Pass-throughs are b�Silent Majorityb� in Tax Reform Debate

As Washington adjusts its focus towards the new Joint Committee on Deficit Reduction, many observers expect the same sort of partisan ideological gridlock that has seized much of the process to this point, but there are those that see a realistic path to a successful compromise by the “super” committee, and they see this scenario reached through some sort of revenue-neutral reform of the tax code. The top tax writers in Congress intend to move forward the tax reform debate this year, through the deficit reduction effort or separately, and have already begun calling corporate CEOs to the table to discuss their ideas for reform. Karen Hube of The Fiscal Times laments in The Washington Post this weekend that the pass-through community has been largely left out of the discussion:

Non-publicly traded companies that are structured as so-called pass-through entities - which are S corporations, partnerships and sole proprietors - have been notably quiet. This is no small omission. While most people probably have never heard of them, pass-throughs make up more than 90 percent of all U.S. businesses, and they collectively account for about 40 percent of business revenue.

On one hand, Hube is correct – the pass-through community does represent a huge segment of the economy. In fact, the Ernst & Young study commissioned by the S Corporation Association earlier this Spring found that pass-throughs are the majority job creators and employ 54% of the private sector workforce. Furthermore, the study finds, one in four private sector jobs are attributable to S corporations.

On the other hand, Hube stands to be corrected: S-CORP and its growing ally base has been far from “quiet” with the release of these statistics, as several members of Congress - including the House Ways and Means Committee Chairman Dave Camp and House Budget Committee Chairman Paul Ryan - have helped us bring these figures into the public consciousness. In many of the congressional tax reform hearings held so far this year, members have engaged witnesses on the importance of protecting the pass-through community and highlighted the harmful inefficiencies of the double tax business model.

A growing coalition of more than 30 business trade associations led by S-CORP are now working together to educate Congress about the significance of the pass-through community. As we wrote this Spring to tax policy leaders in a letter raising broad business opposition to tax reform that would only benefit C corporations and force more pass-throughs into the double tax model:

It is hard to see how a significant tax hike on a large segment of this country’s employers will improve the job market or make U.S. businesses more competitive. As Congress debates the future of the tax code, we strongly encourage the tax-writing committees to pursue reforms that recognize the economic value of all employers, regardless of how they are organized.

But let’s give Hube credit for recognizing that Washington policymakers may not all get the big picture. In her assessment, she highlights the challenges to pass-throughs in the Administration’s once-favored corporate-only approach to tax reform:

If changes are made to the corporate tax code without addressing pass-throughs, “these kinds of businesses may see their taxes go up,” says Robert McIntyre, director of the Institute on Taxation and Economic Policy.

And on the potential hit to pass-throughs:

The top rate is 35 percent in both the corporate and individual income tax systems. So if the corporate rate is lowered from 35 percent and major corporate tax deductions are eliminated, pass-throughs would be at a major disadvantage. For many, deductions would disappear or shrink, yet their top tax rate would remain at 35 percent.

The E&Y study quantifies this potential hit to the pass-through community at $27 billion annually. And, that’s not counting the potential increase in individual tax rates that is currently scheduled to hit these small and medium-sized business owners come 2013.

Hube then suggests that tax reform is a potential vehicle to correct “flaws” within the pass-through rules:

Many tax experts say that as lawmakers address the corporate tax code, they must also address the flaws in rules on pass-throughs.

For example, it used to be these were only small businesses with no more than 10 shareholders. But rules were relaxed through the 1990s and now the structure is possible for companies with up to 100 shareholders.

This is not only a departure from its original purpose - to help small businesses compete – it upends the level playing field for larger pass-throughs and their public competitors.

We believe it has been the deliberate, consistent, and recurring intention of congressional action over the past 50 years to modernize the S corporation rules and encourage S corporation entrepreneurs to grow their private businesses into successful contributors to the American economy, not a legislative accident, or a “flaw.” The “flaws” we see in the system that we hope can be addressed are those outdated rules limiting these S corporations’ ownership, operating flexibility, and access to their own capital. Modernizing the rules in this way would enable privately-held businesses to better navigate changing economic conditions, and provide greater opportunities for job creation and capital investment.

Regardless of what happens or doesn’t happen with the “super” committee, the tax reform conversation has begun. As you all heard yesterday, President Obama has suggested that he will be submitting deficit reduction proposals for the super committee to consider. Then, today, the Treasury Office of Tax Analysis released a new methodology for identifying “small businesses.” Your S-CORP team will be taking a closer look at this analysis in the coming days, but the broader point remains– the challenges to the pass-through community are growing.

The pass-through community should heed Karen Hube’s words and make sure we are loud enough to not be considered “notably quiet” by anyone. We have made some significant strides with the E&Y study and our education efforts on Capitol Hill, but the challenges ahead demand that we build on these efforts to expand our reach with more tools and more voices to help us deliver the strongest possible case for the majority of job creators.

If you’re interested in getting involved, please let your S-CORP team know.

Tax Policy and the “Joint Committee”

Does the debt deal include tax policies? Step One of the plan includes $917 billion in spending cuts only. But Step Two calls on a special “Joint Committee” to develop an additional package of deficit reduction that could include revenue provisions. Here are the details.

Under the plan, the new Joint Committee would be made up of six members each from the House and Senate, evenly divided between Republicans and Democrats. This Joint Committee would be asked to develop a package of deficit reductions equal to $1.2 trillion or more, and to report that package out by November 23rd. It would take a simple majority of Committee members to successfully report out a plan.

If the Joint Committee succeeds, then both the House and the Senate would have until December 23rd to vote on the plan. Under special rules, neither body would be allowed to delay or to amend the plan while a simple majority would be sufficient to adopt it.

If the Joint Committee fails in its task, or either the House or the Senate defeats the plan, then $1.2 trillion in across-the-board additional deficit reduction would be triggered. This sequester is spending reductions only, equally divided between defense and non-defense spending, with no revenues included.

Those are the details. What do we think? Based on our experience, the expedited procedures and sequestration rules included here are real and likely to result in additional deficit reduction of $1.2 trillion or more.

Will it include revenues? Both the White House and other Democrats have made it clear that revenues are “on the table” and that they expect to press for tax provisions as part of the Joint Committee’s product. In a blog post yesterday, National Economic Council Director Gene Sperling made the case for additional revenues:

The Joint Committee is tasked with deficit reduction, and the Committee can reduce the deficit by cutting spending and getting rid of tax loopholes and expenditures. Everything is on the table, as it should be.

First, the Committee can consider getting rid of tax expenditures like subsidies for oil and gas companies or corporate jet owners. These types of tax changes have been a major part of the recent deficit reduction conversation and would be a smart part of an overall balanced plan. No one on any side can dispute that the Joint Committee could consider them.

Second, the Committee can consider the kind of revenue raising tax reform that has broad and growing bipartisan support.

Director Sperling is correct that the Joint Committee can include tax hikes in the plan it presents to Congress if a majority of the Committee members vote to do so. But House and Senate Republican leaders have insisted that they would not nominate anyone to the Joint Committee who would support tax increases. Further, even if a Republican appointee does support a tax hike as part of the Joint Committee plan, that plan would have to pass both the House and the Senate. Why would House Republicans change their position to date and support higher taxes?

Remember, the alternative to the Joint Committee plan is an automatic, across-the-board cut of $1.2 trillion divided between defense and non-defense spending. Certainly, those defense cuts will be difficult for many conservatives in the House to stomach, but so much that they would embrace tax increases instead? We don’t think so. We believe the House will stick to its no tax hikes position and the Joint Committee will need to craft a package that avoids tax hikes if it wants the plan to pass Congress.

But what about budget neutral tax reform? Finance Committee Chairman Max Baucus (D-MT) is considering presenting a broad overhaul of the tax code to the Joint Committee for its consideration.

Again, although tax reform will definitely be part of the conversation during the Joint Committee’s tenure, we believe action is highly unlikely for two reasons. First, there’s simply not time. Tax reform is extremely complicated, and the Joint Committee has less than four months to complete its work. Chairman Baucus earlier indicated that it would take until the end of 2012 to write a comprehensive tax reform bill.

Second, tax reform in theory always enjoys broad support, but tax reform in particular means picking winners and losers. For every dollar of rate reduction, somebody loses a dollar of tax benefit. So tax reform would likely cost the Joint Committee votes it can ill-afford to lose.

So while the pass-thru community will need to be ready to defend Main Street businesses beginning this September, we don’t expect significant tax hikes or comprehensive tax reform to make it into the Joint Committee’s plan. That plan may include some offset tax provisions —  don’t forget, there’s a large package of tax provisions set to expire at the end of this year — but the broader fight over the direction of tax policy will have to wait for another vehicle.

What’s In a Baseline?

Behind the scenes of the debt limit compromise is a fight is brewing over the Joint Committee’s choice of budget baselines and what it means for tax policy.

While this might seem too trivial even for tax geeks, it could make a difference in the outcome of this process, and taxpayers should pay attention.

The question is, which baseline will the Joint Committee use to score its deficit savings — a current law baseline or a current policy baseline? Here’s the difference.

Under the current law baseline, the expiration of the Bush tax cuts in 2013 is considered the base case, so any effort to extend some or all of them would be seen as reducing revenue and increasing the deficit. Under this baseline, the Obama Administration’s proposal to extend just a portion of the Bush tax cuts would be seen as increasing the deficit.

Under the current policy baseline, those same tax cuts are expected to continue into the future, so any effort to roll them back would be seen as a tax hike but it would reduce the deficit. Under this baseline, the Joint Committee could vote to extend all of the Bush tax cuts except those affecting higher income taxpayers, and claim the resulting “savings” as part of their deficit reduction target.

Again, here’s Gene Sperling in his post:

The “baseline” is what deficit reduction is measured against. Reports have suggested that the Committee would have to use a “current law” baseline – a baseline that assumes that all of the 2001 and 2003 tax cuts expire along with relief from the Alternative Minimum tax. That would mean that any tax reform effort that raised less revenue than allowing all those tax cuts to expire would be scored as increasing the deficit. Even conservative Republican proposals for “revenue neutral” tax reform would be scored under this approach as increasing the deficit by more than $3 trillion.

However the claim that the Committee is required to follow this approach is simply false.

Is it? Here’s what the Budget Control Act says:

ESTIMATES.The Congressional Budget Office shall provide estimates of the legislation (as described in paragraph (3)(B)) in accordance with sections 308(a) and 201(f) of the Congressional Budget Act of 1974 (2 U.S.C. 639(a) and 23 601(f))(including estimates of the effect of 24 interest payment on the debt).

And here’s section 308(a) of the Congressional Budget Act:

(a) 1 REPORTS ON LEGISLATION PROVIDING NEW BUDGET AUTHORITY OR PROVIDING AN INCREASE OR DECREASE IN REVENUES OR TAX EXPENDITURES.

(1) Whenever a committee of either House reports to its House a bill or joint resolution, or committee amendment thereto, providing new budget authority (other than continuing appropriations) or providing an increase or decrease in revenues or tax expenditures for a fiscal year (or fiscal years), the report accompanying that bill or joint resolution shall contain a statement, or the committee shall make available such a statement in the case of an approved committee amendment which is not reported to its House, prepared after consultation with the Director of the Congressional Budget Office.

(A) comparing the levels in such measure to the appropriate allocations in the reports submitted under section 302(b) for the most recently agreed to concurrent resolution on the budget for such fiscal year (or fiscal years);

(B) containing a projection by the Congressional Budget Office of how such measure will affect the levels of such budget authority, budget outlays, revenues, or tax expenditures under existing law for such fiscal year (or fiscal years) and each of the four ensuing fiscal years, if timely submitted before such report is filed;

So, our reading of the just-passed bill suggests the savings that will count for purposes of meeting the Joint Committee’s deficit target are savings measured against a current law baseline.

Just for fun, consider the alternative. Say the Joint Committee used a current policy baseline and proposed to extend two-thirds of the Bush tax cuts. If the revenue impact of extending all the tax cuts was $3 trillion, then extending two-thirds would score as $1 trillion in deficit reduction for the Committee.

But the CBO uses the current law baseline for all its major budget reports, including its annual estimates of spending, revenues, and deficits. Under that baseline, extending two-thirds of the Bush tax cuts would increase the deficit by $2 trillion. So, the Joint Committee would have been tasked with deficit reduction, but by picking a more favorable baseline, its work would end up being scored as a deficit increase instead when the CBO updates its baseline next January.

Given the amount of scrutiny the CBO and Congress are under, it’s very unlikely the Joint Committee will choose to do anything but use the same baseline that Congress almost always uses “current law” and score any budget savings from there.

Ryan on S-Corps and Taxes

Earlier this morning, House Budget Committee Chairman Paul Ryan (R-WI) cited from our Ernst & Young study to defend Main Street businesses. We had been in to see Chairman Ryan back during our annual Board meeting. Apparently, our message connected!

As the Chairman notes:

“We don’t think raising tax rates in 2013 is helping the economy today. Not only is the actual rate going to 39.6, when you take the other stuff that was in Obamacare and everything else, the effective marginal tax rate goes to 44.8 percent. Here is the problem: 54 percent of workers in America get their jobs from these kinds of businesses that file as individuals, subchapter S corporations, partnerships. One in four people in America get their jobs from an S corporation. We are raising their top tax rate to 44 percent in 2013? Their competitors aren’t taxed like that.

In Wisconsin, we are competing against Canadians. They are getting taxed at 16 percent, and we are going to raise taxes on our businesses, our job creators, to almost 45 percent? You throw the Wisconsin income tax rate on top of that, it’s more than 50 percent. We see it as a job killer. More importantly, yeah, these taxes hit in 2013, they are going to hurt jobs today because businesses look forward, they are forward looking. When they see this massive tax increase coming, they are not going to hire today.”

The latter point Chairman Ryan makes is critically important. While the E&Y study focused on how the tax burden would increase for pass-thru firms under the Administration’s corporate tax reform proposal — by $27 billion per year — the study used today’s top tax rate of just 35 percent. Imagine what the tax hit would be on jobs and economic growth if E&Y had factored in a top rate of 45 percent?

The 45 percent rate the Chairman refers to is the sum of the statutory 39.6 percent rate in effect beginning in 2013, plus the higher, 3.8 percent Medicare tax enacted as part of health care reform, plus the rate effect of allowing Pease to expire. Add it up, and it’s nearly 45 percent!

The Big Picture on Taxes

Despite all the tax talk this year, there’s been almost no action. Neither the Senate Finance Committee nor the House Ways and Means Committee have taken up what might be considered significant tax legislation this year. They have marked up smaller, narrow bills on this or that, but nothing affecting more than a couple of industries.

Smart people on both sides of the aisle believe this stagnation could last for much of the year, where any movement on taxes will only happen if it’s directly tied to debt reduction efforts, and maybe not even then.

So what is our outlook on debt reduction?

Overall, we see a two-step process. Step one is some sort of deficit reduction package attached to the pending debt ceiling bill. The recent blowup and resumption of high level talks is real enough, but so is the “must-pass” nature of the debt ceiling. It may take some time, but Congress will need to pass a debt ceiling increase.

The amount of deficit reduction that accompanies that increase is what’s in flux. The President floated a target of $4 trillion (over ten years) a while back, but something in the range of $1 to $2 trillion over ten years appears more likely.

Revenue should make up very little of that amount, if any.

It will be hard enough to get rank-and-file House members to vote for any debt ceiling increase, regardless of how it’s structured. Adding an obvious tax hike on employers, like LIFO repeal, would make that task simply impossible. So the rate debate and other broader tax policy decisions we care about are unlikely to be part of the mix.

Step two in the deficit reduction dance takes place either next year or, more likely, after the 2012 elections. This step would consist of a much larger deficit reduction package, and we expect it to include significant changes to the tax code, all under the heading of “tax reform.” The exact components of this package also depend on many factors, including the election, the state of the economy, and the perceived success or failure of step one.

Perhaps the best way of thinking about it is that at some point, negotiators from the White House and Congress will first agree on the size of the deficit reduction package, say $4 or $5 trillion over ten years, and then they will agree on how much of that amount will come from spending cuts and how much, if any, will come from revenue. They will also outline how much of the spending cuts come from entitlements and how much from discretionary accounts.

Then the Budget Committees and the authorizing committees will be tasked with filling in the details. A large package like this will almost certainly be passed in the form of a budget resolution. A budget resolution would only need fifty votes to pass the Senate (compared to the 60 votes needed under normal circumstances) and it sets the stage for fifty-vote thresholds on the tax and entitlement policy changes that would need to follow.

Here is where S corporations need to pay attention: as our E&Y study demonstrates, budget-neutral tax reform can mean that somebody’s taxes are going to go up dramatically.

So our best estimate is that America’s private business sector has a year to eighteen months to get organized and defend how it’s taxed. The E&Y study we released earlier this year was a good start, but more is needed–more studies, more education, more ally recruitment in the business community and on the Hill. Either we build a convincing case for the superiority of pass-thru treatment and how it helps increase employment and capital investment, or Congress is going to move in the opposite direction. If that happens, everybody loses.

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