number of limited partnerships, limited liability companies and S corporations grew from 94,000 in 1984 to 285,000 in 2004.
The Governor looked at the data and decided that Illinois businesses weren’t shouldering their fair share.
But S corporations (and partnerships) pay plenty of tax. They just pay through the individual income tax rather than the corporate tax. This reality has the effect of reducing measured corporate income taxes and increasing tax collections on individuals and families, making it look like businesses are paying less tax than they are.
Moreover, if the GRT is enacted, Illinois S corporation owners will still be expected to pay the 3 percent tax on their business income imposed by the state’s individual income tax. This double tax effectively puts S corporations at a disadvantage relative to traditional C corporations in Illinois, and is patently unfair.
We will keep you updated as we learn more. If you have a business in Illinois, let us know. We’ll help you fight this unwise and unfair tax increase on Illinois businesses.
Just before breaking for the November elections, the Senate Finance and House Ways and Means Committees introduced their tax technical corrections bills (H.R. 6264 & S. 4026) to fix errors and ambiguities in the tax code. The bills are open to review and comment through October 31st, with the expectation that they will be adopted by Congress and sent to the President during the final weeks of this Congress.
One provision included in both bills would increase from 15 percent to 35 percent the tax rate on qualified export income for small business exporters! This provision is not a technical correction and should not be made part of the bill with that heading, or any other heading for that matter.
Under the current code, S corporations that export manufactured goods can set up an Interest Charge Domestic International Sales Corporation (IC-DISC). The features of the IC-DISC are two-fold: Income attributed to the IC-DISC is deferred until it is distributed to the parent S corporation, and then it is taxed as a dividend at a 15 percent rate. The amount of income that can be deferred is capped to ensure this is a small exporter provision. Following the repeal of DISC, FSC, and ETI, the IC-DISC is the last remaining tax provision targeted directly at S corporations and other pass-through exporters. H.R. 6264 and S. 4026 would eliminate this benefit!
The S Corporation Association is working with other affected groups such as the Small Business Exporters Association to ensure that this substantive and controversial amendment does not pass under the guise of a technical correction.
If you or your clients benefit from IC-DISC, please let us know. Also, you can send comments directly to the Finance and Ways and Means Committee protesting the elimination of this important export incentive.
Comments must be submitted by COB on October 31st and should be directed to:
Attn: Comments on the Tax Technical Corrections Act of 2006
U.S. Senate Committee on Finance
219 Dirksen Senate Office Building
Washington, D.C. 20515
Be sure to copy the Ways and Means Committee as well. The form to submit
comments to that Committee can be found at:
For those who missed it, Monday’s Congress Daily does an excellent job of outlining the challenge confronting S Corporations and other flow-through businesses as Congress prepares to take up reconciliation, tax reform, an extension of expiring tax provisions, and other tax legislation this Congress. Continued interest by the press regarding the Joint Committee’s recommendation is a clear signal this issue is not going away…
JCT and the Treasury Department’s Inspector General for Tax Administration have proposed changing the rules to ensure that payroll taxes are levied on all a firm’s income, regardless of how it is counted. Concern in the small business community that Treasury might back a rule change of that nature was heightened when the IRS announced late last month that it was auditing 5,000 S-corporations with an eye toward recommending potential policy changes.”
SOME STARTING TO QUESTION THE IRS’ AUDIT OF S CORPORATIONS…
Last Friday’s BNA Tax Report suggests the IRS’ announcement that it intends to randomly audit 5,000 S Corporations over the next couple of years has left some tax practitioners questioning why the IRS is only targeting S Corporations. “While several practitioners could list areas of possible S corporation noncompliance, many also said they were not aware of any egregious, widespread violations currently occurring. Other practitioners noted several compliance problems may be more prevalent in S corporations than with other types of corporate structures.”
August 8th, 2005
Business Groups Prep For Battle Against S-Corp. Change
Small businesses are fighting a proposal to collect more payroll taxes from millions of S-corporations and partnerships, a plan they fear might be used by tax writers to help underwrite expensive Social Security or tax overhaul efforts. The proposal was floated earlier this year by the Joint Committee on Taxation, which estimates it would raise $57 billion over the next 10 years. That represents one of the largest revenue sources from a single legislative change, as congressional tax writers seek options to shore up the long-term solvency of Social Security and to change the tax code. Congress is awaiting recommendations from President Bush’s tax panel at the end of next month. “The tax panel’s charge is to report recommendations that are revenue-neutral … They’re going to have to come up with offsets someplace,” said Brian Reardon, a former White House economic adviser who is coordinating business efforts against the tax change.
At issue are amounts that small businesses organized as partnerships, limited liability corporations or S- corporations claim as compensation for tax purposes. Current law requires Social Security and Medicare taxes to be levied on all “reasonable compensation” of employees of these pass-through entities. But according to a January JCT options paper, owner-employees have an incentive to under-report their wages to avoid paying excessive payroll taxes. They might take a large chunk of income as a distribution, which would not be subject to those taxes. JCT and the Treasury Department’s Inspector General for Tax Administration have proposed changing the rules to ensure that payroll taxes are levied on all a firm’s income, regardless of how it is counted. Concern in the small business community that Treasury might back a rule change of that nature was heightened when the IRS announced late last month that it was auditing 5,000 S-corporations with an eye toward recommending potential policy changes.
A broad coalition of business groups that includes the National Federation of Independent Business, the National Restaurant Association, National Association of Manufacturers and a number of state chambers of commerce has been formed to lobby against the payroll tax change. The coalition is being coordinated by Reardon of Venn Strategies, which represents the S Corporation Association. Opponents of the JCT proposal claim that the IRS already has the ability to determine whether a taxpayer’s claims of “reasonable compensation” are accurate, and to collect whatever taxes it thinks have gone unpaid. “Our goal is to educate members and educate staff to make sure they understand these are bad policies; they’re bad economics. They would represent a direct, unfair tax on a lot of employers,” said Reardon. But the coalition also faces a unique challenge when communicating the problem to Republican lawmakers in particular: The problem highlighted by JCT was earlier identified by Vice President Cheney in a debate last summer with then-Sen. John Edwards of North Carolina, the Democratic vice-presidential nominee. Cheney raised questions about whether Edwards was avoiding payroll taxes by structuring his law practice as an S-corporation and under- reporting his “reasonable compensation.”
– by Martin Vaughan
August 5th, 2005
Reaction Mixed to IRS Audit Project, But Some See Aid to Compliance Efforts
Practitioner reaction to the Internal Revenue Service’s launch of an ambitious audit project targeting Subchapter S corporations has been mixed, with some puzzled about why such corporations are attracting additional compliance scrutiny . Other practitioners, however, said several compliance problems are more prevalent in S corporations and the project may help address those deficiencies.
IRS announced July 25 it will audit 5,000 randomly selected Subchapter S corporations for tax years 2003 and 2004 in an effort to improve tax law compliance (142 DTR G-1, TaxCore, 7/26/05). The audits are scheduled to begin by the end of 2005.
Higgs, Fletcher & Mack LLP partner and former American Bar Association Section of Taxation Chairman Richard Shaw told BNA Aug. 3 the project could be “very constructive” to enhance taxpayer compliance by the millions of S corporations in existence. While several practitioners could list areas of possible S corporation noncompliance, many also said they were not aware of any egregious, widespread violations currently occurring. Other practitioners noted several compliance problems may be more prevalent in S corporations than with other types of corporate structures.
An IRS spokesman said the audits are not necessarily aimed at targeting specific noncompliant taxpayers; rather, if successful the project will help identify taxpayer trends and practices that will help IRS devote its enforcement resources to areas where they will have the most impact while reducing the number of no-change audits.
Another reason for the examinations is that IRS has not conducted an audit project to identify S corporation compliance issues in more than 20 years, the spokesman said.
Tax Law Changes
In its July 25 announcement, IRS cited the dramatic increase in the use of S corporations as a chief reason the project was launched. IRS said the number of S corporations increased from 724,749 in 1985 to 3,154,377 in 2002. Steptoe & Johnson LLP practitioner Mark Silverman told BNA July 29 the growth in S corporations can be explained, at least in part, by the repeal of the General Utilities doctrine. Prior to 1986, if a corporation sold or distributed assets during its liquidation it did not pay tax on the gain, except recaptured gain, he said.
But due to the implementation of Internal Revenue Code Section 311(b), enacted as part of the repeal of that doctrine, corporations that are not S corporations now have to pay tax on any realized gain when they sell or distribute assets in liquidation.
Many corporations converted to S corporation status as a result of that tax change, which likely contributed to significant S corporation growth after 1985, said Silverman, who leads his firm’s tax practice. Also, Congress has acted to liberalize S corporation rules during the last 10 years to encourage their use, also leading to their popularity as a corporate structure, Silverman and others said.
S Corporation Compliance Issues
Several practitioners said they were not aware of any particular S corporation noncompliance issues currently vexing IRS. “In terms of individual taxpayers, I don’t see any deep abuses that are being conducted through S corporations that cannot be done through other types of entities,” Morgan, Lewis & Bockius LLP associate Daniel Carmody told BNA Aug. 3.
But Ernst & Young LLP tax principal Laura MacDonough noted that S corporation litigation frequently involves a few specific issues, such as unreasonably low compensation levels and the basis for restructured related-party loans. Shaw also listed several compliance issues that involve S corporations which may receive increased attention during the audit project: failure to report employment taxes tied to compensation levels, excessive pass-through of corporation losses to corporate shareholders, and shareholders violating S corporation eligibility rules.
Indeed, closer scrutiny to S corporation eligibility rules may reveal some S corporations have made unintended errors–perhaps years after the error occurred–which technically could cause them to lose their S corporation status and be converted to Subchapter C corporations, said Carmody, a former IRS Office of Chief Counsel senior counsel.
But to date, IRS has been “pragmatic” in limiting its disallowance of S corporation status due to unintended, minor violations, Shaw said.
Second Major NRP Project
The S corporation examination project is the second significant project launched within IRS’s National Research Program. Between October 2002 and September 2004, IRS carried out an audit of approximately 46,000 individual taxpayers in an effort, similar to the S corporation project, to better define the tax gap (60 DTR G-11, TaxCore, 3/30/05). The tax gap is the difference between what IRS is owed in taxes and the amount of tax actually paid in a timely manner. A chief finding of that project was that the tax gap for 2001 alone totaled as much as $350 billion. IRS Office of Research, Analysis and Statistics Director Mark Mazur told reporters March 29 additional and perhaps more refined conclusions of that data will be completed by the end of 2005.
The NRP, launched in 2000, aims to design and implement successful strategies to collect data to use to measure taxpayer payment, filing, and reporting compliance.
By Stephen Joyce
As S-CORP members will recall, S-CORP has been monitoring a number of states considering tax bills that will adversely affect S corporations. We were fortunate to lay the groundwork in Pennsylvania in working with others to Pennsylvania Governor Ed Rendell’s
S corporations fared better in Pennsvylania when, following the recommendation for a new entity-level tax in that state, S-CORP and others lobbied to reject proposed tax hikes on S corporations. Following active communications with the Rendell office, S-CORP scored a major victory when Rendell announced in February 2005 that his budget proposal would not embrace new taxes on S corporations. Rendell went so far as to state that,
While the Commission’s approach has merit, imposing a new entity-level tax at this time would not be consistent with the Governor’s economic development goals. Companies organized as LLCs and subchapter S corporations are major job generators and can respond quickly to new economic opportunities. Imposing a substantial new tax on these firms would be counterproductive at this point in the economic cycle.
This is extremely good news, but it is critical to note that prior to our raising the concerns of S corporations, the Governor’s office had not heard from any S corporations in Pennsylvania.
Governor Ed Rendell’s budget and tax reform proposal was recently introduced in the Pennsylvania House as House Bill 1557. Most importantly, we are pleased to report that the bill accurately reflects the Governor’s original proposal (released in February) and excludes S corporations from a new entity-level tax. The Governor’s Deputy Secretary for Tax Policy has told us that the bill’s outlook and timing are “uncertain” and could certainly “face an uphill battle.” We will continue to monitor to ensure that if the bill moves, the S corporation exemption remains.
IRS Finalizes Rules on Deemed Classification Of Entities Filing for S Corporation Election The Internal Revenue Service May 20 issued final regulations (T.D. 9203) stating that eligible entities that file timely elections to be treated as Subchapter S corporations will be deemed to have elected to be classified as associations taxable as corporations. The rules finalize temporary regulations issued in July 2004 (138 DTR G-2, L-7, 7/20/04).
IRS said the regulations aim to simplify paperwork requirements for entities electing to be classified as S corporations by eliminating the additional requirement of filing an election to be classified as an association. Instead, an eligible entity that makes a timely election to be classified as an S corporation will be deemed to have elected to be classified as an association taxable as a corporation, IRS added.
If the S election and entity classification election are filed late, the entity may need to submit a ruling request to file a late entity classification election and late S corporation election, IRS said. The regulations said Revenue Procedure 2004-48 provides relief for those entities in some cases. No hearing was requested or held on the temporary regulations, and no written or electronic comments were received, IRS said.
The effective date for the regulations is July 20, 2004.
Text of the regulations is in Section L.
S corporations continue to be under direct fire as state legislatures undertake tax reform.
This week, the Ohio House of Representatives is scheduled to pass its fiscal year 2006 budget bill, a measure that includes a tax reform package which could dramatically increase taxes on Ohio S corporations.
In an attempt to help the struggling manufacturing sector, Governor Bob Taft and the legislature are proposing to eliminate the tangible personal property tax, lower personal income taxes, and pay for this with a new commercial activity tax (CAT) of .26% of a company’s gross receipts. If enacted, the measure will apply to pass-through entities that are already subject to the personal income tax. As such, this would mean that S corporation shareholders would see their tax liability increase as much as 5.95% from Ohio operations relative to C corporations.
Ohio legislators need to hear from S corporations with operations in Ohio NOW about the potential harm this provision would inflict on your business. Please contact Noelle Hawley at S-CORP (202) 466-4771 if you can help!
Over the course of the last year, S corporations have faced the threat of similar tax increases in Kentucky and Pennsylvania and elsewhere. On March 18th, Kentucky Governor Ernie Fletcher (R) signed into law major tax reform legislation that cuts corporate personal and income tax rates but raises taxes on S corporations by imposing a new entity tax on all pass-throughs. The new tax is partially offset by a credit to shareholders, and the new tax also exempts the portion of an S corporation that is owned by a non-taxable entity (such as a trust or an ESOP).
S corporations fared better in Pennsvylania when, following the recommendation for a new entity-level tax in that state, S-CORP and others lobbied Pennsylvania Governor Ed Rendell’s to reject proposed tax hikes on S corporations. Following active communications with the Rendell office, S-CORP scored a major victory when Rendell announced in February 2005 that his budget proposal would not embrace new taxes on S corporations. Rendell went so far as to state that, “while the Commission’s approach has merit, imposing a new entity-level tax at this time would not be consistent with the Governor’s economic development goals. Companies organized as LLCs and subchapter S corporations are major job generators and can respond quickly to new economic opportunities. Imposing a substantial new tax on these firms would be counterproductive at this point in the economic cycle.” This is extremely good news, but it is critical to note that prior to our raising the concerns of S corporations, the Governor’s office had not heard from any S corporations in Pennsylvania.
While S-CORP does not have an active lobbying force at the state level, we are committed to working with member companies to weigh in on their behalf against proposals that would be harmful to S corporations. Please contact us at (202) 466-4771 should you be aware of such a proposal in your state or wish to get involved with other S corporations that are working on these issues in states where threats like these have emerged.