The tax community is still waiting for the third version of the Baucus substitute to be released. A “trial balloon” draft circulated yesterday made certain changes, but failed to address many of the sticking points holding up the overall bill.
Meanwhile, Senators Baucus and Reid spent most of yesterday negotiating with swing Republican votes — at this point, just Maine Republican Senators Olympia Snowe and Susan Collins — to identify what changes are necessary in order to gain the 59th and 60th votes needed. As CongressDaily reports:
The chief target appears to be $24 billion to extend higher Medicaid matching funds for six months, first authorized in the stimulus last year. Options floated Tuesday included phasing down the percentage boost and using untapped funds elsewhere in the Recovery Act for offsets. Snowe and Collins were noncommittal, having not seen details. Senior Democrats appeared resigned that the net cost of the Medicaid assistance would be scaled back. “They’re having to cut it back to try to get Republican votes, and it affects my state; it really affects Harry Reid’s state,” said Sen. John (Jay) Rockefeller, D-W.Va., who with Reid was an original lead Senate sponsor of the six-month Medicaid boost. “But it looks like the best we can get.”
The challenge for Senator Baucus is that the deficit spending in the package represents only half the opposition. There is a lot of opposition to the tax increases as well, including the payroll tax hike on S corporations and partnerships. Senator Snowe of Maine has led the fight to strike this provision from the bill. As The Hill notes:
Kyl said he isn’t sure winding down FMAP is the elixir Democrats think it is in garnering Republican support for the bill.“Whether that will satisfy more Republicans remains to be seen,” he said. “There are other issues with the bill as well, including issues related to the tax provisions.”
The current “K Street” rumor is that Chairman Baucus has been given a limited amount of time to round up the 60th vote. If he’s unable to do so, Majority Leader Reid would set the extender package aside and move on to other items. Whether the rumor is true or not (K Street rumors typically run about 50/50 on the accuracy dial), the clock is ticking.
In addition to Senate consideration, this bill would need to return to the House, where its adoption is by no means assured. If the House makes any changes, it would come back to the Senate. And then, since most of the spending and all the tax items expire before the end of 2010, we’d have to do it all over again before January.
We’ve observed previously that getting the entire business community to oppose a bill centered on extending business-friendly tax breaks is fairly remarkable. The current bill before the Senate is anti-business, and would need to be changed significantly before businesses could support it. It appears that several determined senators share those concerns.
Budget’s Impact on Employers
S-Corp allies over at the Manufacturer’s Alliance commissioned a new study on next year’s tax policy and what it means for S corporations and other business forms. Specifically, the study looked at the tax policies in President Obama’s 2011 budget and asked how these policies would impact economic growth and job creation. The verdict?
In terms of macroeconomic effects, the tax proposals in the 2011 budget are forecast to shave an average of 0.2 percent from annual GDP growth through the middle of the decade, resulting in $200 billion of foregone output and a net job loss of almost 500,000 relative to the baseline. Because taxable business revenues are highly concentrated in manufacturing firms, they will account for a disproportionate share of these output and employment gaps.
So despite much of the rhetoric coming from Washington these days, the rules of economics have not been turned on their figurative heads — the tax forecast for next year is higher tax rates imposed on a larger tax base, which means less investment and less job creation over time. Who will get hit the hardest?
The tax provisions of the 2011 budget will affect S corporations and other pass-through manufacturing firms much more heavily than both firms outside of manufacturing and C corporations within manufacturing. Pass-through businesses in the manufacturing sector will see their tax bills increase by an average of 14 percent. Given the growing importance of S corporations and partnerships to economic growth and job creation over the past 25 years, it is important to understand that tax increases intended to help contain deficits will exact a high price in terms of the competitive posture of U.S. manufacturing and the growth of the economy as a whole.
The study’s authors calculate that S corporations and other “pass through” firms will see their aggregate tax burden rise by $177 billion over the next ten years. Ouch.
Earlier today, the Senate voted earlier on its version of the “extenders plus” bill passed by the House a few weeks back. The vote, on a motion to waive a Budget Act point of order, failed miserably (45-52), indicating the Senate Leadership has a long way to go before they gather the sixty votes necessary to move forward.
With this morning’s vote behind us, the process moving forward is becoming clearer–Finance Chairman Max Baucus (D-MT) is expected to introduce a new substitute today. According to BNA:
Baucus is expected to draw up a new substitute amendment that will be a slimmed-down version of what the Senate defeated. That plan would have added $84 billion to the federal deficit, a figure that Republicans, and some Democrats, said was too high to stomach. Baucus has previously said that he would continue to work with senators of both parties to find 60 votes. Issues that could be modified to secure votes include Medicare reimbursement rates for physicians, unemployment insurance benefits, Medicaid funding to states, and possibly language making it more difficult for S corporations to avoid paying employment taxes.
As BNA indicates, the new effort will likely include a modified payroll tax hike. As with the House-passed provision, however, the new tax has been written behind closed doors and without the benefit of public scrutiny. It might be better than the flawed House effort, but we simply won’t know until it’s offered.
The next key vote will take place tomorrow, when the Senate considers Senator John Thune’s (R-SD) alternative “extender plus” package. This package includes all the tax extenders the business community wants, but strikes all the tax hikes the business community opposes (including striking the $11 billion payroll tax hike). Instead, all the tax relief and spending in the package are offset with spending cuts. As with today’s vote, Senator Thune is not expected to get 60 votes tomorrow, but we’re betting he does better than the 45 votes Senator Baucus got today.
Meanwhile, Senator Olympia Snowe (R-ME) continues her fight on behalf of S corporations. As CongressDaily reported this morning:
Snowe is upset about an $11 billion tax increase on small services firms organized as S corporations; Baucus is preparing some tweaks to that provision, and the chamber’s 63-33 adoption of an amendment she co-sponsored to establish an office within the Treasury Department to help homeowners struggling with mortgage payments can’t hurt. Democratic aides said they still have some work to do on their side of the aisle before working to assuage GOP holdouts.
The S corporation community owes Senator Snowe a big debt. Meanwhile, with the first Baucus substitute gone and the second version “to be introduced,” we will just have to wait to see what they have in mind.
The Washington Post this week reported on an issue that shouldn’t come as a surprise for S-CORP readers: President Obama’s tax plans could hurt many of America’s small businesses. Small business owners who report their business profits on their personal income returns (like most small business owners do) are suddenly finding themselves classified as the “richest” Americans, and thereby subject to Obama’s tax increases. The Post explains:
Across the nation, many business owners are watching anxiously as the President undertakes expensive initiatives to overhaul health care and expand educational opportunities, while also reining in runaway budget deficits. Already, Obama has proposed an extra $1.3 trillion in taxes for business and high earners over the next decade. They include new limits on the ability of corporations to automatically defer U.S. taxes on income earned overseas, repeal of a form of inventory accounting that tends to reduce business taxes, and a mandate that investment partnerships pay the regular income tax rate instead of the lower capital gains rate.
The Washington Post is catching up to what S-CORP and its friends have been pointing out for a while now — if your goal is to reinvigorate the economy, placing additional burdens upon the very business that can help pull us out of this crisis is the wrong way to go. The example used by the Post — Gail Johnson of Richmond, Virginia — should give S corporation shareholders pause:
Johnson declined to say whether she voted for Obama. But she said she ignored his tax plans until her husband, who handles real estate and construction for the schools, mentioned it one day. “I’ve since talked to my accountant,” she said. “And, oh, my gosh!”
In a typical year, Johnson’s federal tax bill would be about $120,000. But starting in 2011, the higher marginal rates would add about $13,000 a year, Hurst said. Capping the value of itemized deductions at 28 percent would add another $10,000, for a total increase of $23,000.
And Johnson’s tax bill stands to grow dramatically if Obama were to revive a plan to apply Social Security tax to income over $250,000 instead of capping it at the current $106,800. Because Johnson is an employee and an employer, she would have to pay both portions of the tax, Hurst said, tacking another $30,000 onto her bill.
That’s a potential $50,000 tax increase for a small employer whose family earns about $500,000 a year, including the income from her business. It’s hard to see how increasing her federal tax bill (this does not include state and local taxes) from around $120,000 to $170,000 would not harm Gail’s plans to invest in her business and hire additional employees.
Budget Plan Finished
On that note, perhaps the most frustrating aspect of the tax increases outlined above is that they simply will not be enough. Federal deficits are going sky-high and higher taxes on the middle-class are all but inevitable. House and Senate negotiators this week put the final touches on the budget outline for next year. For S corporations, three major items stand out: total deficit estimates, the estate tax and the inclusion of reconciliation instructions for health care.
The Congressional Budget Office estimates that the Obama budget, if enacted, would result in deficits of $1.8 trillion, $1.4 trillion, $1 trillion, $658 billion, $672 billion, and $749 billion over the next five years. That’s a cumulative of $4.4 trillion over five years, or $1.7 trillion more than if we simply did nothing over the next five years and maintained current law.
The U.S. government has never run deficits of that magnitude and exactly how the debt will be financed is an open question. To put these five-year numbers in perspective, over eight years of President Bush — who is rightly criticized for not paying more attention to holding down spending – debt held by the public increased by $2.4 trillion. The budget offered up by conferees this week has deficit estimates that are smaller than the Obama budget, but not enough to address the question of who is going to finance all that debt.
Regarding the estate tax, the budget agreement calls for maintaining the 2009 rates and exemption levels of 45% and $3.5 million per spouse. While the Senate’s original budget allowed for higher exemption levels and a lower rate, the House ultimately prevailed and stuck with freezing the 2009 rules.
On the reform front, the resolution will include “reconciliation instructions” for health care reform. As S-CORP readers know, reconciliation is valuable to the majority in the Senate because it allows for controversial items to pass the Senate with a simple majority rather than the usual 60 votes.
There are limitations, however, because bills brought to the Senate floor under reconciliation may not increase the deficit outside of the budget window, which means whatever they enact under this budget would have to be sunset after five years.
S corporation shareholders know how these sunsets work — we have been dealing with the uncertainty of the estate tax repeal sunset for a decade now. How effective could broad-based health care reform be if it goes away in just five years?
Moreover, reconciliation bills may not include provisions with no or little impact on revenues and spending. The core provision in most health reform plans is to create a health insurance “exchange” similar to the Connector up in Massachusetts. This may or may not be a good idea, but it doesn’t have a significant impact on either revenues or spending and would likely fall outside of reconciliation. For a full review of these issues, we recommend reading the analysis of S-Corp ally Keith Hennessey.
Bottom line: Attempting to reconcile health care reform could cost the majority more than it’s worth, especially with Senator Specter now aligning himself with the Democratic Caucus.
The advocates over at the Center for Budget and Policy Priorities (CBPP) issued a new study last week demonstrating, once again, how few “real” small businesses would be adversely affected by raising the top two income tax rates back to their old 39.6 and 36 percent levels. As their study states:
“Some critics of the President’s budget charge that his proposals to roll back tax breaks for taxpayers with incomes over $250,000 would harm small businesses. In fact, only 8.9 percent of people with any small business income have incomes of over $250,000 and, thus, would even potentially be affected by these provisions.”
As S-Corp readers know, this is old ground. One side says only a tiny portion of small business owners pay the top two rates. The other side says that small business owners make up a large percentage of those affected. Back and forth, over and again.
Missing from the debate is a sense of scope. For example, there are only six million or so employers in the United States while there are about 30 million businesses. Under the CBPP’s approach, then, a policy to raise taxes on every single employer in America could be dismissed because it “only” affects twenty percent of all businesses. It’s not the number of taxpayers affected that matters, but rather the amount of total economic activity being taxed.
The reality is, as we’ve pointed out before, an enormous amount of business activity is subject to the top two rates. More than half of all business income is taxed at the individual rates (S corporations, partnership, and sole proprietorships), and more than two-thirds of that income is taxed at the top two rates, which means more than one-third of all business income earned in the United States will be subject to higher tax rates under the President’s plan. As the Tax Foundation points out, more than half the new revenues collected from the higher rates would come from business income.
Moreover, those higher rates are going to be applied to a larger tax base. Under proposals put forward by the President and/or the Chairman of the House Ways and Means Committee, the business tax base will be broadened by eliminating or restricting deferral, LIFO accounting, Section 199 deductions, and many other deductions used by business.
Finally, the President’s budget proposes to reinstate the old PEP and Pease rules. These rules phased out the personal exemptions and capped itemized deductions, respectively. Their net impact is to raise the base on which tax rates apply and would increase the number of taxpayers subject to the top two rates, including those who are small business owners.
So the cumulative result of these proposals would be to dramatically raise both the tax rate and tax base for a large percentage of business income earned in the United States. There’s no way to minimize the negative effect of that.
Obama Budget Limits LIFO
Speaking of base broadening, the budget outlined last week by the Obama Administration calls for repealing LIFO. Exactly how he would structure this repeal is unclear — the only reference to the policy is back in the revenue tables.
According to the revenue score, the proposal would increase tax collections by $61 billion beginning in 2012, or just about half of the projected tax increase from the provision included in the 2007 Rangel “Mother of All Tax Bills” legislation ($105 billion).
The Rangel provision applied to all businesses — large and small — using LIFO inventory accounting rules and gave them an eight year period to pay taxes on their accumulated LIFO reserves. (Keep in mind, repealing LIFO is a double whammy for LIFO businesses — their annual taxes go up moving forward but they are also on the hook to pay back-taxes on their accumulated LIFO reserves.)
Until the Treasury Department issues its “Blue Book” to describe all the tax provisions in the Administration’s budget, we won’t know for sure how the Obama repeal differs from the Rangel repeal. They might have limited the change to publicly-held companies, or eliminated the retroactive tax on LIFO reserves.
At this point, however, such differences are meaningless, since whatever President Obama proposes will have to go through Chairman Rangel’s committee anyway.
The headline here, which should be noted by every LIFO business and their accountants, is that the President of the United States, the Chairman of the Ways and Means Committee, the Securities and Exchange Commission, the Financial Standards Accounting Board, and the Joint Committee on Taxation have all weighed in recently against LIFO in one form or another.
The case against LIFO is a wholly contrived money-grab, but with that lineup against us, you might want to begin making contingency plans.
President Obama released a 140-page outline of his budget today that reflects his revenue and spending priorities for the next couple of years.
Chief among these is a major change in federal health care policies. As made clear in his speech to Congress the other day, health care reform is first among the several big reforms on the table and his budget sets aside $634 billion of the estimated $1 trillion he plans to spend on the plan.
To raise the $634 billion, Obama calls for: 1) limiting itemized deductions for families earning more than $250,000, starting in 2011; 2) cutting payments to Medicare Advantage plans; and 3) reducing Medicaid payments to hospitals and drug makers.
Other key proposals include:
- Beginning in 2011, increasing the top two income tax rates to 39.6 and 36 percent respectively while raising rates on capital gains and dividends to 20 percent, consistent with President Obama’s promise to raise taxes on families earning over $250,000.
- Raising $353 billion through the elimination of so-called business loopholes including limiting the ability of firms to defer tax payments on overseas income and LIFO repeal.
- Raising the tax rates applied to so-called “carried interest” earned by hedge fund managers and other professionals.
- Calling for a cap-and-trade program to limit carbon emissions with 100 percent of the credits auctioned off. The resulting revenue would be used to fund clean energy programs and be returned to families and small businesses.
- Locking into place the 2009 estate tax rate and exemption levels.
We will have more reports in coming days, but suffice it to say that the Obama outline, if enacted intact, would result in significantly higher tax rates for many S corporations that would be imposed on a significantly larger income base.
The one piece of good news is that the budget, reflecting the current economic climate, does not attempt to accelerate the rate increases on upper-income families, but rather allows the current rules to take effect whereby the lower rates expire beginning in 2011.
As students of government know, the President’s annual budget submission is required by Congress and is just the first step in the year-long process of establishing the government’s spending and revenue limits. Given the current make-up of Congress, however, we expect the plan outlined today to be the presumptive starting place for congressional deliberations — especially in the House. For S corporations, that means we will be playing a lot of defense for the next few months.
Do Marginal Rates Matter?
Perhaps the biggest tax debate in the next couple years will be over President Obama’s proposal to raise top tax rates back to their pre-2001 levels. Tax cutters argue that higher marginal tax rates will hurt small businesses and the economy as a whole.
Increasingly, we are hearing the counter argument that marginal rates don’t matter. Policymakers on the Hill have told us that and President Obama’s budget outline appears to endorse that notion as well. A back-and-forth on CNBC this morning does a nice job of outlining the debate.
Your intrepid S-CORP team was around in 1993, and we recall that the Clinton rate increases took place in an extremely positive economic and global climate — the Cold War was over, the Thrift Bailout had run its course, and much of the developed world was moving towards market-based policies. Attributing any effect of higher tax rates to economic performance in that climate is a stretch at best.
In many ways, the climate today is just the opposite of what Bill Clinton inherited in 1993, and we are not at all comfortable that higher tax rates applied to a broader tax base will have limited or minimal impacts on economic activity.
The House reversed course today and voted to adopt the expanded Treasury bailout package by a vote of 263-171.
As S-Corp readers know, the Senate took the original Treasury plan, added the tax extender package, some hurricane relief, and a temporary boost in FDIC insurance levels, and passed the broader legislation 74-25 on Wednesday.
Fifty-seven members of the House switched from No to Yea today. The package is now law. The President signed it as soon as the bill traveled sixteen blocks up Pennsylvania Avenue.
So how will this impact S corporations? While we prefer to give our readers frank, direct answers to tough questions, the reality is we don’t know. Here’s how it breaks down:
S Corp Charitable Provision: Positive. This provision was part of the extender package, and is now extended through the end of 2009.
Deficit Impact: Negative. Deficits are going up. Next year’s deficit will likely be in the $600 billion range, or about 4 times the deficit in 2007. Higher deficits mean increased pressure on Congress to raise taxes. The Treasury plan will likely make the deficit worse.
How much? A CBO summary of the plan concludes, “That net cost is likely to be substantially less than $700 billion but is more likely than not to be greater than zero.” So somewhere between $700 billion and zero. Great.
It’s hard to blame the CBO, though. The challenge of valuing these assets is one of the reasons for the bailout. New analysis of the Bear Stearns acquisition does a nice job of highlighting the challenge of valuing these troubled mortgages and the securities based on them. As Bloomberg reports:
The valuation of the $12 billion of Alt-A mortgages varies by as much as $5.4 billion depending on whether the analysts use estimates that Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. or Morgan Stanley apply to their own portfolios, the analysts wrote.
The Treasury plan should help clarify the value of these assets, but it does so by shifting risk from the financial community to the taxpayer. Just how much that risk will cost us is the $700 billion question.
Economic Impact: Positive. The Treasury plan is viewed by the credit markets as necessary, but insufficient by itself, to reverse the declining economy. We were facing a cyclical slow-down coupled with a credit crisis. The Treasury plan helps address the latter, and to the extent it’s successful, it will help make the pending recession less severe and less lengthy.
So the net impact on S corporations and the small business community is mixed. Higher deficits mean higher taxes, while healthier credit markets mean a shorter, shallower recession.
Congress returns November 17th to consider several smaller items. Depending on how the economy fares, it may need to consider additional provisions to help the economy. We are confident that a $700 billion plan drafted and enacted in 14 days will need some refinements. Hopefully, that’s all Congress needs to do.
Today marks the 50th birthday of the S corporation! As you can imagine, here at the S Corporation Association we’ve got the cake and candles ready.
Perhaps more importantly, at a time of economic and political uncertainty, the story of the S corporation and its role in making the American economy more diverse and flexible is worth reviewing.
The S corporation was born at a time when the economy was slowing, Americans were losing their jobs, and an unpopular Republican President was being accused of practicing “trickle-down economics” by a Democratic Congress.
President Eisenhower embraced the S corporation — originally an idea proposed by the Truman Treasury Department — as a means of burnishing his Main Street credentials while addressing concerns of Republicans and Democrats alike that too much economic control was being consolidated into the hands of too few wealthy Americans.
Congress passed the provision as a small part of a much larger miscellaneous tax bill and the President signed on September 2, 1958 while on vacation up on Cape Cod.
Over the past fifty years, the S corporation has helped diversify the American economy while becoming an increasingly important player in the lives of millions of Americans.
While the S corporation has always been a successful vehicle for facilitating private enterprise and innovation, its growth accelerated dramatically in the last thirty years as marketing, communication, transportation and other transaction costs for small firms shrank along with the marginal tax rates they paid.
Lower transaction costs means smaller, more diversified firms and a stronger Middle America. Today, there are over four million S corporations, employing millions of workers and contributing significantly to our national income.
As Congress reconvenes next year and considers what to do with the tax code and how to address concerns of economic concentration, it should keep in mind that the S corporation was created by a Democratic Congress intent on countering economic concentration. It worked, as four million businesses spread throughout communities around the country can attest.
Happy 50th, S Corps and many returns!
The Game of LIFO
More movement on the LIFO front. Last week, the Securities and Exchange Commission approved for comment a roadmap to convert US accounting rules for public corporations over to EU rules.
The transition would take place over the next eight years and include numerous steps, including a decision by the SEC in 2011 on whether to proceed, but the bottom line is the accounting community and the people who regulate them are continuing to move away from rules that allow for LIFO accounting.
As S-Corp readers know, a move to eliminate LIFO for book accounting has implications for tax accounting as well, since the tax code requires companies to use the same broad inventory method for both.
While LIFO accounting debates may appear too technical to matter, this issue has the potential to impose a massive tax increase on manufacturers, retailers and wholesalers around the country. A recent revenue estimate for eliminating LIFO suggested it would raise taxes on these businesses by more than $100 billion over the next ten years.
A tax increase that size is bound to be noticed. It threatens a double hit on businesses that would be forced to pay back taxes on accumulated LIFO reserves while also being hit with higher tax levies in future years.
Tax issues were not a major part of the SEC discussion, although the Commissioners are aware of the tie between book and tax accounting on LIFO and suggested maybe the IRS could do something to fix it. Maybe. But, Congress still needs to find revenues over the next couple of years to offset a very expensive agenda of tax relief and spending increases. Whether the IRS comes to the rescue or not, we expect this issue to be debated in Congress beginning next year.
Extender Picture Muddy as Ever
With energy issues on the front lines, a group of 16 Senators has joined together to support a package of energy provisions that includes, well, just about everything — nuclear, drilling, renewables, and an extension of the production tax credit and other energy tax items.
Looking at the past votes on extenders, if you add the Republican members of the Group of Sixteen to the 55 or so Senators who supported the most recent extender package — the one with revenue offsets — Senate Majority Leader Harry Reid now has a roadmap to getting the necessary 60 votes and help take energy issues off the table before the elections.
What does this mean for the broader tax package, including the AMT relief, R&E tax credit and S corporation charitable deduction expansion? It is not entirely clear, but adoption of the very popular production tax credit and other energy tax provisions separately may ease pressure on Reid to move the larger extender bill.
Foreshadowing things to come, the House on Thursday adopted legislation to increase Veterans education benefits by raising marginal tax rates on individuals—including S corporation shareholders—making $500,000 a year or more. As Congress Daily reported:
“The House, as one portion of a three-part war funding supplemental spending package, approved a provision that would pay for a four-year college degree at any public university for veterans of the wars in Iraq and Afghanistan for at least three years. To pay for the increase — $52 billion over 10 years — the House Thursday voted to impose a 0.47 percent tax on individuals with a gross income of more than $500,000 and couples with income more than $1 million.”
This tax-and-spend approach is unlikely to be adopted by the Senate, and the President has issued a veto threat based on his opposition to the tax increase:
“In addition, amendment number three to the bill would impose a tax increase on individuals and owners of small businesses, totaling more than $50 billion over ten years. A tax increase would be harmful to jobs and economic growth, and the President has been clear that tax increases are unacceptable. If the bill presented to the President contains a tax increase, he will veto it.”
Nonetheless, the S Corporation Association expects that efforts like this will be the norm in coming years rather than the exception. Increasing education benefits for Veterans is a worthy cause, but there are an infinite number of worthy causes, and a limited number of taxpayers. Raising marginal tax rates on small businesses is bad tax policy that deserves to be defeated.
House Extender Package Likely Veto Target
The common perception is that lame duck Presidents have little or no role in on-going policy debates, but reality is slightly different.
President Clinton late in his tenure effectively used his veto pen to either kill legislation outright or negotiate significant changes. This President is doing the same. By our count, more than half of the Statements of Administration Policy issued this year contain veto threats (21 out of 36).
We expect another veto threat when the House takes up the tax extender package next week. The bill would extend for one year a number of tax provisions that either expired at the end of 2007 or will expire at the end of 2008. As outlined in BNA and other publications, the bill would also include two revenues raisers affecting the level of US taxes paid on income earned overseas.
Both the White House and the Senate oppose offsetting the extender package in general and do not like these offset in particular, so the long-term tax picture for extenders and AMT remains as unclear as ever.
Tax Reform Hearing in Senate Finance
The Senate Finance Committee held another in a series of hearings on reforming the tax code. As we have indicated in the past, these hearings and those planned in the House Ways and Means Committee are being held to prepare for the major tax reform expected next year.
What caught your S Corp team’s attention was the uniformity of opinion from the witnesses. All four witnesses argued that rates should be flattened and the base broadened. All four argued for lower taxes on capital income. And all four pointed out that taxes applied to businesses are really paid by individuals.
S Corp readers know the expectation for the next Congress is for higher rates on families and businesses. If Congress does nothing, taxes are going up. If Congress acts, taxes are likely to go up. Given that baseline, it was interesting to hear a panel of witnesses uniformly testify against the direction Congress appears ready to go. Maybe we need to rethink our expectations.
Speaking of baselines, S Corp readers know we have a problem with the baseline accounting Congress uses to score expiring tax provisions. Dr. Foster from the Heritage Foundation included a critique of the current rules:
“The issue arises, of course, because the 2001 and 2003 tax cuts are slated to expire at the end of 2010. This leads some to suggest that extending any or all of the tax provisions, provisions that will then have been in the law for eight or 10 years, is somehow a tax cut. Respectfully to those who make this argument, this is utter nonsense Washington style. Extending current law, or better yet, making it permanent, prevents a tax hike.”
Amen to that.
Everyone in Washington knows Congress will have to address the growth of the Alternative Minimum Tax (AMT) and the expiration of popular tax provisions over the next three years. Just how they will go about it, however, is very much up in the air.
Both the House and the Senate are considering their respective budgets this week. Lots goes into a federal budget, as you can imagine, but nothing is more important for S corporations than how this budget will address the AMT and expiring tax provisions.
On this question, the House and Senate are moving in opposite directions. The House wants to offset the full revenue impact of extending the AMT patch and related expiring tax provisions while the Senate does not.
This difference is reflected in their budgets. The House budget calls for enacting a revenue neutral tax package with a simple majority vote in both the House and the Senate, while the Senate budget would require this package to gain 60 votes in order to pass.
As CongressDaily reported this morning, this fight is a replay of the challenge that confronted Congress last year:
On the tax side, Spratt said House Democrats would stand with the Blue Dog Coalition and insist that a one-year patch to the alternative minimum tax be fully offset. Last year, the Senate was unable to muster the votes for a fully offset AMT patch, and House Democrats were forced to allow an unfunded fix to be enacted. “We’re very insistent on seeing that this time, when we do the AMT extension, the AMT patch, it be offset,” Spratt said. “On the other hand,” he added, “Since Conrad has some problems mustering the votes for that in the Senate, we’ll have to wait and see how it comes out.”
Your S Corp team would point out that while this battle is very serious in its own right, it is merely a precursor to a much larger tax fight that will take place when an increasing share of the tax code expires in coming years.
How big is this impending challenge? The Congressional Budget Office has conveniently put together a table of all the expiring tax provisions between now and 2018 and how much revenue would be lost by their extension.
A few comments are in order. First, just extending the so-called family tax relief—the new 10-percent bracket, the marriage penalty relief, and the refundable $1,000 child credit—will reduce revenues by nearly $650 billion between now and 2018.
Second, the full scope of total expiring provisions is staggering—nearly 100 tax provisions expire between now and 2018. Measured by their revenue, that’s nearly $4 trillion in current tax benefits that will go away between now and then, or about 10 percent of total projected revenue.
Third, the expiration of these provisions is taking place within the context of a rising tax burden, as projected federal revenues take an increasing share of our total national income. According to the CBO, the total tax bite will rise from 17.9 percent this year to 20.3 percent in 2018.
If Congress lives up to its intention to use Pay-As-You-Go budgeting (Paygo), where the extension of any expiring tax provision must be offset with tax increases elsewhere, then we’re looking at an effective real tax increase on families and businesses of unprecedented proportions in coming years.
Paygo and Tax Increases
As you may have noticed, a real concern of the S corporation community these days is the combination of multiple expiring tax provisions and the application of Paygo budgeting.
Consider how this works in practice. In 2010, S corporation shareholder Jim is subject to the top tax rate of 35 percent on both his salary and his business income. In that business, he takes advantage of Section 179 expensing. He also uses LIFO (Last-In, First-Out) inventory accounting and has an IC-DISC (Interest Charge Domestic International Sales Corporation) for his growing export business.
Absent congressional action, in tax year 2011 Jim’s tax rate will rise to 39.6 percent and his ability to write-off new capital investments will decline from more than $125,000 per year to $25,000. In other words, Jim is facing a sharp increase in his federal taxes in 2011.
Under Paygo, Congress can extend Jim’s lower rate and preserve current levels of expensing only by raising taxes elsewhere. (Technically, Congress could cut spending as an offset too, but to date has refrained from using that option.)
So to comply with Paygo, Congress could temporarily extend the lower tax rates and higher expensing limit by, among other offsets, permanently repealing LIFO accounting and the IC-DISC. This being Congress, they would then send out a press release letting Jim know how they prevented his taxes from going up.
But Jim’s taxes did go up. Yes, he retains the lower 35 percent tax on his income and the ability to write-off $125,000 of his capital investments, but he no longer has the ability to use LIFO accounting nor the IC-DISC.
As this example demonstrates, the combination of expiring tax relief and Paygo budgeting has tag-teamed Jim into a significant tax increase.
What’s particularly pernicious about Paygo is Congress’ ongoing habit of making tax relief provisions temporary while making their offsetting tax increases permanent. This combination ensures that tax collections in the future will rise above current projections.
As we mentioned earlier, the total federal tax bite is estimated to increase to record levels in the next decade. The combination of expiring temporary tax relief, permanent offsets, and Paygo will only serve to raise that burden even higher.