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 The EGTRRA phased-out the estate and generation-skipping transfer taxes so that they were fully repealed in 2010, and lowered the gift tax rate to 35 percent and increased the gift tax exemption to $1 million for 2010.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.

And

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.

Tax Policy on the Table for September

Members of Congress are back home and set to return mid-September for a final three week session before the November elections. Add in two or three weeks of possible “lame duck” session, and that’s the extent of time available to tax writers to address the numerous items on their honey-do list:

  • Preventing the 2011 tax hikes (including AMT);
  • Adopting the small business tax bill;
  • Extending the extenders that expired last year;
  • Extending the extenders that will expire this year; and
  • Something on the estate tax.

Given that these issues have been before Congress the entire year, it’s difficult to conceive how Congress would suddenly jump into action on all these items before the clock runs out. And while recent statements by leadership suggest they will make a concerted effort to address most of these items before adjourning for good, the Senate continues to be hamstrung in its ability to move anything. Here’s our take on the where we go from here:

  • Small Business Tax Bill: The bill itself is non-controversial and has bipartisan support. What’s holding it up is a fight over the process — will amendments be allowed and, if so, how many — and on-going debates over extraneous tax items like the future of the estate tax. Majority Leader Reid was very close to a deal with  Minority Leader McConnell just prior to the break. We expect further progress and ultimate adoption of this package in September.
  • Tax Hikes: Last week, Finance Committee Republicans issued a statement calling on the Committee to hold a markup on extending current rates “as soon as possible to bring certainty of continued tax relief.” Meanwhile, House Majority Leader Steny Hoyer is calling for extending only those provisions for taxpayers making less than $200,000. And several Senate Democrats — notably Senators Kent Conrad (D-ND) and Evan Bayh (D-IN) — have expressed support for a one-year extension of everything. No clear path out of this challenge, but we continue to believe a one-year extension of everything is most likely, followed by failure of Congress to pass anything. A one year extension of the middle-class relief is a close third.
  • Extenders: Extenders will likely move as part of the small business tax bill in September, which is good news for manufacturers and families living in states with no state income tax. The bad news is the extension would last just until the end of this year, so another bill would have to follow soon.
  • Estate Tax: We’re now four months away from seeing the estate tax rise from the dead (55 percent top rate and $1 million exemption) with no apparent solution in view. Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) are pressing for lower rates and a higher exemption (35 percent and $5 million) while others support adopting the rules in place in 2009 (45 percent and $3.5 million). Still a third camp is happy to see the estate tax return in full force. Time is short, and no side appears to have the 60 votes necessary to prevail, which means current law has the upper hand.

Regarding the floor situation, Senate Majority Leader Reid set up the small business bill to be pending business as soon as they get back on September 13th. He introduced yet another substitute before they left and filled the amendment tree to block other amendments. He then filed cloture on several democratic amendments to the bill as well as the underlying legislation, setting up a series of 60-vote threshold cloture votes in the first couple days when they return.

While it’s possible these votes take place and fail along party lines, it’s more likely the two leaders come to an agreement on allowing a limited number of amendments — including adding the extender package to the mix - for the bill to move forward. At least that’s what we hope, since there are some very good provisions in the small business bill that should help investment and job creation.

Regarding the other items, including Extenders v. 2011, we’re expecting the rest of the to-do list to get pushed into a lame duck, with some sort of omnibus bill that includes federal funding and tax provisions presented to members in November or December. No idea how that battle royale turns out, but we’ll be sitting in the front row to watch.

More on S Corporations and Employment

The ongoing battle over the pending tax hikes has a tendency to devolve into a debate over the definition of “small” business and other random characteristics a firm needs before it be considered “real” by some policymakers. For example, proponents of the tax hike appear to believe a manufacturer is more “real” than a law firm, even though both are taxed as flow-through entities and both might be defined by the SBA as small.

But this debate over which types of business activity are “real” is silly and misses the point. The point is that a large percentage of the pending tax hike will be imposed on employers and investment. One half of all business income is taxed at the individual tax rates. One quarter to one-third of all business income is subject to the top two rates. That’s a lot of economic activity subject to the pending tax hikes.

Consider this debate from the perspective of the employee: whether your job comes from a large S corporation or a small S corporation makes no difference to you; both are employers, and your job is your job. So why should policymakers care whether you work at a 500 employee manufacturing plant or a 12 person law firm? Why do some policymakers believe one job worth saving but the other not?

One challenge we face in this debate is that while the folks at the Statistics of Income break down firms by structure, they don’t include employment numbers, so it’s difficult to tell how many employees work for S corporations. One way to back out an estimate is to look at their payroll and executive compensation numbers. If we assume the average compensation of an American worker is $40,000 (admittedly a rough estimate) then it appears S corporations employed about 21 million workers back in 2007.

Moreover, S corporation employment gets bigger the more revenue and income a firm makes (as you’d expect). Firms with more than $50 million in revenues employed about 4.5 million workers, while firms with $10 to $50 million in revenues employed 4.4 million workers.

Firms that size have average business income per shareholder exceeding $335,000, which means more often than not, their business income is taxed at the top two rates. Are the nine million employees who work at these firms less deserving than the employees who work at the local coffee shop? Obviously not, but for some reason the other side of this debate spends an enormous amount of time trying to minimize the value of those employees and the firms they work for.

Again, these numbers are just rough estimates, but the point they make is valid nonetheless: flow-through businesses — including S corporations — represent the majority of employers in this country and raising their taxes is not going to help the economy or the job picture.

Joint Committee Estimates Tax Hikes

In response to a request from the Ways and Means Committee, the Joint Committee on Taxation released some estimates last week on who would benefit from foregoing the rate hikes and other tax increases next year. You may have seen related stories focusing on how much “millionaires” would benefit. A couple thoughts:

First, while the JCT estimates that taxpayers earning over $1 million would see an average tax break of $103,834, they also estimated this break would reduce their tax burden by only 11 percent, suggesting that these taxpayers will pay nearly $1 million in income taxes next year on average.

Second, the revenue “cost” of avoiding all the tax hikes next year is not substantially more than the cost of avoiding those for taxpayers making less than $200,000 — $227 billion versus $202 billion.

That’s not as much as we would have expected, and in our view raises the odds that Congress extends for one year all the 2001 and 2003 tax cuts. It’s not a done deal, of course, and total inaction by Congress is also possible, but with the weak job market and pending elections, the legislative equivalent of a punt — a one year extension of everything — is looking increasingly likely.