Led by S-CORP, a coalition of fifteen small business trade associations sent letters last week to the Senate Finance and House Ways and Means Committees urging policymakers to protect the interests of family-owned businesses during the upcoming estate tax debate.
“Penalizing businesses simply because they are family-owned is inconsistent with good tax policy, it creates an unworkable framework with two conflicting definitions of fair market value, it makes it more difficult for these family businesses to be passed on from one generation to the next, and should be rejected by Congress,” the letter states.

Under consideration is the issue of Family Attribution, which has the effect of dramatically raising the estate tax burden on family-owned businesses relative to those not owned by family members. Family Attribution was originally embraced by the IRS in the 1980s, and despite being rejected by the courts in several prominent cases, the idea continues to be put forward. Earlier this year Congressman Earl Pomeroy (D-ND) introduced the “Certain Estate Tax Relief Act of 2009” (H.R. 436), which, among other items, would create an alternative and more punitive definition of fair market value for business assets that are transferred to members of the same family.

S Corporation Association Chairman Dick Roderick applauded the efforts of the coalition and those members of Congress who have a history of supporting family enterprise. “Family businesses play a vital role in our economy, and it is important to ensure their continued success” he noted. “Imposing a higher estate tax on businesses simply because they are owned by a family does not make sense. We look forward to working with our friends on the Hill to ensure this idea does not become law.”

The letter was signed by the following organizations: American Hotel & Lodging Association, AMT – The Association For Manufacturing Technology, Associated Builders and Contractors, Independent Community Bankers Of America, National Association of Manufacturers, National Association of Wholesalers-Distributors, National Beer Wholesalers of America, National Funeral Directors Association, National Lumber and Building Material Dealers Association, National Restaurant Association, National Roofing Contractors Association, Printing Industries of America, S Corporation Association of America, United States Chamber of Commerce, and the Wine & Spirits Wholesalers of America.

House Health Care Bill Surtax

S corporations should be paying strict attention to the health care bill offered up by House leadership last week. The new bill imposes a 5.4 percent surtax on income above $500,000 for individuals and $1 million for families. Like most taxes applied to personal income, this surtax applies to flow-through business income as well as wages. It also applies to capital gains, dividends, rents, etc.  (It may also apply to trusts and other structures — we’re checking.)

Revenue offsets for health care reform need to accomplish at least two goals: raise enough money to cover expanded coverage over the next ten years, and grow at least as fast as health care costs to fully cover expanded coverage costs in years eleven and beyond. The surtax before the House raises $461 billion over the next decade, covering about half the cost of expanding health insurance coverage; the other half is offset with provider payment cuts to Medicare and an assortment of other revenue raisers.

Perhaps just as important, the thresholds for the surtax are not indexed, so the threshold for individuals paying the tax would remain at $500,000 while the threshold for families would stay at $1 million over time. This imbedded bracket creep is necessary for the bill’s authors, since it’s the only way an income tax can be constructed to grow at about the same rate as health care costs.

The Congressional Budget Office indicates that the overall bill – spending minus savings and taxes – results in a surplus for years one through ten, while, in the subsequent decade, the collective effect of its provisions would probably be slight reductions in federal budget deficits. Those estimates are all subject to substantial uncertainty.

So, the House health care reform bill apparently lives up to the promise not to increase the federal budget deficit in the long term, but only at the cost of drastically raising marginal taxes on a significant portion of business income and reversing a quarter-century of tax policy committed to indexing thresholds to ensure the federal government doesn’t profit from inflation. By all accounts, the surtax will face rough sledding in the Senate. We hope so. We also hope policymakers have a chance to fully explore the implications of an un-indexed marginal rate increase of this size.

Marginal Tax Rate Outlook

Economists Barro and Redlick put together the chart below showing the average marginal rates faced by Americans over the past century. As you can see, it has been a consistent upward trend interrupted primarily by the cumulative effects of the Reagan tax relief of 1981 and 1986 and the Bush tax cuts in 2001 and 2003.
What’s concerning your S-CORP team is where that little blue line is headed in coming years. Add 5.4 percent (health care reform) to 4.6 percent (expiring tax relief) to 35 percent (current top rate), and the top federal tax rate on regular income could be 45 percent in just fourteen months. That rate applies to wages and business income alike.

And where will Congress be in fourteen months with top marginal rates at 45 percent? It will be looking at a federal deficit that exceeds one trillion dollars, a Social Security system that is now operating under a cash flow deficit (i.e. its taking money from the general treasury rather than contributing to it), and a Federal Reserve and Treasury working overtime to unwind several trillion dollars worth of balance sheet buildup incurred during the recent financial crisis.

No wonder the markets are spooked. Happy belated Halloween.