S-Corp Organizes Defense of Family Business
Under consideration is the issue of Family Attribution, which has the effect of dramatically raising the estate tax burden on family-owned businesses relative to those not owned by family members. Family Attribution was originally embraced by the IRS in the 1980s, and despite being rejected by the courts in several prominent cases, the idea continues to be put forward. Earlier this year Congressman Earl Pomeroy (D-ND) introduced the “Certain Estate Tax Relief Act of 2009” (H.R. 436), which, among other items, would create an alternative and more punitive definition of fair market value for business assets that are transferred to members of the same family.
S Corporation Association Chairman Dick Roderick applauded the efforts of the coalition and those members of Congress who have a history of supporting family enterprise. “Family businesses play a vital role in our economy, and it is important to ensure their continued success” he noted. “Imposing a higher estate tax on businesses simply because they are owned by a family does not make sense. We look forward to working with our friends on the Hill to ensure this idea does not become law.”
The letter was signed by the following organizations: American Hotel & Lodging Association, AMT – The Association For Manufacturing Technology, Associated Builders and Contractors, Independent Community Bankers Of America, National Association of Manufacturers, National Association of Wholesalers-Distributors, National Beer Wholesalers of America, National Funeral Directors Association, National Lumber and Building Material Dealers Association, National Restaurant Association, National Roofing Contractors Association, Printing Industries of America, S Corporation Association of America, United States Chamber of Commerce, and the Wine & Spirits Wholesalers of America.
House Health Care Bill Surtax
S corporations should be paying strict attention to the health care bill offered up by House leadership last week. The new bill imposes a 5.4 percent surtax on income above $500,000 for individuals and $1 million for families. Like most taxes applied to personal income, this surtax applies to flow-through business income as well as wages. It also applies to capital gains, dividends, rents, etc. (It may also apply to trusts and other structures — we’re checking.)
Revenue offsets for health care reform need to accomplish at least two goals: raise enough money to cover expanded coverage over the next ten years, and grow at least as fast as health care costs to fully cover expanded coverage costs in years eleven and beyond. The surtax before the House raises $461 billion over the next decade, covering about half the cost of expanding health insurance coverage; the other half is offset with provider payment cuts to Medicare and an assortment of other revenue raisers.
Perhaps just as important, the thresholds for the surtax are not indexed, so the threshold for individuals paying the tax would remain at $500,000 while the threshold for families would stay at $1 million over time. This imbedded bracket creep is necessary for the bill’s authors, since it’s the only way an income tax can be constructed to grow at about the same rate as health care costs.
The Congressional Budget Office indicates that the overall bill – spending minus savings and taxes – results in a surplus for years one through ten, while “in the subsequent decade, the collective effect of its provisions would probably be slight reductions in federal budget deficits. Those estimates are all subject to substantial uncertainty.”
So, the House health care reform bill apparently lives up to the promise not to increase the federal budget deficit in the long term, but only at the cost of drastically raising marginal taxes on a significant portion of business income and reversing a quarter-century of tax policy committed to indexing thresholds to ensure the federal government doesn’t profit from inflation. By all accounts, the surtax will face rough sledding in the Senate. We hope so. We also hope policymakers have a chance to fully explore the implications of an un-indexed marginal rate increase of this size.
Marginal Tax Rate Outlook
And where will Congress be in fourteen months with top marginal rates at 45 percent? It will be looking at a federal deficit that exceeds one trillion dollars, a Social Security system that is now operating under a cash flow deficit (i.e. its taking money from the general treasury rather than contributing to it), and a Federal Reserve and Treasury working overtime to unwind several trillion dollars worth of balance sheet buildup incurred during the recent financial crisis.
No wonder the markets are spooked. Happy belated Halloween.
House Releases Health Care Legislation
As expected, House Leadership released its health care reform plan yesterday — America’s Affordable Health Choices Act of 2009 (H.R. 3200). As you can imagine, there are any number of provisions to explore in a 1000-page health care bill, but for S corporations, the big four items appear to be:
- The new health insurance exchange;
- The surtax on high income individuals;
- The health insurance tax credit for smaller firms; and
- The payroll tax penalty for non-participating firms.
Supporters of the plan argue that the combination of the health care exchange and the small business tax credit will provide a net benefit to S corporations and other small businesses. Opponents point to the higher taxes and penalties for firms that choose not to offer health care plans to their employees.
They also question whether the overall plan will actually save money. The CBO estimates it will cost money after all – more than $1 trillion dollars. Of particular importance is the response of the moderate Democratic Blue Dog Coalition. As BNA reported this morning:
Rep. Mike Ross (D-Ark.), chairman of the Blue Dog Health Care Task Force, said his group was committed to passing health care reform. He also said that “reform that does not meet the president’s goal of substantially bringing down costs is not an option.”
We are not in a position to judge how successful the exchange will be. The only example is the one in Massachusetts and that one has both supporters and detractors. As for the other three provisions, here’s our best summary:
Surtax: Starting in 2011, a surtax of 1, 1.5 and 5.4 percent will be applied on “modified” AGI exceeding $350,000, $500,000 and $1 million respectively (joint filers). Unless OMB certifies that the bill’s changes to Medicare and Medicaid result in an additional $150 billion in cost savings, the surtax will rise to 2, 3, and 5.4 percent starting in 2012. If OMB certifies these savings exceed $175 billion, then the lower two surtaxes go away.
Small Business Tax Credit: For employers with fewer than 25 employees and who offer them qualified coverage, they are eligible for a tax credit equal to a percentage of their health care costs. The credit starts at 50 percent for employers with fewer than 11 employees and average annual compensation of less than $20,000. It phases out for more employees and higher salaries. A firm with 25 employees and/or average compensation of more than $40,000 gets no credit.
Payroll Tax Penalty: Firms that do not pay for at least 65 percent of their employees’ qualified coverage are subject to a payroll tax penalty. The tax starts at 2 percent of payroll for firms whose payroll exceeds $250,000 and rises to 8 percent for firms with payrolls exceeding $400,000. It is unclear whether the payroll tax applies to all payroll or just the amount exceeding the threshold.
Suffice to say that the complexity of each provision is worth its own white paper. Trying to gauge the interaction between them is simply impossible. Here are some observations and questions:
- How does the payroll tax penalty work? If an employer does not offer qualified coverage to his/her employees, does the tax apply to all payroll or just the amount above the threshold? How does the bill define firm? By entity or by establishment?
- The plan penalizes employers for expanding their payroll. If the employer offers qualified coverage, raising wages would reduce their credit. If they don’t, increased wages will increase their penalty. Either way, the plan raises the marginal cost of hiring new employees and offering them higher wages.
- The higher surtax rates can be avoided if OMB finds additional savings from Division B in the bill. How is OMB supposed to measure these savings and attribute them to the Division B? If the CBO failed to measure these savings, how will OMB?
- The bill appears to add to the deficit, especially in later years. Is this the plan, or will additional cost savings be offered to make it budget neutral?
- What about the need to balance the budget, reform the Alternative Minimum Tax, extend some or all of the expiring tax relief, or make the corporate tax code more competitive? How will Congress accomplish all these things if it spends $1 trillion on health care reform?
The House Ways and Means, Labor, and Energy and Commerce committees will begin marking up their respective portions of the bill tomorrow. Expect these markups to be extremely contentious. The Speaker’s goal is to get the bill through the full House before the August recess. Given the primary importance both the Speaker and the President have placed on health care reform, we expect this goal will be met. Exactly what changes are necessary to get the plan through the House, however, remains to be seen.
The Surtax and Small Business
The fight over who will pay the surtax has begun. The Ways and Means Committee published its estimates that only 1.2 percent of all taxpayers will pay the tax, and only 4.1 percent of all small business owners.
Our immediate reaction was that small business owners are 3.5 times more likely than the average taxpayer to pay the tax, but even that observation misses the larger point. It’s not the number of taxpayers affected that counts, but rather the amount of economic activity subject to the higher rates.
As we’ve pointed out previously, about two thirds of all small business income is taxed at the top two rates, so any surtax applied to upper incomes is likely to tax a majority of small business income. Moreover, those rates are already scheduled to rise, resulting in a double hit on upper income business owners in 2011 and beyond.
| Marginal Tax Rates Under HR 3200 (Joint Filers) | |||
| AGI | Marginal Rate (2009) | Marginal Rate (2011) | Marginal Rate (2012) |
| $350,000 | 33% | 34.00% | 35% |
| $500,000 | 35% | 41.10% | 42.60% |
| $1,000,000 | 35% | 45% | 45% |
This chart requires several caveats, including pointing out that the surtax applies to “modified” AGI rather than taxable income, but the general point is valid — HR 3200 will return marginal tax rates back to where they were before we started cutting rates in the 1980s.
In addition, this chart doesn’t include the HI tax that now applies to wage income, it doesn’t adjust for taxing “modified” AGI, which includes income from capital as well as labor, it doesn’t include the impact of restoring PEP and Pease, and it doesn’t include state and local taxes. All told, the effective marginal rates on higher incomes will easily exceed 50 percent under this plan.
One last point. When taxing the rich is debated, the discussion usually ignores the actual amount of taxes being paid. Your S-CORP team thinks that’s a mistake.
For example, the CBO reports that the top fifth of taxpayers pay, on average, $64,000 in federal taxes every year. The top one percent pay over half a million.
How much more will HR 3200 add to this burden? And at what level of tax do taxpayers, including small business owners, stop being productive and choose to do something else with their time?
S-Corp Priorities Included in Small Business Tax Relief Bill
Just prior to the July 4th break, Senator Chuck Grassley (R-IA) introduced a package of small-business friendly tax provisions, including one of our S-CORP priorities – built-in gains relief! Specifically, the legislation (S. 1381) includes:
- Reducing the BIG holding period from 10 to 5 years;
- Providing a 20 percent deduction for flow-through business income for businesses with less than $50 million in annual gross receipts; and
- Increasing Section 179 expensing, lowering corporate rates, exempting business credits from the AMT, and other items.
As Senator Grassley stated when introducing the bill, “My bill contains a number of provisions that will leave more money in the hands of these small businesses so that these businesses can hire more workers, continue to pay the salaries of their current employees, and make additional investments in these businesses.”
S-CORP is excited to see Senator Grassley include S corporations in this package and we will keep you apprised of any movement on this legislation. While much of the news coming from Capitol Hill lately has been cause for concern for S corporations (see below), it’s great to see that our S-CORP champions on the Hill continue to recognize the importance of our community to growth and job creation.
S Corporations Survive Scrutiny!
Our friends at BNA reported yesterday that the preliminary results of the IRS “tax gap” look into S corporations are in. For the past seven or eight years, the IRS has been conducting a National Research Program that seeks to get a better idea of how much Americans underpay their taxes. For reasons known only to the IRS, the agency has targeted S corporations for closer inspection while largely ignoring other business structures. Regarding the new numbers, BNA reported:
An Internal Revenue Service study preliminarily found that S corporations underreported $50 billion in 2003 and $56 billion in 2004, an IRS employee in the Research, Analysis, and Statistics Division said July 8 at the IRS Research Conference. Drew Johns, citing the 2003-2004 National Research Program S Corporation Underreporting Study, said the net misreporting percentages, or ratios of the net misreporting amounts to the sum of the absolute values of the amounts that should have been reported, for these years were 12 and 16 percent, respectively. The error rates for each year were 69 percent and 68 percent, respectively, he said.
So what’s your S-Corp team’s take on this? Pretty positive, actually. Total compliance by all US taxpayers is around 84 percent (best in the world), so the IRS is telling us that S corporations are better taxpayers than the population in general. Moreover, that 69 percent error rate is eye-catching only until you realize that he’s talking about any error, even small ones that are immaterial to the amount owed.
One question we do have is why the total noncompliance rate jumped from 12 to 16 percent between 2003 and 2004? A 33 percent increase in non-compliance from one year to the next would appear to be a statistical outlier and deserves a closer look.
So to sum up, the IRS spent the last three or four years diving into S corporation tax returns and what they found is that S corporations are solid taxpaying citizens. Combine that finding with the SBA’s report that S corporations shoulder the highest effective tax burden of any business form, and our conclusion is that S corporations should be praised by policymakers rather than targeted for increased enforcement and higher taxes.
Paying for Healthcare Reform
Speaking of higher taxes, July may be the month when taxpayers learn how Congress intends to pay for health care reform. As we’ve reported, the plans in both the House and the Senate have price tags around $1 trillion over ten years.
About $400 billion of that amount will be offset by spending cuts to Medicare and Medicaid, so the remaining $600 billion would need to come from higher taxes. Finance Committee Chairman Max Baucus (D-MT) stated yesterday he needs to identify about $320 billion in new taxes, so he’s apparently comfortable he’s got about $280 billion in revenue raisers ready to go.
Where will the revenues come from? Until this week, the Finance Committee was focused on raising the revenue within the health care world, creating the expectation that some sort of cap on the employer-provided health care exclusion would be part of the mix. It’s health care, after all, and it’s the largest tax expenditure out there. But, it’s losing favor. The Wall Street Journal reported yesterday:
Sen. Kent Conrad (D., N.D.) and others involved in talks on a health bill said Tuesday that the idea of taxing health benefits is unpopular with voters, though they stressed that it hasn’t been completely swept off the bargaining table.
A proposal to cap the exclusion just above the cost of plans for federal employees would have raised $320 billion. It’s now apparently off the table, so that’s the revenue hole Senator Baucus was referring to in yesterday’s remarks.
Given the size of the tax expenditure, we still think some form of exclusion cap will make it into the final bill, maybe with a much higher cap of around $25,000. That “only” raises $90 billion (seriously, who knew that many health plans cost that much?) so other tax increases will have to be added.
What’s on the list? A proposal mentioned in both the House and the Senate would place a 2% surtax on families making more than $250,000. Bloomberg reported on Tuesday:
Two people familiar with closed-door talks by committee Democrats said a House bill probably will include a surtax on incomes exceeding $250,000, as Congress seeks ways to pay for changes to a health-care system that accounts for almost 18 percent of the U.S. economy. By targeting wealthier Americans, a surtax may hold more appeal for House Democrats than a Senate proposal to tax some employer-provided health benefits.
If this surtax is like the one proposed by Chairman Rangel in 2007, it would be assessed against AGI and it would apply to wages and investment income alike. As you can imagine, a surtax like that raises lots of revenue.
Another potential item would expand the Medicare payroll tax to income like capital gains and dividends — and possibly S corporation income too. Like the surtax, the last time something similar was proposed was back in 2007 in Chairman Rangel’s “Mother” bill. That proposal targeted S corporations engaged in services only, though, and would have raised about $9 billion. The new proposal is much broader and raises a reported $100 billion. The S Corporation Association led the effort to educate policymakers why this was a bad idea back in 2007, and you can bet we’ll have something to say about this broader proposal in 2009.
Other items under consideration — seriously or otherwise — include increased taxes on drug companies and insurers, capping the value of charitable and other tax deductions (preferred by the Obama Administration), taxing sodas and other sugared beverages, and increasing reporting requirement by corporations.
When will all this be put forward? We were hearing the House might make its plans known as early as tomorrow with the Senate following next week. The most current word, however, is both releases are going to be pushed back, perhaps weeks in the Senate’s case. As to the question of what will be in the plan, if we had to guess today, we’d say the revenue package could include:
- A surtax on income;
- Caps on charitable and other deductions;
- The soda tax;
- An expansion of payroll taxes to new income; and
- Modest caps on the employer-provide health benefit exclusion (Senate).
Some mixture of these could easily raise $600 billion or more over ten years. Whether they could pass Congress, particularly the Senate, is another question entirely. The fact that several raise marginal tax rates on job creators in the middle of a recession is certain to be a central part of the debate.
Taxpayer Expectations and the Rangel Surtax
We have had a chance to digest a bit more of the Rangel bill introduced last week.
There was a lot to digest. Repealing section 199, LIFO, and IC-DISC, while extending the depreciation period for intangibles will all adversely impact our members to one degree or another. The fact that these tax increases are being used to offset a rate cut for C corporations doesn’t help matters.
Focusing on the individual side, the bill would substitute a new four-percent surtax on individuals and businesses earning more than $150,000 in order to offset the cost of repealing the individual Alternative Minimum Tax (AMT).
Whether this is a good trade-off depends on your particular circumstances. Some taxpayers will see their overall tax burden increase while some will see their burden go down. The Tax Policy Center has an excellent analysis that breaks out just who benefits under HR 3970 and who will be harmed.
One challenge Chairman Rangel faces in selling this trade off is the question of competing baselines. Congress operates under a current “law” baseline. If the AMT is going to expand from 5 to 25 million taxpayers next year, preventing those 20 million taxpayers from having to pay the AMT is scored as tax relief.
Taxpayers, however, operate under an “expectations” baseline. The 20 million taxpayers who didn’t pay the AMT last year do not expect to pay the AMT this year either. In their view, protecting them from the AMT isn’t tax relief, it’s the status quo.
So if Chairman Rangel successfully substitutes a 4 percent surtax for the AMT, few taxpayers are likely to give him credit for saving them from the AMT, while all the taxpayers subject to the new surtax will know just who to credit.
The tension between these two approaches is captured by two tables in the Tax Policy Center’s report. One uses Congress’ baseline and shows that only 18 percent of taxpayer’s earning between $200,000 and $500,000 will see their taxes increase, while the other uses the expectations baseline and shows that over 50 percent of those taxpayers will see a tax increase.
That’s been the challenge with the AMT all along. Some have observed that since we never intended to collect all this revenue in the first place, we shouldn’t have to offset its repeal. Given the challenge of the competing baselines and the size of the alternative surtax, this perspective is likely to get a lot more popular over the next few weeks.
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.
AMT and Corporate Tax Rates Together? Watch Out…
As we have previously reported, Chairman Charlie Rangel has a deep interest in passing a permanent “fix” to the Alternative Minimum Tax. Meanwhile, Treasury Secretary Paulson has kicked-off efforts to cut the corporate tax rate in order to make our corporations more competitive on the world stage.
Now the word on the Hill is that these two unrelated agendas may collide in the next week or two at a Ways and Means Committee hearing, and possibly at the end of the year as a massive tax reform package.
As BNA reported last week (subscription required), Chairman Rangel has indicated he might be open to cutting the corporate tax rate as part of a broader tax simplification bill to be considered later this year. As BNA noted:
“A committee hearing on corporate taxes could be scheduled later this fall. The Treasury Department has been examining the corporate tax structure as part of an effort to improve competitiveness in the global economy. Rangel said he has been considering potential changes since administration officials said a lower, more competitive rate would be advantageous.
Any changes in the corporate tax structure would come as part of a bill that would reform or possibly eliminate the alternative minimum tax. Rangel has said that measure also would expand the child tax deduction and the earned income tax credit while possibly including provisions to more than double the tax rate paid by private investment managers.”
As a group, the S Corporation Association would support a cut in the corporate tax rate. All things being equal, lower marginal tax rates are better for business, and C corporations are our suppliers, customers, partners, etc. The challenge for S corporations is that, in a pay-as-you-go environment, every dollar in tax relief to corporate America will have to be offset by a dollar tax increase on somebody else.
S corporations are already being targeted to offset part of the cost of AMT reform, either through a 4 percent surtax that would apply to all income above a certain level, including S corporation distributions, or a general increase in the rates of the higher tax brackets. Under an AMT/Corporate Rate package, the additional cost of cutting corporate tax rates would also have to be offset.
Our friends at Treasury are well aware of the important role flow-through businesses play in job creation and economic growth. They have addressed our S-Corp board meetings several times in the last couple years and we had a chance to raise this issue directly with the Secretary.
That said, when the Chairman of the Ways and Means Committee and Secretary of Treasury get together to trade notes, who knows what sort of a bargain may be struck? They don’t call it sausage making for nothing.
Congress’ Must Do List
On a related note, one of the more popular pastimes here in the nation’s capital is guessing when Congress will recess for the winter. Past adjournment dates have ranged from early October (in election years) to a couple days before Christmas.
This year looks more like the latter—it’s not an election year and there’s a long list of must-do items, including:
- Appropriations Bills: Not one (of twelve) has been sent to the President yet, and the fiscal year ends this week.
- AMT Patch: If Congress fails to extend the patch, more than 20 million new taxpayers will be added to the AMT and see their taxes go up April 15, 2008.
- Physician Payments: Medicare payments to doctors are set to be cut next year, but there’s lots of support to block the payment cuts from taking place.
- S-CHIP: The children’s health insurance program expires at the end of the week and the President has said he will veto the current version of the bill when it is sent to him.
Throw in Iraq funding, tax extenders, an energy bill, a possible corporate rate cut and other priorities, and there’s plenty to keep Congress busy right up until Christmas this year. We’re not in the business of making projections, but one senior Senate staffer told us the other day that he booked his Christmas flight home for Saturday, December 22nd.
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.
Lessons from the Failed Senate Energy Tax Package
As reported in the press, last week the Senate failed to add a sizable energy tax package to its comprehensive energy bill prior to adoption.
The Senate voted 57-36 not to end debate (60 votes are needed) on the tax package that was offered as an amendment to the broader energy bill. This vote fell short despite the fact the Finance Committee reported the package out by a bipartisan vote of 15-5 vote just a few days earlier.
While the package itself has little directly affecting S corporations, there are a couple lessons to draw from the challenge Senate leadership is having getting the package adopted.
The first lesson is there’s no such thing as a free lunch, or in this case, a free revenue raiser. The Finance-reported package would have reduced revenues by $32 billion over ten years, and the Committee had paired the revenue losing provisions with tax increases — mostly targeted at the oil and gas industries — of $32 billion. Oil and gas companies are unpopular these days. The Solar, wind, ethanol, and other renewable fuels industries are very popular. Yet, when it came time to vote, the opposition to the revenue offsets was sufficient to overcome support for the renewable tax breaks.
The second lesson is this issue, and most of the revenue raisers in question, will be back. Senate Leader Harry Reid (D-N) has already indicated he plans to bring this package back up for a vote in July, possibly as part of the expected Agriculture authorization bill. The vote on the energy tax package was very close — three votes away from closing off debate — and with four healthy Senators absent from the original vote, there’s a good chance Senator Reid will find the necessary votes.
How the other tax bills on the agenda — education, housing, children’s health insurance, AMT relief, extenders, etc — manage to offset their revenue costs is still very much in the air and something we’ll be watching closely.
Senate AMT Hearing, House AMT Plans
The Senate held a hearing on the Alternative Minimum Tax Wednesday. For AMT junkies — and really, who isn’t one at this point — the Joint Committee on Taxation has just released a really nice summary of the issue, together with some revenue estimates of several solutions.
Meanwhile, House Democrats continue their efforts to produce a permanent AMT bill by the end of July, but their words suggest they may push that deadline back to this fall. Here’s a piece from yesterday’s CongressDaily:
“There is some consideration being given to doing it after August, only because the appropriations bills haven’t moved as quickly as we thought,” Neal said before entering a meeting with Rangel, Democratic Caucus Chairman Rahm Emanuel of Illinois and Rep. Xavier Becerra, D-Calif., to discuss the committee’s plans on AMT and other issues.
Also, the article suggests that the House Democrats’ plan may have narrowed its options on how to pay for AMT reform to the surtax idea we have discussed previously.
For S corporations, this surtax presents two challenges. First, a surtax of 4 percent or so applied to AGI above a certain threshold (they appear to be looking at $500,000) would raise marginal tax rates on S corporation business income, including capital gains, dividends, and interest. Second, since the underlying rates on ordinary income, dividends, and capital gains are scheduled to increase back to their pre-2001 levels beginning in 2011, the actual tax rates S corporations could expect to pay may rise to the mid-40 percent range within the next five years! S corporations haven’t paid this high of a marginal tax rate since 1981. Meanwhile, the top tax rate on C corporations remains at 35 percent.
On the Senate side, it appears there is little appetite for taking on a permanent AMT fix. Nonetheless, whatever action the House takes will set the stage for future discussions on the AMT. Obviously, S corporations have as much at stake on its resolution as anybody.
Tax Bill Offset Tally
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.
Summary Observation
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.
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