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.

Latest on Payroll Tax Hike and Extenders

Earlier today, the Senate voted earlier on its version of the “extenders plus” bill passed by the House a few weeks back. The vote, on a motion to waive a Budget Act point of order, failed miserably (45-52), indicating the Senate Leadership has a long way to go before they gather the sixty votes necessary to move forward.

With this morning’s vote behind us, the process moving forward is becoming clearer–Finance Chairman Max Baucus (D-MT) is expected to introduce a new substitute today. According to BNA:

Baucus is expected to draw up a new substitute amendment that will be a slimmed-down version of what the Senate defeated. That plan would have added $84 billion to the federal deficit, a figure that Republicans, and some Democrats, said was too high to stomach. Baucus has previously said that he would continue to work with senators of both parties to find 60 votes. Issues that could be modified to secure votes include Medicare reimbursement rates for physicians, unemployment insurance benefits, Medicaid funding to states, and possibly language making it more difficult for S corporations to avoid paying employment taxes.

As BNA indicates, the new effort will likely include a modified payroll tax hike. As with the House-passed provision, however, the new tax has been written behind closed doors and without the benefit of public scrutiny. It might be better than the flawed House effort, but we simply won’t know until it’s offered.

The next key vote will take place tomorrow, when the Senate considers Senator John Thune’s (R-SD) alternative “extender plus” package. This package includes all the tax extenders the business community wants, but strikes all the tax hikes the business community opposes (including striking the $11 billion payroll tax hike). Instead, all the tax relief and spending in the package are offset with spending cuts. As with today’s vote, Senator Thune is not expected to get 60 votes tomorrow, but we’re betting he does better than the 45 votes Senator Baucus got today.

Meanwhile, Senator Olympia Snowe (R-ME) continues her fight on behalf of S corporations. As CongressDaily reported this morning:

Snowe is upset about an $11 billion tax increase on small services firms organized as S corporations; Baucus is preparing some tweaks to that provision, and the chamber’s 63-33 adoption of an amendment she co-sponsored to establish an office within the Treasury Department to help homeowners struggling with mortgage payments can’t hurt. Democratic aides said they still have some work to do on their side of the aisle before working to assuage GOP holdouts.

The S corporation community owes Senator Snowe a big debt. Meanwhile, with the first Baucus substitute gone and the second version to be introduced, we will just have to wait to see what they have in mind.

House Releases Health Care Legislation

As expected, House Leadership released its health care reform plan yesterday — America’s Affordable Health Choices Act of 2009 (H.R. 3200). As you can imagine, there are any number of provisions to explore in a 1000-page health care bill, but for S corporations, the big four items appear to be:

 

  • The new health insurance exchange;
  • The surtax on high income individuals;
  • The health insurance tax credit for smaller firms; and
  • The payroll tax penalty for non-participating firms.

 

Supporters of the plan argue that the combination of the health care exchange and the small business tax credit will provide a net benefit to S corporations and other small businesses. Opponents point to the higher taxes and penalties for firms that choose not to offer health care plans to their employees.

They also question whether the overall plan will actually save money. The CBO estimates it will cost money after all - more than $1 trillion dollars. Of particular importance is the response of the moderate Democratic Blue Dog Coalition.B As BNA reported this morning:

Rep. Mike Ross (D-Ark.), chairman of the Blue Dog Health Care Task Force, said his group was committed to passing health care reform. He also said that “reform that does not meet the president’s goal of substantially bringing down costs is not an option.”

We are not in a position to judge how successful the exchange will be. The only example is the one in Massachusetts and that one has both supporters and detractors.B As for the other three provisions, here’s our best summary:

Surtax: Starting in 2011, a surtax of 1, 1.5 and 5.4 percent will be applied on “modified” AGI exceeding $350,000, $500,000 and $1 million respectively (joint filers).B Unless OMB certifies that the bill’s changes to Medicare and Medicaid result in an additional $150 billion in cost savings, the surtax will rise to 2, 3, and 5.4 percent starting in 2012. If OMB certifies these savings exceed $175 billion, then the lower two surtaxes go away.

Small Business Tax Credit: For employers with fewer than 25 employees and who offer them qualified coverage, they are eligible for a tax credit equal to a percentage of their health care costs. The credit starts at 50 percent for employers with fewer than 11 employees and average annual compensation of less than $20,000. It phases out for more employees and higher salaries. A firm with 25 employees and/or average compensation of more than $40,000 gets no credit.

Payroll Tax Penalty: Firms that do not pay for at least 65 percent of their employees’ qualified coverage are subject to a payroll tax penalty. The tax starts at 2 percent of payroll for firms whose payroll exceeds $250,000 and rises to 8 percent for firms with payrolls exceeding $400,000. It is unclear whether the payroll tax applies to all payroll or just the amount exceeding the threshold.

Suffice to say that the complexity of each provision is worth its own white paper. Trying to gauge the interaction between them is simply impossible. Here are some observations and questions:

 

  • How does the payroll tax penalty work? If an employer does not offer qualified coverage to his/her employees, does the tax apply to all payroll or just the amount above the threshold How does the bill define firm? By entity or by establishment?
  • The plan penalizes employers for expanding their payroll. If the employer offers qualified coverage, raising wages would reduce their credit. If they don’t, increased wages will increase their penalty. Either way, the plan raises the marginal cost of hiring new employees and offering them higher wages.
  • The higher surtax rates can be avoided if OMB finds additional savings from Division B in the bill. How is OMB supposed to measure these savings and attribute them to the Division B? If the CBO failed to measure these savings, how will OMB?
  • The bill appears to add to the deficit, especially in later years. Is this the plan, or will additional cost savings be offered to make it budget neutral?
  • What about the need to balance the budget, reform the Alternative Minimum Tax, extend some or all of the expiring tax relief, or make the corporate tax code more competitive? How will Congress accomplish all these things if it spends $1 trillion on health care reform?

 

 

The House Ways and Means, Labor, and Energy and Commerce committees will begin marking up their respective portions of the bill tomorrow. Expect these markups to be extremely contentious. The Speaker’s goal is to get the bill through the full House before the August recess. Given the primary importance both the Speaker and the President have placed on health care reform, we expect this goal will be met. Exactly what changes are necessary to get the plan through the House, however, remains to be seen.

The Surtax and Small Business

The fight over who will pay the surtax has begun. The Ways and Means Committee published its estimates that only 1.2 percent of all taxpayers will pay the tax, and only 4.1 percent of all small business owners.

Our immediate reaction was that small business owners are 3.5 times more likely than the average taxpayer to pay the tax, but even that observation misses the larger point. It’s not the number of taxpayers affected that counts, but rather the amount of economic activity subject to the higher rates.

As we’ve pointed out previously, about two thirds of all small business income is taxed at the top two rates, so any surtax applied to upper incomes is likely to tax a majority of small business income. Moreover, those rates are already scheduled to rise, resulting in a double hit on upper income business owners in 2011 and beyond.

Marginal Tax Rates Under HR 3200 (Joint Filers)
AGI Marginal Rate (2009) Marginal Rate (2011) Marginal Rate (2012)
$350,000 33% 34.00% 35%
$500,000 35% 41.10% 42.60%
$1,000,000 35% 45% 45%

This chart requires several caveats, including pointing out that the surtax applies to “modified” AGI rather than taxable income, but the general point is valid — HR 3200 will return marginal tax rates back to where they were before we started cutting rates in the 1980s.

In addition, this chart doesn’t include the HI tax that now applies to wage income, it doesn’t adjust for taxing “modified” AGI, which includes income from capital as well as labor, it doesn’t include the impact of restoring PEP and Pease, and it doesn’t include state and local taxes. All told, the effective marginal rates on higher incomes will easily exceed 50 percent under this plan.

One last point. When taxing the rich is debated, the discussion usually ignores the actual amount of taxes being paid. Your S-CORP team thinks that’s a mistake.

For example, the CBO reports that the top fifth of taxpayers pay, on average, $64,000 in federal taxes every year. The top one percent pay over half a million.

How much more will HR 3200 add to this burden? And at what level of tax do taxpayers, including small business owners, stop being productive and choose to do something else with their time?

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