President’s Budget is Good for S Corporations—Too Bad Congress will Ignore It
The President’s fiscal year 2009 budget was released this morning together with the “Blue Book” describing his proposed tax policies. Here are a couple thoughts as Congress begins the process of putting together its tax and spending bills for the coming year.
First, the whole process of the President’s budget has a strong element of unfairness to it. For the past three decades, every President has put together a comprehensive annual budget and sent it up to the Hill. And every February, whoever runs the Congress immediately labels it DOA, or “Dead on Arrival.”
The unfairness is that Congress mandates that the President put together a budget each year—it’s required under the 1974 Budget Act. So Congress demands the President produce a budget and then promptly ignores it for the rest of the legislative session. Such is the life of the staff over at the Office of Budget and Management.
This routine is too bad for S corporations—this particular budget is decidedly pro-small business. It calls for extending tax relief, including the lower rates and estate tax repeal. It asks Congress to increase the Section 179 small business expensing limits. And it would extend the relief from the Alternative Minimum Tax that many S corporation shareholders pay for another year.
On the other hand, the new budget reveals a couple more macro trends that will be hard for Congress to ignore. First, the deficit picture has gotten decidedly bleaker. In recent years, the deficit peaked in 2004 at $412 billion dollars and declined in each of the succeeding years, falling to $162 billion in 2007. The weakening economy and lower corporate tax collections are expected to reverse that positive trend in 2008, resulting in a predicted $410 billion deficit.
Second, the cost of making the President’s tax relief permanent is growing. According to the budget, simply extending the lower tax rates on wages and investment will reduce revenues by over $1.3 trillion. Extending all the tax relief, including the repeal of the estate tax, would reduce revenues by nearly $2.2 trillion over the 10-year budget window.
For S corporations, neither is particularly good news. The rate relief is very much in the interest of our members, since all 3.8 million S corporations pay their taxes according to the individual, rather than corporate, tax rate schedules. As the cost of extending the lower rates rises, the likelihood that they expire or are pared back increases as well.
Second, rising deficits mean more focus on the so-called “tax gap” and those policies that promise to close it. Where is the Administration and Congress going to look? Of the $36 billion of proposals to “Improve Tax Compliance” in the President’s budget, nearly all are directed at individuals, small businesses, and independent contractors.
So, once again, the challenge for S corporations in 2008 will be to preserve our victories over the past decade and seek to improve the rules under which we operate, all while fighting off unfair tax increases put forward under the guise of closing the “tax gap.”
Stimulus Package and Other Tax Priorities The Senate will hold a series of votes on the stimulus package on Wednesday. While the ultimate outcome of those votes is unclear, we do expect the House and the Senate to agree to a stimulus package in short order—in the next week or so—and send something to the President that he will be willing to sign. The core components of a likely deal remain the same—checks to families, increased but temporary write-offs for businesses, and loosened restrictions for qualifying mortgages.
Once that bill is completed, congressional tax writers will need to turn their focus to a list of “must-do” items that will look eerily familiar to those of us who followed last year’s tortured process—tax extenders (including those like the R&E tax credit that expired last year), another AMT patch, and new and existing renewable energy tax provisions.
For the AMT and regular extenders, the outlook is as clear as mud. The same challenges that faced Congress last year remain. First, should Congress offset the revenue impact of extending these tax provisions and, second, if they do choose to offset them, where will the tax writers come up with $100 billion or so in tax increases that the House, the Senate, and the President (considering his State of the Union threat to veto all tax increases) can all agree to? Given the stalemate that confronted this question last year, another lame duck session to resolve this issue is looking increasingly likely.
On the energy front, the decision by the Senate Finance Committee to include the non-farm renewable energy tax provisions in the stimulus package indicates that they intend to include the farm-related tax provisions on the farm bill. These provisions—including the ethanol and biodiesel tax incentives—are being used as leverage to get the complicated agriculture bill out of conference and on to the President’s desk.
The challenge with that bill, as with so many legislative items, is the desire by congressional leadership to offset the cost of increasing farm payments by raising taxes. The current farm program’s authorization expires March 15th, so some sort of resolution to this issue will have to be attempted in the next six weeks. Otherwise, expect another short-term extension of existing farm programs.
Accountants Weigh in on Tax Gap
First, the “Big Four” accounting firms weighed in on the Tax Gap. Now, the American Institute of Certified Public Accountants, the trade association for the accounting community, has added its input.
While only 1.3 percent of accountants believe that honest errors are the main source of the Tax Gap — no surprise there, since these are the same folks who prepare our taxes — nearly half suggested the small business community was responsible for the underpayment of the remainder of taxes owed.
The survey is on their website, but just one more reason for the small business community, and S corporations in particular, to be concerned.
Should S Corps Worry about Taxing Hedge Funds?
As you may have heard, both the House and the Senate are taking a hard look at how hedge funds are taxed. The concern is that wealthy hedge fund managers are subject to lower tax rates than most middle class families.
Hedge funds make their money generally through a 1 to 2 percent management fee plus a 20 percent share of any trading profits. This 20 percent “carried interest” is treated as a capital gain and is currently taxed at a top rate of 15 percent. Congress is considering treating carried interest as regular income, which would be taxed at rates up to 35 percent.
How much money is at stake?
According to the Managed Funds Association, there are approximately 8,000 hedge funds with total assets of about $1.2 trillion dollars. If the funds make an average rate of return of 10 percent, then the carried interest earned by hedge fund managers would be about $25 billion a year (20 percent of $120 billion in earnings). Raising the tax rate from 15 to 35 percent on $25 billion would raise $5 billion a year.
Even in Washington, that’s a lot of money.
Should S corporations care? As far as we know, there are no S corporation hedge funds. At its very core, however, the issue before Congress touches on the very difficult question of separating capital income from labor income. Here’s an example:
Two investors partner with a famous chef to start a restaurant. The investors put up money, while the chef puts up his name and reputation. Each receives one-third ownership in the venture. If they sell the restaurant for a profit ten years later, the gain from the sale is treated as a capital gain for federal tax purposes — even the chef’s share.
Although the chef did not put up any money, his investment is considered to be the reputation he has as a chef. Moreover, the gain on the sale of the restaurant was not guaranteed. If the venture failed, the investors would have lost their money, and the chef would have lost his reputation.
Carried interest received by hedge funds has similar qualities. The hedge fund managers do not put up any money of their own, but they are risking their reputations and proven talents. Moreover, they earn carried interest only if the fund makes a profit.
Obviously, there are significant differences between the tax treatment of carried interest and the treatment of small business sales, including the politics of the issue. The Joint Committee on Taxation just issued a comprehensive report highlighting these issues. But the broad theory behind the tax treatment of the two transactions is similar enough that S corporations and other small businesses should pay attention. As with the tax treatment of hedge funds, there’s a lot of money at stake.
Tax Bill Offset Tally
To simplify tracking of the various tax bills under consideration by Congress, we’ve put together a chart of what’s moving and what’s being discussed, including separate tax bills on the AMT, energy production, education, housing, family tax relief, children’s health insurance, and international tax provisions.
As you can see, the total cost of the bills contemplated could exceed $1 trillion (!) over ten years. That’s a lot of offsets for Congress to generate, which suggests many of these bills will be delayed and/or scrapped as Congress weighs the benefits of action with the liability of the revenue raisers.
Another AMT Plan Floated
As you can see from the chart, the primary challenge in stemming the growth of the Alternative Minimum Tax is cost. Any change to the AMT reduces revenues by hundreds of billions over the 10-year budget window. That enormous cost is likely why the House has repeatedly delayed plans to produce a permanent fix to the alternative tax.
A recent plan proposes to offset this cost by imposing a new surtax on high income taxpayers. According to press accounts, the income threshold would be $500,000 and the surtax would be in the 4 to 5 percent range. That tax increase would offset a higher, permanent $250,000 AMT exemption ($125,000 for singles) that is indexed for inflation in future years.
If you are interested in the details, a similar plan has been outlined by Tax Policy Center here in town. The TPC plan would 1) raise the AMT exemption to $200,000 for families ($100,000 for singles) and 2) offset the cost of this increase with a new 4 percent surtax applied to a taxpayer’s Adjusted Gross Income above the $200,000 threshold.
The net effect of this plan on any particular taxpayer is complicated, as are all issues surrounding the AMT. Some taxpayers will pay more tax, some will pay less, and some will pay the same amount. But to date, all the AMT proposals floated in the House have embraced, to one extent or another, marginal rate increases for non-corporate taxpayers.
S corporations should pay attention. This new surtax would apply to all income above the $200,000 threshold, including your S corporation business income as well as any capital gains and dividends you receive. As a surcharge, this tax is applied on top of existing income taxes, resulting in a sizable increase in your effective marginal tax rates.
Big Four Weigh in on Tax Gap
In response to an IRS request for comments and suggestions in their on-going analysis of the tax gap, the large accounting firms have penned a 19-page white paper that outlines the issue as well as putting forward suggestions.
Perhaps an accurate summary of the paper would be: “Big business pays its fair share so the IRS should focus on small business instead.” Here’s the section related to S corporations and other pass-through businesses:
Mid-Size Corporations and Pass-Through Entities
Another potential area of high-risk involves taxpayers and entities that have been subjected to little or no enforcement in recent years. While larger corporations are examined with relatively high frequency (44 percent), mid-size corporations, S corporations, and partnerships are reviewed with much less frequency. The number of S corporations and partnerships has grown rapidly over the last several decades with very little enforcement activity occurring. IRS recently launched a new research project focused solely on S corporation returns. This is an important project to assess the level of compliance for S corporations, which should be completed as soon as possible. Gaining access to timely information from pass-through entities (e.g., partnership Forms K-1) remains a challenge to the ability of individuals, trusts, and estates (and their tax return preparers) to prepare an accurate income tax return on a timely basis. This issue should be considered as part of any effort to evaluate and improve compliance of pass-though entities.
Summary Observation
As IRS continues to reengineer the examination process for larger corporations to provide close to real-time currency and streamlined examinations, and as IRS winds down a number of abusive tax shelter efforts, these resources should be redeployed to the task of assessing the level of compliance of mid-size corporations and pass-through entities and to identify noncompliance trends that should be addressed.
On a related note, the last time Treasury Secretary Hank Paulson appeared before the Senate Finance Committee to talk about the tax gap, he was asked to return in 90 days to let the Committee know what new approaches they were prepared to take. That 90 day window expires around July 18th — so expect some sort of hearing or meeting on the Tax Gap around that time. Exactly what new policies Treasury produces in the 90 days they were given remains to been seen.
Another Tax Gap Hearing, Another Standoff
In case you didn’t already catch the Senate Finance Committee hearing featuring Treasury Secretary Henry Paulson yesterday, here’s a quick summary.
The hearing itself was pretty entertaining and highlighted the on-going stand-off between Paulson and Finance Chairman Baucus. Baucus set a timetable for results saying that he wants a 90% voluntary compliance rate by the year 2017 – placing the responsibility on the Treasury to come up with this plan and deliver it in 90 days – July 18th – to the Committee. Paulson responded that he would be more than happy to come back in 90 days to present their current plan again. Paulson also stressed the difficulty of reaching the 90% rate without delving into the under-reported income area that is responsible for over 80% of the current tax gap – which will cause a lot of pain and require draconian measures.
Other highlights:
- Tax havens were a hot topic during the hearing – raised by Senators Conrad, Stabenow and Baucus. Baucus said there is “a lot of angst in Congress” over these issues.
- Senator Wyden asked Paulson about the status of Treasury’s response to the Tax Reform Panel’s report. Paulson stated that there “isn’t a major tax reform proposal being put forward and I don’t see it happening in the near future” and that the Treasury is focusing on more incremental steps toward tax reform.
- Senator Grassley raised hedge funds with Paulson. He asked if Treasury studied hedge fund tax policy in its financial markets study. Paulson said no, but Assistant Secretary Eric Solomon added that Treasury and the IRS are independently looking at hedge fund issues.
More AMT News
Meanwhile, CongressDaily reports that House Democrats are closing in on their plan to permanently address the Alternative Minimum Tax. For our new members, the AMT is an alternative tax system originally designed to ensure that a few rich taxpayers pay at least a minimum level of income taxes, but the combination of poor design and lower tax rates under the regular code have resulted in the unprecedented growth of the AMT among taxpayers whose incomes are decidedly middle class.
As outlined, the plan right now would eliminate the AMT for all taxpayers earning below $250,000 and reduce it for taxpayers with incomes between $250,000 and $500,000. Presumably, the AMT would be left in place for taxpayers earning above $500,000. To offset the revenue impact of AMT relief, the House is apparently looking at raising income tax rates on taxpayers earning more than $1,000,000 a year. Chairman Rangel’s comments also suggest they may still look at adjusting the rate thresholds, as we reported earlier.
While the story to date has focused on the trade-off between reducing taxes for middle-income AMT taxpayers and raising regular income taxes on wealthier taxpayers, we think it’s important to point out that the math simply doesn’t add up. The reported cost of the AMT plan is about $1 trillion over ten years. It will be simply impossible to raise that much revenue by just focusing on millionaire taxpayers. According to our friends at Statistics of Income, of the 132 million taxpayers who filed in 2004, only 240,000 reported incomes exceeding $1 million. To raise $1 trillion, the annual tax increase for each of these taxpayers would exceed $400,000 a year. To achieve that, the top tax rate of 35% would have to be raised to something around 50% for this group.
You don’t have to be a disciple of the Laffer Curve to recognize that marginal tax rates in the vicinity of 50% will result in serious economic dislocation. It will also hurt small businesses. As we’ve mentioned many times before, S corporations pay their taxes at the individual rates, so raising tax rates on millionaires means raising tax rates on successful small and closely held businesses — the very businesses we rely upon to create most of the jobs in this country.
Marginal tax rates of that magnitude are also politically unfeasible in today’s environment. The last time Congress raised the top tax rate (from 31% to 39.6%) in 1993, the majority lost both the House and the Senate in the subsequent elections. Many House members, including Ways and Means Chairman Charlie Rangel, were around in 1993, and they are unlikely to go down that path again.
Nevertheless, the current rhetoric is beginning to sound very much like 1993, when President Clinton promised to raise taxes on millionaires only and wound up signing a bill that raised taxes on just about everybody. The old line about robbing banks because “that’s where the money is” is overused, but it definitely applies here. Taxing millionaires to cut taxes on the middle-class makes for nice press releases, but when Congress seriously looks to raise revenue, it inevitably looks to the middle class, because that’s where the money is.
As long as the House insists on offsetting any changes to the AMT, the story will not be about rich verses middle class. Instead, it will be about how Congress rearranges tax collections on the same group of taxpayers — those in the middle and upper-income tax brackets. Some will see their taxes fall, and some will see their taxes go up. S corporations need to stay on alert.
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.”
Budget Targets Tax Gap
It is time to start a tally of how many times Congress spends revenues raised from closing the tax gap.
It’s an annual tradition. Each year, Congress picks out its favorite revenue raiser and then uses that revenue over and over again to pay for new spending or tax relief. Past contenders include overturning the Schmidt Baking decision, codification of the IRS’s economic substance test, SILOs, LILOs, COLI, etc. For 2007, the tax gap is the leading contender, and it’s already being used up.
As CongressDaily reported last week, the budget includes more than twenty “reserve funds” that allow for additional spending on a wide range of domestic programs, but only if the additional spending is offset with spending cuts or tax increases. How will all of this new spending get paid for? The tax gap, of course.
“[Senate Budget Committee Chairman] Conrad [contended that] most of the additional revenues required in the next fiscal year could be obtained by closing the “tax gap” by collecting taxes that now go uncaptured, and by curtailing offshore tax havens and tax shelters.
“Frankly, I don’t think it’s very difficult to achieve,” Conrad told reporters afterward. “Anybody who tells me they can’t collect 15 percent of this money that’s in tax havens and tax scams, they better get a new revenue commissioner because it ain’t that hard. I did it when I was a tax commissioner [in North Dakota.]”
The audience of the recent IRS Roundtable on the Tax Gap got a different point of view. From IRS Commissioner Everson to business community representatives such as Macy Davis from the National Federation of Independent Business, the panel uniformly agreed that, while the Congress and IRS should do what they can to ensure people pay what they owe, collecting this revenue is complicated and not pain free, especially for compliant taxpayers who will have to live with the increased reporting and enforcement requirements.
Senator Grassley, Ranking Member on the Senate Finance Committee, has also raised concerns about pressing the tax gap too far. As he stated on the Senate floor this week:
“I find that the tax gap is one of those issues here in Congress that is a little like the weather: Everyone wants to talk about it but no one is doing anything about it. But the way people talk around here, they view that the tax gap is a “cure-all.” Have to pay for AMT? Tax gap. Want to expand spending on health care? Tax gap. Balance the budget? Tax gap. Given the amount of faith people have put into it, tax gap has suddenly become one of those magic elixirs the peddlers used to sell in the old west. ‘It will cure what ails you’ was the slogan the slick salesmen used to say. And so the tax gap has become the elixir for all fiscal problems. I’m surprised folks don’t think the tax gap can cure baldness.”
Of course, the real danger is that Congress pays for its new spending plans with tax increases that have little or nothing to do with the tax gap. We have already seen an increase in S corporation payroll taxes paraded under that banner. Before these new “reserve funds” are funded, we’ll probably see it again.
Energy Tax Bill and Energy Offsets
For those small business groups who are thinking that Big Oil will foot the bill for any energy tax title enacted this year, a new CRS report issued Tuesday provides little comfort.
The report, entitled “Oil and Gas Subsidies: Current Status and Analysis,” summarizes the current state of tax provisions targeted directly at the oil and gas industries. What they found is those tax “subsidies” are not as valuable as many people have assumed. As the report concludes:
“Although the above oil and gas tax subsidies may not be justified based on economic theory, and considering the high oil and gas prices over much of the policy period, they are not large when measured relative to the industries’ gross product, which measures in the hundreds of billions of dollars. Another misconception is that industry was the beneficiary of many and significant tax breaks before these provisions were enacted. The industry did benefit historically from significant tax subsidies; however, most of these had been either eliminated or pared back since the 1970s.”
Bottom line: For all the talk of eliminating big tax subsidies for big oil, the best minds in Washington can only come up with about $10 billion over ten years in revenue raisers. That’s a lot of money in the traditional sense, but it’s not nearly enough to offset the cost of new tax benefits targeted at renewable energy sources ($10-20 billion), relief from the AMT ($40-60 billion per year!), or extending other popular tax breaks that expire in the next couple years ($10-20 billion)…
It’s All About the Tax Gap These Days
Meanwhile, the Tax Gap continues to be the focus of congressional tax writers and budgeters. BNA today reports that Senate Budget Chairman Kent Conrad is continuing to look to tax gap proposals as a means of closing the budget deficit. As BNA reports:
“The tax gap–the difference between total taxes assessed and those paid on time–has been estimated at close to $350 billion in 2001. But how much of that gap can be recaptured and how much in extra enforcement efforts would be needed to do so remains unclear. Conrad said he had talked with Finance Committee Chairman Max Baucus (D-Mont.) and they agreed on the need to do something about the tax gap and “offshore” tax schemes, where corporations identify a low-tax country such as the Cayman Islands as a corporate headquarters for tax purposes.”
We have yet to meet an S corporation that has moved to the Cayman Islands, so our principal concern is not with the offshoring of corporate headquarters; but that offshore tax havens, like oil and gas subsidies and Medicare fraud, will prove to be less lucrative to tax collectors than the press releases suggest. Just another reason for S corporations to be prepared…
Is Official Washington Targeting S Corporations? Sure Looks That Way
As our readers know, the IRS is currently targeting S corporations, and only S corporations, for audits as part of its on-going “Tax Gap” research project. And the Joint Committee on Taxation and Treasury Inspector General for Tax Administration have, over the past couple year, proposed to dramatically increase the application of payroll taxes on S corporation income.
Now the Congressional Budget Office issues its new biannual “Budget Options” report, and there, on page 297 is an option entitled, “Repeal Tax-Free Conversions of Large C Corporations to S Corporations.” What follows is a long narrative of the history of C corporation conversions, the advent of LLCs in 1988, and the resulting disparity of converting from C to S verses converting to an LLC.
History aside, the option proposed by the CBO is just another shot at the S corporation community. Their reasoning, apparently, is to level the playing field between the treatment of S corporations and LLCs. As the report states:
“A major advantage of this option is that repealing tax-free conversions by C corporations would treat economically similar conversions — from two-tiered corporate tax systems to single-tiered systems — in the same way. Equalizing that tax treatment would, in turn, allow society’s resources to be allocated more efficiently by making tax considerations less important in decisions about what legal form a business should take.”
If equalizing tax treatment is the CBO’s motivation, why not just allow tax-free conversions of LLCs? The same economic arguments apply. Moreover, what about the myriad of advantages LLCs have over S corporations, like no limitations on the number or types of shareholders, the ability to issue multiple classes of stock and convertible debt, or the passive investment and built-in gains rules that apply to converted S corporations? We looked for CBOs recommendations to level the playing field in these areas, but were unable to find any.
The bottom line is the S corporation community needs to be as active as ever to ensure that Congress has all the facts when considering the rules under which we operate. With S corporations in the cross-hairs, anything less than constant vigilance is simply not going to succeed.
House Passes Small Business Tax Package — What’s the Next Step?
Real quick, the House just passed its small business tax package (H.R. 976) to accompany the proposed minimum wage increase, 360-45. This action follows a very bipartisan markup last Monday, where the tone of the hearing was a dramatic departure from what we’ve come to expect from Ways and Means meetings. That this comity occurred over a $1 billion package that included no S corporation provisions was a little disconcerting, but it is something we will have to work on.
So what’s the next step? The Senate could take up the House-passed bill, substitute in the Senate’s $8 billion small business tax relief package (including the S corporation tax title we care about), and ask for a conference with the House. Or the two bodies could negotiate away their differences now, and then pass the resulting product out of the Senate and House.
Either way, it looks like the tax writers have two or three weeks of work ahead of them to reconcile their differences. Common ground over the competing revenue raisers should be particularly difficult to find. We’ll keep plugging away to ensure the Senate-passed S corporation provisions survive negotiations and that they take effect immediately.
Senators Offer Middle Class Tax Package
Finance member Charles Schumer (D-NY) and five freshmen Democratic members introduced legislation yesterday (S. 614) to target tax relief at middle class families. According to the authors, the bill would reduce revenues by $137 billion over ten years in order to:
o Double the Child Credit to $2,000 for a child’s first year;
o Increase the dependent care credit to 35 percent for certain families;
o Extend AMT relief; and
o Consolidate existing education deductions in a single, $2,500 credit to cover tuition, fees, and books.
So, in the era of PAYGO, how should the Congress offset $137 billion in tax relief? You guessed it — the tax gap. As BNA reported this morning, “Schumer mentioned several possible ways to pay for the middle class relief, including raising income taxes on families making $400,000 per year, repealing oil industry tax breaks, and/or narrowing the tax gap.”
S corporations and small businesses need to be on their guard that talk about reducing the tax gap doesn’t turn into broad-based tax increases on the small business community. The S corporation payroll tax provision, repealing LIFO accounting rules, and raising taxes on small business exporters are all provisions that have been suggested in the context of addressing the tax gap.
Rangel Ready to Prepare Small Business Tax
Good news for S corporations and other closely-held businesses! Ways and Means Chairman Charles Rangel (D-NY) indicated yesterday that he plans to put together a package of small business provisions to be coupled with the minimum wage increase that has already passed both the House and the Senate. This announcement reverses the previous position of the House leadership, who had indicated they wanted to send the President a “clean” minimum wage bill. As BNA reports:
House Ways and Means Committee Chairman Charles Rangel (D-N.Y.) said Feb. 6 that the House would put together its own tax package to be married with minimum wage increase legislation (H.R. 2) in the Senate, but gave no indication of the size of the package or what it would include. Rangel had previously given little indication of his plans for the future of the minimum wage increase. The House passed a minimum wage increase as a stand-alone measure Jan. 10 and the Senate approved an increase with an $8 billion tax package Feb. 1. He told BNA Jan. 30 that the $8 billion Senate package was too expensive and would use up too many revenue raisers.
Your S Corp team has already started discussions with House tax writers on the importance of including S corporation reforms in this package, and of making sure the provisions take effect immediately to offset any increased labor costs from the higher minimum wage. Expectations is that the Ways & Means Committee will mark-up its bill as early as next week. We’ll keep you apprised of any progress.
S Corp Audits Back in the News
Remember the National Research Program over at the IRS? This project is designed to give the IRS better information regarding tax compliance and the “tax gap.” The NPR began by looking closely at high-income individuals. Next, NPR targeted 5000 S corporations for intensive audits to identify better means of ensuring their compliance with the tax laws.
Yesterday, the Treasury Inspector General for Tax Administration (TIGTA) released a progress report on the audits. While the report itself focuses on the technical challenges faced by auditors, there were a couple of interesting points. First, TIGTA observes that, for 2005, there were 3.6 million S corporations, a significant jump from previous years. We’ll have to update our website! Second, 99 percent of the 5000 audits have been initiated, and 17 percent are complete to date.
Finally, BNA’s coverage of the report reflects one of our principle concerns with the audits. The IRS is looking only at S corporations right now. Partnerships are not being studied, even though the LLC community is, by many accounts, growing faster than the S corporation community.
The S corporation research project emanated from a pilot study conducted in 2004 involving about 130 audits of S corporations and partnerships. IRS decided to focus on S corporations for the NRP project to determine how agency auditors could “do a better job” of auditing the flowthrough entities, IRS Research, Analysis, and Statistics Director Mark Mazur said at an August Senate Finance Committee hearing. The NRP project is auditing about 1,200 taxpayers from tax year 2003 and about 3,800 audits from tax year 2004. The audits will focus on taxpayers’ Forms 1120S.
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