S-CORP Opposes Senate Sequestration Bill

The Senate is voting today on legislation to swap the sequester spending cuts with a package evenly divided between other spending cuts and targeted tax hikes.

The core tax hike in this package is our old friend - the Buffett Tax. We’ve previously pointed out the serious flaws in both the premise and the execution of the Buffett Tax. The provision contained in S. 388 suffers from all these flaws.

How would it work?

In this case, the bill would impose a new, minimum tax of 30 percent on taxpayers earning $5 million or more. The minimum tax would begin to phase-in once a taxpayer’s income rises above $1 million. In effect, the new tax would result in three distinct tax codes, each with its own rate schedule and definition of income:

  • The Individual Income Tax
  • The Alternative Minimum Tax
  • The New Fair Share Tax

So, if enacted, shareholders of successful S corporations and other taxpayers would be forced to calculate their taxes three different ways. First, they’d have to calculate their regular income tax, then they’d have to calculate their liability under the AMT, and then, finally, they’d have to calculate their new Fair Share tax obligation. In the end, they would pay whichever is greater.

For successful S corporations and other pass-through businesses, this policy would just add to the long list of tax challenges they face. C corporations would not pay the Buffett Tax just as they don’t pay the individual AMT (there is a corporate AMT, but it doesn’t seem as pervasive). And unlike C corporations, the top rates on pass-through businesses just went up from 35 percent to a high of nearly 45 percent.

At a time when the rest of Washington is focused on tax reform, the Senate is considering policies that move in exactly the opposite direction. This is anti-tax reform, but apparently it polls well, so it’s in the package.  The Senate will defeat this effort to swap lower spending for higher taxes today, and at some point, serious minds will assert themselves and begin to consider serious efforts at comprehensive tax reform that lowers the rates and broadens the base. In the meantime, we have this.

“Corporate-Only” Tax Reform

It’s hard to distinguish “corporate” tax reform advocates with “corporate-only” advocates these days. We like the former and work closely with them to support comprehensive tax reform - reform that includes individuals, pass-through businesses and C corporations. On the other hand, the latter group seems to spend as much time pushing for higher taxes on pass-through businesses as they do calling for lower rates on C corporations. They are definitely not our friends.

So, which category does this group fall into?

We are writing as a group of academic and consulting economists who believe that the U.S. corporate income tax rate should be reduced from its current 35 percent level to one that is competitive with the rates in almost all other major industrial countries.Such a move would likely lead to a more efficient allocation of resources, increased investment and employment in the United States, and higher wages.

Let’s be clear. We agree that the 35 percent corporate rate is too high and should come down. Moreover, many of the 20 economists who signed the letter are our friends and agree with us nine times out of ten on what constitutes “good tax policy.”

That being said, what about the rates imposed on pass-through businesses? The letter is silent on them despite the fact that those businesses that earn most of the business income and employ most of the workers? Their top rate is closer to 45 percent, not 35 percent. That higher rate also “undermines job creation and reduces wages,” doesn’t it?

You bet it does, but this economist statement fails to acknowledge even the existence of America’s flow-through sector and it ignores the impact of the new higher rates on pass-through businesses and the 70 million workers they employ. Worse, by limiting its focus to rate reduction for C corporations, it lends credibility to those few remaining voices who argue that the “corporate-only” approach is both feasible and good policy. The simple response is its not - Congress either tackles tax reform in a comprehensive manner or not at all.

Perhaps it’s time for a “Pass-Through Business Economist Statement.”

Health Care Update

The idea of taxing high cost plans is relatively new, and there are many outstanding questions about how it would work. For example, how exactly how would this excise tax raise revenue? The Senate plan imposes a 40 percent excise tax on high value plans with a cumulative cost of more than $21,000. But medical loss ratios for private health insurance plans easily exceed 60 percent of premiums, so insurance companies confronted with a 40 percent excise tax will simply stop issuing those plans.


At the employer level, that means if an employer used to offer his employees a $30,000 package of health benefits, he will now offer them a $21,000 plan and pay the remaining $9,000 to them in the form of wages and non-health benefits. These extra wages, in turn, are subject to income and payroll taxes, resulting in higher tax collections by the federal government.The revenues raised from the excise tax come from higher income and payroll taxes on employees, not from excise taxes on insurance companies.

It’s this aspect of the Senate plan that has unions united in opposition. The excise tax is coupled with a refundable tax credit available to families making less than 400 percent of the federal poverty level (about $88,000 for a family of four). But many union members make more than that while most union members enjoy health insurance benefits that exceed the Baucus threshold. So for many union members, the Baucus plan would reduce their health benefits and raise their income and payroll taxes, but exclude them from the refundable tax credit.

What about S Corporations? How would they be impacted? Here’s chart we put together:

Earns More than 400% FPLB Earns Less Than 400% FPLB
Has High Cost Plan Taxes Are Higher Mixed
Has Low Cost Plan Not Affected* Taxes Are Lower*
We put an asterisk by the “low cost plan” results because of another quirk in the excise tax that deserves review, the indexing for its thresholds. As we mentioned, the Baucus bill sets the initial threshold for a family’s high cost plan at $21,000. This threshold includes all forms of health care spending — premiums, preventive care, flexible spending accounts — and is indexed not to health care inflation (about 8 percent), but to regular inflation plus one percent (about 3-4 percent). That means over time, the value of your low cost insurance plan is going to catch up to the threshold and become subject to the tax.
This aspect of the Baucus plan would have been fixed had it not been essential to the procedural challenges facing health care reform. Simply put, both the House and the Senate are attempting to offset health care spending, which grows at 8 percent per year, with tax increases, which rise at five percent per year. The costs of the plans grow faster than the offsetting taxes, resulting in deficits in the out years.
By comparison, the Baucus tax, because of the indexing details, grows faster than health care spending and produces surplus revenues in the out years. As much as the unions complain, coming up with an offset that keeps the President’s and congressional leadership’s promise not to make the deficit picture worse is going to be hard to find.
Thus, the friction between the House and Senate tax offsets, and yet another obstacle between healthcare reform and a signing ceremony. The House surtax targets closely held businesses while the excise tax targets union workers. Nobody said raising taxes by half a trillion dollars would be easy.

Estate Tax Update

We expect Round 1 in the great estate tax battle to take place this fall/winter. The tax goes away in 2010, and then returns in full form in 2011, giving just about everybody a reason to come to the table.

In preparation for this debate, forty-six trade associations, including your S Corporation Association, the Chamber of Commerce, NIFB, and the National Association of Manufacturers sent a letter to Congress urging them to support a permanent estate tax fix that includes a 35 percent top rate and a $5 million per spouse exclusion.

As Martin Vaughn of Dow Jones reported:

The groups said they will support a permanent rate of 35%, with the first $5 million of wealth exempted, and up to $10 million in the case of married couples. Those are the terms that are being pushed in the Senate by Sens. Jon Kyl, R-Ariz., and Blanche Lincoln, D-Ark.

On timing, the expectation continues to be that Congress will take up legislation to extend certain expiring tax provisions before the end of the year, and that the estate tax fix will be made part of that bill.

Tax Reform Panel Report Update

Remember the President’s Economic Recovery Board headed by Paul Volcker? The President announced its creation at the beginning of the year but it’s been quiet since then. The principle reasons for this silence are federal sunshine laws that require any gathering to be open to the public. It is hard to provide the President with critical insights into how to fix the economy when the whole worlds watching.

One offshoot of the Board that has been active is the White House Tax Reform Panel. They had their first (and last?) public meeting last week, chaired by CEA Member Austan Goolsbee. During the meeting, Goolsbee made clear that the Panel was not seeking to create a new tax system but rather would focus its recommendations on three specific areas — tax simplification, enforcement and corporate tax reform. The panel is accepting public comments through October 15th and then will make its own recommendations known to Treasury Secretary Geithner by December 4th.

In the past, it has been easy to dismiss the work of presidential or congressional tax reform panels. They tend to come and go, after all, with little to show for their efforts. This time, however, the combination of huge deficits and an expiring tax code make some sort of dramatic changes to the tax code almost a certainty. Given the landscape, we intend to follow the efforts of this group closely.


Estate Tax & PAYGO


The House is scheduled to take up a Paygo bill — short for b”pay-as-you-go” — this week that makes room for an estate tax fix. Paygo was established back in 1990 as a means of controlling the Federal deficit. Under Paygo, any increase in the deficit, either by a reduction in revenues or an increase in mandatory spending, must either be fully offset or it will be added to the Paygo scorecard and possibly trigger an across-the-board spending cut (called sequestration) at the end of the fiscal year.

Of interest to S-CORP readers, the bill to be considered by the House (H.R. 2920) specifically exempts four policies from the Paygo rules:


  • Adopting the doctor payment fix proposed to Medicare;
  • Extending the higher exemption levels under the Alternative Minimum Tax;
  • Extending select tax cuts from the 2001 and 2003 tax bills; and
  • Extending the 2009 estate tax rules to 2010 and beyond.



In other words, Congress is seeking to ensure it pays for any tax cuts or spending increases, except for the four policies listed above.B As the Congressional Budget Office reported, “In effect, that rule would allow the Congress to enact legislation that would increase deficits by an amount in the vicinity of $3 trillion over the 2010-2019 period without triggering a sequestration.”

The theory behind the exemption is to allow Congress room to continue “current policy” in each of these areas.B The $1000 child tax credit, for example, expires at the end of 2010.B Extending the credit would reduce revenues by $243 billion over ten years.B H.R. 2920 shields this cost and the cost of other similar policies from Paygo.

What does this signal for estate taxes?B The policy exempted in H.R. 2920 is an extension of estate tax rules for 2009.B As the bill outlines:

(B) with respect to the estate and gift tax, assume that the tax rates, nominal exemption amounts, and related parameters in effect for tax year 2009 remain in effect thereafter without change;

The exempted policy is consistent with the Obama Administration’s budget proposal and was scored by the JCT to reduce revenues by $243 billion over ten years. What doesn’t get exempted is any further reduction in the estate tax beyond the 2009 rules.

For example, Members have been working on a compromise that would lower the estate tax rate to 35 percent and increase the exemption to $5 million per spouse. That’s certainly better than the 2009 levels of 45 percent and $3.5 million but, under H.R. 2920, the increased revenue reduction from the compromise would need to be offset with tax increases elsewhere.

Where would Congress find offsets to a potential estate tax compromise? Both the Obama Administration and Congressman Pomeroy (D-ND) have proposed targeting family businesses for higher taxes by inflating the value of their estates. Exactly how much revenue this would raise is unclear, but family businesses need to be on alert.

A package that lowers rates below 2009 levels while inflating the tax base has the potential to raise, not lower, estate taxes on family-owned enterprises and may be no compromise at all.

Do Small Businesses Really Create All Those Jobs?

A recent paper by Alan Viard at the American Enterprise Institute raises two fundamental questions: Are smaller firms responsible for creating a majority of new jobs in our economy and is there a bias towards smaller firms in the tax code? With small businesses at the epicenter of the debate on reforming our health care system, clearing the record on these questions is critical.

The “small businesses do not really create all those jobs” argument has been around for a long time. However, it is usually raised by folks with a history of supporting Big Government and Big Business. Thus, having someone with Alan’s background on the other side is a new twist.

Regardless of who asks the question, however, the answer is the same. Yes, small businesses really do create all those jobs.B Hereb�s what the Small Business Administration’s (SBA) Office of Advocacy writes:

Since the mid-1990s, small businesses have created 60 to 80 percent of the net new jobs. In the most recent year with data (2005), employer firms with fewer than 500 employees created 979,102 net new jobs, or 78.9 percent. Meanwhile, large firms with 500 or more employees added 262,326 net new jobs or 21.1 percent.

Critics argue that this analysis suffers from several flaws, including how to best classify firms using longitudinal data.B For example, if a firm begins at 450 employees and grows to 550, the SBA says that’s 100 jobs created by small business. But if the same firm shrinks from 550 to 450 employees the next year, it’s a loss of 100 jobs for big business. Classifying the firm based on its initial size biases the results in favor of smaller firms.

But seriously, how many firms “cross the threshold” each year? There simply are not that many firms with more than 500 employees.B Adjusting for these instances may move some numbers around, but the basic tenet remains intact — businesses employing fewer folks create most of the new jobs and policymakers should pay attention.

A study from the Bureau of Labor Statistics adjusting for these statistical challenges found that firms with fewer than 500 employees created about 80 percent of net new jobs. Enough said.

The question of whether the tax code is biased towards small businesses is more difficult. The tax code, after all is incredibly complex and it does include numerous provisions — like Section 179 — targeted to help smaller enterprises. How do you tally up all the variables?

S-CORP readers may remember Dr. Viard from the LIFO debate. Alan pointed out that, if LIFO accounting is an undeserved tax windfall, why is the effective tax burden under LIFO similar to that tax burden shouldered by other forms of capital investment? How could it be a windfall if the tax burden is the same?

The same approach may work here as well. If the tax code is too small business friendly, then the effective tax burden on S corporations, partnerships, and sole proprietorships should be lower than for other taxpayers. But a study commissioned by the Small Business Administration found that the effective tax burden for small businesses (including small C corporations) in 2004 was 19.8 percent, or 3.5 points above the average for all taxpayers that year.B S corporations, by the way, faced the highest effective rate of 26.9 percent.

Moreover, limiting the analysis to income and payroll taxes does small business a disservice. Home Depot doesn’t worry about the estate tax, the family-owned lumber yard down the street does. And studies show that the burden of federal regulations falls more heavily on smaller firms than larger ones.

Finally, we believe Alan’s argument misses a broader point. Your S-CORP team is not comprised of legal theorists, but we do recall that government grants corporations the same legal status as individuals in order to encourage their creation and economic growth. Corporations can enter into contracts and appear in court. Perhaps most importantly, the owners of corporations are shielded from liability.

The S corporation was created, in part, to counter the advantage the corporate structure gives to larger firms. The idea behind the S corporation was to allow smaller firms to thrive by extending some of the essentials of the corporate structure without the onerous tax rules.But S corporation rules also limit their ability to grow and raise capital. They limit the number and type of shareholder and they limit how the firm can be structured.B How do these rules enter into the question of bias in the tax code?

The bottom line is that the effective tax rate on small businesses is higher than the rate for taxpayers in general. Given that reality, itb�s difficult to see how small businesses are somehow advantaged. If Congress wants to help larger businesses by cutting the corporate rate, web�re all for it.B But donb�t forget who creates most of the jobs out there. It’s small business, and during economic downturns, the role they play is more important than ever.

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