With the Republican convention behind us and the Democratic one this week, we thought it would be worthwhile to assess what the business community can expect on taxes in the next six months. We break the outlook into three buckets:
- First, the need to extend the tax policies set to expire on January 1;
- Second, the need to make more fundamental changes to the tax code; and
- Third, what to do about those pesky tax “extenders”?
2001 & 2003 Tax Cuts
Bucket one is easiest, since both sides have outlined their positions. The Republican House adopted legislation to generally extend all the 2001 and 2003 tax policies for one year (together with expedited consideration of broader tax reform). One big deviation from previous Republican actions was the decision to extend current estate tax rules ($5 million and 35 percent top rate) rather than the repeal included in the original 2001 legislation.
Senate Democrats countered with legislation (which failed to muster the necessary 60 votes) to extend the middle-class portions of the 2001 and 2003 tax relief only. Investors, business owners, and income-earners making more than $250,000 ($200, 000 for single filers) would see their taxes go up. An exception in the Senate bill was the dividend rate, which would rise to 20 percent rather than the 39.6 percent rate called for under current law. Also, current estate tax rules were not extended, meaning the top rate would revert back to 55 percent next year coupled with a lower, $1 million exemption.
(Neither the House nor the Senate bill addressed the pending new 3.8 percent tax on investment income enacted as part of the health care reform, by the way.)
As to the outlook, the odds of either side prevailing in this fight depend heavily on the election outcome. The election won’t change any votes before next year — the President and Congressional leadership will stay the same — but moral authority plays a key role in moving legislation in lame duck sessions, so, if either side can declare a conclusive electoral victory, their respective position will gain momentum. That’s the positive outlook for action.
Inaction is also possible, however, and should be taken seriously. Several Senate Democrats are already on record arguing against taking any action this year — they say the fiscal cliff is more of a fiscal slope and that there will be time to address these issues in early 2013. Meanwhile, it’s difficult to see how House Republicans accept the Senate position and proactively vote for legislation that raises tax rates on anyone in this political and economic environment.
It’s also difficult to see how President Obama pivots off his current position and signs into a law a comprehensive extension. Finally, the inability or unwillingness of Senate Majority Leader Harry Reid to successfully move large, complex bills in the Senate is a particular challenge and should not be discounted.
For those reasons, we believe a Republican victory in November will signal that Congress will adopt something very close to the House bill — a one-year extension of everything coupled with some sort of expedited reform process — or, if the Senate and President stand firm, do nothing at all. If Democrats prevail, then the likely outcomes shift to either the Senate-debated position of extending just the middle-class relief or, if the House refuses to go along, nothing at all. So, regardless of who wins in November, there’s an even chance nothing gets done.
Additional variables that could affect the outcome include the pending sequestration cuts to defense and the strength of the economy. The worse the economy does, the more likely it is that Congress takes action, and vice versa. Meanwhile, the push by hawks and conservatives to stop the pending cuts to defense could result in them giving in other areas, including tax policy. Something to keep an eye on.
Bucket two includes tax reform or changes to the tax code broad enough that they look like tax reform. We believe there’s a good chance Congress will act on such a package beginning early next year for the following reasons:
- It will need to raise the debt limit (again);
- There’s broad agreement that the deficit needs to be addressed;
- There’s agreement that our corporate rate is too high; and
- The annual game of extending all these tax provisions, including rates, the AMT patch, estate tax parameters, and traditional extenders is simply unsustainable and needs to end.
Put another way, Congress will need to raise the debt ceiling sometime early in 2013. To get the House on board, significant spending cuts will need to be part of the package, just like in 2011. To gather additional support, particularly in the Senate, taxes will also need to be part of the package. This tax package could be budget neutral, or it could raise significant levels of revenue. The elections will largely determine that mix.
Let’s say the President and Congressional leaders agree to raise the debt limit coupled with $4 trillion in deficit reduction over the next ten years. An Obama Administration and Democrat-run Senate might seek a 50-50 package of spending cuts and tax increases. A Romney Administration coupled with a Republican Senate might shoot for 100 percent spending cuts. Compromises necessary to move the package through the Congress under either scenario would argue that the final package will fall somewhere in between.
What sort of base-broadening might apply? Likely groupings include:
- Previously targeted business tax items like LIFO, Section 199, and carried interest;
- Traditional extenders that fail to gain sufficient support; and
- Individual tax expenditures, including at least some portion of the exemption for employer-provided health insurance.
So, broad tax changes are likely to be on the table in 2013. A revenue-neutral package would broaden the tax base by eliminating certain tax expenditures and unpopular provisions and use all those revenues to cut rates, while a tax-increasing package would do the same, but cut rates to a lesser degree. As long as the House remains in Republican hands, a package that actually raises headline rates is highly unlikely.
Could Congress get through 2013 without considering broad tax legislation? It’s unlikely but possible, particularly if the Senate remains under Democratic control. The Senate has refused to act in other critical areas in recent years, like doing a budget. But just as the debt ceiling fight forced the Senate’s hand in 2011, we expect the same dynamic to play out in 2013. A budget resolution is optional; raising the debt ceiling is not.
Bucket three is the large list of tax extenders, many of which already expired at the beginning of the year. Both the Ways and Means and Finance Committees have taken action to define and adopt a package of tax extenders in recent months, but the ultimate outcome remains unclear.
Just prior to the August break, the Senate Finance Committee adopted legislation to extend a package of expired or expiring tax extenders through 2013. The $205 billion package includes a two-year AMT patch together with an extension of the state sales tax deduction, the higher Section 179 expensing amounts, the R&E tax credit, and the energy production credit and other energy incentives, among other items. Importantly for Washington Wire readers, the package also extends built-in gains tax relief and the basis adjustment for S corporations making charitable contributions of property. The Committee report and legislative language were released last week.
In a foreshadowing of the fight to come this fall, Committee leaders noted that their extender package deleted 20 provisions from extender packages of prior years, while several dissenting Republicans argued that the Committee should have gone further and that they look forward to further reducing the list as part of comprehensive tax reform. Senate leaders are hopeful to consider this legislation on the Senate floor in the few remaining legislative days before the November election, but it’s a full schedule already with only a few days of session.
On the House side, the Ways and Means Committee began their examination of tax extenders back in April, when members had the opportunity to advocate on behalf of their favorite extenders. In June, a panel of tax experts testified on which is the best framework to test each extender provision and eliminate those that fall short. It is unclear if the Select Revenue Subcommittee will hold another hearing in September, but Subcommittee Chairman Pat Tiberi (R-OH) was reported as noting that the House will not act on its version of an extender package until after the November elections, not before.
At that point, the tension between considering an extenders package separately this year or rolling these decisions into a broader tax reform package will have to be addressed. Given that Congress also will face the broader issues of the 2001/2003 tax cuts, sequestration cuts, the FY2013 appropriations process and the rest of the congressional kitchen sink, there’s not a lot of time and continued broad disagreement over direction.
For that reason, we believe it is fifty-fifty that Congress acts on extenders this year, with success most likely tied not to policy, but rather to whether Congress is able to move on some of these other fiscal matters. Movement in those areas would suggest an agreement over extenders is also possible, while a stalemate on the 2001/2003 cuts, spending and sequestration might bleed into the extender debate.
Just to be clear, this is our outlook, but it’s not our preference. Here at S-CORP, our fingers are crossed that Congress returns after the election and resolves all of these critical tax questions. For the business sector, action and clarity are better than inaction and uncertainty, so let’s hope this year’s lame duck session does not live up to its name and is instead positive and productive.
The Senate began debate on the bloated tax extender package today. The House passed its version 215-204 shortly before leaving for the Memorial Day recess on May 28th.
That vote was supposed to take place earlier in May, leaving time for the Senate to take action, but opposition to the tax hikes and higher deficits called for in the bill delayed consideration until the Leadership was able to cobble together the votes. As a result, the Senate had already left town and is just now taking up the bill today.
Regarding the schedule, Senator Reid faces a tight window to get the bill done: he needs every Democrat plus at least one Republican to move this, but Senator Lincoln (D-AR) is back in Arkansas for today’s run-off tomorrow and won’t be available until tomorrow.
Meanwhile, there are no votes on Friday or next Monday and debate on Senator Murkowski’s Resolution of Disapproval (climate change) is set to consume much of Thursday.
That basically leaves Wednesday as the only day this week where Senator Reid might have the votes to move the process along, and it’s apparent from the news today that he’s not there yet. Senator Snowe (R-ME), a long-time S-CORP champion, indicated as much to CongressDaily:
Snowe said on Monday she was still waiting to see details. But she said the combination of deficit spending and tax increases, such as a new 15 percent payroll tax on small services-providers organized as “subchapter S” corporations, were giving her pause. “Pretty far from it at this point,” Snowe said, when asked about her comfort level with the bill, adding that it was unlikely to pass this week.
On the policy side, the delay in the House has been a boon for good tax policy, since the longer this payroll tax provision is out there, the worse it appears. Swapping a “reasonable compensation” standard for a “principal asset” test is not an improvement to the Tax Code. Exactly how is the IRS supposed to enforce an annual valuation of the “skill and reputation” of a firm’s three key employees?
Tom Nichols, a long-time S corporation attorney and head of the ABA’s Tax Section on S Corporations penned a letter to Congress making this point and many others. Meanwhile, the blogs of tax practitioners across the country are beginning to weigh in, raising numerous concerns that should have been dealt with through the normal legislative process — except there wasn’t one. The blog Tax Prof has links to a long list of critical commentators. As one observed:
But even assuming that you should hit service providers with self-employment tax on all of their K-1 income, you should do so in a way that is fair, understandable to taxpayers, and enforceable by the IRS. The S corporation provision in H.R. 4213 is none of these.
The Senate being the Senate, we expect this issue to be debated into the next week at least, and we plan to use that time to educate policymakers and improve the bill. There are taxpayers out there that use the S corporation to block payroll taxes they otherwise owe, and we support going after them, either through increased use of the “reasonable compensation” standard by the IRS or though a well-thought and well-targeted statutory provision. The provision before the Senate right now doesn’t meet that test.
Reasonable Compensation Standard in Action
Speaking of the “reasonable compensation” standard, the following post showed up in BNA this morning–as it makes clear, the IRS can and does go after payroll tax scofflaws using the “reasonable compensation” standard:
The U.S. District Court for the Southern District of Iowa May 27 held that David E. Watson P.C. must pay employment taxes on “all remuneration for employment.” David Watson incorporated an accounting firm as an Iowa professional corporation and chose to be taxed as an S corporation. Watson authorized himself a salary of $24,000 a year and he paid federal employment taxes on that amount. In addition to his salary, Watson received more than $200,000 in what he claimed were dividend payments. The Internal Revenue Service determined the dividend distributions should be recharacterized as wages, subject to employment taxes. (David E. Watson PC v. United States)
A fair reading of the House-passed bill is that the new, untested “principal asset” test for S corporations would be much more difficult for the IRS to enforce than the existing standard being used here. It would also be more costly for firms, as they would be required to value all their assets every year to determine if they are subject to the new tax. In order to enforce this new rule, the IRS would need to do the same.
The bill is now before the Senate, which has a reputation for debate and deliberation. We are hoping they expend a little deliberation on this provision. It could use it.
At the employer level, that means if an employer used to offer his employees a $30,000 package of health benefits, he will now offer them a $21,000 plan and pay the remaining $9,000 to them in the form of wages and non-health benefits. These extra wages, in turn, are subject to income and payroll taxes, resulting in higher tax collections by the federal government. The revenues raised from the excise tax come from higher income and payroll taxes on employees, not from excise taxes on insurance companies.
It’s this aspect of the Senate plan that has unions united in opposition. The excise tax is coupled with a refundable tax credit available to families making less than 400 percent of the federal poverty level (about $88,000 for a family of four). But many union members make more than that while most union members enjoy health insurance benefits that exceed the Baucus threshold. So for many union members, the Baucus plan would reduce their health benefits and raise their income and payroll taxes, but exclude them from the refundable tax credit.
What about S Corporations? How would they be impacted? Here’s chart we put together:
|Earns More than 400% FPL||Earns Less Than 400% FPL|
|Has High Cost Plan||Taxes Are Higher||Mixed|
|Has Low Cost Plan||Not Affected*||Taxes Are Lower*|
Estate Tax Update
We expect Round 1 in the great estate tax battle to take place this fall/winter. The tax goes away in 2010, and then returns in full form in 2011, giving just about everybody a reason to come to the table.
In preparation for this debate, forty-six trade associations, including your S Corporation Association, the Chamber of Commerce, NIFB, and the National Association of Manufacturers sent a letter to Congress urging them to support a permanent estate tax fix that includes a 35 percent top rate and a $5 million per spouse exclusion.
As Martin Vaughn of Dow Jones reported:
The groups said they will support a permanent rate of 35%, with the first $5 million of wealth exempted, and up to $10 million in the case of married couples. Those are the terms that are being pushed in the Senate by Sens. Jon Kyl, R-Ariz., and Blanche Lincoln, D-Ark.
On timing, the expectation continues to be that Congress will take up legislation to extend certain expiring tax provisions before the end of the year, and that the estate tax fix will be made part of that bill.
Tax Reform Panel Report Update
Remember the President’s Economic Recovery Board headed by Paul Volcker? The President announced its creation at the beginning of the year but it’s been quiet since then. The principle reasons for this silence are federal sunshine laws that require any gathering to be open to the public. It is hard to provide the President with critical insights into how to fix the economy when the whole world’s watching.
One offshoot of the Board that has been active is the White House Tax Reform Panel. They had their first (and last?) public meeting last week, chaired by CEA Member Austan Goolsbee. During the meeting, Goolsbee made clear that the Panel was not seeking to create a new tax system but rather would focus its recommendations on three specific areas — tax simplification, enforcement and corporate tax reform. The panel is accepting public comments through October 15th and then will make its own recommendations known to Treasury Secretary Geithner by December 4th.
In the past, it has been easy to dismiss the work of presidential or congressional tax reform panels. They tend to come and go, after all, with little to show for their efforts. This time, however, the combination of huge deficits and an expiring tax code make some sort of dramatic changes to the tax code almost a certainty. Given the landscape, we intend to follow the efforts of this group closely.
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.
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.
Two weeks ago, the Senate Finance Committee released its summary of options to pay for health care reform. As expected, the list was long and could be divided up any number of ways. One item missing from the list, however, is a source of revenue folks are talking about for health care reform and other spending priorities too — a value added tax (VAT).
The Finance Committee summary followed the release of papers on improving health care delivery and expanding coverage. The key to all three papers is that, while they give the reader a sense of where the Committee is headed, the exact plan remains shaded by options and generalities. So are the costs.
Exactly how much will health care reform cost? Some advocates — including the Obama Administration’s top economists — argue that a properly structured plan would save the taxpayer money, but that’s mere rhetoric. Expanding health care coverage to more Americans will cost money. Lots of it.
That’s why President Obama’s budget set aside $326 billion in tax increases to help pay for health care reform, but that may not be enough. Most observers believe the ultimate price tag will be several times higher while many of President Obama’s proposed pay-fors are simply non-starters with Congress. Enter the latest idea of a pay-for — the value-added tax. The Washington Post reported last week:
With budget deficits soaring and President Obama pushing a trillion-dollar plus expansion of health coverage, Some Washington policymakers are taking a fresh look at a money-making idea long considered politically taboo: a national sales tax… A recent flurry of books and papers on the subject is attracting genuine, if furtive, interest in Congress. And last month, after wrestling with the White House over the massive deficits projected under Obama’s policies, the chairman of the Senate Budget Committee declared that a VAT should be part of the debate.
The story points out that, in addition to several well-placed congressional advocates, there are a few folks within the Obama Administration who support a VAT, such as Office of Management and Budget health advisor Ezekiel Emanuel (who also happens to be White House Chief of Staff Rahm Emanuel’s brother).
While this proposal is clearly far from becoming a reality, it is indicative of just how hungry Washington is for money these days that perhaps the most feared of all taxes — the VAT — is being floated as a possible revenue source.
How Progressive is Progressive?
The American economy is remarkably dynamic, with a large percentage of folks moving from one income group to another every couple years. This movement is often the product of life-cycle earnings, where workers earn little when they start out and then slowly increase their incomes until they reach their peak earnings years of around 40 to 65.
It stands to reason that mature job-creating businesses are highly profitable too. If they are structured as S corporations, then their income is subject to the effective tax rates illustrated above. Something to think about as the unemployment rates approaches 10 percent.
Canada Runs Surpluses
Who knew Canada was running surpluses these days? How did they do it?
First, they cut spending at the Federal level from more than half of their national income to less than 40 percent. That, in turn, produced budget surpluses that were used to pay down their national debt.
What’s the lesson here for S corporations? While Congress and the new Administration search the tax code for new revenues to offset new spending and reduce the deficit, the experience of Canada and others demonstrates that deficit reduction begins with spending restraint — not tax increases.
Good news for S corporations! S-CORP allies Senator Blanche Lincoln (D-AR) and Orrin Hatch (R-UT) today introduced the “S Corporation Modernization Act of 2009.” This legislation is similar to bills offered in previous Congresses and includes many of our Association’s priorities for the year. In a statement accompanying the bill, Senator Lincoln noted:“A strong economic recovery will depend on the health and strength of our small business sector,” Lincoln said. “Over four million of our small businesses across the nation are organized as S corporations, including more than 40,000 in Arkansas, and at least 60 percent of the new jobs created over the last decade have come from small businesses. Congress has not updated many of the rules governing S corporations, and as a result many privately-held businesses are not ideally positioned to deal with the current downturn in the economy. We must modify our outdated rules so that these businesses that are starved for capital have the means to expand and create jobs.”
The bill is designed to update and simplify S corporation rules — some that date back 50 years — to make it easier for these small and closely-held businesses to raise capital and compete in a difficult economy. The “S Corporation Modernization Act” would:
• Enhance the ability of S corporations to attract and raise capital;
• Make it easier for family-owned S corporations to stay in the family; and
• Encourage additional charitable giving by S corporations and the trusts that hold them.
The whole S-Corp team thanks Senators Lincoln and Hatch for continuing their support of America’s small and closely-held businesses and we look forward to working with them to get these important reforms enacted into law this Congress!
More S Corps than Ever!
Just in time for our advocacy of the S Corporation Modernization Act, our friends at Statistics of Income have published their taxpayer Data Book for 2008 and guess what?
For 2008, there were nearly 4.4 million S corporations, an increase of more than 300,000 firms from 2007 and 1.7 million more than just 10 years ago.
Now if the SOI folks would only update their more in-depth “S Corporation Returns” study, we could dive into these numbers and get a better sense of the source of this growth. The most recent study is from 2003, and newer analysis is long overdue.
Obama Administration’s Tax Hikes
This week President Obama released the details of his proposals to raise taxes on multinational corporations. The two main components of the plan are new limits on deferral and the foreign tax credit and additional enforcement tools targeted at overseas “tax havens.”
Reaction on Capitol Hill was somewhat underwhelming. Senate Finance Committee Chairman Max Baucus (D-MT) referred to the proposals as “controversial,” and noted, “We’ll look at it. I don’t know how much is going to be enacted this year.” Despite this less than glowing review, we do expect some form of the President’s proposal to move through the Congress this year — their need for new revenues is just that strong.
What about S corporations? These proposals do not directly affect S corporations, but they are a worrisome indicator of the Obama Administration’s overall approach to business taxation. This Administration is looking to the business community to raise the tax revenues. During his press conference yesterday, Obama decried the “broken tax system, written by well-connected lobbyists on behalf of well-heeled interests and individuals. It’s a tax code full of corporate loopholes that makes it perfectly legal for companies to avoid paying their fair share.”
But businesses don’t pay taxes — people do — and the burden of raising taxes on corporations will fall primarily on the workers of those companies. Capital can and does move from one country to the next. For workers, it is just a little more difficult. It’s more difficult for S corporations too.
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.
|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.
Following a closed-door planning session today of members of the Senate Finance Committee, we expect the Committee will mark-up the tax portions of a stimulus package as early as January 22nd. As we indicated previously, committee members are committed to exerting their jurisdiction over the tax portions of the package. Moreover, there appears to be a growing debate over certain provisions in the Obama plans. As Dow Jones reports this afternoon:
“When asked about specific tax cut proposals made by Obama, Kerry said, “I think there are cuts that are not going to stand the test of whether they will create jobs. Coming in for specific criticism were an Obama plan to give companies a $3,000 tax credit to offset the cost of new hires, and a $500 tax credit for workers that would be spread out over a period of time in take-home pay. “Is a $3,000 tax credit going to get you to hire somebody to build cars that nobody’s buying?” asked Sen. Kent Conrad, D-N.D., speaking to reporters after the committee meeting.”
Exactly what replaces those unpopular tax cuts — more tax relief or more spending — is an open question. Let’s hope it’s more tax relief for businesses. Having both the Ways and Means and Finance Committee members weigh in on the stimulus package, however, gives our S corporation allies a better chance to make the package more small business friendly, especially with regard to built-in gains reform. We expect the Ways and Means Committee to also hold a mark-up as early as the week of the inauguration. S-CORP In the News
Speaking of small business tax relief, the Baltimore Sun published an op-ed by S-CORP Executive Director Brian Reardon highlighting the history of the small business corporation and outlining how Congress can best help ensure the small business community is adequately armed to respond to the on-going economic recession:
What should Congress do? First, follow President-elect Obama’s lead and make small business tax relief the center of any economic stimulus plan. Relief that increases small business’ access to capital would be especially timely. For S corporations, the tax code forces many of them to sit on appreciated assets rather than sell them and put the money to better use. Another rule prohibits them from accepting direct foreign investment. Changing these out-of-date rules would free up capital and encourage new business formation.
Second, keep the rates on small business income low – certainly no higher than what large corporations pay. Actions like these would signal to millions of small businesses that they will not be punished to pay for the excesses of Wall Street, which should make it easier for them to grow their businesses and create jobs.
New Members on Ways and Means
The House Ways and Means Committee for the 111th Congress is now complete, with both Democrats and Republicans announcing their final additions to the committee. House Republicans had six seats to fill and announced their selections yesterday. New members include:
Rep. Charles Boustany (LA-07)
Rep. Ginny Brown-Waite (FL-05)
Rep. Geoff Davis (KY-04)
Rep. Dean Heller (NV-02)
Rep. David Reichert (WA-08)
Rep. Pete Roskam (IL-06)
Earlier this week House Democrats filled their one remaining spot on the Ways and Means Committee with the selection of Linda Sanchez (D-CA), after Representative Raul Grijalva (D-AZ) turned down the position in December. Combined with the Democrats’ earlier additions, that’s a total of 11 new members for the tax-writing Committee.
You can bet your S-CORP team will be reaching out to new and old members alike in coming weeks. Small business tax relief is on the table, and we need to get the message out.
The ongoing soap opera of the auto bailout continues, with Congress failing to find a means of balancing the needs of Detroit with the concerns of taxpayers and Senate Republicans. As a result, the bailout stalled in the Senate last week and the Administration appears poised to step in and use whatever authority it has — TARP, Treasury, Fed — to provide the companies with the liquidity necessary to survive into the New Year and the next Administration. A nice little Christmas present for the Obama economic team, indeed.
Whatever happens, what is clear is that the plight of Detroit will continue into next year and will provide yet another catalyst for a major stimulus package early next Congress. Just how early may surprise folks.
The Senate Finance Committee reportedly plans to begin formal consideration of a stimulus package January 8th, twelve days before President-elect Obama is sworn in. According to our friends at Dow Jones:
The package is expected to include between $600 billion and $700 billion to jump-start the economy, and congressional leaders say they want to pass it before President-elect Barack Obama takes office Jan. 20.
For those of us focused on the tax code, that means the next vehicle for tax provisions will be drafted over the next couple weeks. How much of the package will be devoted to tax relief?
The panel’s chairman, Sen. Max Baucus, D-Mont., said in a news conference last week that tax cuts for businesses and individuals could comprise as much as half of the package. U.S. House Speaker Nancy Pelosi on Monday estimated the tax portion of the package at closer to one-third.
With that time table in mind and with tax policies on the table, we’re working with our allies on the Hill to ensure that S corporation changes to the built-in gains rules are considered as part of this package. If the economy needs capital, S corporations are sitting on lots of it, and BIG relief would help put it to work. Our Hill champions are working the issue, armed with a letter from our association allies as well as a statement of support from four Senators to their leadership.
New Taxwriters Selected
The combination of Democratic gains and lots of retirees means the Ways and Means Committee will be welcoming at least eleven new faces when it reconvenes for the 111th Congress. Democratic gains shifted the ratio of the overall House close to two-thirds/one third, so Democrats last week set the new ratio of Members on the Committee at 26 Democrats to 15 Republicans — up from 24-17 in the 110th Congress — and selected four of the five new members necessary to fill the seats. New Democratic Members include:
Rep. Danny Davis (IL)
Rep. Bob Etheridge (NC)
Rep. John Yarmuth (KY)
Rep. Brian Higgins (NY)
Note: One of the seats was offered to Rep. Raul Grijalva (AZ) but apparently he turned it down, so an additional name will have to be selected. On the Republican side, Representative Dave Camp (R-MI) was selected Ranking Member following the retirement of current Ranking Member Jim McCrery (R-LA). Republicans did not make any other committee membership decisions but rather put off the appointment of six new members to fill the vacancies when Congress returns in January.
On the Senate side, the report is the same as just after the election, with leadership waiting to see how the election in Minnesota goes before setting committee ratios and picking new members. One new development is President Obama’s selection of Senator Ken Salazar (D-CO) to be Secretary of Interior. His departure from the Finance Committee means Democrats will likely have two new members on the committee next year rather than just one.
Estate Tax Update
We’ve forecast that one of the few tax challenges likely to get addressed in 2009 will be some sort of deal on the estate tax. As readers know, the estate tax is scheduled to go out of existence in 2010 only to return from the grave the following year, looking very much like the youthful and hungry estate tax of the year 2000. This repeal and restoration routine gives both sides a strong incentive to come to a compromise — estate tax apologists don’t want to face its repeal in 2010 and estate tax critics don’t want to see its resurrection in 2011.
We noticed that Len Burman over at the left-leaning Tax Policy Center agrees. In an open letter to President-elect Obama, he raises the red flag over the pending estate tax repeal from the pro-estate tax perspective:
One more thing. You probably want to fix the estate tax before the end of 2009. Otherwise, the tax disappears for only a year in 2010, returning in full force in 2011. We just don’t want to see how greedy potential heirs would respond to the incentives created by a one-year “death tax” holiday…
Yeah, Len just wants to make the world safe from greedy heirs. Thanks. Setting aside the obvious question of who’s greedier — individuals with money or policy makers who want to take it from them — his point just reinforces our notion that the estate tax is going to be front and center of policymakers come next summer.