Recap of a Busy Week in Tax Policy

Patent/Innovation Box

Rep. Charles Boustany (R-LA) and Rep. Richard Neal (D-MA) unveiled their proposed “innovation box” legislation aimed at keeping intellectual property registered in the United States. The bill would lower the rate on qualified income from patents and intellectual property to 10 percent, but only for firms with domestic R&E expenses. Similar laws already exist in Europe, and there are signals that this could become part of a Ways and Means international tax package later this year. Here’s Chairman Ryan on the proposal:

The proposal from Reps. Boustany and Neal can help us stem the tide and protect good American jobs. It will also help ensure the United States continues to be the world’s leader in innovation. Their plan would allow American businesses to better compete with foreign companies and keep their research and development facilities here in the U.S. This is just one piece of international tax reform, but it’s an important one. I applaud Charles and Richie for their work, and look forward to refining the proposal as we move forward on a broader plan to make America more competitive and promote high-paying jobs.

Senators Rob Portman (R-OH) and Chuck Schumer (D-NY), who authored the Senate Finance Working Group report on international reform, were also supportive. You can read their respective statements here. With support in both chambers, it appears the innovation box will be a factor in international tax negotiations later this year.

As the proposal currently stands, it doesn’t appear as if innovative pass through businesses would be eligible for the innovation box. The sponsors have made clear that the legislative text released this week is a “draft” and that they are eager for input.  We will be working with the rest of the pass through community to coordinate our comments and make sure S corporations are well represented.

 

Highway Bill & Patent Boxes

Why release the patent box draft now, just before the long August recess? We believe the goal was two-fold.  First, it is a genuine effort to get feedback on the proposal, which is a new concept for the Ways and Means Committee and they’d like to get the policy right.  Second, it helps to keep the ball moving on Chairman Ryan’s two step plan to getting international tax reforms done this year – pass a short term highway extension now and follow it up with a bigger package of highways and international tax reforms this fall.  The innovation box idea is a key “sweetener” in the larger international package, so getting it out now helps to move the overall plan forward.

For the past year, Ryan’s goal has been to combine highways, international reforms, and tax extenders into one big package Congress would enact at the end of 2015.  He believes the general desire by both parties to get a highway bill done can help push his international package over the finish line.

Senate Majority Leader McConnell, on the other hand, thinks any plan to reform taxes with this President in office is doomed to fail and wanted to get highways done and off the table at least through the elections.  So McConnell proposed to do long-term highways now with little in the way of tax policy, while Ryan advocated for addressing highways in December with as much international reform as he can muster.

The three-month extension adopted by Congress this week represents a compromise between the two positions.  It means Congress will have to revisit the issue prior to December, but it also keeps alive Ryan’s international reform efforts.

 

Built-In Gains Relief Introduced in Senate! 

Good news!  Sens. Pat Roberts (R-KS) and Ben Cardin (D-MD) introduced legislation Thursday to provide a permanent five-year recognition period for built-in gains (BIG) assets.

We’ve been advocating on BIG for years and, even after all of the leadership changes in Washington, DC over the past several elections, built-in gains relief continues to receive strong bipartisan support in both chambers. We are glad that Congress has recognized the importance of such relief by continuing to extend temporary relief – as included in the tax extender package recently adopted by the Senate Finance Committee.  Permanent BIG relief, however, is the only way to offer business owners the certainty they need, so we’ll keep working to get the Roberts/Cardin bill across the finish line.

Also in the Senate this week, the Small Business Committee adopted a “Sense of the Committee” resolution endorsing legislation introduced by Committee Chairman David Vitter (R-LA) that includes “sting” tax repeal!  Eliminating the “sting tax” has been a priority of the S Corporation Association for years and it’s a key part of the S Corporation Modernization Act introduced by Representatives Reichert (R-WA) and Kind (D-WI) last month.

Fixing this particular passive income rule has been long overdue—in fact, the Joint Committee on Taxation recommended the repeal of this termination rule back in 2001!  As with permanent BIG relief, we plan to spend this fall pushing the tax writing committees to adopt Sting Tax relief as part of any tax legislation moving this year.

 

Hillary Clinton Proposes Tax Hikes on S Corps

In her bid to reform so-called “quarterly capitalism,” presidential candidate Hillary Clinton proposed this week to hike the capital gains tax on investments held less than two years to the top individual rate of 39.6% (plus the 3.8% net investment tax), or nearly double the tax today. Under her plan, the tax rate would gradually decline for investments held between two and five years, while investments held six years or longer would get the current 20% rate.

So while all of Washington, including the Obama Administration, is working on ways to reduce the tax on investment and encourage more companies to remain here in the US, candidate Clinton would increase the cost of domestic investment instead.  Clinton did add that capital gains would be eliminated for select long-term investments in small businesses. That doesn’t sound bad, but it begs a few questions. What is her definition of “small business”? How long would the investment need to be held?

Moreover, if lower capital gains for small businesses would stimulate long-term investment, why limit it to small businesses?  Why not reduce or eliminate the capital gains rate on all domestic investments, as Senator Rubio has proposed? As the Wall Street Journal points out, this proposal may do little more than distort investment decisions in the short-term and prevent the efficient allocation of capital:

A high and sliding tax-rate scale also harms the efficient allocation of capital by expanding what economists call the “lock-in effect.” If owners of capital must wait years to pay a lower tax rate, many will decline to realize their gains solely for tax purposes. This artificially reduces the mobility of capital.

Economic growth is enhanced when capital is able to efficiently find its highest return. “Buy and hold” often works well for individual investors in specific stocks. But no economic theory says one- or two-year investments are worse than 10-year, and sometimes they’re better.

Worst of all, this would leave owners of pass-through businesses on the hook for corporate “quarterly capitalism.” Since many pass-throughs are family-owned through multiple generations, they’re already making the kinds of long-term investments that Clinton is looking to promote. Her campaign has said she is committed to producing a full tax plan, and we’ll be sure to analyze it when it becomes public.

Tax Reform Rehash

The release of Finance Committee tax reform discussion drafts on cost recovery and international tax have laid bare a reality that’s been hiding just below the surface for two years now the visions for reform embraced by the key House and Senate tax writing committees are dramatically different and move in opposite directions.

The international drafts are a good example. The Ways and Means draft would move the tax treatment of overseas income towards a territorial system, while the Baucus draft would move towards a more pure worldwide system by largely eliminating deferral. Here’s how the Tax Foundation described it:

Of the 34 most advanced countries, 28 use a territorial tax system, while only 6, including the U.S., use a worldwide tax system with deferral. No developed country imposes a worldwide tax system without deferral, though some have tried it with near disastrous effects.

Exactly how the two committees could bridge these broad differences in vision is unclear.

For pass-through businesses, the differences are just as stark. Neither committee has released details on overall rates or the treatment of pass-through businesses, but both have made clear the general direction they plan to take.

The Ways and Means Committee seeks comprehensive reform where the top rates for individuals, pass- through businesses, and corporations would be lowered and the differences between them reduced, helping to restore the rate parity that existed from 2003 to 2012. Other provisions in Chairman Camp’s draft would seek to close the differing treatment of partnerships and S corporations, creating a stronger, more coherent set of pass-through rules.

Finance Chairman Max Baucus, on the other hand, appears to actively oppose rate reductions for individuals and pass-through businesses even as he constructs his reform package around a core of cutting rates for C corporations. The inherent inconsistency of lowering corporate rates to make US businesses more competitive while simultaneously defending significantly higher rates on pass-through businesses is stark. The Baucus draft does make a vague reference to “considering” the impact on pass-through businesses, but it is clear that consideration amounts to nothing more than increased small business expensing or something similarly limited.

So the Finance Committee would cut corporate rates and ask S corporations and other pass through businesses to help pay for them. In the end, C corporations would pay a top rate of 28 or 25 percent, while pass-through businesses would pay rates 13 to 20 percentage points higher.

How do they justify this disparate treatment? The double tax on corporate income is often raised as leveling factor. As the Washington Post recently reported, “Today, the Treasury estimates, as much as 70 percent of net business income escapes the corporate tax.”

But “escaping” the corporate tax is not the same as escaping taxation. The simple fact is that pass through businesses pay lots of taxes, and they pay those taxes when the income is earned. The study we released earlier this year found that S corporations pay the highest effective tax rate (32 percent) followed by partnerships (29 percent) and then C corporations (27 percent on domestic earnings).

These findings include taxes on corporate dividends, so some of the double tax is included. They do not include capital gains taxes due to data limitations. Including capital gains would certainly close the gap between C and S corporations, but enough to make up 5 percentage points of effective tax? Not likely. Meanwhile, the study focused on US taxes only, so it doesn’t attempt to capture the effects of base erosion or the ability of C corporations to defer taxes on foreign income for long periods of time.

All in all, the argument against pass through businesses is based on some vague notion that these businesses are not paying their fair share. The reality is just the opposite. By our accounting, they pay the most. That means that, all other things being equal, today’s tax burden on S corporations makes them less competitive than their C corporation rival down the street.

Real tax reform would seek to make all business types more competitive by lowering marginal rates while also helping to level out the effective tax rates paid by differing industries and business structures. That’s the basis behind the three core principles for tax reform embraced by 73 business trade associations earlier this year: reform should be comprehensive, lower marginal rates and restore rate parity, and continue to reduce the double tax on corporate income.

These principles are fully embraced by Chairman Camp and the Ways and Means Committee. They appear to have been rejected by the Finance Committee. Which begs the question: What exactly is the goal of the Finance Committee in this process? Is it just to raise tax revenues? You don’t need “reform” to do that.

Whatever their goal, the gap between the House and the Senate is enormous, and unlikely to be closed anytime soon. Chairman Camp continues to press for reforms that would improve our tax code, but he’s going to be hard pressed to find common ground with what’s being outlined in the Senate.

Extenders

With the timeline for tax reform being pushed back, there is a bit more discussion of what to do about tax extenders. The whole package of more than 60 provisions expires at the end of the year and to date there’s been little discussion regarding how or when to extend them. As the Tax Policy Center noted this week:

It isn’t unusual for these mostly-business tax breaks to temporarily disappear, only to come back from the dead a few months after their technical expiration. But this time businesses are more nervous than usual. Their problem: Congress may have few opportunities to continue these so-called extenders in 2014. This doesn’t mean the expiring provisions won’t be brought back to life. In the end, nearly all will. But right now, it is hard to see a clear path for that happening.

While the future is murky as always, a few points of clarity do exist:

  • Nothing will happen before the end of the year. The House will recess this weekend and not return for legislative business until mid-January. Even if it took up extenders promptly after returning, which is highly unlikely, the soonest an extender package can get done would be February or March.
  • Coming up with $50 billion in offsets to replace the lost revenue will also be a challenge. Congress is tackling a permanent Doc Fix right now, which requires nearly three times that level of offsets. Coming up with an additional $50 billion will not be easy.
  • The lack of an AMT patch also is hurting urgency for the package. Congress permanently addressed the Alternative Minimum Tax earlier this year, which is good news, but that action also removed one of the most compelling catalysts for moving the annual extender package. Annually adopting the AMT patch protected 20 million households from higher taxes. That incentive is now gone.

All those points suggest that the business community has a long wait before it can expect to see an extender package move through Congress.

Or does it? One of the most popular extenders is the higher expensing limits under Section 179. This small business provision allows firms to write-off up to $500,000 in capital investments in 2013, as long as their overall amount of qualified investments is $2 million or less.

Beginning in 2014, these limits will drop to $25,000 and $200,000 respectively.

You read that correctly. Starting January, business who invest between $25,000 and $2 million in new equipment will no longer be able to write-off some or all of that cost in year one. Talk about an anti-stimulus. Coupled with the loss of bonus depreciation, the R&E tax credit, and the 5-year holding period for built in gains, and the expiration of extenders will have a measurable effect on the cost of capital investment for smaller and larger businesses alike.

This reality is beginning to sink in both on Main Street and the investment community, where certain industries rely on these provisions as a core part of their business plans in coming years. It’s too soon to see how much momentum the loss of these provisions will generate in coming months, but cutting the expensing limit from $500,000 to $25,000 in one year is bound to attract somebody’s attention.

2-Year Extension Set to Pass

Here’s an early Christmas present — the Senate voted this afternoon 81-19 to move forward on the tax deal cut between President Obama and congressional Republicans. We expect the package to pass intact early tomorrow.

For S corporations, the package means the top tax rate on S corporations remains at 35 percent and rates on capital gains and dividends remain at 15 percent for the next two years. On the estate tax front, the plan calls for a top rate of 35 percent and an exemption of $5 million per spouse.

Democratic opposition in the House is coalescing around the estate tax provisions, and if there is an attempt to change the bill, that’s where it’s likely to happen. Leadership there may attempt to raise the tax rate to 45 percent (from 35 percent) while reducing the exemption level from $5 million to $3.5 million. This amendment, however, or any other substantive change to the package, is unlikely to pass for a variety of reasons.

The size of the Senate majority makes it difficult for the opposition to characterize the deal as anything but bipartisan and broadly supported. Moreover, recent polls show the plan is popular with voters, too. According to Chris Cillizza:

Two new national polls out today affirm that political popularity. In a new Washington Post/ABC News poll, a whopping 69 percent support the tax package — support that cross party lines with 75 percent of Republicans backing the deal while 68 percent of Democrats and Independents offered their support.

A new Pew poll showed 60 percent supporting it including 62 percent of Republicans, 63 percent of Democrats and 60 percent of independents. The simple reality for Democrats writ large — and President Obama more specifically — is that they need a win in the eyes of the American public following a disastrous election that saw the party lose control of the House and lose ground in the Senate.

And finally, the clock is working against the opposition. Any deal blocked now will be taken up and passed by the Republicans when they take control in January. So either this week or first thing next year, a package very similar to what passed the Senate will be adopted by Congress and be signed by the President. Good news indeed!

Republican Opposition

We don’t want to overstate Republican opposition to the deal, but a number of high-profile Republicans are publicly opposing the plan, arguing that the party could do better if it waited until the New Year and the new Congress.

Republicans comprised five of the fifteen votes against cloture on Monday, four of whom appear to have opposed the deal because it could be better — Coburn (OK), DeMint (SC), Ensign (NV), and Sessions (AL).B Meanwhile, a number House Republicans have come out opposed to the package. Representative Steve King (IA) and Michele Bachmann (MN) announced their opposition earlier, and Mike Pence (IN) announced his opposition just yesterday, stating:

 

“I’ve no doubt in my mind that the first order of business for the new Congress [if the compromise does not pass] will be to enact a bill that extends all the current tax rates on a permanent basis,” Pence continued. “We’ll do it. We’ll send it to the Senate if this bill falters. There’s always time to do the right thing.”

 

Republican Presidential candidate Mitt Romney is also opposed, arguing Republicans should hold out for something permanent.

“Given the unambiguous message that the American people sent to Washington in November, it is difficult to understand how our political leaders could have reached such a disappointing agreement,” Romney wrote in an op-ed for USA Today. “The new, more conservative Congress should reach a better solution.”

We’re confident that the Republican House could pass a permanent tax bill. We’re also confident such a bill would stall in the Senate and would be opposed by the Administration. In the meantime, real taxes would be going up on real businesses and estates, starting January 1. Given the circumstances, the agreement achieved by negotiators is as good as the business community could have hoped.

The Rate Debate Continuesb&

Finance Committee Chairman Max Baucus staked out unique turf yesterday, calling for keeping tax policy stable for middle class taxpayers, allowing rates to rise for taxpayers making more than $250,000, but for taxing capital gains and dividends at 20 percent.B As BNA reports:

“I’m going for policy, and I think 20 percent for both capital gains and dividends is the right policy,” Baucus told reporters. Baucus acknowledged that the tax cut would specifically benefit the same $200,000 per year individuals that he has said should not expect to see their ordinary income tax rates cut again for 2011, but said the difference is that capital gains and dividends deserve to be treated the same under the tax code.

For wages and salary income for top-earning taxpayers, Baucus reiterated his position that Congress should focus on permanent tax cuts for only middle-class households and not entertain any temporary extensions of tax cuts for high-income individuals.

In effect, Senator Baucus is pressing for the tax policies outlined in President Obama’s budget.B That budget called for taxing dividends at 20 percent, but the rhetorical battle over the past year has allowed that fact to slip aside.B As your S corporation advocates, we feel compelled to observe the inconsistency of a policy that would keep (dividend) rates low for C corporation shareholders but would allow rates to go up for S corporation shareholders.B Why is one better than the other?

Exactly how all this gets done also is unclear.B There may be some effort in the Senate to bring up and pass a Baucus-like bill before the Senate adjourns (probably at the end of next week now), but that effort will likely be wrapped up with strict limits on debate and amendments, and the Republican minority has been successful this Congress blocking such requests.

If the Majority Leader wants to get anything done before the elections, he’ll need to set some time aside and let the Senate work its will.B With time so short, we don’t expect that to happen.

S-CORP in Wall Street Journal

With the focus on flow-through businesses and the pending tax hikes, your S-CORP team is getting more press these days.B The latest was earlier this week in the Wall Street Journal, where journalist John D. McKinnon quoted S-CORP Executive Director Brian Reardon on a story summarizing the rate debate.B As the Journal writes:

Republicans cite studies showing roughly half of all such income would be affected by raising the top two rates. Democrats say only about 3% of households reporting such income account for that half. That suggests much of the income comes from big businesses operating under small-business structures, they say. Businesses affected by the top tax rates include all sorts of concerns, from farms and manufacturers to high-tech and professional firms.

That trend has been under way for years. Congress authorized Subchapter S corporations in 1958 to encourage the growth of small companies. The popularity of pass-through entities grew in the 1980s with the lowering of individual tax rates and other rule changes.

By now, “the vast majority of employers in this country are organized as flow-throughs,” said Brian Reardon, executive director of the S Corporation Association, which represents such companies.

Later, John gets to the heart of the matter:

But the new-found importance of such enterprises-regardless of their size-means raising individual tax rates could have significant economic impacts. This week, Moody’s Economy.com said raising taxes on higher earners would reduce GDP by 0.4 percentage point in 2011, while payroll employment would be 770,000 lower by mid-2012.

As we’ve pointed out before, the debate over tax rates is really a debate about jobs.B The current obsession of policymakers over distinctions between small and large businesses or manufacturers verses professional services businesses is really beside the point.B There are S corporations and partnerships in all business sectors, and they are all employers.

Finance Reviews Economic Impact of Tax Hikes

It’s July 14th, 2010. There are approximately 30 legislative days before the fall elections and less than six months before huge portions of the tax code expire, so it’s only appropriate that today, the Senate Finance Committee held the first substantive hearing on the implications of allowing the Bush tax cuts to expire. Some key points:

  • Chairman Max Baucus (D-MT) clearly takes a dim view of flow-through taxation for certain firms and appears dismissive of arguments that higher rates will hurt the business community and employment. Washington Wire readers are encouraged to watch the hearing and see for themselves, but it’s obvious that we have lots of work to do in defending the basic S corporation structure.
  • Dr. Doug Holtz-Eakin alone made the point that as long as federal spending was too high — well above historic norms already, with the explosion in entitlement spending still before us — and until it is addressed, tax policy is going to be an exercise in second-best options.

In one “laugh out loud” moment, Professor Len Burman pointed out that higher tax rates may increase entrepreneurship because business owners have access to more deductions. In other words, let’s raise taxes because that will encourage taxpayers to come up with novel ways to avoid paying them?B Being entrepreneurial in your tax avoidance is not the sort of entrepreneurship we’re looking for here.

Perhaps the best point of the hearing was made by S-CORP ally Dr. Holtz-Eakin, who, in a back-and-forth with Chairman Baucus, made the case for flow-through taxation as cogently as anybody to date. Boiled down, his point is that because individuals pay all business taxes anyway, it makes good policy sense to tax business income at the individual rates directly.

So what to conclude? The list of witnesses and tone of the majority–especially the Chairman’s–suggest this hearing was designed to lay the policy predicate for higher rates next year. What’s unclear is exactly which taxes the Committee plans to raise. Despite what you might read, most of the Bush tax cuts enacted in 2001 and 2003 went to middle- and low-income Americans, not the rich. So the pending tax hike is going to impact regular families in a very real and harmful way. With just 30 days of legislative session left before the elections, even a well intentioned effort to extend those tax policies may fall short.

Perhaps more importantly, the hearing demonstrated the lack of a plan for what happens beyond 2010. Even if Congress extends some or all of the 2001 and 2003 tax cuts, something more comprehensive is needed if the United States is not to follow Greece down the path towards the third world. Senators Ron Wyden (D-OR) and Judd Gregg (R-NH) have introduced what they describe as a budget neutral tax reform plan. In the absence of any other ideas, it might be worth a look to see what they propose.

Estate Tax Fix Introduced in Senate

In more tax news, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) yesterday evening introduced an amendment to make permanent changes to the estate tax. As the entire tax world knows, the estate tax is taking a one-year hiatus in 2010 before returning in 2011 with a top rate of 55 percent and an exclusion of $1 million.

This dramatic shift, from a regime that applies a capital gains tax on inherited assets when they are sold to a very high 55 percent rate imposed at the death of the estate’s principal is possibly the largest marginal rate hike in history and is giving estates and estate planners alike a very real case of whiplash. Nobody predicted we would be in this situation a year ago, and the uncertainty is having a very real impact on how folks are behaving.

The Lincoln-Kyl proposal is designed to mitigate this harm and uncertainty by making permanent a middle ground on taxing estates. Key provisions in the bill include:

  • Reducing the top estate tax rate to 35 percent;
  • Increasing the exclusion from $1 million to $3.5 million; and
  • Allowing the estates of deceased taxpayers to choose between no estate tax and limited “carryover basis” or the provisions included in this plan for 2010.

Missing from the proposal are any revenue increases or spending cuts to offset the revenue loss of the lower rates and higher exclusion. The selective pay-go rules adopted by Congress earlier this year allowed Congress to extend 2009 estate tax rules without offsets, but any reduction in the estate tax beyond that would have to be offset or face a 60 vote Budget Act point of order. Filling this revenue hole, which has been estimated in the $50-$75 billion range over ten years, has been a significant challenge for the Lincoln-Kyl team, and it appears it still is unresolved.

While the Lincoln-Kyl proposal is targeted at the pending small business bill, it is unclear whether they will get a clean vote on the issue. Majority Leader Reid has filled the so-called amendment tree and is taking other steps necessary to limiting changes to the underlying bill. Regardless, the introduction of this legislation is the first substantive effort in the Senate to enact a permanent estate tax fix, which is progress. The question now is whether there’s enough time in the legislative calendar for this debate to play out. Stay tuned.

error: Content is protected !!