The Business Roundtable (BRT), an association of some of America’s largest multinational corporations, today sent a letter to congressional leaders and the President calling for comprehensive tax and entitlement reform, but also leaving the door open for higher tax rates on individuals and smaller businesses.
In response, Brian Reardon, Executive Director of the S Corporation Association issued the following statement:
“We agree with the Business Roundtable that the only way to address our long-term fiscal challenge is through comprehensive reform of both the tax code and our entitlement programs, but we disagree that Congress should consider raising marginal rates on pass-through businesses as part of those reforms.”
“Both the Congressional Budget Office and Ernst & Young have made clear that higher marginal rates will result in fewer jobs now and in the future. The business community needs to unite behind comprehensive tax reform that lowers marginal rates on all businesses, not just multinational corporations.”
While everyone in Washington waits for Tuesday’s election results, this story in The Hill caught our eye: “Fiscal cliff already weighing on economy.” According to the story:
While the expiring tax cuts and automatic spending cuts that make up the cliff do not take effect until the beginning of 2013, Pawlenty said he is hearing from financial firms that businesses are already halting business activity because they are not sure what will happen.
For example, 61 percent of JPMorgan’s U.S. clients are altering their hiring plans because of the cliff, and 42 percent of fund managers for Bank of America identify it as their greatest investment risk.
That’s consistent with what our S-CORP members are telling us. Faced with higher tax rates, uncertain health insurance prospects, and lagging employment growth, the S corporations we hear from are choosing to forego hiring and investment decisions until they feel more confident about the future of public policy and the economy.
This suggests the so-called fiscal cliff is more of a downward slope, and we’re already on it. Employers are holding back, which is suppressing investment and hiring decisions right now, and that’s reflected in the less-than-stellar jobs and GDP numbers we’ve been seeing for the past six months.
That also means that any signal that Congress is prepared to address the cliff and block these tax hikes would help the economy immediately– not just after January 1st.
So, what’s at stake for S corporations? Here’s a short list:
Tax Rates: The best case is that current rates are extended for 2013. The worst case is total gridlock in Congress and rates rise to their pre-2001 levels and beyond. (Beyond because of the tax hikes included in health care reform). Here’s a table summarizing the options:
Wage & Salary
S Corp Income
Keep in mind, the best case scenario includes both extending current rates and repealing the new 3.8 percent investment tax imposed under Obamacare. Not impossible if Romney wins and Republicans take the Senate, but not easy either.
AMT: One of the findings in our E&Y study released this summer was the significant number of pass-through owners who pay the AMT. According to E&Y, of the 2.1 million business owners who earn more the $200,000 annually, 900,000 pay the top two tax rates, while 1.2 million pay the AMT. This suggests that the expiration of the so-called AMT patch last year may have more impact on pass-through business owners than the expiration of the lower rates. Treasury estimates that 30 million additional taxpayers will be pulled into the AMT April 15th under the current rules (if the AMT patch remains expired). The findings of E&Y suggest many of those taxpayers are business owners. Business owners most at risk are those with dependent children and those living in high-tax states like New York and California.
Extenders: Congress has gotten into a [bad] habit of ignoring the expiration of all those tax provisions falling under the title of “extenders” — the R&E tax credit, the state and local tax deduction, the shorter built-in gains holding period, etc. The Senate Finance Committee has passed a package of extensions, but the House has yet to act. If and how these important issues are addressed during the lame duck are still to be determined, and unfortunately seem to have taken a backseat to dealing with the “must-do” broader 2001/2003 extenders that are set to expire at year’s end.
Those are the tax provisions directly impacting the S corporation community. Couple them with the spending cuts scheduled to begin January 1st, and the total makes up the $700-plus billion fiscal cliff.
What might happen?
Our friends at International Strategy & Investment in the past suggested that the choice before Congress is not “all or nothing” and we agree. Rather than be constrained by the idea that we will either fall off the cliff or step back entirely, our view is that Congress will take a half-step back, avoiding the most damaging pieces of the cliff while allowing others to take effect. Here’s a list with those cliff provisions most likely to be avoided starting at the top:
- Middle-Class Tax Relief
- Doc Fix
- Tax Extenders
- Extended UI Benefits
- Upper Income Tax Relief
- Health Care Reform Tax Hikes
- Discretionary Spending
We’ve highlighted the tax rates on upper income taxpayers, including S corporations, since their extension depends almost entirely on who wins the White House. The odds they get extended is close to zero under President Obama, and perhaps 50-50 under a new Romney Administration. Romney has made clear he will push for them, as has the House — it’s the Democrats in the Senate that are the wild card. As for the rest of the provisions, there may be some movement based on the elections, but not much.
In addition to the policies, there’s a question of timing. The general notion is that any deal on the fiscal cliff must occur before the end of 2012, but several of the provisions listed above could just as easily be dealt with in the first few weeks of 2013 with little additional harm to the economy, particularly if Congress and the incoming Administration effectively signaled what they had in mind. Moreover, with only a few weeks between the elections and the holidays, there may simply be insufficient time for the differing parties to come together.
But that doesn’t mean it’s okay to wait. Action immediately after the election to address the entire fiscal cliff — including the top tax rates — would help improve people’s lives now through increased hiring and increased business investment. Congress should act, and act quickly.
But will they? Not if their recent behavior, particularly in the Senate, is any indication. So our best pre-election guess is that Congress will act eventually, but only at the last minute, and that most of the fiscal cliff will be averted either prior to the end of the year or shortly thereafter.
House leadership has made clear they will take up legislation to extend the current tax rates and other policies through 2013, combined with expedited procedures for tax reform to be enacted in 2013.
This one-two punch is designed to address two challenges facing policymakers today. The first is the tax component of the “fiscal cliff” we face at the end of the year. The pending expiration of the lower rates on wages, business income, and investment income is having a tangible, negative impact on investment and job creation right now and, left unchecked, threatens to push the economy back into recession. Businesses simply don’t know what the rules are going to be moving forward, and are reluctant to tax risks and hire new people as a result.
The second goal is to address the underlying instability in the tax code and its impact on jobs and investment through tax reform. The code is rife with challenges, including:
- The devolution of the Alternative Minimum Tax into a tax on millions of middleclass families;
- The growth in the number of temporary tax provisions, including the estate tax rules, that need to be extended every year or so; and
- The emergence of the U.S. tax rates on corporations and pass-through businesses alike as the highest in the developed world.
The purpose of the expedited process is to enable Congress to more easily develop and pass legislation addressing these challenges, while cutting overall marginal rates and improving incentives for work and investment.
While there is an element of “wait and see” to the reform portion of this package, our view is that the legislation outlined by House leadership is the most promising and responsible path for Congress to take right now and it deserves our support. A little clarity for employers coupled with the promise of reform would go a long way to improving the economic outlook now and into next year.
What are the bill’s prospects?
The House appears to have the votes to pass the legislation described above — a strong bi-partisan majority is not out of the question — but what about the Senate? Doesn’t the Democratic majority in that body have the votes to kill it? Maybe not.
The Hill today highlights an emerging group of Senate Democrats who oppose raising taxes on anyone right now. According to The Hill:
A growing number of Senate Democrats are signaling they are not prepared to raise taxes on anyone in the weak economy unless Congress approves a grand bargain to reduce the deficit.
At least seven Democratic senators have declined to rule out supporting a temporary extension of the Bush-era income tax rates, breaking with party leaders who have called for letting the rates expire for people earning more than $1 million per year.
Combined with the 47 Senate Republicans, those seven votes would give the proposed House bill majority support in the Senate, which is certainly good news.
That doesn’t mean the House bill will pass, however. It’s clear a minority of Senators are willing to stand aside and watch as tax rates on higher income taxpayers and businesses go up, and perhaps middle income Americans too. Again, according to The Hill:
Some Senate Democrats in safe seats have even gone so far as to privately propose allowing all the Bush tax rates to lapse to maximize their bargaining power with Democrats.
Democrats in Republican-leaning states blanch at this idea. They do not want to have to explain an across-the-board tax hike to constituents when economic growth is sluggish and unemployment is high.
So the House will pass a one-year extension in the next month, and then this debate will shift to the Senate, where it appears a minority of Senators will work to block the legislation from passing that body.
What can the S Corporation Association and its members do? Make clear to members in both the House and the Senate that allowing the current tax rates on business and investment income to expire is simply not an option. They must be extended if the economy is to return to its normal growth rates.
We’ve been on the Hill with that message for over a year now, and its beginning to gain traction. The pending vote in the House is a big step in the right direction, and our goal is to get as many votes — Republican and Democratic — as possible to send a signal that the Senate needs to act.
Good news for job creators! The Senate just voted against moving forward on legislation that would increase taxes on S corporations by $9 billion. The legislation was opposed by a broad coalition of business groups, led by the S Corporation Association, including the US Chamber of Commerce and the National Federation of Independent Business. A motion to close debate and proceed to the bill was defeated on a party-line vote — 52-45. (Sixty votes are required to end debate in the Senate.)
This is the second time in two years the business community has successfully blocked legislation to increase payroll taxes on S corporations and partnerships. Two years ago, a similar provision was blocked from moving forward on a 56-40 vote. This time, S-Corp was joined by 37 other business groups on a letter to Senate leadership detailing the negative impact this tax increase would have on closely-held businesses, and we’re happy to see that the Senate stood with us.
Just How High Can Rates Go?
A question we’re hearing increasingly raised, particularly by policymakers seeking to raise taxes, is just how high marginal rates can go before they start to impede economic growth and become counter-productive. That is, begin to cost the government revenue rather than raising it.
For example, Ezra Klein of the Washington Post polled several prominent economists back in 2010 and got some hair-raising responses:
- Emmanuel Saez,University of California at Berkeley: Revenue maximizing rate “means a top federal income tax rate of 69% (when taking into account the extra tax rates created by Medicare payroll taxes, state income tax rates, and sales taxes) much higher than the current 35% or 39.6% currently discussed.”
- Brad DeLong, University of California at Berkeley: “At 70%.”
- Dean Baker, Center for Economic and Policy Research: “It would be somewhere around 70 percent and possibly a bit higher.
These responses would be ‘fall out of your chair’ funny if they weren’t being taken so seriously in Congress. Which makes the Alan Reynolds piece in today’s Wall Street Journal so important. Reynolds takes an in-depth look at a couple of recent papers, the first by Peter Diamond from MIT and Emmanuel Saez from Berkeley, and the second by Saez and Thomas Piketty of the Paris School of Economics, that form the intellectual foundation for these claims. Here’s Reynolds:
The authors arrive at their conclusion through an unusual calculation of the “elasticity” (responsiveness) of taxable income to changes in marginal tax rates. According to a formula devised by Mr. Saez, if the elasticity is 1.0, the revenue-maximizing top tax rate would be 40% including state and Medicare taxes. That means the elasticity of taxable income (ETI) would have to be an unbelievably low 0.2 to 0.25 if the revenue-maximizing top tax rates were 73%-83% for the top 1%. The authors of both papers reach this conclusion with creative, if wholly unpersuasive, statistical arguments.
But the ETI for all taxpayers is going to be lower than for higher-income earners, simply because people with modest incomes and modest taxes are not willing or able to vary their income much in response to small tax changes. So the real question is the ETI of the top 1%.
So what is the real tax responsiveness of this top 1%?
A 2010 study by Anthony Atkinson (Oxford) and Andrew Leigh (Australian National University) about changes in tax rates on the top 1% in five Anglo-Saxon countries came up with an ETI of 1.2 to 1.6. In a 2000 book edited by University of Michigan economist Joel Slemrod (“Does Atlas Shrug?”), Robert A. Moffitt (Johns Hopkins) and Mark Wilhelm (Indiana) estimated an elasticity of 1.76 to 1.99 for gross income. And at the bottom of the range, Mr. Saez in 2004 estimated an elasticity of 0.62 for gross income for the top 1%.
A midpoint between the estimates would be an elasticity for gross income of 1.3 for the top 1%, and presumably an even higher elasticity for taxable income (since taxpayers can claim larger deductions if tax rates go up.)
But let’s stick with an ETI of 1.3 for the top 1%. This implies that the revenue-maximizing top marginal rate would be 33.9% for all taxes, and below 27% for the federal income tax.
Just as a reminder folks, we’re at a top rate of 35% now, and scheduled to hit almost 45% at the end of the year, so this has direct consequences to the pass-through community and S corporations. Congress will be debating rates as early as this fall, and unlike the corporate rate debate, where there seems to be some consensus over what the rate should be in the future, the debate over the top individual rates is all over the map. For that debate, papers like the Diamond/Saez paper have their audience. That’s what makes the Reynolds response so important.
The release of Newt Gingrich’s tax return has returned the issue of payroll taxes and S corporations to the public’s attention. This issue first came to prominence during the 2004 election cycle, when Vice Presidential nominee John Edwards was accused of using an S corporation to avoid paying Medicare taxes on some of his income as a lawyer.
Now it appears Newt Gingrich may be using a similar structure. USA Today has an excellent report on the issue. Here are a couple excerpts:
Gingrich’s tax return shows his S Corporation, Gingrich Holdings, accounted for the bulk of his $3,142,066 adjusted gross income in 2010. The corporation paid him nearly $2.5 million in distributions beyond his salary and wages total of $252,500, his tax return and 2011 federal financial disclosure filing show.
Non-salary distributions from S Corporations are not subject to the 2.9% Medicare tax rate, half paid by the corporation and half by the employee.
But the IRS requires S corporations to pay “reasonable” salary compensation to employees for their services before paying non-wage distributions. That’s designed to prevent the corporations from avoiding Medicare taxes by issuing disproportionate payments in distributions, rather than wages.
An IRS publication about S Corporations states that if most of the gross receipts and profits are associated with an employee’s personal services, “then most of the profit distribution should be allocated as compensation.”
DeSantis said the candidate’s speaking engagements and television appearances produced the bulk of the payments received by Gingrich Holdings.
McKenzie said the IRS would typically ask how much investment an S corporation filer put into her or his business. Gingrich Holdings was renamed Gingrich Productions last year, corporate records in Georgia show and his spokesman confirmed. Gingrich’s federal financial disclosure report, filed in July, lists Gingrich Productions as an asset valued at between $500,001 and $1 million.
“The general rule of thumb they’ll usually apply is they don’t view anything greater than a 20% return on investment as reasonable. The rest should be paid as salary,” said McKenzie.
As USA Today points out, the IRS has two tools it can use to test whether a taxpayer is paying the appropriate level of tax — a “reasonable compensation” test and a “reasonable return” test on the businesses capital investments.
Several years ago, the House tried to replace these enforcement tools and re-write the rules surrounding how and when S corporation income is subject to payroll taxes. The effort was badly flawed and with the help of Main Street allies, it died in the Senate.
Well, now it’s back. House Ways and Means Member Peter Stark (D-CA) introduced legislation this week called the “Narrowing Exceptions for Withholding Taxes (NEWT) Act.” The bill appears to be identical to the changes that passed the House back in 2010. According to a summary, Congressman Stark’s concern is that the current reasonable compensation test is too dependent on the facts and circumstances of each individual case. In our view, however, the fix he is proposing is worse. Here’s how it’s described:
Certain employee-shareholders of S corporations would have to calculate their Medicare payroll tax obligation based on their share of the S corporation’s profits or dividends, not just income reported as wages. The individuals subject to the provision are the employee-shareholders of a professional service business where the principal assets of that business are the skills and reputations of three or fewer individuals.
How is a “principal asset” test easier to enforce than the existing “reasonable compensation” test?
- It would require affected businesses to get a valuation of each of its significant assets in order to determine which asset was its “principal” asset.
- This analysis would require the valuation of assets that are very difficult to value (i.e., skill and reputation).
- The bill taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except that it has four key employees.
- The bill requires difficult legal conclusions about uncertain areas. For example, whose asset is an employee’s “skill and reputation”- the employee’s or the company for which the employee works?
- The bill provides no definition of “asset”- it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single “asset” for purposes of determining the “principal” asset of a company.
The bottom line is that the IRS already has sufficient tools to combat the payroll tax problem and it has successfully litigated cases in which taxpayers have taken compensation that was less than reasonable.
They can apply a “reasonable compensation” test to the shareholder’s salary income, or they can apply a “reasonable return” standard to the company’s capital investment. And while it’s true that these tools are dependent on the facts and circumstances of each particular business, so is the new standard outlined above. Only more so.
Here’s an early Christmas present — the Senate voted this afternoon 81-19 to move forward on the tax deal cut between President Obama and congressional Republicans. We expect the package to pass intact early tomorrow.
For S corporations, the package means the top tax rate on S corporations remains at 35 percent and rates on capital gains and dividends remain at 15 percent for the next two years. On the estate tax front, the plan calls for a top rate of 35 percent and an exemption of $5 million per spouse.
Democratic opposition in the House is coalescing around the estate tax provisions, and if there is an attempt to change the bill, that’s where it’s likely to happen. Leadership there may attempt to raise the tax rate to 45 percent (from 35 percent) while reducing the exemption level from $5 million to $3.5 million. This amendment, however, or any other substantive change to the package, is unlikely to pass for a variety of reasons.
The size of the Senate majority makes it difficult for the opposition to characterize the deal as anything but bipartisan and broadly supported. Moreover, recent polls show the plan is popular with voters, too. According to Chris Cillizza:
Two new national polls out today affirm that political popularity. In a new Washington Post/ABC News poll, a whopping 69 percent support the tax package — support that cross party lines with 75 percent of Republicans backing the deal while 68 percent of Democrats and Independents offered their support.
A new Pew poll showed 60 percent supporting it including 62 percent of Republicans, 63 percent of Democrats and 60 percent of independents. The simple reality for Democrats writ large — and President Obama more specifically — is that they need a win in the eyes of the American public following a disastrous election that saw the party lose control of the House and lose ground in the Senate.
And finally, the clock is working against the opposition. Any deal blocked now will be taken up and passed by the Republicans when they take control in January. So either this week or first thing next year, a package very similar to what passed the Senate will be adopted by Congress and be signed by the President. Good news indeed!
We don’t want to overstate Republican opposition to the deal, but a number of high-profile Republicans are publicly opposing the plan, arguing that the party could do better if it waited until the New Year and the new Congress.
Republicans comprised five of the fifteen votes against cloture on Monday, four of whom appear to have opposed the deal because it could be better — Coburn (OK), DeMint (SC), Ensign (NV), and Sessions (AL). Meanwhile, a number House Republicans have come out opposed to the package. Representative Steve King (IA) and Michele Bachmann (MN) announced their opposition earlier, and Mike Pence (IN) announced his opposition just yesterday, stating:
“I’ve no doubt in my mind that the first order of business for the new Congress [if the compromise does not pass] … will be to enact a bill that extends all the current tax rates on a permanent basis,” Pence continued. “We’ll do it. We’ll send it to the Senate if this bill falters. There’s always time to do the right thing.”
Republican Presidential candidate Mitt Romney is also opposed, arguing Republicans should hold out for something permanent.
“Given the unambiguous message that the American people sent to Washington in November, it is difficult to understand how our political leaders could have reached such a disappointing agreement,” Romney wrote in an op-ed for USA Today. “The new, more conservative Congress should reach a better solution.”
We’re confident that the Republican House could pass a permanent tax bill. We’re also confident such a bill would stall in the Senate and would be opposed by the Administration. In the meantime, real taxes would be going up on real businesses and estates, starting January 1. Given the circumstances, the agreement achieved by negotiators is as good as the business community could have hoped.
Congress is set to return for its lame duck session the week after next. With Thanksgiving in the middle and Christmas at the end, Congress has maybe three weeks to fund the government and figure out what to do with tax policy.
Before the election, we believed two outcomes were possible on extending the tax rates: either Congress adopts a one-year extension of everything (with some middle ground for the estate tax), or Congress does nothing and the new Republican House takes the issue up first thing in January.
The President’s original preference of extending only the middle-class tax relief does not enjoy majority support in the House and is not an option. His more recent offer of extending the upper income relief for one year and making permanent all the rest — so-called decoupling — has a better chance to pass, but we think it’s simply too complicated to construct and pass quickly. So the choice is between everything and nothing.
Our metric of which option might prevail was yesterday’s results — if Republicans had a big day, then the odds of Option 1 increased and action in the lame duck would be most likely. Well, Republicans had a big day and we now expect to see Congress and the Administration come together on a one-year deal before the New Year.
Why one year? Because the Administration does not want this issue to hang over into 2012 and their reelection. How certain are we? Not very — maybe two in three that Congress passes a one-year extension. There is still a serious risk that nothing gets passed and rates go up.
S Corporation Reform
Champions of S corporation reform had a mixed day yesterday. On the positive side, S-Corp champion Representative Ron Kind (D-WI) withstood a serious challenge and won reelection in western Wisconsin. Representative Kind was the lead sponsor of our S Corporation Modernization Act (H.R. 2910) this Congress, and helped shepherd through built-in gains relief this year. His cosponsor, Dave Reichert (R-WA), also survived a tough reelect up in Washington State. With the reelection of Representatives Kind and Reichert, S-Corp’s reform team remains intact in the House.
On the other hand, Senator Blanche Lincoln (D-AR) lost her reelect bid in Arkansas. Each election cycle seems to have at least one member who, despite representing their state well, loses out to the broader wave. In 2008, it was S-Corp champion Gordon Smith (R) who lost a close election in Oregon. This time around, it was Senator Lincoln. Lincoln was our lead sponsor in the past two congresses, spearheaded our Sting Tax success in 2007, and has been a tireless advocate for private businesses. Her leadership on these issues will be missed.
Another S-Corp Champion, Senator Chuck Grassley (R-IA) easily won reelection to the Senate. Senator Grassley was instrumental in moving built-in gains relief last summer — his five-year holding period became law this fall — and he partnered with Senator Olympia Snowe (R-ME) to defeat the ill-advised payroll tax hike last summer. Senator Grassley will be stepping aside from his position as Ranking Member on the Finance Committee, though he will remain a senior member of the Committee, and his replacement will be another S-Corp champ, Senator Orrin Hatch (R-UT). Senator Hatch has sponsored our modernization bill for over a decade, and we’re looking forward to his leadership on the Committee.
Improving the rules governing how S corporations are structured and operate continues to be the central role of the S Corporation Association and, with our remaining champions, we’re eager to build on this year’s successes and get the new Congress started off on the right foot
Macro Policy Outlook
It’s never too early to look towards the next election, and this cycle in particular could play a significant role in how Congress — specifically the Senate — acts over the next two years.
Our basic view is there will be three distinct entities vying for control over the next two years: the Republican House, a largely ungovernable Senate, and the Obama Administration.
The House is designed to be the body of the majority, and with a 20-plus seat advantage, future Speaker John Boehner (R-OH) should have a relatively easy time constructing and passing Republican-oriented legislation. On most issues, we expect the House to produce clear statements of policy consistent with their majority and the underlying political landscape.
In the Senate, on the other hand, two key factors stand out. First, the Democratic majority is reduced. They went from 60 to 52 or 53 seats in less than a year. Second, of the remaining Democratic members, more than 20 are up for reelection in 2012. Having that many members up for reelection at the same time is a challenge, and the combination of a small majority and lots of nervous members means that Majority Leader Reid has his work cut out for him. Given these challenges, predicting what legislation emerges from the Senate, and what alliances form to pass it, is simply beyond our forecasting ability. The Senate is a wild card.
We are also likely to see a high level of distrust between Senate Democrats and the Obama White House. The President’s policies — particularly the health care bill and his cap-and-trade efforts — played a significant role in Democratic losses, while successful Democratic candidates largely ran away from those policies, a trend that’s been noted up on the Hill. (West Virginia’s Democratic Senator-elect Joe Manchin literally shot a bullet through the cap-and-trade bill.) So for the next two years, the Democratic caucus will be made up of a handful of Senators who ran opposing the Obama agenda and a larger group of Senators in cycle and running similar campaigns. Under such circumstances, a stable alliance between the Obama Administration and the Democratic Senate is unlikely to emerge.
All of which suggests we’re going to have a three-headed government beginning next year, and two possible macro policy trends. One possibility is the tri-headed government proves unworkable and gridlock prevails. As we observed yesterday, gridlock is not our friend. Current law includes a number of negatives — expiring tax provisions, pending tax hikes, the growth of the AMT, costly 1099 reporting requirements, pending greenhouse gas regulations, etc.
If gridlock prevails, we will see higher taxes and increased regulation, so the business community loses.
The second possibility is that the pressures of deficits, a weak economy, and expiring tax policies will force the tri-headed government to come together and address these issues. That would mean legislation on spending and deficits, permanent tax policies going forward, and clarity on how the EPA is going to move forward (or not) on greenhouse gas regulation. With a divided government, any legislation in these areas inevitably means compromise. Given the alternative, however, a little clarity packaged in a mixed bag might be better than the status quo.
The President’s press conference today signaled more gridlock. It’s possible he was just avoiding negotiating with himself on taxes and health care, but at no point in the back-and-forth with reporters did he indicate a willingness to step back from his current policies. Time will tell, but the American people elected a divided government yesterday, and division is just what they might get.
In a capital-starved economy, what makes more sense than allowing firms access to their own capital? For one year beginning in 2011, hundreds of thousands of S corporations around the country will be able to do just that, thanks to the efforts of the S Corporation Association and its allies in Congress, particularly Senators Grassley, Lincoln, Hatch, and Snowe and Representatives Kind and Reichert.
On September 27th, President Obama signed into law the Small Business Lending Fund Act of 2010 (HR 5297). Among other business friendly provisions, the bill includes one of the S Corporation Association’s tax priorities, a reduction in the built-in gains holding period. The provision is for 2011 only, but it allows firms that converted as few as five years ago to sell appreciated assets without paying the punitive built-in gains tax.
This success builds on last year’s reduction in the holding period to seven years, and we hope it signals a move towards permanently reducing the holding period below the old ten-year requirement. Ten years is a long time, and in a world where capital is dear, it only makes sense for firms planning new investments to begin by accessing their own capital.
Latest on Tax Outlook
House Speaker Nancy Pelosi (D-CA) has lost control of the tax debate headed into the November elections. Last week, 31 House Democrats signed a letter supporting extending all the individual tax rates, including the top two rates. Then, 47 Democrats wrote Speaker Pelosi calling for keeping dividend and capital gains rates at their current 15 percent. As The Hill reports:
Forty-seven House Democrats have signed a letter calling on Speaker Nancy Pelosi (D-Calif.) to extend the current tax rate on capital gains and dividends. “By keeping dividends and capital gains tax rates linked and low for everyone, we can help the private sector create jobs and allow seniors and middle-class households to save and invest more,” the letter states. Under current law, beginning next year capital gains will be taxed at 20 percent while dividends will be taxed at ordinary income rates that go as high as 39.6 percent.
As a result, a majority of House members now support extending all the current rates, at least temporarily. How is it possible that an issue that’s been 10 years in the making is still unresolved eight weeks before the election? Keith Hennessey has a very good entry on his blog outlining the steps Congress took to get here. As Keith points out:
The sequence of events was:
1. The President picks a big fight on the tax extension and highlights the partisan split;
2. a handful of Senate Democrats signal they’re not onboard; (first warning)
3. the Speaker says “the Senate will go first;” (second warning)
4. the President doubles down on the fight and elevates the conflict by making it the centerpiece of his election-cycle argument;
5. the President’s just-resigned budget director guts the President’s argument in his first New York Times column; (third warning)
6. (same day as #5) the President proposes “new” policies that are ignored by both sides; (confusion reigns)
7. Members return from August recess;
8. 30 House Democrats bail on the President’s position; (final blow)
9. Senate Democrats delay the vote until after the election.
That’s not poor coordination, it’s a total absence of coordination. Going into a highly partisan conflict on the other team’s turf, you either make sure your team is unified first, or when you figure out they’re not, you concede or switch topics quickly. We have seen a strategy and an alliance slowly collapse over a several month period. I don’t understand how the blue team [Democratic] leaders could allow that to happen.
So that’s how we got here. How does the Speaker respond? Last month, we listed the possible outcomes of the rate debate. Congress could:
- Extend all current tax policies (except the estate tax rules) for one or two years;
- Extend just those policies benefiting families making less than $250,000; or
- Do nothing and leave this issue to the next Congress.
The events of the last week have killed option two. There may be a way for the Speaker to move a middle-class-only bill through the House, but we are unable to think of how. There’s talk they may consider the bill under the Suspension Calendar, but suspensions need two-thirds support in order to pass, and the Speaker doesn’t control a simple majority on this issue. Once you lose the majority on an issue in the House, you generally lose.
Option one is becoming increasingly likely, but it would require the Speaker to allow a vote on blocking all the tax hikes when Congress returns in November. She may not control a majority on this issue, but she does control the floor. It would also require an emboldened Republican conference to accept a temporary fix to an issue they probably would like to fight next year.
So while “extending all” is moving up on the options list, we continue to believe the most likely outcome is that this issue will remain unresolved through the end of the year and would be the first order of business for the new Congress.
More on “Big” vs. “Small”
Meanwhile, the debate over how higher rates might impact business continues. On Meet the Press Sunday, Representative Chris Van Hollen (D-MD) made the following point about extending all the tax rates:
They have tried to mask this as an issue with small businesses. Well, it turns out that only 2 percent of small businesses are affected. And when you look at the definition of small businesses, you find that they’re big hedge funds, big Washington lobbying firms, KKR, Pricewaterhouse. Because, under the definition of tax code, anything that’s an S corporation qualifies. So I want Mike to tell us whether he really believes that KKR, whether Pricewaterhouse, whether those are the kind of small businesses that need help? Because that’s the folks that they’re trying to help out.
S-CORP ally and AEI economist Alan Viard warned policymakers about this argument earlier this month. As he wrote in an AEI research piece:
A common argument is that the high-income rate reductions lower taxes on small business. The valid form of this argument, recently explained by Kevin A. Hassett and myself, is that the rate reductions lower marginal tax rates on investment by all firms, including small businesses. Unfortunately, the more common forms of the argument adopt an exclusive focus on small business and obscure the growth implications.
To begin, the argument is often founded on the mistaken premise that small firms are inherently better than large firms, which suggests that the government should interfere with market forces to promote the former over the latter. In a previous Outlook, Amy Roden and I explained that firms of all sizes contribute to national prosperity and demonstrated that small firms do not play a disproportionately large role in job creation. By focusing only on small (more precisely, pass-through) firms, the argument ignores the adverse effect of letting the high-income rate reductions expire on investment by big business. The data cited above suggest that the affected high-income households finance a greater fraction of corporate investment than pass-through investment. The potential tax-rate increase on corporate investment is also larger, at least if the dividend tax cut fully expires.
While in the past we’ve disagreed with Alan on the job creating capabilities of smaller businesses, we agree wholeheartedly with him that allowing the rate debate to devolve into a fight over the size of the businesses affected is simply a distraction. This is a debate about jobs and not raising taxes on employers, regardless of how many people they employ.
On the question of large S corporations, the IRS does a nice job of breaking down the S corporation community by size and industry in its SOI reports. The most recent numbers can be found in the IRS data book while more in-depth figures date back to 2007. Here’s a quick profile we pulled from the numbers:
- There are 4.5 million S corporations (2009);
- The average S corporation has $1.5 million in revenues and $100,000 in income (2007); and
- Assuming a wage of $40,000, the average S corporation has five employees (2007).
These are simple averages, but they provide a general sense of the S corporation world. In terms of revenues, the majority of S corporations can be found in wholesale and retail, followed by construction, manufacturing, and then professional services.
In short, S corporations are large and small. They are active in every industry and in every community, and they provide millions of much-needed jobs to families across the country — even the big ones.
Finance Committee Chairman Max Baucus staked out unique turf yesterday, calling for keeping tax policy stable for middle class taxpayers, allowing rates to rise for taxpayers making more than $250,000, but for taxing capital gains and dividends at 20 percent. As BNA reports:
“I’m going for policy, and I think 20 percent for both capital gains and dividends is the right policy,” Baucus told reporters. Baucus acknowledged that the tax cut would specifically benefit the same $200,000 per year individuals that he has said should not expect to see their ordinary income tax rates cut again for 2011, but said the difference is that capital gains and dividends deserve to be treated the same under the tax code.
For wages and salary income for top-earning taxpayers, Baucus reiterated his position that Congress should focus on permanent tax cuts for only middle-class households and not entertain any temporary extensions of tax cuts for high-income individuals.
In effect, Senator Baucus is pressing for the tax policies outlined in President Obama’s budget. That budget called for taxing dividends at 20 percent, but the rhetorical battle over the past year has allowed that fact to slip aside. As your S corporation advocates, we feel compelled to observe the inconsistency of a policy that would keep (dividend) rates low for C corporation shareholders but would allow rates to go up for S corporation shareholders. Why is one better than the other?
Exactly how all this gets done also is unclear. There may be some effort in the Senate to bring up and pass a Baucus-like bill before the Senate adjourns (probably at the end of next week now), but that effort will likely be wrapped up with strict limits on debate and amendments, and the Republican minority has been successful this Congress blocking such requests.
If the Majority Leader wants to get anything done before the elections, he’ll need to set some time aside and let the Senate work its will. With time so short, we don’t expect that to happen.
S-CORP in Wall Street Journal
With the focus on flow-through businesses and the pending tax hikes, your S-CORP team is getting more press these days. The latest was earlier this week in the Wall Street Journal, where journalist John D. McKinnon quoted S-CORP Executive Director Brian Reardon on a story summarizing the rate debate. As the Journal writes:
Republicans cite studies showing roughly half of all such income would be affected by raising the top two rates. Democrats say only about 3% of households reporting such income account for that half. That suggests much of the income comes from big businesses operating under small-business structures, they say. Businesses affected by the top tax rates include all sorts of concerns, from farms and manufacturers to high-tech and professional firms.
That trend has been under way for years. Congress authorized Subchapter S corporations in 1958 to encourage the growth of small companies. The popularity of pass-through entities grew in the 1980s with the lowering of individual tax rates and other rule changes.
By now, “the vast majority of employers in this country are organized as flow-throughs,” said Brian Reardon, executive director of the S Corporation Association, which represents such companies.
Later, John gets to the heart of the matter:
But the new-found importance of such enterprises-regardless of their size-means raising individual tax rates could have significant economic impacts. This week, Moody’s Economy.com said raising taxes on higher earners would reduce GDP by 0.4 percentage point in 2011, while payroll employment would be 770,000 lower by mid-2012.
As we’ve pointed out before, the debate over tax rates is really a debate about jobs. The current obsession of policymakers over distinctions between small and large businesses or manufacturers verses professional services businesses is really beside the point. There are S corporations and partnerships in all business sectors, and they are all employers.
Following yesterday’s comments by President Obama, the S Corporation Association joined together with more than 30 other business associations to make the case for action by Congress to avoid the massive tax hike on private enterprise looming next year. As the letter states:
Main Street businesses are America’s job creators. They are responsible for 60 percent of the net new jobs created in the last decade. But uncertainty about the economy and looming tax hikes have kept this sector from hiring new workers, resulting in a weak economic recovery and slow to nonexistent job growth. Until Main Street begins to hire, we fear the unemployment rate will remain unacceptably high.
Congress returns next week and the first order of business will be the much-delayed package of small business tax provisions. This legislation is the perfect vehicle for extending the tax rates and Congress should jump at the chance. According to the Joint Committee on Taxation, failure to take action would mean that taxes next year will rise on families and businesses by $227 billion.
Despite the President’s opposition, momentum for extending all the expiring rates appears to be growing. In recent weeks, senators Ben Nelson (D-NE), Kent Conrad (D-ND) and Evan Bayh (D-IN) have all expressed support for extending all of the rates. Meanwhile, former OMB Director Peter Orzag wrote in the New York Times earlier that, given a choice between doing nothing and extending everything next year, Congress should extend everything.
Each of these Senate defections is significant since any effort to extend current tax policy will need 60 votes, and the Democrats only control 59 prior to the elections. As The Hill noted today:
Senate Democrats would need all 59 Democrats and at least one Republican to pass the Obama administration’s plan to extend tax cuts for the middle class while allowing the tax breaks for the highest-income tax brackets to expire. That plan could be a non-starter in the Senate without Nelson’s support, since another GOP vote would be needed for passage.
Moreover, the Democrat’s majority may shrink immediately after the November elections. Three states — Delaware, Illinois, and West Virginia — will immediately seat their new Senators after the elections in November rather than wait until January, which means if any of those seats change parties, support for a full extension would grow.
As before, we continue to believe the most likely outcome is continued stalemate on extending the rates and no action by Congress this year, followed closely by Congress choosing to extend all of the rates for at least a year. Each additional defection, combined with any Republican victories in Delaware, West Virginia, and Illinois, increases the odds that the latter option becomes law.
S-CORP on Fox Business News
S Corporation Association Executive Director Brian Reardon appeared on Fox Business News last week to discuss the Obama Administration’s newest stimulus proposals.
As discussed above, if the Obama Administration wants to see some real stimulus, it should seek to remove the policy uncertainty hanging over the private sector and support extending all of the current tax provisions that either expired last year or are scheduled to expire next year.
While some of the specific tax items offered up — particularly expensing and a permanent R&E tax credit — are attractive to members on both sides of the aisle, finishing the existing “honey-do” list of tax items is more important.
The amount of capital available to the private sector — and currently buried in money market funds and ridiculously low-interest Treasuries — completely dwarfs the $180 billion package proposed by the President, even without the offsetting tax hikes that are planned to accompany the package. Getting that capital off the sidelines is the first step towards helping the job market recover.