House Passes Health Care Reform and "Fix"

After a long legislative odyssey, the House passed the broad health care reform package on Sunday evening by a vote of 219-212. This legislation is identical to the Senate bill adopted on Christmas Eve and is now ready to go to the President. As CongressDaily noted:

The House took a historic vote late Sunday night to approve an overhaul of the nation’s healthcare system after more than a year of debate, a few near-deaths for the measure and an intense final week marked by loud and angry protests outside the Capitol.

The House also adopted 220-211 a package of “fixes” to the larger bill that will now go to the Senate for consideration. This narrower package makes numerous changes to the broader bill, including imposing a new 3.8 percent tax on unearned income that hits S corporations, and will be considered in the Senate under reconciliation rules that only require a simple majority vote.

The Senate vote is expected to occur later this week and, by all accounts, the Senate Democrats have the votes to prevail. (Note: There are two remaining bumps in the legislative road to look out for. First, there is a lot of talk about a possible Social Security point of order that would bring down the entire “fix” bill. Second, there are numerous so-called Byrd Rule violations in the “fix” bill that will need to be removed, which means the Senate “fix” bill will differ from the House version. That means a conference and a more protracted debate.)

About a month ago, we predicted that health care reform would stall and eventually be set aside by other legislative priorities. Its adoption yesterday demonstrates both the risk of trying to predict the future, and also the determination of the Obama Administration and Congressional Leadership to see this effort through. It’s an impressive legislative victory, albeit a costly one for private enterprise.

S-Corp Leads Response

Last week was a busy one for your S-Corp team. Early in the week, we learned that the House would consider, as part of the health care “fix” bill, a new 3.8 percent tax on certain types of income.

While the tax has been inflicted with various labels — in a nod to reality, the House dumped the original “Medicare Tax” title — the simplest description is that it’s a tax on investment income — just about any taxable investment — including S corporation and partnership income attributed to non-active shareholders and partners.

So, if your income is high enough and you invest in Microsoft, you’ll pay this tax on any dividends or capital gains Microsoft earns you. Similarly, if you invested in your daughter’s S corporation, you also pay the new tax.

In response, your S-Corp team quickly organized a business community letter opposing the new tax in the strongest terms. The letter, sent to Hill leadership and signed by 24 small business groups, makes the case that this new tax is going to hurt job creation and economic growth in future years. As the letter states:

Finally, while the tax has been described as applying to the “unearned” income of only a few taxpayers, it is actually a direct tax on the majority of taxable savings in this country. In 2007, households with incomes exceeding $200,000 accounted for 47 percent of all interest income, 60 percent of all dividends, and 84 percent of all capital gains reported on tax returns.

Businesses and workers rely on these savings to increase their productivity and wages. At a time when businesses are having a hard time accessing credit, millions of workers are unemployed, and the entire economy needs to recapitalize, raising taxes by this amount on that much capital is simply reckless.

Despite this harm, the House retained the provision. It now heads to the Senate. While we expect the Senate to adopt the tax as well, the tax itself doesn’t take effect until 2013, giving the S Corporation Association and our allies two years to educate policymakers on why this is a really bad idea.

The “3.8%” Tax and Future Tax Rates

Peter Cohn in CongressDaily has an interesting piece on where tax rates, especially the tax rate on dividends, are headed in the next couple years. Here’s the lead:

Democrats may be boxed in to letting the tax rate on dividends for upper-income earners top 40 percent in January — or coming up with tens of billions of dollars to pay for a lower rate — due to new budget rules signed into law in February.

The general assumption has been that Democrats will enact President Obama’s tax policies, averting that scheduled increase by capping it at 20 percent for wealthier earners. But the pay/go law only assumes the dividend rate will stay at its current 15 percent for middle-class taxpayers. For the wealthy, the rate would revert to its pre-2003 levels corresponding to ordinary income tax rates, unless Congress finds a way to pay for holding it to 20 percent.

With Federal deficits exceeding $1 trillion, we’re not holding our breath here that the same Congress that just imposed a new 3.8 percent tax on investment income would turn around and cut the base tax rates on that same category of income.

Which means, coupled with where the marginal tax rates are scheduled to go already, the new 3.8 percent tax has the potential to drive tax rates to their pre-1986 levels — capital gains rates would be 25 percent while the tax on interest, dividends, royalties, and other forms of investment income would be nearly 45 percent. More from Peter Cohn:

Observers outside the Beltway are baffled why the issue isn’t getting more attention. “I don’t think anyone is really focused on the dividend tax,” said Jeffrey Kwall, a professor of tax law at University of Loyola Chicago Law School. “And I don’t think people have really thought through what kind of impact it would have on the market” for the top rate on dividends to skyrocket by 165 percent.

Congress spent a year focused on expanding the Federal government’s obligations to health care while ignoring one of the most basic issues affecting the economy and job creation — the after- tax rate of return on investment. Outside observers should be baffled.

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