Chairman Rangel Proposes Payroll Tax Increase on Small & Family-Owned Businesses
When Congress created the S corporation in 1958, the IRS ruled that only S corporation shareholders who are active in their business should be subject to payroll taxes, and then only on amounts received for their labor.
Fast forward fifty years. While the payroll tax has grown dramatically, the application of payroll taxes has always applied to labor income only – not capital income.
Last week, all this changed. House Ways and Means Committee Chairman Charlie Rangel [D-NY] introduced legislation that turns 50 years of tax policy on its head.
The bill, the “Tax Reduction and Reform Act of 2007,” would lower the corporate tax rate and eliminate the individual AMT. However, one of the many revenue increases included, is a provision that would raise $9.5 billion over ten years by expanding the application of payroll taxes on S corporation shareholders who also work at the business.
This tax increase would be limited to those businesses primarily engaged in service businesses, and only on the income related to that service business. Nonetheless, it represents a payroll tax increase on taxpayers that are already fully complying with the law – setting the stage for future efforts to apply payroll taxes to all S corporations, including manufacturers and farmers.
S-Corp members appreciate the concern that certain taxpayers are paying less than their fair share of payroll taxes. The IRS already has the tools, however, necessary to identify these taxpayers and require them to pay the correct level of tax. And while applying these tools may be time intensive and costly, the alternative is to raise payroll taxes on small and family-owned businesses that are fully complying with the law and paying all the taxes they owe.
Even when limited to service sector businesses, this proposal violates decades of established tax policy and imposes a new tax on a significant portion of America’s small and family-owned business community.
More Details on the Rangel Tax Bill
At a members briefing this evening, Ways and Means Chairman Charlie Rangel outlined his “Mother of All Tax Bills” to the Committee membership. In essence, he outlined three separate bills that he will introduce in one package:
- A bill to repeal the individual AMT and provide tax benefits for low income families; - A bill to extend for one year a group of tax provisions scheduled to expire at the end of 2007, including the temporary AMT “patch”; and - A bill to cut the corporate tax rate down to 30.5 percent.
As S-Corp readers know, the tax benefits from these three bills are great. It’s the offsets that are the problem. Here’s the current summary:
Individual Bill
§ Repeals the AMT beginning 2008;
§ Expands the EITC, increases the standard deduction, and increases the refundable portion of the child credit.
§ Offset is a 4 percent surtax on incomes above $150,000 ($200,000 joint).
Extender Package
§ Extends for one year all the major tax provisions scheduled to expire at the end of year, including the AMT patch.
§ Offsets include carried interest, deferred comp on offshore hedge funds, basis reporting of securities, and higher payroll taxes on service sector S corporations.
Corporate Rate Cut
§ Corporate Tax Rate Lowered to 30.5 percent.§ Offsets included repeal of Section 199 manufacturing deduction, repeal of LIFO accounting rules, and expense allocation rule changes.
While most of these provisions affect S corporations in one way or another, the four that stand out as particularly harmful are the individual surtax, the S corp payroll tax increase, LIFO repeal, and the repeal of the Section 199 manufacturing deduction.
What’s unclear is if the LIFO and Section 199 repeal distinguishes between C corporations who benefit from the lower corporate rates and S corporations, who do not. Treasury separated them in their corporate rate cut study back in July. We’ll have to wait until tomorrow to find out what the Committee has in mind. As you can guess, we will have more to say about the S corporation payroll tax proposal as well.
Congress Returns
Congress came back from its August break this week and is picking up right where it left off—struggling with the question of what to do with the Alternative Minimum Tax and examining how to appropriately tax the carried interest earned by hedge fund managers and other general partners.
These questions are connected, obviously, in that addressing the AMT will be very expensive while raising the tax rates on carried interest would presumably raise lots of revenue. That’s one reason why both the Ways and Means and Finance Committees held hearings on the issue.
For S corporations, the concern is twofold. First, once Congress begins exploring proposals for widespread changes to the tax code, it’s hard to know where they will stop. As the Wall Street Journal quoted Ways and Means Chairman Charlie Rangel this morning, “If it’s in the tax code, we have an interest in it.” Already they have floated the idea of imposing a four percent surtax on individual incomes above $500,000. As we’ve previously noted, this surtax would impact S corporations and other flow-through businesses, but not C corporations.
Moreover, we continue to hear rumblings about a proposal to increase payroll taxes on S corporation income. This idea was first put forward by the Joint Economic Committee back in 2005, and despite our best efforts to kill it, it keeps coming back.
Given the size of the AMT challenge and the lack of consensus between the House and the Senate on how to address it, we are sticking by our prediction that Congress will stay in session right up until the Christmas holiday and that many, if not all of these tax issues will be rolled into one big omnibus bill, similar to the bill that passed Congress last year in mid-December.
Exporter Tax Increase Back in Play
One component of that omnibus tax bill will likely be a technical corrections title. Remember the aborted “Tax Technical Corrections” bill from last fall? It was proposed in September but never got off the ground, in large part due to a provision that would raise taxes on small and closely held exporters. We’re hearing that congressional tax writers are going to try again, and that the export tax increase—affecting dividends from an IC-DISC—is likely to be part of the proposed package.
Why some in Congress are thinking about raising taxes on exporters is beyond us. Our growing export community is one of the few bright spots in the economy right now. Moreover, there are lots of business groups that oppose this change. A large number of them, lead by your S Corporation Association, recently wrote congressional tax writers asking that they strike this provision from the proposed bill.
You’ll be hearing more about this in the coming weeks.
S Corporation Accomplishments, 1996-2007
Since its inception in 1996, the S Corporation Association has helped guide numerous positive changes to the S corporation rules through the Congress and on to the President’s desk. Recently, one of our members asked us to catalog all the improvements to the S corporation rules since the S Corporation Association has been active in Washington DC.
Here is what we came up with, beginning with the recently enacted “Small Business and Work Opportunity Act” –including an entire title of S Corporation improvements–all the way back to the “Small Business Job Creation Act of 1996.” Since 1996:
- The number of allowed S corporation shareholders has increased from 35 to 100, and members of the same family now count as just one shareholder;
- S corporations can now own other businesses, including C corporations, with streamlined rules for allocating income and loss;
- S corporations’ expanded access to capital, with more types of shareholders allowed to invest in S corporations than ever before, including certain trusts, IRAs, and other tax exempt entities; and
- C corporations that convert to S status face fewer obstacles, including relief from the ‘sting tax”
It is important to note that this list does not include other S Corporation Association accomplishments, such as fighting efforts to impose payroll taxes on all S corporation income and broader tax changes that benefit S corporations like lower tax rates and higher small business expensing limits. Back in 1996, for example, the top tax rate on S Corporations was nearly 40 percent. Today, it’s 35 percent.
Take a look at the list, and we think you’ll agree that the S corporation community has benefited greatly from our efforts and those of other small business champions in Congress and elsewhere. This just goes to show what a concerted effort can accomplish for the small business community.
Is Official Washington Targeting S Corporations? Sure Looks That Way
As our readers know, the IRS is currently targeting S corporations, and only S corporations, for audits as part of its on-going “Tax Gap” research project. And the Joint Committee on Taxation and Treasury Inspector General for Tax Administration have, over the past couple year, proposed to dramatically increase the application of payroll taxes on S corporation income.
Now the Congressional Budget Office issues its new biannual “Budget Options” report, and there, on page 297 is an option entitled, “Repeal Tax-Free Conversions of Large C Corporations to S Corporations.” What follows is a long narrative of the history of C corporation conversions, the advent of LLCs in 1988, and the resulting disparity of converting from C to S verses converting to an LLC.
History aside, the option proposed by the CBO is just another shot at the S corporation community. Their reasoning, apparently, is to level the playing field between the treatment of S corporations and LLCs. As the report states:
“A major advantage of this option is that repealing tax-free conversions by C corporations would treat economically similar conversions — from two-tiered corporate tax systems to single-tiered systems — in the same way. Equalizing that tax treatment would, in turn, allow society’s resources to be allocated more efficiently by making tax considerations less important in decisions about what legal form a business should take.”
If equalizing tax treatment is the CBO’s motivation, why not just allow tax-free conversions of LLCs? The same economic arguments apply. Moreover, what about the myriad of advantages LLCs have over S corporations, like no limitations on the number or types of shareholders, the ability to issue multiple classes of stock and convertible debt, or the passive investment and built-in gains rules that apply to converted S corporations? We looked for CBOs recommendations to level the playing field in these areas, but were unable to find any.
The bottom line is the S corporation community needs to be as active as ever to ensure that Congress has all the facts when considering the rules under which we operate. With S corporations in the cross-hairs, anything less than constant vigilance is simply not going to succeed.
Do S Corporations Pay the Minimum Wage?
Now that the Senate has adopted a package pairing the minimum wage together with provisions to improve S corporation rules, one of the questions our Capitol Hill friends have asked us is, “Do S corporations pay the minimum wage?” The answer is an emphatic yes. While there are no studies to our knowledge that directly track the payment of minimum wages by businesses structured as S corporations (to be sure, there is little economic data on wage levels period), a couple of items demonstrate that S corporations are more likely to be adversely impacted by an increase in the minimum wage than other forms of business.
According to the IRS, S Corps represented three out of five corporations in 2003 (the last year numbers are available), but only received one dollar out of five. That means the average revenues for a C corporation is six times larger than the average revenues of an S corporation. All things being equal, the average S corporation will be harder hit by an increase in labor costs than the average C corporation.
Moreover, the incidence of minimum wage workers is dominated by industry type. For example, a professional services corporation is less likely to pay at or around the minimum wage than the local Wendy’s. Here’s the breakdown of S corporations in 2003 by industry from SOI (numbers have been rounded):
Agriculture, forestry, fishing, and hunting: 81,000
- Mining 17,000
- Utilities 3000
- Construction 450,000
- Manufacturing 150,000
- Wholesale 190,000
- Retail 375,000
- Transportation & warehousing 103,000
- Information 67,000
- Finance and Insurance 135,000
- Real Estate and Leasing 372,000
- Professional and Scientific 513,000
- Holding Companies 22,000
- Waste and Remediation 168,000
- Education 27,000
- Health and Social Services 208,000
- Arts and Entertainment 74,000
- Food and Accommodation 188,000
- Other Services 196,000
By number of firms, S corporations in minimum wage heavy sectors like agriculture, retail, education, health care services, and other services represent about 45 percent of all S corporations. By total receipts, the prevalence is greater — the retail and wholesale sectors alone comprise 42 percent of all S corporation receipts.
So while S corporations represent a broad swath of the business community, they are characterized by having significantly lower average revenues than C corporations while at the same time having a large presence in sectors more likely to pay the minimum wage. Providing them relief is consistent with the notion of targeting those business most likely to be affected, and it allows Congress to do so in a much broader manner than targeting one specific industry over another, since S corporations are represented in all industry types.
Wall Street Journal on the Tax Gap
Earlier this week, the Wall Street Journal weighed in on the tax gap debate, highlighting the challenge Congress faces as it attempts to address the tax gap in a constructive manner that does more good than harm. As the WSJ noted:
To put the tax gap in perspective, consider that the IRS took in tax receipts in fiscal 2005 of more than $2.2 trillion and that the overall U.S. tax compliance rate is about 85%. This isn’t perfect, but it also isn’t Italy. It’s especially good considering the U.S. tax system is based on voluntary compliance. Nina Olson, the IRS’s taxpayer advocate, told Congress last year that IRS auditors have found that an estimated 94% of noncompliance is the result of honest mistakes by tax filers who simply don’t understand the 17,000-page beast of a tax code.
The WSJ also highlighted the challenge S corporations face in warding off an unfair increase in payroll taxes.
Here’s another bad idea: Many doctors and lawyers who are incorporated under subchapter S will often pay themselves lower wages but higher dividends, in order to reduce self-employment taxes. The law is vague on the limits of this practice, and it is undoubtedly abused. But the Joint Tax Committee’s preferred solution is to make all professional income — even dividend payments — subject to self-employment taxes; this is nothing more than a backdoor tax hike.
The S Corporation Association does not advocate for businesses that fail to pay the proper amount of tax. But fixing tax gap is a complicated matter, and many of the proposals offered up to close the gap are just tax increases in disguise. The S Corporation Association has joined the Coalition for Fairness in Tax Compliance to help play a constructive role in the tax gap debate. This broad-based group includes the NFIB and US Chamber of Commerce and is going to be very active in the ongoing tax gap discussion. We’ll keep you apprised.
Finance Holds Small Business Tax Relief Hearing — S–CORP Submits Testimony
Today, the Chairman of the S Corporation Association Advisory Committee, James Redpath, submitted testimony on S Corp reform to the Senate Committee on Finance. The Senate Finance Committee held the hearing on small business tax relief as part of its preparation for Senate consideration of the minimum wage increase. As Jim pointed out in his testimony:
I am concerned that many of the companies that will bear the impact of this increase in labor costs are closely-held or family-owned businesses structured as Subchapter S corporations. My goal is to provide you with a first hand account of how to offset some of this new labor cost to small businesses by improving the outdated rules currently governing S corporations.
Jim goes on to highlight some of the S Corp priorities that would most improve the ability of today’s S Corp to compete and create jobs, including provisions to ease the burden of the built-in gains and sting taxes, increase their access to capital, and level the rules applying to S Corps and LLCs. The current tax relief plan, as outlined by Chairman Baucus, would reduce revenues by $8 to $10 billion over the next five years and include:
- A one-year extension of Section 179 small business expensing;
- A one-year extension of the lower, 15-year depreciation rules for retail businesses;
- A permanent extension of the Work Opportunity Tax Credit; and
- A higher, $10 million threshold for businesses wishing to use cash accounting.
Chairman Baucus also made clear that this tax relief would be fully offset by other tax increases, but he declined to be more specific. (While we’re told that none of the so-called revenue raisers we’ve worked to oppose will be included — raising payroll taxes on S Corps, LIFO repeal, etc — we’re going to keep working with our allies in the business community to ensure they don’t surface on this bill or any other.) Moreover, the Chairman indicated that they were open to suggestions for other small business friendly provisions that might be included.
On that front, Senator Blanche Lincoln, the sponsor of several S Corp reform bills, spoke up and raised the importance of including S Corp reforms in this legislation, to which the Chairman replied, “Those are great suggestions.” We agree, and we’ll continue to work with Senator Lincoln’s office and other S Corp friends to get these provisions enacted…
One complication is the fact the House is passing a minimum wage increase without any offsetting tax relief. The House bill would increase the wage by the following schedule:
- From $5.15 to $5.85 60 days after the legislation is signed;
- From $5.85 to $6.55 one year later;
- From $6.55 to $7.25 two years later.
Since the Constitution says all revenue bills must originate in the House, we’re interested to see how the House reacts to the Senate-passed tax relief. It could simply refuse to take up the provisions, we’ll be sure to keep you apprised of any developments. Social Security Reform and S Corps
We’ve been hearing all sorts of rumors these days about the direction Social Security reform has taken. Robert Novak reports that Treasury Secretary Hank Paulson has offered an increase in the Social Security Earnings Limit as a means kick -starting reform talks. Our Treasury friends adamantly deny that rumor, saying the Secretary has done no such thing.
In reaction to these rumors, House Republicans yesterday reaffirmed their strong opposition to raising the cap. Meanwhile, the White House renewed its call for the creation of Personal Accounts to accompany Social Security reform. Maybe the earnings cap idea was just a trial balloon to kick start reform talks? If so, it looks like we’re back to square one, with the White House insisting on Personal Accounts and congressional Democrats refusing to talk until the President takes them off the table.
Just to be clear, raising or eliminating the Social Security earnings limit would represent a massive tax increase on individuals and businesses. For example, an S Corp with $120,000 in income would see its tax burden increase in 2007 by nearly $3,000. For perspective, that tax increase more than offsets any tax relief the business enjoyed from the 2003 Tax Relief Act.
The current cap for 2007 is $97,500. Wages up to that point are subject to payroll taxes, totaling 15.3 percent of wages and fund Social Security and Medicare benefits to seniors. Above that level, only the 2.9 percent Medicare tax applies.
IRS TARGETS S CORPS!
As a follow-up to its broader “Tax Gap” study completed last spring, the IRS yesterday announced it will engage in a multiyear study of about 5000 taxpayers reporting S corporation income or losses. According to the IRS release (see below), the study “will be used to more accurately gauge the extent to which the income, deductions and credits from S corporations are properly reported on returns filed by the flow through corporations and their shareholders.”
The S Corporation Alliance strongly supports appropriate IRS administration of the tax code, but numerous questions arise from the IRS announcement, including why the IRS has chosen to focus solely on S corporations, rather than all business types – C corporations, LLCs and other partnerships, and sole proprietorships. We’ll provide more information as it becomes available.
HILL MEETING UPDATE
Over the past two weeks, we’ve met with tax counsels for Senate Majority Leader Frist and Senators Lott and Lincoln. All three indicated that timing on a Senate Finance Committee Social Security reform proposal is still uncertain, but that it is helpful that we are out there educating staff about the harmful nature of the tax increase proposal. There seems to be a consistent refrain that this issue is very much alive and something the tax writers continue to focus upon.
TREASURY NOMINEES QUESTIONED
Remember the Treasury Inspector General for Tax Policy’s recommendation to greatly – and unfairly – increase the application of payroll taxes on S corporation income, regardless of whether the income is due to capital investment, or even distributed? Senator Lincoln, a long-time friend to small and family-owned businesses, has helpfully submitted questions to pending Treasury nominees, asking them if this is indeed the position of President Bush’s Department of Treasury. Eagerly anticipated answers to follow…
S CORPORATION ALLIANCE LETTER UPDATE
The S Corporation Alliance is still working to get additional signatures on our letter opposing the proposed payroll tax increase on S Corporations. We are currently at 38 signatures but there is always room for a couple more. Keep up the good work and keep those names coming!
TAX REFORM PANEL HOSTS 10th MEETING; DECISIONS REVEALED
The President’s tax reform panel met last week to make some baseline decisions in anticipation of their September 30th report deadline. According to the documents released during the meeting, Chairman Mack has divided his panel into four separate working groups, each tackling the tax code from a different perspective:
- Complete replacement of the current tax code;
- Hybrid tax system;
- Fundamental reform within the existing code; and
- Partial replacement of the existing tax code.
While Senator Mack suggested these titles don’t necessarily foreshadow the final recommendations of the panel, they certainly provide a strong clue where the panel is headed. Moreover, discussions during the panel meeting left the strong impression the panel, even with its more moderate reform recommendations, is taking a strong look at consolidating business structures within the tax code into a single business type. Friends of S corporations, LLC’s, and sole proprietorships take note. The S Corp Association will continue to monitor the panel’s progress.
Get Email Updates
- S-Corp Supporters
