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.

Tax Outlook for 2010 — Starting in a Hole

The economic fear that gripped folks in the Fall of 2008 has resulted in a historic collapse of federal revenues.

Revenue collections since 1960 have stayed in a relatively tight pattern centered around 18 percent of our GNP. Considering the range of tax policies we’ve imposed on taxpayers during that time, the steadiness of the 18 percent mean is remarkable and suggests some sort of political or economic boundary is in effect.

That steadiness was broken last year when federal collections fell to their lowest level since 1950. Meanwhile, Washington’s response to the crisis has driven federal spending to levels not seen since World War II.B Record low revenues and record high spending means record high deficits.

While record high deficits are obviously a negative, what your S-CORP team finds most troubling is the long-term outlook. For the next decade, the trend is definitely not our friend.

Once we get past the immediate effects of the “fear” and revenues move back to their historic mean, deficits of 4 or 5 percent GNP will persist. And when revenues move well above their historic mean? Deficits of 4 or 5 percent will persist.

And this is the baseline! It doesn’t include expensive policies that are either set to expire or those that are simply politically unsustainable.

Obama 2009 Tax Proposals vs. CBO Baseline Deficit


The chart above takes CBO’s September deficit estimates and superimposes CBO’s June estimates of President Obama’s 2009 tax proposals. Not exactly kosher, but the underlying point is undiminished: even the President’s modest policies to extend just part of the Bush tax relief would add hundreds of billions to the deficit each year.

“Unsustainable” is the word that comes to mind. Herb Stein once observed that unsustainable trends will not be sustained, which suggests these projected deficits are unlikely to become a reality, but that just means something has to give. Stuck between a rock (record deficits) and a hard place (a weak economy), there are simply no easy answers.

For S corporations, the challenge is to spend the next year demonstrating to taxwriters the economic importance of our community, especially as Congress grapples with the “too big to fail” concept for financial services.

S corporations were created to fight economic consolidation. They move economic power and decision-making away from Wall Street and on to Main Street. If policymakers want proactive policies that reduce the incidence of systemic risk, empowering closely-held businesses is a sure-fire means of doing so.

Health Care Pay-Fors

Health care reform is in the final stages of its legislative journey — last half of the fourth quarter perhaps? — and while the pro-reform team has plenty of momentum, exactly what tax items make it into the final package remain undecided.

Of most concern to S corporations are the marginal rate increases included in both bills. In the House, it is the 5.4 surtax applied to individual incomes above $500,000, while in the Senate it is the 0.9 percent HI tax increase applied to individual incomes over $200,000.

Moreover, recent stories on possible compromises should raise S corporation eyebrows. As first reported in CongressDaily, negotiators are considering expanding the Medicare HI tax beyond wages to include all types of income, including S corporation income.

According to JCT, applying the existing 1.45 percent payroll tax to investment income, including capital gains, taxable interest, dividends, estate and trust income and income from rents, royalties, S corporations and passive partnership income, to those earning above the $200,000/$250,000 thresholds would raise $111 billion over a decade.

S-CORP has a long history of fighting efforts to expand payroll taxes beyond, well, payrolls. Payroll taxes like the HI tax were designed to resemble private insurance premiums on the premise that Medicare and Social Security were “earned” benefits. This proposal would blur the line beyond taxes on labor and taxes on capital, undermine the notion that Medicare is an “earned” benefit, and should be of considerable concern to the business community.

GAO Releases S Corporation Report

In response to a request by Senators Max Baucus (D-MT) and Charles Grassley (R-IA), the Government Accountability Office spent the last year looking into tax compliance by the S corporation community. The GAO presented its findings in a report released yesterday.

Reports like this always carry with them a large degree of headline risk. Words like “noncompliance” and “misreported” jump off the first few pages. Look beyond the first couple pages, however, and the GAO has compiled a comprehensive review of the challenges S corporation face when calculating their taxes.

Questions covered by the GAO include why some businesses choose to be S corporations, what are the types of S corporation non-compliance, and what are the options for improving S corporation compliance. To answers these questions, the GAO interviewed numerous stakeholders, including the S Corporation Association, and, in their just-released report, came to the following conclusions:

  • Congress should require S corporations to calculate and report the basis for their shareholders’ ownership shares;
  • The IRS should research options for improving the performance of professional tax preparers;
  • The IRS should provide additional guidance to new S corporations on calculating basis and compensation; and
  • The IRS should require examiners to document analysis of compensation, and provide more guidance on compensation.Having given the report a first read, what is our reaction? First, the S corporation was created to encourage private enterprise, not avoid lawfully-owed taxes. We don’t support or help those taxpayers who knowingly avoid paying their taxes.
    Second, the legislative recommendation included in the report is for Congress to require an entity-level basis calculation. According to the GAO, this proposal would help address the problem of shareholders claiming losses beyond their basis in the firm. This recommendation is new to S-CORP and we have asked our advisors to weigh-in on its merits.

    Third, we’re glad to see the GAO agrees with us that the IRS has tools to address one of the larger areas of non-compliance. Some S corporation owners who work in their business underpay their salaries in order to reduce their payroll tax obligations. As the GAO notes, the IRS needs to do a better job of both defining the existing “reasonable compensation” standard in its guidance, and applying the standard in its examinations.

    As to the headline risk, last summer the IRS reported that tax compliance by S corporations likely was as good, and possibly better, than taxpayers’ compliance in general. Meanwhile, the SBA reported last year that S corporations shoulder the highest effective tax burden of any business type. As an investor, as an employer, and as a taxpayer, S corporations are a valuable component of America’s business community. The GAO has given us some suggestions on how we can do better.

Second Stimulus on the Horizon

A second stimulus package is being formulated up on the Hill, but is by no means a done deal at this point.B Just before adjourning for the election, the House passed a $61 billion bill containing infrastructure spending, aid to state governments and increased unemployment benefits, which will likely serve as a starting point for second stimulus discussion.B That package included:

  • $30 billion for infrastructure projects including highways, bridges, transit and water projects;
  • $1 billion for public housing;
  • $2.6 billion for food stamp program;
  • A temporary increase in Federal Medicaid assistance to states; and
  • An extension in unemployment benefits.

Other items that could be contained in a second stimulus package include the Columbia Free Trade Agreement, middle class tax relief, and changes to the TARP program. Emily Barrett from the Wall Street Journal reports that Treasury is “under pressure to broaden eligibility for assistance to smaller banks, as well as the cash-strapped autos sector.” Other actions related to the stimulus include:

  • Speaker of the House Nancy Pelosi and Senate Majority Leader Harry Reid met with the CEO’s of America’s automakers last week to discuss billions of dollars of additional assistance to the industry. The two leaders subsequently asked Treasury to make relief to the automakers part of the $700 billion TARP plan.
  • President-elect Obama made an economic stimulus his top priority at last week’s press conference. He indicated if one was not enacted during next week’s lame duck session, he would make it the first order of business in 2009. He also indicated that the package needed to focus on assisting the middle class with job creation and an extension of unemployment benefits.
  • RollCall reports that Majority Leader Hoyer (D-MD) is suggesting that, absent an agreement with the Bush administration — which he described as “elusive” — the House might not ask rank-and-file members to come back next week.

All this activity suggests that, while the odds of a package getting enacted are extremely high, it will probably be early next year before anything moves.

Endangered Tax Species — LIFO

Your S-CORP staff is tempted to create an Endangered Species List for tax provisions. Deferral and Section 199 would top the list as the most likely to be extinct before the end of the next Congress.

LIFO accounting is another. A subset of accounting and tax professionals have been pursuing LIFO for years, and they are closing in. The Joint Committee on Taxation — the tax professionals that Congress uses to help them assess changes to the tax code — fired another shot last week.

In its annual “Tax Expenditures” report, the Committee has for the first time (to our knowledge) listed LIFO. For those of you who don’t follow such things, a tax expenditure is a congressional concept identifying tax provisions that divert from the basic approach to taxing income and measuring the revenue lost by those provisions — tax credits, certain deductions, and lower rates on investment income all qualify as tax expenditures. The concept was first introduced into budget speak in the 1960s and has been highly controversial ever since.

Conservatives especially dislike the idea since it implies that all your income is the government’s and if the government chooses not to take it from you, then that’s the equivalent of giving you a subsidy. Supporters argue that the point is to give policy makers better information on how much certain tax policies reduce revenues so they can make better decisions.

Either way, getting LIFO listed as a tax expenditure gives LIFO opponents one more argument to make in attempting to repeal it.

We will write more on this in the future, but suffice to say that LIFO does not belong on the tax expenditures list anymore than FIFO does. Moreover, while the JCT states its goal in revising the methodology of the expenditure report was to create a more neutral approach, we’re not sure they succeeded.

Capital Gains and Dividends

We’ve written about the likelihood that the capital gains rate is going up in the next couple years. Lots of our members would like to know just when that is going to occur so they can plan accordingly.

The economic distress of the last year and the rising deficit opens the possibility that Congress could enact a rate hike next year but make it effective January 1, 2010. The outcome of the prospective effective date would be to stimulate economic activity — and federal revenues — in 2009. A similar rate increase adopted in 1986 (made effective January 1, 1987) resulted in an enormous increase in federal tax revenues in 1986 as taxpayers rushed to sell their assets and qualify for the lower rates.

As S-CORP readers know, we favor lower rates over higher ones, especially when the higher rates only apply to S corporations and not C corporations. That said, encouraging asset sales at a time when many investors and companies are being forced into asset fire sales already might not be the best policy. Encouraging sales of appreciated property into a bear market may have the opposite of the intended economic effect by further driving down asset prices for everyone.

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