Payroll Tax Update

Congressional taxwriters, especially in the House, continue to express interest in raising payroll taxes on active S corporation shareholders as an offset to the tax extender package under consideration, and the business community has responded.

Nineteen groups penned letters to Chairmen Levin of Ways and Means and Baucus of Senate Finance, highlighting their concerns with the proposal. As BNA reported:

Small business groups urged in an April 28 letter that House Ways and Means Committee Chairman Sander Levin (D-Mich.) abandon a proposal that would raise payroll taxes paid by S corporation shareholders. The proposal is being considered as a possible way to raise additional revenues to pay for the annual tax extenders legislation (H.R. 4213) that includes $31 billion in extensions of popular tax cuts that expired at the end of 2009.

Setting aside the politics of raising taxes on small employers during an economic downturn, another significant challenge confronting tax-writers is the lack of an actual proposal. This idea has been around for years, yet the number of bills introduced with some form of this provision included is few — maybe only the Rangel Mother bill introduced in the fall of 2007. The association letters focused on that provision because it’s the only one out there.

A member of the American Institute of Architects had a chance to speak to this issue yesterday when he testified before the House Small Business Committee:

Although the details of the proposal currently under consideration are unclear, it is my understanding that the proposal would expand the application of payroll taxes to active shareholders of S corporations primarily engaged in the performance of services. I understand that there is concern that some S corporations misclassify salary compensation as earnings distributions in order to avoid paying payroll taxes. However, my fear is that the proposal will entrap millions of small business owners who are legitimately and correctly classifying salary and earnings distributions, with limited public policy benefit.

Yesterday’s hearing was unique in that, to the best of our knowledge, it was the first public testimony on this topic in years. The head of the Joint Committee on Taxation outlined a proposal to apply self-employment taxes to all partnership, LLC, and S corporation income before the Senate Finance Committee, but that was five years ago! We are unaware of any other legislative activity on this topic before last month, when the concept was floated to Ways and Means Members as a possible pay-for for extenders.

Overturning fifty years of tax policy should be a big deal and approached in an orderly fashion, not done at the last minute and on the run.

Payroll Taxes and the 3.8 Percent Investment Tax

With the S corporation payroll tax issue front and center, we’ve been revisiting the adoption of the 3.8 percent investment income tax as part of healthcare reform. There are a number parallels that deserve to be pointed out.

First, both taxes were introduced into the process at the eleventh hour. The 3.8 percent tax was introduced into the debate after both the House and Senate had passed their respective health reform bills and barely a few weeks before the whole package was signed into law. In terms of size and speed, the 3.8 percent investment tax is the LeBron James of the tax world. It’s likely nothing that size ($210 billion over ten years) has moved from introduction to law that quickly in the history of democracy.

Meanwhile, the S corporation tax is under consideration for the extender package. That package has already passed both the House and the Senate and the S corporation provision was not part of either bill. As with the 3.8 percent tax, it hasn’t actually been introduced in any legislation — it’s just a concept. And, like the 3.8 percent tax, this concept has never been subject to hearings or review.

Second, while both taxes are described generically as payroll taxes, they aren’t. The 3.8 percent tax is a tax on savings and investment only. It does not apply to wages or other forms of labor income. The same is true for the S corporation tax. For law-abiding shareholders, it’s a tax on returns from business investment.

Third, one of our arguments against the S corporation payroll tax is that it would, for the first time, fund Medicare with taxes on capital rather than labor. Some have suggested that the 3.8 percent tax broke that barrier already — not true.

There is no connection between the 3.8 percent investment tax and Medicare. The House struck the Medicare connection in the manager’s amendment filed the day before the package was adopted. So, while the tax still has “Medicare” in its title, none of the revenues raised by the tax go to the HI or related Medicare trust funds. Calling the 3.8 percent tax a Medicare tax, or even a payroll tax, is simply incorrect.

Finally, the 3.8 percent tax applies to just about all forms of investment income — rents, royalties, annuities, partnership income, etc. — except for business income earned by active shareholders of S corporations. Active shareholders of S corporations were explicitly exempted. Yet, the new S corporation payroll tax currently under consideration for the extenders package would effectively reverse this policy decision by applying a 3.8 percent tax to the business income of active shareholders!

Americans Love Small Business

The American economy’s reliance on small, closely-held businesses is unique in the developed world. Most other major economies focus their economic energies on large public corporations, but not the United States. Notwithstanding the financial crisis, the Jeffersonian concept of the yeoman farmer is alive and well and lives on Main Street.

As we’ve pointed out before, this emphasis on small and independent didn’t happen by accident. It was the result of conscious efforts by past Congresses — both Republican and Democratic — to empower Main Street business.

A recent poll by the Pew Research Center suggests this reliance on private enterprise is in synch with the American people. As reported in USA Today:

According to the just-released study by the highly respected Pew Research Center, small business is the most trusted institution in America. More than churches. More than colleges. More than technology companies. And certainly more than labor unions or large corporations.

The results were “striking,” according to Carroll Dougherty, Pew’s Associate Director. “At a time when a lot of institutions are viewed negatively, small business is viewed very positively. What’s really interesting is that large corporations are viewed almost as negatively as Wall Street. The contrast between large corporations and small business is enormous.”

“So much of this survey is partisan,” Dougherty continued. “In this case, it’s bipartisan. It crosses party lines.” 72% of Republicans, 70% of Democrats and 73% of independents say small businesses have a positive effect on the way things are going in the country.

Now if we could only translate those positive vibes into positive legislation.

Health Care Reform and S Corporations

President Obama released a list of proposed changes to the Senate-passed health care reform bill on Monday, and while there is plenty to interest any American, one item in particular should catch the attention of S corporation owners:

The President’s proposal adopts the Senate bill approach and adds a 2.9 percent assessment (equal to the combined employer and employee share of the existing HI tax) on income from interest, dividends, annuities, royalties and rents, other than such income which is derived in the ordinary course of a trade or business which is not a passive activity (e.g., income from active participation in S corporations) on taxpayers with respect to income above $200,000 for singles and $250,000 for married couples filing jointly. The additional revenues from the tax on earned income would be credited to the HI trust fund and the revenues from the tax on unearned income would be credited to the Supplemental Medical Insurance (SMI) trust fund.

By all appearances, the Administration has decided to apply a new 2.9 percent tax to all forms of “unearned” income, including S corporation income earned by shareholders not active in the business. [That is our take at this time — we are reaching out to taxwriters to make certain that is what the Administration intends]. This tax would be imposed on top of other applicable taxes and would be used to offset the cost of health care reform. CongressDaily reported on this provision yesterday:

President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed. But critics charge it could open the floodgates to a raft of companies re-structuring their businesses as subchapter S corporations in order to avoid the tax.

That is the glass half full version. The half empty view is the Administration just proposed to raise marginal tax rates on S corporation shareholders with day jobs. Here’s how we see it applying:

  • Taxpayer A works at his S corporation, earns a salary above $200,000 and receives a distribution of S corporation earnings. He would now pay an extra .9 percent on his salary, but not pay more on any earnings from the S corporation.
  • Taxpayer B makes more than $200,000 at another job and is a shareholder of an S corporation. She would now pay an extra .9 percent on her salary as well as an extra 2.9 percent on any earnings from the S corporation.

This proposal raises all sorts of alarm bells. First, as we have pointed out, it takes the notion of the ”payroll” tax and throws it in the trashcan. Second, it continues the illusion of the Medicare and SMI Trust Funds; revenue raised by this tax pays for health care reform, not Medicare benefits. Third, it raises the cost of capital (especially if it is combined with next year’s scheduled increase in the capital gains and dividend rates) at a time when our financial institutions are capital-starved. The whole point of TARP was to recapitalize our financial system, remember?

Beyond those broad policy concerns, the mechanics of this tax are particularly challenging. Does Taxpayer B pay a total Medicare tax of 3.8 percent on her salary above $200,000, but only 2.9 percent on any passive income, including S corporation earnings? And what about Taxpayer A? He already faces the challenge of making certain he pays himself a “reasonable” wage or he risks being accused of tax avoidance. This proposal would increase that temptation and the broader policy challenge.

Finally, how does the Administration plan to distinguish between passive and active shareholders? Here is how IRS Publication 925 (Passive Activity and At-Risk Rules) defines “Active Participation”:

Active participation depends on all the facts and circumstances. Factors that indicate active participation include making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees. Factors that indicate a lack of active participation include lack of control in managing and operating the activity, having authority only to discharge the manager of the activity, and having a manager of the activity who is an independent contractor rather than an employee.

It’s pretty sketchy. So now will all those non-active S Corp shareholders try to become active so they can avoid the new “payroll” tax? Sounds like another enforcement headache for the IRS. Expect to hear lots more on this issue in coming weeks.

More Intel on Estate Taxes

Two ideas are being floated in the Senate on the estate tax. A while back, Dow Jones reported on a proposal to allow taxpayers to prepay their estate taxes. As Martin Vaughn wrote:

A proposal to allow wealthy people to prepay estate taxes while they are still alive, in exchange for a lower tax rate, has caught the attention of Senate staff trying to craft a bipartisan, permanent compromise on the estate tax. The plan would allow wealthy people to place assets in a prepayment trust while they are still alive. Those assets would be subject to a 35% tax, which the estate owner would have five years to pay, according to a document describing the plan, obtained by Dow Jones Newswires.

The value of this option for taxpayers is obvious: you get a lower rate. For the government, the value is that it would be scored as a revenue raiser. Congress operates on a finite budget window, so the prepayments would be scored as new revenues while some of the estate taxes foregone would fall outside the budget window and wouldn’t count. Not exactly kosher, but the point is this idea could, just like the old Roth IRA concept, fit the needs of Congress and help them move towards a resolution of the estate tax dilemma.

The other idea to break the current impasse is to impose a “toll charge” on family foundations as a means of offsetting the cost of lowering the estate tax below 2009 levels. The Hill reported earlier this week:

The Gates Family Foundation - arguably the biggest charity in the world with assets over $35 billion according to 2008 records - is in the crosshairs of Sens. Jon Kyl (R-Ariz.) and Blanche Lincoln (D-Ark.), who see it as a money pot to help pay for a legislative fix for the estate tax. Well-placed sources say the senators might create a “toll charge” on charitable foundations that would sock Democratic heavyweights like Bill Gates and Warren Buffet.

During last year’s budget debate, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) offered an amendment to reduce the top estate tax rate from 45 to 35 percent while increasing the exclusion from $3.5 million to $5 million. That amendment garnered majority support but less than the 60 votes needed to clear the Senate. Moreover, it left unresolved how the sponsors would make up the revenue difference between their amendment and 2009 estate tax rules. That’s where the toll charge on foundations might come in.

In terms of timing, the clock is ticking. We are now two months into the year of repeal and more estates are finding themselves in estate tax limbo. Senator Kyl addressed this concern yesterday, suggesting he would begin blocking other Senate business in order to force an agreement to take up an estate tax fix. As the Hill quoted Reid yesterday:

Very soon we’re going to have a process on how estate tax reform is going to move forward. I will insist on an agreement on how to proceed, if we’re going to have unanimous consent on how to proceed with any of these subsequent bills.

At the end of this process, it is possible no permanent fix can get 60 votes, the estate tax stays repealed for the rest of the year with the old 55 percent and $1 million exclusion coming back in 2011. All this recent activity suggests some sort of effort is just around the corner, however, and we may know the outcome soon.

S Corporations and Payroll Taxes are Back in the News

A couple weeks ago, House-Senate health care negotiators raised the idea of paying for health care reform by expanding the types of income subject to the Medicare payroll tax. Payroll taxes are limited to wages at the moment, but this proposal would also tax cap gains, dividends, interest, rents, and limited partners. Oh, and S corporation income.

S-CORP has a long history of advocacy on these issues and, while the future of health care reform is wholly uncertain following the special election in Massachusetts, we felt it was important for the business community to weigh in on this issue with strong opposition. The result is a letter signed by 20 trade associations opposing this concept. As the letter notes:

Expanding the application of the Medicare payroll tax to non-wage income is an unprecedented policy that would undermine the principle that Medicare is an earned entitlement, damage the integrity of the Medicare Trust Fund, and hurt Main Street businesses and jobs. We strongly urge you to reject this misguided policy.

This morning, a CongressDaily article makes clear that this idea continues to be actively discussed between House and Senate negotiators. While the prospects for health care reform are dim, leadership continues to press for some sort of resolution and apparently this payroll tax item is part of those talks. Peter Cohn reports that the House and Senate are divided on how to expand the Medicare tax:

Senate negotiators want to keep active S corporation income — other than income from passive investments — exempt from the payroll tax, fearing their chamber’s fragile voting math can ill afford what could be seen as a new small business tax, aides said. House lawmakers disagree, citing the revenue loss, relatively few actual small-business employers that would be affected, and potential to game the system — such as opting for S corporation status simply to avoid the tax.

We’ll keep you apprised on any new developments on this front. As we’ve mentioned before, our assessment is health care reform will be talked about for the next month or so and then just fade away as other priorities take center stage. There won’t be a funeral or closure, but the votes simply do no exist to move forward right now. That said, no bad idea ever goes away and we fully expect to see this payroll tax expansion to be raised on other bills.

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