Mark to Market for Dead People

The President’s budget is out and, as we have in the past, we will start with a disclaimer.  Congress requires the President to issue a budget every year, and every year the President (regardless of party) complies with a ridiculously long and labored set of phone book-like documents outlining the budget.  And every year Congress yawns and says it’s dead on arrival.  So take our commentary below with a grain of salt, as most of the provisions in this budget are going nowhere, fast.

That said, the budget includes a couple tax proposals that caught the attention of our members, including:

  • A higher, 28 percent tax rate on capital gains and dividends;
  • A mandatory 28 percent tax on appreciated assets when the owner dies;
  • A new 30-percent minimum tax (Buffett tax) on high-income individuals; and
  • Applying self-employment taxes to the business income of professional services businesses.

We addressed the so-called Buffett tax and Gingrich-Edwards loophole when they were first proposed in prior budgets.  The capital gains proposals, on the other hand, are new.  The President first talked about them in his State of the Union Address this year.  You can read the White House explanation here and a more detailed Treasury Department summary here.

The basic premise is that wealthy people don’t pay their fair share and need to pay more in taxes.  This, of course, is nonsense.  The federal tax code has many faults, but the lack of progressivity is not one of them.  According to the Congressional Budget Office, the tax code is remarkably progressive and has been for a long time.

The CBO’s estimates on who pays what are from 2010, so they don’t include the recent hike in capital gains and individual tax rates enacted as part of the 2013 fiscal cliff deal.  Combined with the Affordable Care Act taxes put in place that year, capital gains rates increased from 15 to nearly 24 percent.  The new proposal would raise them again to 28 percent, or nearly double their level from just three years ago.

These higher rates work against the Administration’s 2012 framework to reduce corporate tax rates.  What’s the point of reducing the corporate tax rate from 35 to 28 percent if you’re just going to hike the tax paid by corporate shareholders at the same time?  As the CBO pointed out back in December, the marginal effective tax rate on corporate investments includes both layers of the corporate tax.

In 2012, the combined marginal rate on corporate investment was 45 percent (the 35 percent corporate tax plus the 15 percent shareholder tax times the remaining corporate income).  After health care reform and the fiscal cliff, today’s marginal tax on C corporation investment is 50 percent.  If Congress agreed with the President and cut C corporation rates while also hiking capital gains and dividend rates, the net result would be a 48 percent marginal tax.  You’ll notice that’s higher than when we started, which begs the question of how all this is supposed to make the U.S. a more attractive place to invest?

The capital gains tax hike is bad for pass-through businesses too.  For many business owners, selling the business is their retirement plan.  One of the advantages of S corps and partnerships is that their owners get capital gains treatment when they sell the business.  The President’s proposal would raise the tax on those sales to 28 percent.

For owners who choose to pass their business on to their children or employees, the proposal would force them (their estates, really) to pay the capital gains tax at the time of their death, along with any estate tax that is owed.  The Administration used this example:

The largest capital gains loophole – perhaps the largest single loophole in the entire individual income tax code – is a provision known as “stepped-up basis.” Stepped-up basis refers to the fact that capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the “tax basis” of inherited assets used to compute the gain if they are later sold is immediately increased (“stepped-up”) to the value at the date of death – making the capital gain income forever exempt from taxes. For example, suppose an individual leaves stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is “stepped up” to the $50 million gain when he inherited it – so no income tax is due on the sale, or ever due on the $40 million of gain. Each year, hundreds of billions in capital gains avoid tax as a result of stepped-up basis.

Let’s take a step back.  There are two reasons for stepped-up basis.  The secondary reason is to ease record keeping.  Ask the American Farm Bureau how hard it is to keep track of basis from one generation to the next.  The Administration “solves” the record keeping challenge by forcing the estate (heir, really) to recognize any capital gain when the owner dies.

So if the stock left to an heir in the Administration’s example is a pass-through business, the estate is going to need to raise around $10 million to pay the capital gains tax.  For most estates, coming up with that sort of cash without selling or liquidating the business is simply out of the question, so the proposal will result in an increase in the number of private businesses sold at the death of the owner or, most likely, when the owner is still alive and able to plan the transaction.  Warren Buffett will love this proposal.

But record keeping is the secondary reason for stepped up basis.  The primary reason is the existence of the estate tax.  That $10 million owed by the estate is in addition to the estate tax already owed on the business.  Since the resolution of the fiscal cliff in 2013, the estate tax owed in the Administration’s example is 40 percent on the value of the estate over $5 million, or $18 million.  The tax code recognizes this liability by giving the heir of the estate a step-up in the basis of the assets they just inherited (and the estate just paid tax on).  The Administration ignores this dynamic in their write up and proposal.

So under the President’s plan, the heir inherits a $50 million business but also (in effect) inherits a $28 million tax bill.  What business could survive that sort of tax hit?

The Administration claims their proposal includes protections to ensure that no “small” business would have to be sold to pay the tax, but we’re skeptical.  Congress tried to protect family businesses from the estate tax back in the 1990s, and it was your basic disaster.  Almost no businesses were able to jump through the necessary hoops to gain the protection, and the qualified family-owned business provision was scrapped.

But those are just minor details and quibbles compared to the scale of the tax envisioned by the President – over 50 percent in the example above!  Thomas Piketty would be proud.  The new Republican Congress will never go along with these ideas, of course, so they only serve to remind us of just how far apart Congress and the Administration are on tax policy.  It’s just one more reason to be skeptical of tax reform or any other broad tax policy being enacted this year.

Rate Debate is All But Over

Another interesting week in our nation’s capital. The big news is the tax deal struck between Congressional Republicans and the White House. We expect this deal to pass, with few changes, either next week or when Congress returns the first couple weeks in January.  Here are some useful summaries and the legislative text if you’re interested:

The Senate is going to take the package up on Monday and should pass it Tuesday night or Wednesday morning. It then goes to the House, where it faces an angry liberal caucus and its leadership. According to the Hill:

House Majority Leader Steny Hoyer (D-Md.) said earlier Thursday night that the House will probably take a vote but on what remains to be seen.

“Well, we’re going to see what comes from the Senate,” he said on MSNBC. “But we’re going to vote on something, I’m sure. Whether it’s exactly what the president made a deal with on the Republicans or not, that remains to be seen.”

For S corporations and the markets, though, the key was to get an agreement. It is less important that the deal is being temporarily blocked and more critical that we have a little clarity on tax policy for the next two years. Either this year or very early next year, Congress will pass a two year extension of most existing tax policies. The delay of a few weeks might matter to the IRS and short-term withholding tables, but not to real investment and hiring decisions.

In the meantime, the question for policymakers is whether to make concessions to the current House Democratic leadership in order to get them to bring up the bill next week. Knowing that they can pass the deal intact on January 3rd, Republicans are going to be reluctant to make substantive changes to the deal, especially on key items like the estate tax, so the leverage of House leadership should be limited. We’ll see.

Estate Tax Compromise

We know lots of folks care about the estate tax provisions in the deal so here is summary of those provisions. Considering the alternative — higher rates and lower exemptions from now on — the negotiators did a remarkable job getting this agreement:

Temporary estate, gift and generation skipping transfer tax relief. The EGTRRA phased-out the estate and generation-skipping transfer taxes so that they were fully repealed in 2010, and lowered the gift tax rate to 35 percent and increased the gift tax exemption to $1 million for 2010. The proposal sets the exemption at $5 million per person and $10 million per couple and a top tax rate of 35 percent for the estate, gift, and generation skipping transfer taxes for two years, through 2012. The exemption amount is indexed beginning in 2012. The proposal is effective January 1, 2010, but allows an election to choose no estate tax and modified carryover basis for estates arising on or after January 1, 2010 and before January 1, 2011. The proposal sets a $5 million generation-skipping transfer tax exemption and zero percent rate for the 2010 year.

Portability of unused exemption. Under current law, couples have to do complicated estate planning to claim their entire exemption (currently $7 million for a couple). The proposal allows the executor of a deceased spouse’s estate to transfer any unused exemption to the surviving spouse without such planning. The proposal is effective for estates of decedents dying after December 31, 2010.

Reunification. Prior to the EGTRRA, the estate and gift taxes were unified, creating a single graduated rate schedule for both. That single lifetime exemption could be used for gifts and/or bequests. The EGTRRA decoupled these systems. The proposal reunifies the estate and gift taxes. The proposal is effective for gifts made after December 31, 2010.

President Mentions Tax Reform

With the tax outlook for the next two years almost in place, we’re wondering what’s next? The current extension takes us right up to the President’s reelect in 2012 (and the reelect of 23 Democratic Senators) and we can’t imagine they’d welcome a reprise of this year’s battle over rates, etc.

So what’s the plan? The Hill’s On the Money Blog suggests it could be broad based tax reform. According to the Blog:

An administration official said the tax reform ideas are now being examined under the direction of Assistant Treasury Secretary Michael Mundaca and Treasury adviser Gene Sperling.

Treasury and the President’s Economic Recovery Advisory Board previously had examined reforming corporate tax rates, but had not considered eliminating individual tax breaks and lowering individual rates as part of a deficit reduction package until the commission raised the idea, the official said.


The administration official said a likely next step will be for placeholder language for tax reform to appear in the Obama 2012 budget, with the details of the tax reform to be worked out in the following months. The deficit commission report recommends putting the new tax code in place by 2012.

Lots of folks are skeptical that this President will be able to work with the incoming Republican House, especially on something like tax reform, but the tax deal just agreed to is evidence that the two sides can work together when circumstances force their hands. With massive deficits projected from now on, the circumstances should be there.

Taxes and Elections

With Congress gone, we thought we might dust off the old S-CORP Crystal Ball and make some predictions. By all accounts, the seats in play this cycle are well above the norm and this could go down as an historic election, much like 1974 or 1994.

So what do we expect? We predict that Republicans will control the House next year, while Democrats will retain the majority in the Senate, albeit with just a one or two vote majority. We come to this conclusion after reviewing the following sources:

We recommend each, especially the RCP site. It’s an eye-opener. The RCP has Republicans winning 212 House seats, excluding the results of 44 toss up races. It takes 218 seats to control the House, so Republicans would only need to win 6 out of 44 to get there. No wonder Intrade predicts there’s an 88 percent chance they win the House.

Meanwhile, RCP has Republicans winning 46 seats (up from 41 now) with six seats in the toss up category (no, the Delaware seat is not one of them). Joe Biden is the Vice President and the President of the Senate, so Republicans would need to win five of six toss-up seats in order to control that body. It is possible, but highly unlikely.

So we predict the House flips while the Senate stays. What are the implications for tax policy and S corporations?

Rates: We’ve written extensively about this and our general view remains the same. Of the three possible broad outcomes - 1) nothing happens, 2) an extension of middle-class relief only, and 3) an extension of everything for one year — it’s a close race between nothing and everything, with the middle-class option nowhere to be seen.

For example, we can see how Congress comes back from the election and, despite an unusual number of seats switching parties, the stalemate over this issue continues. Speaker Pelosi will still control the House floor, after all, and the President would still be waiting with his veto pen. To date, they have yet to change their “middle-class only” position.

What might cause them to change? The size of Republican gains is one possible variable. If they win the bare minimum to claim the House — 40 to 50 — then we expect the Speaker and President to hold firm and nothing to happen. If Republicans win a huge number however — 60 to 70 — then there’s a chance the Speaker may step aside and allow the House to extend everything for one year. The President also may embrace an opportunity to kick this issue into next year.

The other key variable here is the economy. It continues to struggle, and it is hard to believe the President’s economic team would welcome a $230 billion one-year tax hike on families and businesses. We’ve made the case for extending the current top rates. It’s a question of jobs and investment. But what about the threat to the economy if nothing gets extended? The experts we listen to suggest it sharply raises the possibility of a Double-Dip Recession.

That has to be a concern for everybody, which is why we believe a one year extension of everything (rates, dividends, cap gains, credits) is now the slight favorite for the Lame Duck.

Estate Tax: How do you handicap a race that shouldn’t have happened? Congress should have passed something last year. Then it should have acted quickly early this year. People were leaving large estates in limbo as their attorneys waited to learn what the rules would be. Last summer, too, was a good time to provide clarity.

Now, almost a year later, they are still waiting. Ouch.

One explanation for this inaction is that Congress, or at least those folks running things, are happy with the status quo. They might not have the votes to reinstate the old estate tax proactively, but they can get to the same place through inaction. Just wait a couple months and you’ll see.

Another explanation is that no particular fix enjoys sufficient support to pass. They could make permanent 2009 rules. They might embrace the Kyl-Lincoln formula of 35 percent rats and $5 million exemptions. They could allow the old 2000 rules to rise from the dead with their 55 percent top rate and measly $1 million exemption. Or anything in-between. With so many options, no one option appears to have the 60 votes needed to pass the Senate.

So what is our prediction? We don’t have one, or more accurately, we don’t have a strong sense that one option will prevail. Which suggests that nothing happens and the status quo — a return to 55 percent and $1 million — has the best chance for next year. And if you passed away in 2010? Well, you were lucky, estate-tax-wise. You’re probably also not reading this. But we digress.

Meanwhile, careful S-Corp readers will remember we were particularly concerned with valuations. Congressman Earl Pomeroy (D-ND) introduced legislation this Congress that caught the attention of the valuation crowd. Among other things, the bill would disallow minority interest discounts for family-owned businesses. The argument is that related parties always act in concert, so if the broader family controls the business, minority discounts should not apply.

There are numerous problems with this approach– families don’t always act in concert, you can’t have two competing valuation systems, etc. With the [likely] pending flip in the House, and the possibility that Pomeroy loses his seat (he’s down), what are the odds that this issue lives?

Surprisingly good, unfortunately. Both President Obama and key tax folks on the Hill believe this approach is good tax policy and we expect to see some version of this policy in the President’s budget. Which means we need to keep after this issue, and not let it be described as a “tax loophole” or “tax evasion.” Even a Republican Congress will need to find new revenues. Punishing family businesses with higher estate taxes should not be the source.

Payroll Tax: A provision included in the House-passed tax extender package last summer included an $11 billion tax hike of S corporations in the form of higher payroll taxes for some service sector companies.

S-Corp led the charge to oppose this unjustified tax, convincing a bare minimum of forty-one Senators to oppose the package, including S-Corp champ Olympia Snowe (R-ME). It was close, but ultimately Finance Committee Chairman Max Baucus (D-MT) dropped the provision from the broader package.

But what about next year? This issue has been around as long as S corporations (more than fifty years) but it really gained notoriety when former Senator John Edwards used his S corporation to block paying payroll taxes on his law practice. Edwards is gone, but the issue lives on.

With Republicans taking the House, the pen for drafting tax policy will shift from Congressman Sander Levin’s (D-MI) hands to Congressman Dave Camp’s (R-MI). They are both from Michigan, but that’s where any similarity ends. We do not expect a payroll tax hike to emerge from a Camp-led Ways and Means Committee. Using an S corporation to block payroll taxes you legally owe is tax avoidance. It’s against the rules, and the IRS has the tools to go after you. The $11 billion tax hike passed by the House last year was about revenue, not tax enforcement.

The provision could emerge from the Senate and the Administration, however, so we’ll continue to work this issue and educate policymakers on the distinction between a tax loophole and tax avoidance.

So those are our S-CORP Crystal Ball predictions into the future. The predictions are based on a Republican House and Democratic Senate. That seems to be the most likely outcome this November, but things change. If they do, we’ll come back with some new assessments. It’ll give us something to write about while Congress is gone.

President Obama — Tax Cutter?

The New York Times ran a piece the other day entitled, “From Obama, the Tax Cut Nobody Heard Of.” What they are referring to is the $400 Making Work Pay credit adopted as part of the broader 2009 stimulus package. This credit was available in 2009 and 2010 and had a total price tag of $116 billion.

The point of the story is that the President, contrary to the popular perception, is actually a tax cutter. From our perspective on the front lines of many of these battles, we’re not sure we agree.

First, many of these credits went to families with no tax burden. Of the credit’s $116 billion cost, about $37 billion takes the form of transfer payments from one taxpayer to another and are not properly described as tax relief. For example, a family filing jointly with two kids and making $40,000 typically has no income tax liability and would receive an additional $800 refund under this credit. Not bad, but it’s not tax relief.

Second, the credits were — by design — temporary.The net tax relief from the credits took place in 2009 and 2010. So even if you could describe the President as a tax cutter because of this provision, it only was only temporary. Tellingly, the President’s most recent budget only calls for a one-year extension of the credit. Again, temporary.

Finally, the credit’s net tax relief is fully offset by tax hikes the President either has signed into law or has put forward as part of his two budgets. Unlike his tax cutting accomplishments, this list is long and permanent, and includes the $400 billion-plus tax increase enacted as part of health care reform, including the new 3.8 percent tax on all investment income.

Taken on balance, it is hard to make the case that this President is a tax cutter. He has proposed tax cuts in the past, and signed some of those into law. But he has signed into law or proposed many more tax hikes — including a $700 billion permanent tax hike about to take effect this January — and has made clear in his rhetoric and his budgets that he believes a significantly higher tax burden is both necessary and appropriate.

So what to make of the new effort to label the President a tax cutter? Could it be a trial balloon preceding a shift in his tax policies in the new Congress? We’ll see.


S-Corp Joins Panel on Tax Policy

Looking for a concise review of the tax issues facing private businesses? Look no more!

Last month the Heritage Foundation hosted a forum on b�Pro-Growth Tax Policy for All Americans.b�B S-Corp Executive Director Brian Reardon joined several other tax experts, including the Tax Foundationb�s Scott Hodge, in reviewing the state of tax policy and where itb�s headed in 2011.