Estate Tax & PAYGO
Of interest to S-CORP readers, the bill to be considered by the House (H.R. 2920) specifically exempts four policies from the Paygo rules:
- Adopting the doctor payment fix proposed to Medicare;
- Extending the higher exemption levels under the Alternative Minimum Tax;
- Extending select tax cuts from the 2001 and 2003 tax bills; and
- Extending the 2009 estate tax rules to 2010 and beyond.
In other words, Congress is seeking to ensure it pays for any tax cuts or spending increases, except for the four policies listed above. As the Congressional Budget Office reported, “In effect, that rule would allow the Congress to enact legislation that would increase deficits by an amount in the vicinity of $3 trillion over the 2010-2019 period without triggering a sequestration.”
The theory behind the exemption is to allow Congress room to continue “current policy” in each of these areas. The $1000 child tax credit, for example, expires at the end of 2010. Extending the credit would reduce revenues by $243 billion over ten years. H.R. 2920 shields this cost and the cost of other similar policies from Paygo.
What does this signal for estate taxes? The policy exempted in H.R. 2920 is an extension of estate tax rules for 2009. As the bill outlines:
(B) with respect to the estate and gift tax, assume that the tax rates, nominal exemption amounts, and related parameters in effect for tax year 2009 remain in effect thereafter without change;
The exempted policy is consistent with the Obama Administration’s budget proposal and was scored by the JCT to reduce revenues by $243 billion over ten years. What doesn’t get exempted is any further reduction in the estate tax beyond the 2009 rules.
For example, Members have been working on a compromise that would lower the estate tax rate to 35 percent and increase the exemption to $5 million per spouse. That’s certainly better than the 2009 levels of 45 percent and $3.5 million but, under H.R. 2920, the increased revenue reduction from the compromise would need to be offset with tax increases elsewhere.
Where would Congress find offsets to a potential estate tax compromise? Both the Obama Administration and Congressman Pomeroy (D-ND) have proposed targeting family businesses for higher taxes by inflating the value of their estates. Exactly how much revenue this would raise is unclear, but family businesses need to be on alert.
A package that lowers rates below 2009 levels while inflating the tax base has the potential to raise, not lower, estate taxes on family-owned enterprises and may be no compromise at all.
Do Small Businesses Really Create All Those Jobs?
A recent paper by Alan Viard at the American Enterprise Institute raises two fundamental questions: Are smaller firms responsible for creating a majority of new jobs in our economy and is there a bias towards smaller firms in the tax code? With small businesses at the epicenter of the debate on reforming our health care system, clearing the record on these questions is critical.
The “small businesses do not really create all those jobs” argument has been around for a long time. However, it is usually raised by folks with a history of supporting Big Government and Big Business. Thus, having someone with Alan’s background on the other side is a new twist.
Regardless of who asks the question, however, the answer is the same. Yes, small businesses really do create all those jobs. Here’s what the Small Business Administration’s (SBA) Office of Advocacy writes:
Since the mid-1990s, small businesses have created 60 to 80 percent of the net new jobs. In the most recent year with data (2005), employer firms with fewer than 500 employees created 979,102 net new jobs, or 78.9 percent. Meanwhile, large firms with 500 or more employees added 262,326 net new jobs or 21.1 percent.
Critics argue that this analysis suffers from several flaws, including how to best classify firms using longitudinal data. For example, if a firm begins at 450 employees and grows to 550, the SBA says that’s 100 jobs created by small business. But if the same firm shrinks from 550 to 450 employees the next year, it’s a loss of 100 jobs for big business. Classifying the firm based on its initial size biases the results in favor of smaller firms.
But seriously, how many firms “cross the threshold” each year? There simply are not that many firms with more than 500 employees. Adjusting for these instances may move some numbers around, but the basic tenet remains intact — businesses employing fewer folks create most of the new jobs and policymakers should pay attention.
A study from the Bureau of Labor Statistics adjusting for these statistical challenges found that firms with fewer than 500 employees created about 80 percent of net new jobs. Enough said.
The question of whether the tax code is biased towards small businesses is more difficult. The tax code, after all is incredibly complex and it does include numerous provisions — like Section 179 — targeted to help smaller enterprises. How do you tally up all the variables?
S-CORP readers may remember Dr. Viard from the LIFO debate. Alan pointed out that, if LIFO accounting is an undeserved tax windfall, why is the effective tax burden under LIFO similar to that tax burden shouldered by other forms of capital investment? How could it be a windfall if the tax burden is the same?
The same approach may work here as well. If the tax code is too small business friendly, then the effective tax burden on S corporations, partnerships, and sole proprietorships should be lower than for other taxpayers. But a study commissioned by the Small Business Administration found that the effective tax burden for small businesses (including small C corporations) in 2004 was 19.8 percent, or 3.5 points above the average for all taxpayers that year. S corporations, by the way, faced the highest effective rate of 26.9 percent.
Moreover, limiting the analysis to income and payroll taxes does small business a disservice. Home Depot doesn’t worry about the estate tax, the family-owned lumber yard down the street does. And studies show that the burden of federal regulations falls more heavily on smaller firms than larger ones.
Finally, we believe Alan’s argument misses a broader point. Your S-CORP team is not comprised of legal theorists, but we do recall that government grants corporations the same legal status as individuals in order to encourage their creation and economic growth. Corporations can enter into contracts and appear in court. Perhaps most importantly, the owners of corporations are shielded from liability.
The S corporation was created, in part, to counter the advantage the corporate structure gives to larger firms. The idea behind the S corporation was to allow smaller firms to thrive by extending some of the essentials of the corporate structure without the onerous tax rules. But S corporation rules also limit their ability to grow and raise capital. They limit the number and type of shareholder and they limit how the firm can be structured. How do these rules enter into the question of bias in the tax code?
The bottom line is that the effective tax rate on small businesses is higher than the rate for taxpayers in general. Given that reality, it’s difficult to see how small businesses are somehow advantaged. If Congress wants to help larger businesses by cutting the corporate rate, we’re all for it. But don’t forget who creates most of the jobs out there. It’s small business, and during economic downturns, the role they play is more important than ever.
Congressional Budget Takes Form
Lots of budget related news in recent days with implications for small business taxpayers. First, the Congressional Budget Office weighed in last week with its analysis of the Obama budget outline and estimated that the Administration’s proposals, if enacted intact, would double the overall deficit over the next ten years. The numbers are truly staggering and should scare any reasonable person who plans to be a taxpayer over the next several decades. Starting with a deficit of around $1.8 trillion this year — easily the highest annual deficit since we were defeating Hitler — the ten year total is nearly $10 trillion dollars!
Obviously, deficits of this magnitude will have the effect of restraining efforts to increase Federal spending while placing additional pressure on Congress to raise tax burdens. That’s challenge number one for S corporation owners.
Next, both the House and Senate Budget Committees will take up their respective budget resolutions today, with the goal of getting a final budget in place before Congress breaks for the Easter recess in a few weeks.
For those who have bothered to look, the actual text of a budget resolution is disappointing. It’s primarily a list of budget functions and related spending numbers, most of which have little or nothing to do with the real process of establishing tax and spending policy.
The real meat in any budget is the total amount of discretionary spending allowed (the Appropriations Committee gets to divide it up from there), the overall ceilings on spending and floors on revenue, any reserve funds designed to protect specific initiatives from Budget Act points of order, and finally, and perhaps most importantly, any reconciliation instructions.
Reconciliation allows permanent changes in tax and mandatory spending to be enacted with a simple majority in the Senate, and usually signals what is really important to the leadership in Congress.
This year, the Senate chose not to include any reconciliation instructions while the House included them for health care reform. Cap and trade only got a reserve fund (see below for more on cap and trade), which reinforces the growing perception around town that of the three big reforms on the table — health care, climate change, and tax reform — the Administration and Congress have decided to make health care reform their priority for this year.
Small Business Roundtable
Last week, your S-CORP team spent a morning with House Small Business Committee Chair Nydia Velazquez, several other members of the Committee, and a large percentage of the small business organizations around town.
The point of the meeting was for Committee members to hear directly from small business groups on the issues important to them. Frequently mentioned topics included estate tax reform, LIFO repeal, depreciation and several deductions that are important when businesses have little or no income. Only two groups, your S Corporation team and the National Association of Manufacturers, raised the issue of individual tax rates and how they impact job creators.
Another S-CORP ally — Bill Rys from the National Federation of Independent Business — did a great job of making the same case on MSNBC the other day:
Visit msnbc.com for Breaking News, World News, and News about the Economy
Chairwoman Velazquez has been extremely proactive in making the small business perspective part of the debate in the House, especially when it comes to tax issues. Legislation she introduced last Congress included a number of small business friendly provisions, including full repeal of the non-resident alien restriction for S corporations (a priority of the S Corp Association).
With so many tax items on the table for this year and next, we expect to see many of the topics raised last week explored by the Committee in future hearings and really appreciate the willingness of Chairwoman Velazquez to reach out and listen to the concerns of the small business community.
Climate Change Coming
There’s the old line that everybody talks about the weather but nobody ever seems to do anything about it. Apparently, our friends over at the EPA don’t understand that it’s supposed to be a joke.
Last week, they sent the White House recommendations to make an endangerment finding for greenhouse emissions under the Clean Air Act. This finding is in response to the Supreme Court decision in Massachusetts vs. EPA.
If the White House signs off on the EPA’s recommendation — and all indications are it will within the next couple months — then that agency will have the ability to regulate an enormous percentage of economic activity taking place in the United States. If whatever you are doing has the potential to emit greenhouse gases into the atmosphere, then the EPA may have something to say about it.
We usually try to stick to tax policy here at the S Corp Association, but this issue is simply too big to ignore. Plus, the solutions being considered in Congress — primarily carbon cap and trade — are market based and would have the effect of placing a tax levy on carbon emissions.
Given the choice between the EPA regulating carbon under the forty year old Clean Air Act or Congress addressing it through a cap and trade system, many folks will choose cap and trade. For that reason, the failure of the Budget Committee to reconcile instructions for a cap and trade bill this year does not mean the issue will not come up. The EPA’s action last week may ensure that it does.
Estate Tax Fix Poses Threat for Family Businesses
As we have noted, the stars appear to have aligned for a big estate tax compromise later this year, most likely to be focused on freezing the 2009 rules for at least a year. This means the current top tax rate of 45 percent and $3.5 million exclusion will stay the same for a while. But there’s lots of mischief that can take place under those broad levels.
As tax reformers will tell you, the base is just as important in determining your tax burden as the rates.
With that in mind, several S-Corp allies have pointed out legislation introduced by Congressman Pomeroy (D-ND) earlier this year — H.R. 436 — and asked us whether the base broadening included in this bill might get considered later this year. The answer is a definitive “Yes.” According to our quick read, H.R. 436 would do the following:
- Freeze the tax rate and exclusion at 45 percent and $3.5 million;
- Restore the step-up in basis;
- Restore the recapture of graduated rates; and
- Limit the use of minority discounts for family businesses.
To put the total impact of these provisions in perspective, here’s a simplified example of a family business where current rules would value the business at $7 million, but under H.R. 436 the value would be $10 million. For comparison’s sake, we included the tax burden on that estate under the rules in place in 2000, this year, in 2010 when the estate tax repeal takes place, and under the Pomeroy bill.
| 2000 | 2009 | 2010 | H.R. 436 | |
| Top Rate | 55% | 45% | 0 | 45% |
| Exclusion | $1 million | $3.5 million | NA | $3.5 million |
| Estate Tax Base/Basis | $7 million | $7 million | $650,000 | $10 million |
| Estate/Capital Gains Tax | $2.9 million | $1.45 million | $1.4 million | $2.8 million |
As you can see, eliminating planning techniques used for closely-held businesses results in an estate tax under H.R. 436 that is nearly the same as the estate tax under the pre-2001 rules, and about twice as much as the current tax.
This is obviously a simplified example that doesn’t include many of the nuances associated with estate planning. Moreover, a smaller estate would experience less of an impact from changes to the valuation rules whereas larger estates would see a substantial increase.
For both, however, changing the rules under which estates are valued seriously threatens the ability of family-held businesses to survive one generation to the next, and should be treated very carefully by policymakers.
So while business groups are focused on the rates and exclusion, we should be just as worried about proposals that would affect the base. Be prepared to see this issue gather more ink in coming months.
So What’s Next?
With Washington focused like a laser on the stimulus package for the past few months, a natural question is: “What’s next?” Your S-CORP team has been asking around, and here’s what we’ve come up with:
Energy Bill: Both the House and the Senate will consider energy legislation this year that, among other items, will include a tax title extending and modifying expiring energy tax items like the Section 45 production tax credit. Many of these popular provisions are scheduled to expire at the end of the year and need to be extended. The Senate may move as early as March on a stand-alone bill, while the House looks like it will pair traditional energy issues — a renewable electricity standard, energy efficiency standards, and tax items — with a carbon cap-and-trade bill.
Housing & Financial Services: Congress is geared up to take up President Obama’s housing plan this spring together with a rewrite of the rules governing what’s left of Wall Street and the mortgage markets. The housing plan will cost money, so we expect a tax title to offset the revenue loss.
Rangel “Mother Bill”: Remember the “Mother of All Tax Bills” introduced in 2007? It swapped the AMT for higher income tax rates, cut the corporate rate while broadening the business tax base, and targeted benefits at low and middle-income families. Word is Mr. Rangel has been redrafting and could reintroduce the package sometime this spring. Once again, his goal would be to encourage an active discussion over the future of tax code. Actual action will likely wait until 2010 or later.
Middle-Class Tax Relief: Senator Baucus has made noises about moving legislation to provide permanent middle-class tax relief. Such relief could include an effort to permanently extend the middle-income tax rates, the child tax credit, and marriage penalty relief.
Estate Tax: An estate tax compromise is on the table and likely to be considered before the kids go back to school next fall. (See above)
Health Care Reform: We expect a push to provide Americans with more health insurance options at some point this summer. While most of the bill will be focused on Medicare, Medicaid, and an expansion of health coverage, we expect changes to the current tax treatment of health benefits to be included. Swapping the current health care deduction with a tax credit would not only balance the tax treatment of health care consumption, it would also raise lots of money that could be used to expand coverage.
As you can see, Congress’ plate is full. Even if only half of these items get addressed this year, it is a full agenda with lots of opportunities for mischief.
Moreover, with the deficit approaching $2 trillion and Congress done with the $800 billion stimulus package, its focus should shift to budget neutral reforms and deficit reduction, placing even more pressure on the tax code and taxpayers.
We’ll keep watch and make sure closely-held businesses are represented.
Peering into the Future of Tax Policy
We’ve been asked to gaze into our crystal ball and see what the future of tax policy looks like. For S Corporations, it looks a lot like when the Ghost of Christmas Future popped in to see Ebenezer Scrooge. Nothing has been etched in stone yet, but it’s still not a pretty picture of things to come.
On the macro level, three factors are going to frame the tax policy debate in the next Congress:
1. All the tax relief enacted in 2001 and 2003 expires at the end of 2010. Unless Congress takes action, tax rates on individuals and flow-through businesses, the child credit, estate tax, marriage penalty, small business expensing, etc all revert to their pre-2001 levels.
2. The Alternative Minimum Tax will continue to take over the tax code. In tax year 2007, about five million taxpayers will pay AMT. Absent action, that number will rise to 25 million in 2008 and grow from there.
3. The long term budget deficit picture is bleak. Over the next five years, the federal budget actually moves towards balance. Beyond five years, however, the growth of Social Security and Medicare will crowd out all other categories of federal spending, driving up deficits to unsustainable levels.
The combination of 1 & 2 also raises the projected federal tax burden on families and businesses to historic levels. As the CBO reports:
Under the assumption that current laws and policies will remain the same, total revenues reach 20.3 percent of GDP in 2018, a level not reached since 2000, and prior to that, not since World War II.
So the baseline is higher taxes on S corporations (and everybody else) together with growing deficits. With that as the backdrop, what is likely to happen? While much depends on who controls Congress and sits in the Oval Office next year, a couple things are clear.
First, the bias is for tax rates to rise. If Congress chooses to do nothing, or even if it’s deadlocked and unable to move meaningful tax bills that take the tax code in either direction, rates are going to go up.
Second, the current obsession with “pay-as-you-go” tax policy will pressure Congress to raise rates even higher. For example, Democrats and Republicans alike are eager to extend the $1000 child tax credit and marriage penalty relief. But extending this tax relief counts against the baseline and under PAYGO would require an offset.
That’s the dilemma for PAYGO advocates. They want to extend the tax relief for middle income families, but they want to offset the associated revenue loss too.
How high is the revenue loss? The President’s recent budget submission puts the ten-year revenue loss of the child credit and marriage penalty provisions at over $300 billion—more than the cost of extending the lower rates on dividends and capital gains.
Add to that the cost of eliminating the AMT and you get a sense of just how hungry Congress is going to be for tax revenues in the next three years.
As a result, we expect there to be a big push to enact tax reform next Congress. Ways and Means Chairman Charlie Rangel plans a series of hearings on the issue in coming months and use those hearings as the basis for moving a broad reform package next Congress.
What will it look like? His “Mother” bill introduced last fall is good place to start. We previously highlighted the particular dangers this legislation poses to S corporations. In fairness to Chairman Rangel’s staff, they’ve listened to our concerns and expressed a sincere desire to continue communications. Nonetheless, the factors highlighted above would tie the hands of even the most pro-S corporation Committee. The Mother bill reflects those challenges.
For starters, it assumes all the Bush tax relief expires in 2011. It then reduces taxes (or increases refunds) for lower income families, swaps the AMT for a four-percent surtax on families and businesses earning more than $150,000, and cuts the corporate tax rate while eliminating numerous deductions used by C and S corporations alike. The net result for S corporations is higher tax rates applied to a broader base of income.
The Christmas Carol had a happy ending because Ebenezer changed his behavior and thus his future. In that regard, he had an advantage over S corporations. Ebenezer, after all, was master of his own destiny. The S corporation community must work within the legislative process.
Nonetheless, we do have the ability to influence tax policy. As an Association, we intend to continue to work with our allies to ensure Congress understands the role S corporations play in job creation and economic growth. With a new President, Congress, and tax reform on the table for 2009, this education effort is more important than ever.
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.
Death Tax Compromise Talks in Senate
At the Finance Committee markup last week on the Agriculture bill, Senator Jon Kyl (R-AZ) offered an amendment to make permanent changes to the estate tax.
The Kyl amendment would have created a new framework for future estate tax levies with a $5 million unified exemption (per spouse) and a two-tiered rate system: capital gains rates for estates up to $25 million and 30 percent rates for estates above $25 million.
In exchange for Senator Kyl withdrawing his amendment, Finance Committee Chairman Senator Max Baucus (D-MT) promised to hold hearings on the estate tax later this year followed by a markup of legislation to take place sometime next spring.
This promise from the Chairman appears to have been inevitable once the House added tax provisions to its version of the Agriculture bill—in effect turning the bill into a revenue measure eligible for additional tax provisions. Death tax coalitions have always relied on the imagery of farms and small businesses to press their case, and a farm bill with estate tax reform attached is an attractive marriage of messaging and policy.
The big question now is whether the major business groups—NFIB and the Farm Bureau to start—will actively support a potential compromise on the estate tax or hold out for full repeal. Remember, the death tax goes away completely in 2010 followed by the return of the full death tax (55 percent top rate, $1 million exemption) in 2011, so the clock is ticking for something permanent to be done.
House Defeats Permanent Death Tax Repeal
Speaking of full repeal, the House voted on full repeal of the estate tax yesterday during the floor debate over the IRS’s use of private debt collectors. The motion failed on a mostly party-line vote of 196-212. Ten Democrats joined 186 Republicans in favor of the motion.
Even if all the Republicans in the House were present and voting, the total support for repeal would have tallied just 210 votes; eight short of a majority and significantly lower than in previous years.
These simultaneous and disparate approaches on the estate tax in the House and Senate illustrate the on-going tension between estate tax opponents who are holding out for full repeal and those who advocate cutting the best deal possible given the new leadership and current political trends. The estate tax repeal effort was successful because it focused on the fundamental unfairness of the underlying tax. Given the erosion of votes in support of repeal, however, the chorus of estate tax opponents who support some sort of compromise is growing.
S Corporation Valuation Issue
Pop Quiz: Did you know that the IRS discriminates against S Corporations when it comes to estate taxes and other matters where business valuation plays a role?
Under the current IRS approach, S corporations are subject to a 60 percent or higher premium over similar C corporations when they are being valued as part of an estate. This discrimination stems from the Gross v. Commissioner case back in 1999. The effect of that decision is that, in many cases, the IRS fails to adjust the fair market value of an S corporation to reflect the business’s overall tax liability, as they do when assessing the fair market value of a C corporation.
S-Corp advisors Nancy Fannon and Chris Treharne have written extensively on the subject, including this submission to the Department of Treasury on behalf of the S Corporation Association. More recently, Chris has put together a presentation and Nancy has written a book on the subject, The Comprehensive Guide to S Corporation Valuation, both of which do a great job of laying out the entire issue.
If there is an estate tax compromise in the cards, Congress should be aware of this on-going discrimination on the part of the IRS against S corporations. S corporations do pay taxes—through their owners—and this tax burden should be reflected in their fair market value when they are part of an estate.
Treasury Holds Conference on Business Tax Issues
Treasury Secretary Hank Paulson will hold a one day conference on July 26th to focus attention on the US tax treatment of business income and how it might be improved. The conference will include a larger meeting in the Treasury Cash Room open to the press followed by at least two “break out” sessions for conference participants.
Why focus on corporate tax policy now? The Wall Street Journal, Bloomberg Markets, and other publications have recently observed how the United States’ corporate tax rate is now the highest among our major trading partners. While our corporate tax has stagnated, other countries have been cutting rates. The Wall Street Journal writes:
There’s a trend here. At least 25 developed nations have adopted Reaganite corporate income tax rate cuts since 2001. The U.S. is conspicuously not one of them. Vietnam has recently announced it is cutting its corporate rate to 25% from 28%. Singapore has approved a corporate tax cut to 18% from 20% to compete with low-tax Hong Kong’s rate of 17.5%, and Northern Ireland is making a bid to slash its corporate tax rate to 12.5% to keep pace with the same low rate in the prosperous Republic of Ireland. Even in France, of all places, new President Nicolas Sarkozy has proposed reducing the corporate tax rate to 25% from 34.4%.
What do politicians in these countries understand that the U.S. Congress doesn’t? Perhaps they’ve read “International Competitiveness for Dummies.” In each of the countries that have cut corporate tax rates this year, the motivation has been the same — to boost the nation’s attractiveness as a location for international investment. Germany’s overall rate will fall to 29.8% by 2008 from 38.7%. Remarkably, at the start of this decade Germany’s corporate tax rate was 52%.
Aside from high rates, other aspects of our corporate tax code are also blamed for hamstringing American corporations’ ability to compete, including our policy of taxing US citizens on their income worldwide, rather than just within our borders.
Flow-through businesses like S corporations and partnerships will also be addressed at the conference. Speakers and panelists will be asked to address the impact of the tax code on business formation and structure and what impact the overall tax burden has on entrepreneurial activity. Anytime tax writers get together to discuss the divergent tax treatment of C and S corporations, S-Corp members should pay attention.
The different tax treatment of C versus S corporations and partnerships parallels recent policy discussions of the treatment of hedge fund earnings. When different types of income are taxed at different rates, activity tends to flow into the activity that faces the lower tax. As CBO Director Peter Orzag observed at Wednesday’s Finance Committee hearing on hedge fund taxation:
Much of the complexity associated with the taxation of carried interest arises because of the differential between the capital gains tax rate and the ordinary income tax rate, which creates an incentive to shift income into a form classified as capital gains. Further widening of the differential between the taxation of ordinary income and of capital gains would create even stronger incentives to shift income into the tax-preferred capital form.
Those of us who know Peter can guess how he’d close the gap — raise the tax rate on capital gains and dividends. But that would increase the double tax on corporate income, exaggerate the tax gap between C and S corporations, and put additional pressure on the S corporation community to defend its current tax treatment.
There is another way to close a tax rate gap — cut them for the disadvantaged party. As the Treasury tax conference will highlight, the rest of the world is cutting tax rates and making their corporate citizens more competitive. Will the United States follow?
Illinois Governor Proposes Gross Receipts Tax!
S Corp Member Alert! Governor Blagojevich proposed last month to replace the Illinois state corporate income tax with a gross receipts tax (GRT). Under the current proposal, the state’s current 4.8% corporate income tax rate would be phased out over four years and the new GRT would be imposed on all revenues realized by IL businesses from the sale of good and services – .85% for goods and 1.95% for services. The change will increase projected annual revenue collections more than four-fold and has been characterized by the non-partisan Tax Foundation as the largest state tax increase this decade.
A massive tax increase is bad enough. But a gross receipts tax? These taxes are considered to be the most economically damaging of all taxes. As the Tax Foundation observed:
- The new tax would be problematic not only because of the additional tax burden it would impose, but also because of the way in which it would do so. Gross receipts taxes are one of the most economically damaging ways for states to extract revenue, and economists from all ends of the political spectrum are nearly unanimous in their opposition to them.
As bad as gross receipts tests are, the reasoning behind the increase is worse. Apparently, the Governor is concerned that corporate taxpayers in Illinois have seen their share of total tax burden decline over the past three decades, from about one dollar in five to one dollar in seven. Why? Because of the dramatic growth of pass-through businesses like S corporations. According to the Governor’s office, the reported number of limited partnerships, limited liability companies and S corporations grew from 94,000 in 1984 to 285,000 in 2004.
The Governor looked at the data and decided that Illinois businesses weren’t shouldering their fair share.
But S corporations (and partnerships) pay plenty of tax. They just pay through the individual income tax rather than the corporate tax. This reality has the effect of reducing measured corporate income taxes and increasing tax collections on individuals and families, making it look like businesses are paying less tax than they are.
Moreover, if the GRT is enacted, Illinois S corporation owners will still be expected to pay the 3 percent tax on their business income imposed by the state’s individual income tax. This double tax effectively puts S corporations at a disadvantage relative to traditional C corporations in Illinois, and is patently unfair.
We will keep you updated as we learn more. If you have a business in Illinois, let us know. We’ll help you fight this unwise and unfair tax increase on Illinois businesses.
Small Business Tax Package Passes Senate for Second Time
It’s getting so you can’t tell the tax bills without a program. The Small Business Tax package that includes the S Corporation Reform tax title has been adopted by the Senate for the second time, this time as a Baucus/Grassley amendment to the Iraqi War supplemental.
An earlier version of this package was adopted as part of the effort to raise the minimum wage. Differences between the House and the Senate stalled that bill, and the House attached its version to the supplemental as a means of breaking the stalemate. What happens now is unclear. The supplemental is likely to be vetoed in its current form, while the minimum wage package is being held up in the Senate pending Senate Republicans demand of a pre-negotiated agreement over what the final bill will contain.
The S Corporation Association has weighed in strong support of these improvements to the rules under which S corporations operate. Our Chairman has written a letter of support to the tax writers, we have organized a coalition of business groups to support the provisions, our champions in the Senate have weighed in with their leadership, and our S corporation members have met with their Senators and Representatives to build support for these helpful reforms, including S Corp priorities of reducing the impact of the Sting Tax and expanding the ownership pool for S corporations.
In addition to the Baucus/Grassley amendment, S Corp Champions Senators Smith and Coleman have filed an amendment to harmonize all the effective dates for the S corporation provisions to January 1st, 2007. If our members are going to pay higher labor costs in 2007, it makes sense for all of the offsetting tax relief to begin this year as well.
Despite the current logjam, your S Corp team is confident that these reforms will wind up on the President’s desk this year, in a form that he can sign into law. In the meantime, we’ll keep advocating for these and more. Your advocacy is welcome as always.
Cato on Tax Gap
Cato’s Dan Mitchell has written an excellent summary of the tax gap issue, noting among other things that the U.S. enjoys the smallest shadow economy of any of our major competitors. As Dan writes:
“By global standards, the United States has very little tax evasion. According to the world’s leading expert, Friedrich Schneider of Austria’s Johannes Kepler University, the U.S. shadow economy accounts for just 8 percent of gross domestic product, which compares to an average of 16 percent for 21 major industrial countries he examined. Indeed, Schneider finds that the United States has the smallest shadow economy of 145 nations analyzed.
A comparatively modest tax burden is perhaps the main reason why American taxpayers are less likely to evade taxes than are their foreign counterparts. Table 1 shows that lower-tax nations such as the United States, Singapore, and Switzerland have the least tax evasion. With lower tax burdens, taxpayers have less incentive to hide their money from tax authorities.
However, some U.S. taxes have high marginal rates, which undermines compliance. One study found that a 1 percentage point increase in marginal tax rates is associated with a 1.4 percentage point increase in the underground economy.”
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