Fiscal (Slope) Cliff Forecast

While everyone in Washington waits for Tuesdaybs election results, this story in The Hill caught our eye:B bFiscal cliff already weighing on economy.bB 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.

Thatbs consistent with what our S-CORP members are telling us.B 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 webre already on it.B Employers are holding back, which is suppressing investment and hiring decisions right now, and thatbs reflected in the less-than-stellar jobs and GDP numbers webve 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, whatbs at stake for S corporations?B Herebs a short list:

Tax Rates:B The best case is that current rates are extended for 2013.B The worst case is total gridlock in Congress and rates rise to their pre-2001 levels and beyond.B (Beyond because of the tax hikes included in health care reform).B Herebs a table summarizing the options:

Top Rates

Worst Case

Best Case

Wage & Salary

44.7%

37.9%

Cap Gains

23.8%

15.0%

Dividends

44.7%

15.0%

Interest

44.7%

35.0%

S Corp Income

44.7%

35.0%

Keep in mind, the best case scenario includes both extending current rates and repealing the new 3.8 percent investment tax imposed under Obamacare.B Not impossible if Romney wins and Republicans take the Senate, but not easy either.

AMT:B One of the findings in our E&Y study released this summer was the significant number of pass-through owners who pay the AMT.B 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.B 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.B 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).B The findings of E&Y suggest many of those taxpayers are business owners.B Business owners most at risk are those with dependent children and those living in high-tax states like New York and California.

Extenders:B B Congress has gotten into a [bad] habit of ignoring the expiration of all those tax provisions falling under the title of bextendersb — the R&E tax credit, the state and local tax deduction, the shorter built-in gains holding period, etc.B The Senate Finance Committee has passed a package of extensions, but the House has yet to act.B 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 bmust-dob broader 2001/2003 extenders that are set to expire at yearbs 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 ball or nothingb and we agree.B 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.B Herebs a list with those cliff provisions most likely to be avoided starting at the top:

More LikelyB

  • AMT
  • Middle-Class Tax Relief
  • Sequestration
  • Doc Fix
  • Tax Extenders
  • Extended UI Benefits
  • Upper Income Tax Relief
  • Health Care Reform Tax Hikes
  • Discretionary Spending

Less Likely

Webve highlighted the tax rates on upper income taxpayers, including S corporations, since their extension depends almost entirely on who wins the White House.B The odds they get extended is close to zero under President Obama, and perhaps 50-50 under a new Romney Administration.B Romney has made clear he will push for them, as has the House — itbs the Democrats in the Senate that are the wild card.B As for the rest of the provisions, there may be some movement based on the elections, but not much.

In addition to the policies, therebs a question of timing.B 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.B 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 doesnbt mean itbs okay to wait.B Action immediately after the election to address the entire fiscal cliff — including the top tax rates — would help improve peoplebs lives now through increased hiring and increased business investment.B Congress should act, and act quickly.

But will they?B Not if their recent behavior, particularly in the Senate, is any indication.B 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.

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