Extenders and Immigration

Last week, we did a post-election analysis that highlighted the broad implications of the new Republican Congress. A return to “regular order” and increased legislative activity overall, including in the tax space, was our basic conclusion.

One wild card at the time was the possibility of President Obama issuing an Executive Order on immigration. He’s promised to do so and, despite pushback from Republicans and many members of his own party, he appears poised to release something on Friday.

What are the implications of such an action on tax extenders in the Lame Duck? Absent action on immigration, the options for extenders are:

  1. A one-year extension for 2014 only;
  2. A two-year extension for 2014 and 2015; or
  3. A two-year extension together with some provisions being made permanent.

For S corporations, the option Congress embraces makes a big difference. Two S corporation-specific provisions – the shorter holding period for built-in gains and the basis adjustment on charitable donations – are in play. Permanent versions of both provisions passed the House twice this year. Beyond those items, we hear from our members consistently on the importance of the R&D tax credit and the increased limits on 179 expensing. These items, too, are in play to be made permanent.

On which option prevails, there are lots of variables but the key variable is the number of House conservatives – the “Hell No” Caucus – who argue that Congress should do only the minimum on extenders (one year for 2014) and then come back next year and use their new majority to reshape the package with the intent of eliminating certain provisions while making other items permanent.

Right now, it’s wholly unclear just how many conservatives hold this position. Speaker Boehner might be able to move a broader package despite their opposition, but it may take a test vote to find out.

What is completely clear is that membership in the Hell No caucus will grow multi-fold and may include members of the Republican Leadership if the President chooses to go his own way on immigration.

At that point, any prospect of permanence for tax extenders, or even a two-year extension, goes away. Instead, the universe of possible outcomes reverts to a one-year extension of most if not all the provisions or, less likely but also a possibility, no action at all. It’s hard to adopt tax policy if the federal government is shut down, starting December 11th when the current funding expires.

That’s not good for tax policy nor those families and businesses relying on these provisions. Nor is it good for the government or the economy to be moving into crisis mode so quickly after the voters had a chance to express their preferences.

On the other hand, voters also chose to re-elect President Obama, and the ball is in his court on this one.

S Corporations Hit by Tax Hikes

Our friends at McGladrey LLP have a new survey out of mid-market firms showing just how hard those companies have been hit by the tax rate hikes championed by President Obama and his allies in Congress.

Recall that in the run-up to the Fiscal Cliff, Ernst & Young released a paper on our behalf that predicted the higher rates set to begin in 2013 would hurt investment and job creation by significantly hiking taxes on mid-sized employers.  Over the long-term, E&Y estimated the U.S. would lose 710,000 jobs.

Now McGladrey’s survey shows just how those job losses and lower investment levels emerge.   According to them:

While middle market companies are adding jobs, and have been for several years, some have had to reduce their workforces over the past year. More than 50 percent of the middle market companies that reported having cut jobs (56 percent) said the 2013 tax reform bill was a factor in their decision to take these actions.

McGladrey defines “mid-market” as businesses with revenues between $10 million and $1 billion.  Census Department statistics make clear that firms in that revenue range are a huge source of employment in the U.S. and an important part of the economy.  Raising tax rates on these employers made little sense back in 2012 and even less sense now.

Another key finding in the survey provides additional support to the Harvard study on bonus depreciation we highlighted last week.  As you’ll recall, the study found that US companies responded strongly to the investment incentive, with privately-held companies responding strongest of all.

The McGladrey study reveals the other side of that coin.  When investment incentives are allowed to expire, as Section 179, the R&E tax credit, and bonus depreciation are right now, then firms respond by reducing their investments.  According to McGladrey:

Half of all companies that reported cutting back on research and development (R&D) said that the reform law had influenced their decision to do so. Not surprisingly, the manufacturing industry – a key component of the middle market – reported the most severe impacts. More than three-quarters (78 percent) of middle market manufacturers said that the R&D tax credit’s expiration had led to an increase in their tax bills, and 63 percent of manufacturers that reported having cut R&D over the past year said  the tax credit’s expiration contributed to their decisions to do so.

So there you have it.  We now have prospective and retrospective evidence that hiking rates on Main Street employers hurts investment and job creation.  With the debate over tax reform focused almost wholly on large multinational companies, the McGladrey survey is a solid reminder that tax reform needs to embrace the whole business community, not just publicly traded companies.

BIG Tax Relief on House Floor

It’s a big week for S corporations!  The House is scheduled to vote on several small business tax items, including permanently higher section 179 expensing limits and S corporation modernization legislation too!

The S corporation bill, newly-named the S Corporation Permanent Tax Relief Act of 2014, will bundle together HR 4453 (permanent 5-year BIG period) and HR 4454 (basis adjustment for charitable contributions). We expect the bill to be considered by the Rules Committee later today with debate and a vote on the bill to take place Thursday.

Making the five-year recognition period for built in gains permanent has been an S-CORP priority for years, and while we have been successful at enacting temporary reductions in the past, this week’s action marks the first time either the House or the Senate has considered a permanent fix.

By way of background, here are some of the documents we have developed over the years to support the shorter holding period as well as the charitable donation provision:

The case for the shorter five-year recognition period is strong and is certain to help encourage business investment.  As Jim Redpath testified early this year:

I find the BIG tax provision causes many S corporations to hold onto unproductive or old assets that should be replaced. Ten years is a long time and certainly not cognizant of current business-planning cycles. Many times I have experienced changes in the business environment or the economy which prompted S corporations to need access to their own capital, that if taken would trigger this prohibitive tax. This results in business owners not making the appropriate decision for the business and its stakeholders, simply because of the BIG tax.

We are recirculating the business community letter to allow additional groups to sign on is support of BIG tax relief.  We’ll post the letter tomorrow and we will be working with our House allies to ensure the vote on Thursday is as broad as possible.

Senate to Vote on Buffett Tax

While the House is working to reduce the tax burden for S corporations, the Senate is seeking to raise them.  This week, the Senate will consider legislation to provide student loan relief paid for with our old friend, the so-called “Buffett Tax”.

We’ve criticized both the theory and execution of the Buffett tax in the past (here, here and here), and all those arguments still apply:

  • The federal tax code is already steeply progressive;
  • The tax code already has three distinct income taxes – the regular income tax, the Alternative Minimum Tax, and the Affordable Care Act investment tax.  The Buffett Tax would be a fourth!
  • Much of the Buffett tax will fall on the owners of pass-through businesses; and
  • For sales of S corporations, the Buffett tax would eliminate the benefit of the lower tax on capital gains.

The Tax Foundation agrees with our concerns, and posted a nice analysis of the provision when it was introduced last month.   Here’s what they had to say about the structure of the tax:

Besides the 30 percent effective tax rate in the Buffett rule, there is a phase-in of the tax over $1,000,000 of AGI. This phase-in creates a spike in taxpayer’s marginal tax rate of over 50 percent. Our current tax code is no stranger to hidden marginal tax rates caused by phase-ins and phase-outs. However, these are not positive aspects of the code. They obscure peoples’ true tax burden, add unnecessary complexity, and create marginal tax rate cliffs that incentivize people to change behavior to avoid them.

The Buffett Tax vote is tomorrow.  We doubt it will receive the 60 votes necessary for this poorly thought out policy to move forward, but it will be interesting to see who votes to raise taxes on Main Street businesses in order to increase federal spending.

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