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.

Baucus III

The tax community is still waiting for the third version of the Baucus substitute to be released. A “trial balloon” draft circulated yesterday made certain changes, but failed to address many of the sticking points holding up the overall bill.

Meanwhile, Senators Baucus and Reid spent most of yesterday negotiating with swing Republican votes — at this point, just Maine Republican Senators Olympia Snowe and Susan Collins — to identify what changes are necessary in order to gain the 59th and 60th votes needed. As CongressDaily reports:

The chief target appears to be $24 billion to extend higher Medicaid matching funds for six months, first authorized in the stimulus last year. Options floated Tuesday included phasing down the percentage boost and using untapped funds elsewhere in the Recovery Act for offsets. Snowe and Collins were noncommittal, having not seen details. Senior Democrats appeared resigned that the net cost of the Medicaid assistance would be scaled back. “They’re having to cut it back to try to get Republican votes, and it affects my state; it really affects Harry Reid’s state,” said Sen. John (Jay) Rockefeller, D-W.Va., who with Reid was an original lead Senate sponsor of the six-month Medicaid boost. “But it looks like the best we can get.”

The challenge for Senator Baucus is that the deficit spending in the package represents only half the opposition. There is a lot of opposition to the tax increases as well, including the payroll tax hike on S corporations and partnerships. Senator Snowe of Maine has led the fight to strike this provision from the bill. As The Hill notes:

Kyl said he isn’t sure winding down FMAP is the elixir Democrats think it is in garnering Republican support for the bill. “Whether that will satisfy more Republicans remains to be seen,” he said. “There are other issues with the bill as well, including issues related to the tax provisions.”

The current “K Street” rumor is that Chairman Baucus has been given a limited amount of time to round up the 60th vote. If he’s unable to do so, Majority Leader Reid would set the extender package aside and move on to other items. Whether the rumor is true or not (K Street rumors typically run about 50/50 on the accuracy dial), the clock is ticking.

In addition to Senate consideration, this bill would need to return to the House, where its adoption is by no means assured. If the House makes any changes, it would come back to the Senate. And then, since most of the spending and all the tax items expire before the end of 2010, we’d have to do it all over again before January.

We’ve observed previously that getting the entire business community to oppose a bill centered on extending business-friendly tax breaks is fairly remarkable. The current bill before the Senate is anti-business, and would need to be changed significantly before businesses could support it. It appears that several determined senators share those concerns.

Budget’s Impact on Employers

S-Corp allies over at the Manufacturer’s Alliance commissioned a new study on next year’s tax policy and what it means for S corporations and other business forms. Specifically, the study looked at the tax policies in President Obama’s 2011 budget and asked how these policies would impact economic growth and job creation. The verdict?

In terms of macroeconomic effects, the tax proposals in the 2011 budget are forecast to shave an average of 0.2 percent from annual GDP growth through the middle of the decade, resulting in $200 billion of foregone output and a net job loss of almost 500,000 relative to the baseline. Because taxable business revenues are highly concentrated in manufacturing firms, they will account for a disproportionate share of these output and employment gaps.

So despite much of the rhetoric coming from Washington these days, the rules of economics have not been turned on their figurative heads — the tax forecast for next year is higher tax rates imposed on a larger tax base, which means less investment and less job creation over time. Who will get hit the hardest?

The tax provisions of the 2011 budget will affect S corporations and other pass-through manufacturing firms much more heavily than both firms outside of manufacturing and C corporations within manufacturing. Pass-through businesses in the manufacturing sector will see their tax bills increase by an average of 14 percent. Given the growing importance of S corporations and partnerships to economic growth and job creation over the past 25 years, it is important to understand that tax increases intended to help contain deficits will exact a high price in terms of the competitive posture of U.S. manufacturing and the growth of the economy as a whole.

The study’s authors calculate that S corporations and other “pass through” firms will see their aggregate tax burden rise by $177 billion over the next ten years. Ouch.

Jobs Bill on Senate Floor Next Week

Senate leadership has committed to taking up a Jobs bill next week. The details of the package are still being worked out, but the list released by the Senate Democrats includes:

  • Job Creation tax credit
  • UI and Cobra Extensions
  • Bonus depreciation and 179 expensing
  • Highway funding
  • Build America Bonds
  • SBA loans
  • Export Promotion
  • Some energy related tax items

Although it’s not mentioned, we do expect the tax extenders to also be part on the mix. On the other hand, an estate tax fix is not likely to be included. Senator Reid told reporters that he still plans to move legislation restoring the estate tax, just not now. Meanwhile, policymakers are increasingly worried that time is slipping by. As BNA reported earlier:

Proponents of making the estate tax retroactive to Jan. 1 say case history is on their side, although they admit it will be more complicated because the longer they wait to enact legislation, the more people will attempt to game the tax system.

We are not exactly sure how one would “game” the current system. You have to pass away, after all, to take advantage of the current rules. Final jeopardy, indeed. Takeaway: more chatter about getting something done, but no clarity on when they would do it, what it would look like, whether the House is on board with the retroactive application, or whether they have better guidance on the constitutionality question.

Also, we are hearing from folks that a possible solution would be to offer estates the option of using the 2009 rules or the repeal rules. Point of this would be to protect those mid-sized estates (around $7 million) from paying more under repeal than they would have under last year’s rules. That would certainly get around the retroactive question, but it would also raise the cost of acting.

Rep. Paulsen Weighs in on Marginal Rates

The battle over tax rates is heating up. This week, Congressman Erik Paulsen (R-MN) sent the President a letter asking him to focus on proposals that would hold down marginal tax rates and spur small business growth.

The letter refers to a bill introduced by Rep. Paulsen (H.R. 2284) in May that would allow individual taxpayers an exclusion from gross income for certain items of partnership and S corporation pass-through income up to $250,000 ($500,000 for married couples filing joint returns). As Rep. Paulsen notes, this ability to defer taxes on reinvested income “ensures that small business owners are taxed only on the profits taken out of their business, and also allows for the deferment of taxes on income that was placed back into developing their business. By encouraging reinvestment and incentivizing job creation, we can reach our shared goal of economic growth.”

Paulsen also discusses the possibility of creating “an alternative rate schedule for income stemming from small business activity, including sole proprietor, partnership, and S corporation income” in order to “ensure that marginal tax rates would not rise for America’s job creators during a weak economy.”

Amen to that. America has a vibrant, active Main Street business sector because past Congresses have proactively adopted policies to encourage small business creation and growth. Creation of the S corporation was one of those policies. Now is not the time to reverse course.

John Edwards and S Corporations

One of our allies asked us, “How did John Edwards come to be the poster child for S corporations?” He’s featured prominently in a recent CongressDaily story and, frankly, it’s not an association we’re eager to continue.

The Edwards issue first emerged during the 2004 presidential campaign when we learned that, prior to be elected, Senator Edwards operated his law practice as an S corporation. According to reports — recapped by CongressDaily — Edwards took most of his earnings in the form of S corporation distributions which are not subject to payroll taxes.

As you can imagine, this use of the S corporation caught everybody’s attention and the “John Edwards Issue” was born. We still hear “Oh, is this that John Edwards thing?” when we talk to staff about payroll taxes.

While the payroll tax issue continues to be difficult for policymakers and tax collectors alike, the rules governing when S corporation shareholders pay payroll taxes have been in place for long time. Since the IRS released Revenue Ruling 59-221 back in 1959, S corporation shareholders have been required to pay payroll taxes, but only if they work at their business and only on the wages they pay themselves. Revenue Ruling 74-44 made clear that “dividends” paid to shareholders will be recharacterized as wages when the dividends are in lieu of reasonable compensation for services performed for the S corporation.

Despite these clear rules, when Congress lifted the cap on the Medicare payroll tax back in 1993, it created an arbitrage opportunity for business owners whose income exceeds the Social Security wage base. Organize as an S corporation, pay yourself little or no salary, and avoid paying the Medicare tax.

The S Corporation Association’s position on this is three-fold. First, people should pay the taxes they legally owe — we don’t support tax avoidance. Second, while it is admittedly time-consuming, the IRS has the tools necessary to deal with this issue and collect the money owed. As the IRS wrote one taxpayer back in 2003:

Generally, under the rules described above, if a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services. An S corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed.

Third, every legislative proposal we have seen to date to “fix” this issue has been overly broad and would raise taxes on shareholders already fully complying with the law.

As we mentioned, applying the “reasonable compensation” standard is difficult and time-consuming, but the standard is well established and ensures that payroll taxes only apply to shareholder income derived from their services, as opposed to income stemming from their investments in the business and its employees. As you can imagine, capital-intensive industries like manufacturers and others are keenly interested in making certain this line of demarcation is preserved.

The GAO spent the last year looking into S corporations and the tax policy challenges they present. On the payroll tax issue, the GAO recognized that the IRS has the tools in place to enforce current law. Its recommendation:

To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed.

We understand the current rules are not a perfect solution to the “John Edwards Issue.” But then, nothing else is either. We hope the IRS follows the GAO’s recommendation and works to improve its guidance and enforcement of reasonable compensation. Effective enforcement would take the pressure off policymakers to codify new rules, and remove from the S corporation community the threat that fifty years of tax policy will be turned on its head.

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