Senate Passes Built-In Gains Relief
After months of maneuvering, the Senate today adopted H.R. 5297, the Small Business Jobs and Credit Act. This legislation includes a number of business-friendly provisions, including the built-in gains tax relief so important to the S Corporation Community. This is a big (excuse the pun) victory for S corps everywhere!
The bill now moves back to the House, where it could take two paths. On the first path, the House takes up the Senate version, passes it intact, and sends it to the President for his signature. The second path would include House amendments and more floor debate. At that point the bill would return to the Senate, taking up time Congress simply doesn’t have.
For that reason, we expect the House to take the first path, so we should have a signing ceremony–and a five year BIG holding period starting next year–by the end of the month. Good news indeed.
Payroll Tax Dropped from Extenders
During consideration of the small business bill, Finance Chairman Max Baucus (D-MT) sought to add a new package of “tax extenders” to the bill. Republicans blocked the effort, pointing out that this was a wholly new package and that once again the minority was being blocked from offering amendments on the Senate floor.
The core of this package (the fourth or fifth version he has put together over the past year) would extend for 2010 all the provisions that expired at the end of 2009 — the R&E tax credit, state sales tax deduction, the S corporation charitable deduction, etc.; it also includes a number of unrelated spending items.
More good news for S corporations: the payroll tax hike included in earlier versions of the extender package is not included here. With the short calendar we don’t expect this issue to return this year, but it will return. We’ll continue to work to make certain any provision drafted to address this issue is well constructed and doesn’t target law-abiding S corporations.
House Moderates Oppose Tax Hike on Private Employers
As we mentioned in the last Washington Wire, a letter in support of extending all the expiring tax provisions was circulating among moderate Democrats in the House. If enough Democrats signed on, the letter had the potential to change the legislative prospects of blocking the pending tax hikes in the House.
Well, the letter is out, and 31 moderate Democrats signed on– more than enough to signal a tipping point on the issue. As the letter concludes:
We urge quick passage of legislation to extend the tax cuts so that American families and businesses have the certainty required to plan and make informed decisions. The sooner we act, the sooner our nation’s economy will benefit.
Added to the base of Republican support, this level of support from Democrats puts proponents of a full extension within spitting distance of majority support and increases the odds of a stalemate on this issue. After all, how does the Speaker limit extending the tax relief to the middle-class only if a majority of House members support a full extension?
This difficulty was reflected in the Speaker’s comments earlier this afternoon. As The Hill reported:
Pelosi argued at length for allowing the tax cuts on the top brackets to expire, but she could not say whether she had the votes to do so. Asked if there was any chance the top rates would be extended, even temporarily, the Speaker dodged. “The only thing I can tell you is tax cuts for the middle class will be extended this Congress,” Pelosi said.
Meanwhile, our friends on the Senate side are telling us nothing is likely to happen before November, at the least. The House is unlikely to move on this issue until the Senate acts, and the Senate lacks the necessary 60 votes to move anything, so it’s off to the “lame duck” we go.
After the elections, we continue to believe that of the three possible outcomes — no action, protecting the middle class only, or protecting everybody — the most likely outcome is “no action” this year. The next most likely outcome is a temporary extension of all the tax rates.
Legislation limited to extending the middle class provisions was always unlikely to move. This letter makes it less so.
Volcker Report Released. On a Friday. In August.
The headline says it all. The long-awaited Volcker Tax Reform Commission report was released last Friday and was immediately put on a shelf someplace in the basement of the Ways and Means Committee. According to the Commission members:
The Board was asked to consider various options for achieving these goals but was asked to exclude options that would raise taxes for families with incomes less than $250,000 a year. We interpreted this mandate not to mean that every option we considered must avoid a tax increase on such families, but rather that the options taken together should be revenue neutral for each income class with annual incomes less than $250,000.
In general, the report’s authors sought to provide “helpful advice to the Administration” on “options for changes in the current tax system to achieve three broad goals: simplifying the tax system, improving taxpayer compliance with existing tax laws, and reforming the corporate tax system.” The Board was not asked to consider major tax reforms.
Just how helpful this advice is remains to be seen, but the low-key manner in which the report was released suggests the Administration does not see the report itself as a useful message vehicle. Proposals to raise taxes seldom are.
For S corporations, two recommendations stand out:
Payroll Tax Provision: The report suggests that payroll tax policy could be changed so that all active S corporation shareholders, LLC members and limited partners pay payroll taxes on all distributions from their businesses. Under the heading of “Disadvantages”, the report states:
The revenues raised from the proposal would come primarily from owners of small businesses. Moreover, it would impose employment taxes on income that is partially a return on capital rather than a return on labor.
Our point exactly.
Business Structure Neutrality: As a part of corporate tax reform, the report states that “a goal of reform in this area is tax neutrality with respect to organizational form” including these two options:
One option would be to require firms with certain “corporate” characteristics—publicly traded businesses, businesses satisfying certain income or asset thresholds, or businesses with a large number of shareholders—to pay the corporate income tax. In effect, this would broaden the corporate tax base by applying the corporate tax to more businesses….
An alternative option would eliminate the double taxation of corporate income and harmonize tax rates on corporate and non-corporate income through “integration” with the individual income tax. In one example of such a system, individual investors would be credited for all or part of the tax paid at the corporate level against their individual taxes.
In other words, you could harmonize the tax treatment of business income by either imposing the corporate tax on more entities or by reducing the double tax currently paid by C corporation shareholders. Again, the disadvantages of option one highlighted by the Commission speak volumes:
Achieving neutrality between corporate and non-corporate businesses by subjecting more businesses to the corporate tax would increase the cost of capital and thus decrease investment in those businesses.
Yep.
More on Pending Tax Hikes
Our friends on the Hill pointed out a new survey of the National Association of Business Economists membership on the pending tax hikes. The survey found that more than half of NABE economists support extending all the marginal tax rates (including the upper brackets) while six out of ten support keeping the rates on capital gains and dividends at 15 percent. Other interesting results:
- Three quarters support promoting economic growth over reducing the deficit;
- Three quarters oppose further fiscal stimulus; and
- A large plurality support “clarity on future regulation and tax policy” over other ways in which the government can best “encourage increased employment.”
We are hearing this last point repeatedly these days — the best thing Congress can do is provide a little policy certainty to the markets. Congress is not doing the things it is supposed to (budgets, tax extenders, etc.) while it is considering and adopting dramatic changes to rules by which businesses relate to their employees, their customers, and their government. Markets do not like uncertainty, yet the current policy climate here in D.C. is rife with it. CNN points out that in the area of tax policy alone, more than 100 tax relief provisions affecting just about everybody are waiting to be extended.
Finally, on the National Commission on Fiscal Responsibility and Reform, four out of five respondents did not believe the Commission would produce a credible plan that could pass Congress. On that one, we’re not so sure. A growing number of smart folks around town are suggesting the Commission may be the best chance we have in the next couple years to get the federal deficit under control. Maybe; but either way, we’re guessing that report won’t be released on a Friday.
Small Business & Extender Tax Bill Update
If you watched the Senate floor yesterday, you might be under the impression that nothing was happening. The Senate spent most of the day in a Quorum Call (Senate code for nothing happening), and when a member did take the floor, often it was to speak about something other than small business taxes.
Ah, but still waters run deep, don’t they. Behind the scenes, two efforts were taking place. First, Leaders Reid and McConnell were continuing their back-and-forth over whether Reid would allow any amendments to the underlying small business tax bill and, if he did, what those amendments would be. McConnell’s office sent around the list of eight amendments he was asking for, including amendments to:
- Repeal the new 1099 requirements starting in 2012;
- Extend for one year the R&D tax credit;
- Extend the expired biodiesel fuel tax credit; and
- Fix the current estate tax mess.
Later yesterday evening, Senator Reid offered a shorter list of both Republican and Democratic amendments — each side would get three so-called side-by-side amendments. McConnell objected to that request. Reid then objected to McConnell’s longer list, and we’re back at square one.
Meanwhile, Finance Chairman Max Baucus has spent the last couple weeks working with key members to revise his tax extenders package. His staff sent around a list of proposed changes yesterday evening, and he is expected to release Baucus IV sometime later today.
Good News Alert: We believe the S corporation payroll tax provision has been dropped!
So what’s going to happen? The Senate is scheduled to vote on ending debate on the small business tax package (Reid amendment #4519) — without Baucus IV or other amendments — this morning. As BNA is reporting:
Absent an agreement, Senate Majority Leader Harry Reid (D-Nev.) said the chamber would vote early July 29 on one cloture motion on a substitute amendment (S. Amdt. 4519) and one on the underlying bill. “We reached an impasse here,” Reid said late July 28 after he and Minority Leader Mitch McConnell (R-Ky.) traded potential agreements on the floor and then disagreed to both.
The motion to end debate would need 60 votes to prevail, and Democrats are telling folks they don’t expect to succeed. We’re not so sure, but we’ll find out shortly. If the vote does fall short, the whole issue will likely get kicked into September.
Baucus III
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.
Latest On Extenders and the Payroll Tax
So the Senate just adopted a stand-alone, six month Doc Fix. Adoption of this provision sends a couple signals for the broader extender package.
This action follows on last night’s failed 56-40 cloture vote on Baucus II. While this vote represented a significant improvement over the 45 votes in support of Baucus I, it still signaled to the Senate (and House for that matter) that the “extenders plus” package was not going to be completed this week. Hence the need for the stand-alone Doc Fix. Moreover, the adoption of this very large — and ultimately offset — spending item suggests that other non-tax parts of the “extender plus” package could get peeled off as well, calling into question the viability of the underlying tax parts.
As long as the majority insists on offsetting temporary extensions of current law with permanent, new tax hikes, this is going to be a problem and ultimately result in a much more burdensome tax code. Has anybody done a Net Present Value analysis of the relative values of the extenders and the tax hikes that offset them? Only in DC budget parlance are they at all equal.
Which brings us to the S corporation payroll tax hike envisioned by the Finance Committee. As we’ve mentioned, Baucus II is better than Baucus I, but it still fails the very basic test of being better targeted, less complicated and easier to enforce than current law.
Talks continue between the Finance Committee staff and those Senators concerned about raising taxes on small businesses in the middle of a recession — including S-Corp champions Snowe and Enzi. The trick is how to get at the tax avoiders without punishing compliant S corporations, because every dollar this provision takes from taxpayers already complying with the law is one less dollar they have to invest in their employees and businesses.
This debate will now spill into next week. We hope it gets resolved soon, because it’s almost time to take up the extension of the very tax provisions under consideration — they expire in six short months, after all.
Single Class of Stock and Payroll Tax Avoidance
Part of the frustration experienced by the S corporation community on the payroll tax issue is the lack of understanding of how S corporation rules effectively block payroll tax avoidance in multiple shareholder firms. It is extremely difficult if not impossible to effectively avoid payroll taxes year after year in an S corporation where no one shareholder controls the firm. Consider the following example:
A fictional John Edwards and his brother lawyer are both partners in a larger law practice. They agree to form an S corporation where each has a 50 percent share in the business and designate the S corporation as the partner in the law firm. John and his brother agree to pay themselves a nominal wage and take the rest as income on their K-1.
In year one, both John and his brother earn $1 million in legal fees. As the partner in the law firm, this money is paid to the S corporation. As agreed, they both pay themselves $200,000 in wages and take the rest as a distribution from the S corporation. By doing this, they successfully avoid HI payroll taxes on $1.6 million, or $46,400. [Editors Note: Here the IRS steps in, audits the brothers, applies a reasonable compensation test, and dings both of them for unpaid taxes and penalties.]
In year two, John wins a big case and has fees of $5 million, while his brother has legal fees of $1 million. Under their agreement, they would pay themselves $200,000 each and then distribute the rest as S corporation income. But S corporations can only have one class of stock, so any S corporation income would have to be divided up according to their ownership interest, or 50/50. This means John will have to share his $5 million legal fee with his brother. Both brothers would get $2.8 million in S corporation income, or total compensation of $3 million each, and avoid paying $81,200 in HI payroll taxes each.
So John Edwards’ clever scheme to avoid paying $81,200 in HI payroll taxes costs him $2 million in income.
Obviously, a real person would never enter into such an arrangement. And while the brothers could adjust their wages to get around the “single class of stock” limitation, those wages would be subject to payroll taxes and defeat the purpose of creating the S corporation in the first place.
This is an extreme example, but it makes clear the challenge of attempting to avoid payroll taxes in an S corporation with no one controlling shareholder. The HI tax is 2.9 percent, after all, so any effort by taxpayers to avoid this tax is going to be tempered by the cost of doing so. The simple rule is that, unless the earnings potential of all the active shareholders in the S corporation are remarkably stable over a number of years, it is next to impossible to structure an ownership agreement that can last.
Baucus Substitute, Part II
After falling 15 votes shy of the 60 needed to close debate and move forward on the “extender plus” package, Finance Chairman Max Baucus offered up a second substitute last evening and Senator Reid immediately filed a cloture motion to end debate. That motion requires 60 votes and the vote would take place on Friday.
The new Baucus substitute is “slimmer” than the previous effort and apparently was designed to mirror the deficit impact of the House-passed bill. As such, its goal is not only to attract 60 votes in the Senate, but also to pass the House as well. As CongressDaily noted:
The effort appears calculated to not only get 60 Senate votes — and at least one wavering Democrat, Sen. Evan Bayh of Indiana, signaled he plans to support the bill — but get though the House. The new version would add roughly the same amount to the deficit as the “extender” bill that passed the House on a 215-204 vote before Memorial Day.
On the payroll tax issue, the substitute makes significant changes that narrow the scope of the test while apparently expanding the base of S corporations that would be affected. The Committee summary reads like this:
A provision passed by the House and included in the original Baucus substitute would address this abuse in situations where (1) an S corporation is a partner in a professional service business or (2) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals. This provision does not change the ability of S corporations to use some income to make business investments or deduct those small business investments. To make the second alternative more administrable and more targeted, this amendment changes the language so that the policy applies only if 80 percent or more of the professional service income of the corporation is attributable to the services of 3 or fewer owners of the corporation. This proposal, as amended, is estimated to raise $9.15 billion over 10 years.
As the summary indicates, “Baucus II” would replace the flawed “principal asset test” with what might be described as a “principal rainmaker” test — if three or fewer shareholders bring in 80 percent or more of the firm’s gross income, then additional payroll taxes would apply. Here’s the section:
(ii) any other S corporation which is engaged in a professional service business if 80 percent or more of the gross income of such business is attributable to service of 3 or fewer shareholders of such corporation.
On the surface, that’s a big improvement over the “principal asset” test. Our advisors believe it would be easier to administer and less subject to litigation than the earlier version. That said, the key question for policymakers is not whether Baucus II is better than the untested House-passed version, but whether it’s an improvement over current law.
We convened our advisors last evening and their opinion was that it’s not an improvement over current law, especially for firms that don’t already track hours and directly attribute revenues to certain shareholders. Law firms and CPAs usually are set up that way; engineering consultants and architects often are not.
Keep in mind, the IRS can and does go after tax avoiders (its tax avoidance it’s illegal; it’s not “fraud” or “abuse” or a “loophole”) using the reasonable compensation test. They just won a big case out in Iowa using that standard. So how is having the IRS enforce a “principal rainmaker” test any easier?
Other changes, or lack of changes, are also troubling. The pool of S corporations affected by this new version appears to have expanded. The House-passed definition of “Professional Services Business” reads like this:
For purposes of this subsection, the term ‘professional service business’ means any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.
The new version reads the same, except they took out the words “substantially all of the activities of such a trade or business involve”, which begs the question, exactly how much lobbying or engineering or investment advice do you have to provide before you fall into the “Professional Services” pool?
The flawed “Family Attribution” paragraph remains intact. This provision discriminates against inactive family shareholders and sets the stage for further assaults on family-owned businesses in the future.
Finally, the provision continues to target firms with “3 or fewer” key shareholders. As we’ve noted, 94 percent of all S corporations have “3 or fewer” shareholders, but other than that threshold, we do not understand the significance of “3”. The GAO, TIGTA and others have identified single-shareholder S corporations as the predominant source of this problem.
Sharing our concerns, Senators Snowe and Enzi re-filed their amendment to strike this provision from the new substitute. We are continuing to work with those offices and others to highlight our concerns with this provision and get it struck or significantly amended.
If you are an S corporation and you provide any of the services listed above, now is the time to reach out to your Senators and let them know how this would affect you. The next key vote is scheduled for tomorrow, and the entire package could be finished and sent to the President by the end of next week, so now is the time to act.
Latest on Payroll Tax Hike and Extenders
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.
Senators Snowe and Enzi Take On Small Business Tax Hike
The payroll tax hike in the House-passed extenders bill moves to the front burner in the Senate this week.
Senators Olympia Snowe (R-ME) and Mike Enzi (R-WY) introduced an amendment late last week to strike the provision from the bill. As a potential swing vote on the overall package, Snowe’s opposition in particular is sure to catch Leadership’s eye.
“At a time when Congress continues to dither on enacting a small business jobs bill, Section 413 is a poison pill in this tax bill, robbing American small businesses of the capital they need to create new, good-paying jobs,” Senator Snowe said in a release accompanying the amendment. “Indeed, this is a job-killing tax hike that will force entrepreneurs across the nation to retrench and reconsider any plans for hiring employees or expanding their business.”
Meanwhile, Senator Enzi raised this issue at a Finance Committee hearing last Thursday, first questioning Treasury Secretary Timothy Geithner about it and then entering into a colloquy with Chairman Max Baucus (D-MT). In response to Enzi’s concerns, Senator Baucus made clear his staff was working on an alternative.
The business community has come together as well, with twenty-seven business groups signing a letter spearheaded by the S Corporation Association highlighting the many flaws with the House-passed provision. In addition to focusing on the policy challenges, the letter notes the complete lack of legislative history accompanying this major new tax:
Finally, this new tax is an excellent example of what happens when the legislative process is short circuited. It was never the subject of hearings or public review, it was made public just a few short weeks ago, and it has been attached to legislation that already passed both the House and the Senate. It is an accident of the legislative calendar that we are in a position to offer our views at all.
If it were not for the deliberative nature of the Senate, this provision would have been enacted and signed into law before anybody in the business community—including legal and accounting professionals who advise them—knew it was even under consideration.
The Senate’s rules and the Memorial Day recess delay gave us time to get the message out, however, and we’re beginning to hear from practitioners and affected businesses from around the country. As a Dow Jones Newswire story makes clear, S corporations targeted by this provision extend well beyond the “lawyers and lobbyists” highlighted by the Ways and Means Committee:
Gabriel Durand-Hollis, owner of a San Antonio, Texas-based architecture and interior design firm, is no John Edwards. But he could nonetheless see his taxes rise as a result of a Senate measure that seeks to crack down on a technique Edwards, a former U.S. Senator from North Carolina, once used to avoid paying hundreds of thousands in payroll taxes…. Durand-Hollis, one of two owners of a firm that employees 25, said the provision, if enacted, would boost his federal tax bill by $30,000 or more. “If we had to send a big check like that to the IRS at the end of the year, we’d have to take a hard look at whether we can afford Christmas bonuses, or that new software purchase,” Durand-Hollis said in an interview.
On the process front, we expect Majority Leader Harry Reid (D-NV) to file cloture on the underlying bill (Baucus substitute, really, but we digress) sometime tomorrow or Wednesday. That would set up a key vote on closing debate as early as Thursday. Word is that Senator Reid is short of the 60 votes he needs right now and that changes to the underlying bill will be necessary for him to attract those key swing votes.
With the introduction of the Snowe-Enzi amendment, the odds of positive changes to the small business payroll tax hike shot up dramatically. That’s good for the small business community and good for good tax policy. The House-passed provision is clearly a step backward for taxpayers and the Tax Code. It would impose new costs on small businesses while asking the impossible of the IRS. With the leadership of Senators Snowe, Enzi, and others, we’re hopeful we can fix all that.
Payroll Tax Hike Taken Up in the Senate
The Senate began debate on the bloated tax extender package today. The House passed its version 215-204 shortly before leaving for the Memorial Day recess on May 28th.
That vote was supposed to take place earlier in May, leaving time for the Senate to take action, but opposition to the tax hikes and higher deficits called for in the bill delayed consideration until the Leadership was able to cobble together the votes. As a result, the Senate had already left town and is just now taking up the bill today.
Regarding the schedule, Senator Reid faces a tight window to get the bill done: he needs every Democrat plus at least one Republican to move this, but Senator Lincoln (D-AR) is back in Arkansas for today’s run-off tomorrow and won’t be available until tomorrow.
Meanwhile, there are no votes on Friday or next Monday and debate on Senator Murkowski’s Resolution of Disapproval (climate change) is set to consume much of Thursday.
That basically leaves Wednesday as the only day this week where Senator Reid might have the votes to move the process along, and it’s apparent from the news today that he’s not there yet. Senator Snowe (R-ME), a long-time S-CORP champion, indicated as much to CongressDaily:
Snowe said on Monday she was still waiting to see details. But she said the combination of deficit spending and tax increases, such as a new 15 percent payroll tax on small services-providers organized as “subchapter S” corporations, were giving her pause. “Pretty far from it at this point,” Snowe said, when asked about her comfort level with the bill, adding that it was unlikely to pass this week.
On the policy side, the delay in the House has been a boon for good tax policy, since the longer this payroll tax provision is out there, the worse it appears. Swapping a “reasonable compensation” standard for a “principal asset” test is not an improvement to the Tax Code. Exactly how is the IRS supposed to enforce an annual valuation of the “skill and reputation” of a firm’s three key employees?
Tom Nichols, a long-time S corporation attorney and head of the ABA’s Tax Section on S Corporations penned a letter to Congress making this point and many others. Meanwhile, the blogs of tax practitioners across the country are beginning to weigh in, raising numerous concerns that should have been dealt with through the normal legislative process — except there wasn’t one. The blog Tax Prof has links to a long list of critical commentators. As one observed:
But even assuming that you should hit service providers with self-employment tax on all of their K-1 income, you should do so in a way that is fair, understandable to taxpayers, and enforceable by the IRS. The S corporation provision in H.R. 4213 is none of these.
The Senate being the Senate, we expect this issue to be debated into the next week at least, and we plan to use that time to educate policymakers and improve the bill. There are taxpayers out there that use the S corporation to block payroll taxes they otherwise owe, and we support going after them, either through increased use of the “reasonable compensation” standard by the IRS or though a well-thought and well-targeted statutory provision. The provision before the Senate right now doesn’t meet that test.
Reasonable Compensation Standard in Action
Speaking of the “reasonable compensation” standard, the following post showed up in BNA this morning–as it makes clear, the IRS can and does go after payroll tax scofflaws using the “reasonable compensation” standard:
The U.S. District Court for the Southern District of Iowa May 27 held that David E. Watson P.C. must pay employment taxes on “all remuneration for employment.” David Watson incorporated an accounting firm as an Iowa professional corporation and chose to be taxed as an S corporation. Watson authorized himself a salary of $24,000 a year and he paid federal employment taxes on that amount. In addition to his salary, Watson received more than $200,000 in what he claimed were dividend payments. The Internal Revenue Service determined the dividend distributions should be recharacterized as wages, subject to employment taxes. (David E. Watson PC v. United States)
A fair reading of the House-passed bill is that the new, untested “principal asset” test for S corporations would be much more difficult for the IRS to enforce than the existing standard being used here. It would also be more costly for firms, as they would be required to value all their assets every year to determine if they are subject to the new tax. In order to enforce this new rule, the IRS would need to do the same.
The bill is now before the Senate, which has a reputation for debate and deliberation. We are hoping they expend a little deliberation on this provision. It could use it.
S-CORP Opposes Extender Pay-For
Your S-CORP team has been busy hitting the Hill in opposition to this payroll tax provision in recent days. Late last week, the House Ways and Means Committee released its package of tax extenders, partially offset by an expansion of the S corporation payroll tax to firms in service industries.
While the S corporation community knew the payroll tax hike was under consideration, this was the first time we had seen an actual proposal and it took us a couple days to get a read on who would be affected.
The provision is much broader than advertised. It begins by defining the population of firms targeted — professional or personal services firms in the area of law, engineering, architecture, performing arts, etc. The Committee’s choice to create a new definition for “Professional Services Business” was, we believe, predicated on the desire to target financial services firms as well as athletes, movie stars and other highly compensated individuals who might use an S corporation to block payroll tax obligations.
Once you fall into the “Professional Services Business” pool of S corporations, the provision asks, is your firm the partner in a service partnership and does that partnership consume substantially all of the activities of the S corporation? This test is targeted directly at the “John Edwards case” where a successful lawyer used the S corporation to block payroll taxes on his legal fees. Our members have raised few concerns about this test.
The second test, however, is more troubling. It would apply to “any other S corporation which is engaged in a professional services business if the principal asset of such business is the reputation and skill of 3 or fewer employees.” It took us a couple reads to realize this provision is not nearly as narrow as it first appears.
First, the test is not limited to firms with three or fewer employees. Firms with numerous employees could be affected, as long as only three are “key.”
Second, “principal asset” does not mean their skill and reputation comprises the majority of the value of the firm. Instead, that asset just has to be bigger than all the other assets of the firm. So, a business at which the largest asset is equal to 10 percent of the firm’s value would be affected if the “skill and reputation” of three employees are worth 11 percent.
With that as background, here is a list of concerns we’ve shared with the Committee over their new, never-before-seen provision to tax service S corporations:
- The provision would require a “disqualified” small business to determine whether its principal asset is the “skill and reputation” of fewer than three employees. This would require every “disqualified” small business to get a valuation of each of its significant assets every year in order to determine which asset is its “principal” asset.
- The provision arbitrarily discriminates against small businesses. It taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except they have four key employees.
- The provision tests for highly-skilled “employees” rather than shareholders. Why? Is there evidence that indicates that highly-skilled employees are underpaid by S corporations?
- The provision requires difficult legal conclusions about uncertain areas, such as whose asset is an employee’s “skill and reputation”– the employee’s? Or the company for which the employee works?
- The provision provides no definition of “asset”– it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single “asset” for purposes of determining the “principal asset” of a company.
- The provision would discriminate against family-owned S corporations by applying payroll taxes to family members not active in the business. This provision would reduce the ability of S corporations to raise capital from family members.
- And finally, how exactly does one go about establishing the value of “skill and reputation” of employees on a widespread basis? This, and the other undefined terms used in this provision are simply inviting litigation.
All of these technical challenges beg the question: What problem is the second test designed to solve? The first test, after all, captures the “John Edwards case” that everybody, including S-CORP, would like to address. What is the magic value of “three or fewer” employees? 60 90 percent of S corporations are owned by three or fewer shareholders. Is it just a money grab?
Beyond the policy, the lack of process or public review should be enough to bring about this provision’s defeat. No specific hearings on the proposal, no markups, no floor debate, not even a draft bill to comment on, and yet this $11 billion tax hike is supposed to be considered by the House and the Senate before the Memorial Day recess.
The IRS already has the tools to go after John Edwards and others like him. It has successfully litigated cases where taxpayers have taken compensation that was less than reasonable. Spicer Accounting Inc. v. US, 918 F2d 90 (9th Cir. 1990); Dunn & Clark, PA v. US, 853 F. Supp. 365 (D. Idaho 1994); Radtke v. US, 712 F. Supp. 143 (ED Wis. 1989) , aff’d per curiam, 895 F2d 1196 (7th Cir. 1990) Veterinary Servs. Corp., PC, 117 TC 141 (2001) . Veterinary Surgical Consultants, P.C., 117 TC 141 (2001) , aff’d, 54 Fed. Appx. 100, 2003-1 USTC ¶ 50,141 (3d Cir. 2002).
We’re not in the business of proposing tax hikes on our members, but if the problem resides with single shareholder S corporations in the service sector, why not start with that population and whittle it down from there? And what about an employee threshold? Who is going to hire lots of people at market salaries in order to reduce their personal tax rate by a little more than 2 percent?
We understand Congress needs revenue to offset its priorities, but to try to raise $11 billion on the backs of closely-held businesses without having one public review of the policy strikes us as a little much. Take a little time, engage the public, and you might get a better product.
Extender Package Stalls in the House
On a related note, timing for consideration of the “extender plus” package is very much up in the air. It was supposed to go to Rules earlier this week with floor consideration today or tomorrow, but that might not happen.
Although members are concerned with the offsets in the package, it is the number of extraneous items and their cost to taxpayers that is slowing any progress at this point. In addition to extenders, the package includes a UI extension, Cobra benefits, the Doc Fix, and other expensive items. The size of the package is causing moderate members concern:
“I’m concerned about it,” said Sen. Ben Nelson, D-Neb. When combined with “emergency”-designated extensions of unemployment insurance and COBRA health benefits for laid-off workers, Medicaid assistance to states and perhaps Temporary Assistance for Needy Families funds, the unpaid-for cost of the bill could top $170 billion. “Obviously, my preference is to have offsets, and look hard at nonemergency issues. Everything can’t be called an emergency to avoid having offset requirements,” Nelson said.
And:
Sen. Kent Conrad, chairman of the Senate Budget Committee, said Tuesday he has concerns with the size of a large tax and benefit bill Democratic leaders hope to pass this week, casting doubt on the chances of the legislation being approved. Mr. Conrad (D., N.D.) said the current net cost of the measure to public finances—$141 billion over a five-year period—was too high.
So the package is getting larger, but only those provisions extending tax benefits for families and employers are going to be offset, and those provisions will be offset with tax hikes on families and employers.
To put this discussion into perspective, the current extender package extends provisions that expired last year. The extension is only twelve months, which means Congress will have to come back later — most likely in a Lame Duck session — and pass another extension if all these tax provisions are not to expire at the end of 2010. The tax hikes, on the other hand, are permanent.
Groups targeted for tax hikes in this bill need to be wary. Taxwriters will be on the hunt for another $30 billion in just a few months, so any deal cut today will be revisited tomorrow.
Estate Tax Update
The inability of any estate tax proposal to garner 60 votes in the Senate is becoming increasingly apparent. There’s still a chance for a breakthrough, but time is getting short and opposition is getting more vocal.
As reported in numerous publications, estate tax negotiators have hit a wall in crafting a compromise plan that can pass. As Dow Jones reported last week:
Senators that want to reduce estate tax rates even further have in the past two weeks closed in on a compromise that would not add any more to the deficit, at least in the short-term, than Obama’s plan. The plan would start at Obama’s proposed levels in 2011, but gradually phase down to a 35% rate and a $5 million exemption level.
But Tuesday they said that a proposed compromise is in limbo. “Nothing is clear about how the estate tax will be considered,” said Sen. Jon Kyl (R., Ariz.), the lead Republican in the negotiations. “Last week I believed there was an agreement on what the details were going to be. That may not be the case now.”
“There’s no agreement on estate tax, neither on substance nor on process. None whatsoever,” said Senate Finance Committee Chairman Max Baucus (D., Mont.), who is one of two Democrats involved in the talks, the other being Sen. Blanche Lincoln (D., Ark.).
Meanwhile, the lack of progress and the short calendar is emboldening the opposition. According to CongressDaily:
That would be fine with Sen. Bernie Sanders, I-Vt., who said reverting to pre-2001 law would only affect about 2 percent of the nation’s estates. When asked about a plan to reduce the tax to 35 percent and lift the exemption to $5 million, Sanders replied: “I will do everything I can to stop that.”
CongressDaily goes on to quote another Senator as estimating that up to 80 percent of the Democratic conference is opposed to any sort of estate tax compromise. While he quickly backed off that estimate, anywhere near that level of opposition would doom an estate tax compromise this year and allow the pre-2001 rules to take effect beginning in 2011.
This stalemate also is blocking the Senate small business tax package, including built-in gains relief, from moving forward. The package has been negotiated between Finance Committee Democrats and Republicans and was ready to be marked-up last week until the estate tax roadblock emerged.
At this point, the path forward is unclear. Taxwriters could resolve their differences on the estate tax or they could agree to set that issue aside and let the small business package proceed (perhaps directly on the Senate floor). A third option would be to resolve nothing and let both estate tax relief and the small business package die. Let’s hope it’s not option three.
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