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.

Business Community Supports Estate Tax Relief

Last week, the S Corporation Association joined a group of nearly 50 small business organizations to support estate tax legislation (H.R. 3905) to make permanent rates and exclusion levels more favorable than those in place in 2009. In a letter to family business allies on the Ways and Means Committee, the Family Business Estate Tax Coalition stated: 

The cost of the estate tax falls heavily on family businesses and farms. The cost comes not only from paying the tax itself, but also from estate tax planning costs. Resources diverted from businesses to pay for estate tax planning would be better invested in business operations and expansion.

The goal of the FBETC continues to be repeal of the estate tax, but this legislation will provide much needed additional relief above the current law. The higher exemption level and reduced rate will lessen the burden of the estate tax and provide family businesses and farms with more capital to reinvest in their business.

As S-CORP readers know, there are three key questions to any estate tax solution — what is the rate, what is the exclusion, and what is the base? Earlier this month, your S-CORP team was joined by fifteen other business groups to make sure Congress doesn’t increase the estate tax base for family owned businesses. This legislation would lock in the other two and help set the stage for continued estate tax relief in the future.

Taxes Are Going Up

The consensus in Washington is that taxes are going up. Just how high is debatable, but higher tax rates appear to be baked in whatever policy cake we are eventually served. So what does the Obama Administration think about higher rates? Obama economist Austan Goolsbee was on CNBC the other day and has this exchange on health care reform after CNBC Squawk Box host Joe Kernen pointed out marginal rates in his home state of New Jersey would soon approach 60 percent:

Goolsbee: We need health care reform so that small business can thrive. You know very well in every small business survey the unaffordability of health care is the thing that small business says is the number one barrier to their growth.

Kernen: But is there a marginal rate were you would say this is a disincentive for small businesses. Is there somewhere where you’re willing, where the administration is willing to draw the line?

Goolsbee: I don’t like high marginal rates, Joe, I agree with you. But to say the marginal rate is going to be 60 percent is totally nuts.

But Joe is right. Marginal rates are going much higher than what they were under Clinton if the House health care reform is adopted. Here’s a rough summary of tax rates in 2011 if the House health care bill is adopted:

Rates in 2011*
Top Rate 39.6
Health Reform Surtax 5.4
Medicare 2.9
State Average 6
Pease 1.2
Total 55.1
Dr. Goolsbee took pains to point out that state taxes are deductible at the federal level. Fair enough. That would reduce the average state rate from around 6 percent to maybe 4 percent and the total effective rates to around 53 percent.  But Pease reduces the value of that deduction, and the surtax applies to “modified” AGI thus it actually has a bigger impact that a regular rate increase. In other words, worrying that the top effective marginal rate may approach 60 percent in high tax states is not so nuts after all. Go Joe.

(S-CORP ally Bob Carroll at the Tax Foundation issued a nice paper last summer summarizing these concerns and pointing out that high marginal rates are an extremely inefficient means of raising tax revenue.)

The good news is that it is still just 50/50 that the House surtax will survive in health care reform and make it to the President’s desk. The bad news is that won’t matter much, since the fiscal pressures facing Congress are almost unprecedented. As former CBO Director Doug Holtz-Eakin testified before the Senate Budget Committee earlier this week:

Any attempt to keep taxes at their post-war norm of 18 percent of GDP will generate an unmanageable federal debt spiral. In contrast, a strategy of ratcheting up taxes to match the federal spending appetite would be self-defeating and result in a crushing blow to economic growth.

In other words, we’re stuck between the proverbial rock and the hard place. Federal spending levels far exceed their post-war averages and unless taxes are raised to match them, the resulting deficits will be enormous. On the other hand, raising taxes by the necessary amount will, at best, retard economic growth and job creation for years to come.

And what is team Obama doing about this? Downplaying valid concerns about higher marginal rates and supporting legislation that will add more than $1 trillion to our spending obligations over the next ten years.

Update on Healthcare Reform in the Senate

Senate Majority Leader Harry Reid (D-NV) is still working to combine the two health care packages passed by the Senate Finance Committee and the Health, Education, Pensions and Labor Committee.  Word is the cost of the plan may be going up. He also is reportedly looking at raising the threshold for the “high cost” plan from $21,000 to $25,000, resulting in lower tax collections from the excise tax. As a result, the Majority Leader is apparently looking into a new way to help pay for the cost of the package by applying Medicare taxes to non-wage income earned by couples making over $250,000. As Bloomberg News reports:

Reid’s proposal would apply Medicare taxes to non-wage income earned from capital gains, dividends, interest, royalties and partnerships for U.S. couples earning more than $250,000, the aides said. He’s also considering an alternative that would simply increase the 1.45 percent Medicare tax on salaries of couples who earn more than $250,000, one of the aides said.

The Wall Street Journal this morning has a bit more on the item, suggesting the proposal could include raising the HI tax to 1.75 percent for individuals starting at $200,000 and couples starting at $250,000.

This new pay-for is an attempt to scale back the previously proposed tax on so-called “Cadillac” health plans. So what does this mean for S corps? More pressure on rates, higher taxes on business income, and less capital to invest and hire new workers. And these hikes would take place during the worst economy since at least 1980 and maybe before. What are they thinking?

 

House Releases Health Care Legislation

As expected, House Leadership released its health care reform plan yesterday — America’s Affordable Health Choices Act of 2009 (H.R. 3200). As you can imagine, there are any number of provisions to explore in a 1000-page health care bill, but for S corporations, the big four items appear to be:

 

  • The new health insurance exchange;
  • The surtax on high income individuals;
  • The health insurance tax credit for smaller firms; and
  • The payroll tax penalty for non-participating firms.

 

Supporters of the plan argue that the combination of the health care exchange and the small business tax credit will provide a net benefit to S corporations and other small businesses. Opponents point to the higher taxes and penalties for firms that choose not to offer health care plans to their employees.

They also question whether the overall plan will actually save money. The CBO estimates it will cost money after all - more than $1 trillion dollars. Of particular importance is the response of the moderate Democratic Blue Dog Coalition.B As BNA reported this morning:

Rep. Mike Ross (D-Ark.), chairman of the Blue Dog Health Care Task Force, said his group was committed to passing health care reform. He also said that “reform that does not meet the president’s goal of substantially bringing down costs is not an option.”

We are not in a position to judge how successful the exchange will be. The only example is the one in Massachusetts and that one has both supporters and detractors.B As for the other three provisions, here’s our best summary:

Surtax: Starting in 2011, a surtax of 1, 1.5 and 5.4 percent will be applied on “modified” AGI exceeding $350,000, $500,000 and $1 million respectively (joint filers).B Unless OMB certifies that the bill’s changes to Medicare and Medicaid result in an additional $150 billion in cost savings, the surtax will rise to 2, 3, and 5.4 percent starting in 2012. If OMB certifies these savings exceed $175 billion, then the lower two surtaxes go away.

Small Business Tax Credit: For employers with fewer than 25 employees and who offer them qualified coverage, they are eligible for a tax credit equal to a percentage of their health care costs. The credit starts at 50 percent for employers with fewer than 11 employees and average annual compensation of less than $20,000. It phases out for more employees and higher salaries. A firm with 25 employees and/or average compensation of more than $40,000 gets no credit.

Payroll Tax Penalty: Firms that do not pay for at least 65 percent of their employees’ qualified coverage are subject to a payroll tax penalty. The tax starts at 2 percent of payroll for firms whose payroll exceeds $250,000 and rises to 8 percent for firms with payrolls exceeding $400,000. It is unclear whether the payroll tax applies to all payroll or just the amount exceeding the threshold.

Suffice to say that the complexity of each provision is worth its own white paper. Trying to gauge the interaction between them is simply impossible. Here are some observations and questions:

 

  • How does the payroll tax penalty work? If an employer does not offer qualified coverage to his/her employees, does the tax apply to all payroll or just the amount above the threshold How does the bill define firm? By entity or by establishment?
  • The plan penalizes employers for expanding their payroll. If the employer offers qualified coverage, raising wages would reduce their credit. If they don’t, increased wages will increase their penalty. Either way, the plan raises the marginal cost of hiring new employees and offering them higher wages.
  • The higher surtax rates can be avoided if OMB finds additional savings from Division B in the bill. How is OMB supposed to measure these savings and attribute them to the Division B? If the CBO failed to measure these savings, how will OMB?
  • The bill appears to add to the deficit, especially in later years. Is this the plan, or will additional cost savings be offered to make it budget neutral?
  • What about the need to balance the budget, reform the Alternative Minimum Tax, extend some or all of the expiring tax relief, or make the corporate tax code more competitive? How will Congress accomplish all these things if it spends $1 trillion on health care reform?

 

 

The House Ways and Means, Labor, and Energy and Commerce committees will begin marking up their respective portions of the bill tomorrow. Expect these markups to be extremely contentious. The Speaker’s goal is to get the bill through the full House before the August recess. Given the primary importance both the Speaker and the President have placed on health care reform, we expect this goal will be met. Exactly what changes are necessary to get the plan through the House, however, remains to be seen.

The Surtax and Small Business

The fight over who will pay the surtax has begun. The Ways and Means Committee published its estimates that only 1.2 percent of all taxpayers will pay the tax, and only 4.1 percent of all small business owners.

Our immediate reaction was that small business owners are 3.5 times more likely than the average taxpayer to pay the tax, but even that observation misses the larger point. It’s not the number of taxpayers affected that counts, but rather the amount of economic activity subject to the higher rates.

As we’ve pointed out previously, about two thirds of all small business income is taxed at the top two rates, so any surtax applied to upper incomes is likely to tax a majority of small business income. Moreover, those rates are already scheduled to rise, resulting in a double hit on upper income business owners in 2011 and beyond.

Marginal Tax Rates Under HR 3200 (Joint Filers)
AGI Marginal Rate (2009) Marginal Rate (2011) Marginal Rate (2012)
$350,000 33% 34.00% 35%
$500,000 35% 41.10% 42.60%
$1,000,000 35% 45% 45%

This chart requires several caveats, including pointing out that the surtax applies to “modified” AGI rather than taxable income, but the general point is valid — HR 3200 will return marginal tax rates back to where they were before we started cutting rates in the 1980s.

In addition, this chart doesn’t include the HI tax that now applies to wage income, it doesn’t adjust for taxing “modified” AGI, which includes income from capital as well as labor, it doesn’t include the impact of restoring PEP and Pease, and it doesn’t include state and local taxes. All told, the effective marginal rates on higher incomes will easily exceed 50 percent under this plan.

One last point. When taxing the rich is debated, the discussion usually ignores the actual amount of taxes being paid. Your S-CORP team thinks that’s a mistake.

For example, the CBO reports that the top fifth of taxpayers pay, on average, $64,000 in federal taxes every year. The top one percent pay over half a million.

How much more will HR 3200 add to this burden? And at what level of tax do taxpayers, including small business owners, stop being productive and choose to do something else with their time?

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