Payroll Tax Hikes Back On The Agenda

Last week, the S corporation community was put on high alert when we received word that an S corporation payroll tax increase similar to the provision from the old Rangel Mother bill (H.R. 3970) was being discussed as an offset to the extender package. The “Mother” provision (see Sec. 1211) would apply payroll taxes to all the service-related income of active shareholders of S corporations primarily engaged in service businesses. While we anticipate that the language of any new provision will differ somewhat from its 2007 predecessor, the general concept remains the same. As CongressDaily noted:

Sources familiar with the House Ways and Means and Senate Finance discussions said applying payroll taxes to certain S corporation profits could raise anywhere from $10 billion to $15 billion, depending on how it is structured. Revenues in that ballpark would go a long way toward closing a $30 billion gap tax-writers need to fill to pay for extensions of numerous expired provisions.

An earlier proposal floated in 2007 was estimated to raise $9.4 billion over a decade by subjecting S corporation and partnership income earned from providing services to payroll taxes, although the new healthcare law would raise the Medicare portion of the tax beginning in 2013 for wealthier earners. The 2007 proposal was scaled back from an earlier option outlined by the Joint Committee on Taxation that would have applied the payroll tax to all S corporation income, estimated to raise $57.4 billion over a decade.

Team S-CORP has had to fight this battle in the past, and we have been in to discuss this provision with Ways and Means on several occasions to get a better idea what they have in mind. Letters sent back in 2007 on behalf of S-CORP as well as our allied trade associations should give you a better sense of the history of this issue.

The future of this particular effort is still very much up in the air. Our communications with the Hill suggest there continues to be strong interest in legislating on this issue — you could characterize this as just one more legacy item left to us by former Senator John Edwards and his law practice — albeit it may take place on a bill other than extenders.

We have pledged to work constructively with taxwriters on a resolution to this issue, but unless they are willing to dramatically pare back the Mother provision to target only bad actors, it is going to be very difficult for business groups to support yet another tax increase on their members.

Stay tuned. More to come.

Latest on Dividends

Whither Tax Rates? The Hill’s On the Money Finance & Economy Blog had an excellent discussion this month on the topic, focusing on the future of dividend rates.
As On the Money notes, “President Barack Obama has proposed that the current rate of 15 percent on dividends be extended for most taxpayers. He’d raise the tax on dividends for individuals making $200,000 or more and families making $250,000 or more to 20 percent. There are several reasons to think wealthier taxpayers will get hit with a much higher tax.”

Meanwhile, The Hill mentions that one possible outcome would be for the dividend tax to fall somewhere between the current 15 percent rate and the top rate on ordinary income. Any divergence from the baseline, however, would require positive action by Congress. As The Hill observes, that’s not something to be taken for granted:

Finally, the lesson of the expired estate tax also has dividend-tax watchers nervous. Congress was expected to extend the estate tax last year, but instead let it expire when Republican and Democratic senators could not reach a compromise. The estate tax is set to kick in again in 2011 at a much higher rate if no action is taken this year.

Also at play is a possible House-Senate dynamic. Our impression is Senate leadership would like to keep capital gains and dividends taxed at the same rates, while their House counterparts are more comfortable seeing the rate on dividends go back to 39.6 percent.

In the end, we believe process will dictate outcome here. The recently enacted ”pay-go” rules require Congress to offset any reduction in the dividend tax rate below 39.6 percent for 2011. Exactly what tax increases would Congress use to offset dividend tax cuts for folks making more than $200,000? We don’t know either, and expect the tax hikes already imbedded in current law will take place as scheduled.

Long To-Do List

Tax policy is in danger of becoming that honey-do list that never gets done. The traditional tax extenders — R&E tax credit, state sales tax deduction, etc. — all expired at the end of last year and, almost five months later, are still expired. Legislation to extend them is stuck between the House and Senate without a pay-for, yet (see above).

Meanwhile, the estate tax fix that was supposed to be done last year — before the tax took its one-year sabbatical — remains stalled in the Senate. Efforts to negotiate some sort of permanent fix are actively taking place in the Senate, so there’s hope. As with the extender package, however, the hold-up is primarily over offsets.

There’s also the most recent in the growing line of “jobs” bills being considered by Congress this year. The latest one passed the House under the banner of a “small business jobs” bill, despite the fact that most of its benefits went to Build America Bonds. We expect the Senate to take up a bill that’s more small-business oriented soon.

Finally, there’s the burning issue of all those tax cuts expiring at the end of the year.

With that as background, reasonable folks might ask themselves: “What’s the plan?” Ways and Means Committee Chairman Sander Levin (D-MI) addressed this question earlier this month, stating he hopes to complete work with the Senate on both tax extenders legislation and the House-passed small business bill by the end of May, telling reporters, “These bills are a critical priority for the leadership of this Congress and the president. These are jobs bills and we need to get these done.”

According to BNA, Levin met with Senate Finance Committee Chairman Max Baucus (D-MT) to discuss the two bills, but the two “did not discuss efforts to address the estate tax, which expired at the start of 2010, and no detailed plans have been set for how lawmakers will deal with the middle-class tax cuts of 2001 and 2003 that are set to expire at the end of the year.”

Your S-CORP team has numerous member companies who are intently interested in Congress moving forward on both the estate tax and the expiring tax provisions. We are five months into 2010 already. It’s time for Congress to act.

Built-In Gains in Play

Team S-CORP spent the last couple weeks on the Hill, educating members and staff on the virtues of reducing the built-in gains (BIG) holding period.

When a company converts to an S corporation, it must hold onto any appreciated assets for 10 years or face a punitive level of tax. This tax effectively locks up these assets, preventing the company from selling them and putting the resources to better use. We’ve raised this issue before, but allowing private companies access to their own capital makes lots of sense in an economy where capital is scarce. It also reflects the reality of today’s shorter lifespan for key business investments.

Last year, Congress agreed and included a shorter, seven-year holding period in the stimulus package. That seven-year period expires at the end of 2010 and needs to be made permanent. A five-year period would work, too. Last summer, Senator Grassley (R-IA) introduced legislation to reduce the BIG tax holding period to five years which we view as tremendously valuable to S corporations struggling to raise capital.

With the Senate actively considering provisions to help small businesses grow and create jobs, a shorter BIG holding period is going to give you more job-creating umph than any other tax provision we know. It would benefit Main Street firms located in every state and every sector of the economy and should be included in the final package.

Private Enterprise and Jobs

A recent Washington Times article by Mike Whalen, chief executive of Heart of America Restaurants and Inns, should give policymakers pause as they worry about weak job growth while simultaneously piling one tax on top of another onto job-creating companies. Using 2008 numbers, Whalen runs through all the taxes a single 100-room limited service hotel located in Iowa pays:

For starters, we pay property taxes to the tune of about $199,000 annually. Next, there is a 7 percent “pillow tax” that generates about $162,000 annually. Then we pay a 6 percent sales tax on revenue that yields about $124,000 annually. Then we also pay sales tax on things like toilet paper, shampoo, soap, continental breakfast food and amenities and other items that the state of Iowa says are not really part of the product we sell because it says we are selling space. It may come as a surprise to you that toilet paper is not part of what you are buying when you rent a hotel room in Iowa, but the state considers it a gift. Those extra sales taxes come to about $1,800 per year.

Now on to Round 2. This little hotel also pays about $3,000 a year in various licenses and fees. Payroll taxes come to about $60,000. The federal government says the depreciable life of a hotel is 39.5 years, but we refurbish the hotel on a constant basis and pay sales tax on related purchases, such as new carpet, mattresses and bedding, and even paint. Anyone who doesn’t believe we already have a partial value-added tax (VAT) like Europe, isn’t in business. Now, between Round 1 and Round 2, we’re at $548,000 in taxes annually.

So, even if we don’t make a dime of profit, and before we pay the mortgage to the bank or buy new stuff, we pay $548,000 in various taxes, licenses and fees.

As Whalen points out, this tax burden doesn’t include state or federal income taxes. Those taxes are going up. And the alternatives aren’t pretty either:

If I sell the hotel, I’ll pay a hefty capital gains tax of 25 percent, and it’s probably going up. Alternatively, when my wife and I die, I’ll pay another 45 percent if the estate tax returns in 2010. But don’t worry: We have diverted money from productive investments to pay for life insurance to partially pay this bill.

A central question to any economy is, “Where are tomorrow’s jobs going to come from?” A small hotel in the Midwest may not immediately come to mind as part of the answer, but ask folks in Iowa whether those jobs are important. And then ask yourself whether the tax changes just enacted, coupled with those on the horizon, are going to make it easier or harder for Mike and other entrepreneurs to take risks, invest in properties like a limited service hotel, and create jobs. The answer is pretty obvious.

Whither Tax Rates?

Following the release of the S Corporation Association letter on the new 3.8 percent tax and its impact on future tax rates, we got into a back and forth with a reporter over what is the appropriate baseline for measuring future rates.

We used a current law baseline, which is the same baseline the Congressional Budget Office and the Joint Committee on Taxation use when making their estimates. Under current law, for example, the tax rate on dividends is scheduled to rise from 15 percent today to 39.6 percent next year to nearly 45 percent in 2013 when the new 3.8 percent tax kicks in. That’s three times the current tax!

The reporter, on the other hand, suggested it would be more appropriate to use President Obama’s proposals as the correct baseline. Under the President’s plan, the top rate on dividends would rise to 25 percent in 2013 based on his proposal to tax capital gains and dividends at a 20 percent base rate. Here’s a comparison of the two baselines and their respective rates:

Top Marginal Tax Rates in Future Years
2010 2011 2013
Current Law*
Capital Gains 15% 21% 25%
Dividends 15% 41% 45%
Interest Income 35% 41% 45%
Obama Budget
Capital Gains 15% 21% 25%
Dividends 15% 21% 25%
Interest Income 35% 41% 45%
* Current Law and Obama Budget include the phase-out of itemized deductions (Pease)

Unless you’re actually working for the White House or OMB, using the President’s budget proposals as the baseline requires a certain amount of faith — faith he will press for those proposals, faith the Congress will pay attention, faith other priorities will not get in the way. The President’s budget does call for a statutory rate of 20 percent for 2010 and beyond, but most observers are betting rates of 28 percent or higher are more likely.

But that’s all beside the point. As the chart demonstrates, tax rates on investment are going up sharply regardless of which baseline you use.

More on the Investment Tax and S Corporations

Our Google Alert did its job and alerted us to another website devoted to S corporations — It appears they too are concerned about the new 3.8 percent tax on investment income and S corporations. As web author Stephen Nelson explains, even S corporation shareholders active in the business may end up paying this tax on some of their S corporation income:

Once a taxpayer’s income exceeds the threshold amount, investment income gets hit with the tax. But it’s important to note that investment income earned inside an S corporation retains its character as the income flows through to investors. This means that even working shareholders may pay the new Medicare tax on the chunk of the S corporation’s profit that occurs because of interest, dividends, capital gains, or rental income earned by the S corporation.

Example: Your share of an S corporation’s profit is $100,000 but only $80,000 of this $100,000 represents profits from the business operation. The remaining $20,000 of profit comes from dividends, interest and capital gains earned on investments held by the S corporation. In this case, no matter whether you’re a working shareholder or a passive shareholder, you’ll pay the Obamacare Medicare tax on the $20,000 of investment income that flows through to you if your income exceeds the threshold amounts.

This result suggests the new tax may be more expansive than it appeared at first glance, especially for mature S corporations that control more than one entity.

House Passes Health Care Reform and "Fix"

After a long legislative odyssey, the House passed the broad health care reform package on Sunday evening by a vote of 219-212. This legislation is identical to the Senate bill adopted on Christmas Eve and is now ready to go to the President. As CongressDaily noted:

The House took a historic vote late Sunday night to approve an overhaul of the nation’s healthcare system after more than a year of debate, a few near-deaths for the measure and an intense final week marked by loud and angry protests outside the Capitol.

The House also adopted 220-211 a package of “fixes” to the larger bill that will now go to the Senate for consideration. This narrower package makes numerous changes to the broader bill, including imposing a new 3.8 percent tax on unearned income that hits S corporations, and will be considered in the Senate under reconciliation rules that only require a simple majority vote.

The Senate vote is expected to occur later this week and, by all accounts, the Senate Democrats have the votes to prevail. (Note: There are two remaining bumps in the legislative road to look out for. First, there is a lot of talk about a possible Social Security point of order that would bring down the entire “fix” bill. Second, there are numerous so-called Byrd Rule violations in the “fix” bill that will need to be removed, which means the Senate “fix” bill will differ from the House version. That means a conference and a more protracted debate.)

About a month ago, we predicted that health care reform would stall and eventually be set aside by other legislative priorities. Its adoption yesterday demonstrates both the risk of trying to predict the future, and also the determination of the Obama Administration and Congressional Leadership to see this effort through. It’s an impressive legislative victory, albeit a costly one for private enterprise.

S-Corp Leads Response

Last week was a busy one for your S-Corp team. Early in the week, we learned that the House would consider, as part of the health care “fix” bill, a new 3.8 percent tax on certain types of income.

While the tax has been inflicted with various labels — in a nod to reality, the House dumped the original “Medicare Tax” title — the simplest description is that it’s a tax on investment income — just about any taxable investment — including S corporation and partnership income attributed to non-active shareholders and partners.

So, if your income is high enough and you invest in Microsoft, you’ll pay this tax on any dividends or capital gains Microsoft earns you. Similarly, if you invested in your daughter’s S corporation, you also pay the new tax.

In response, your S-Corp team quickly organized a business community letter opposing the new tax in the strongest terms. The letter, sent to Hill leadership and signed by 24 small business groups, makes the case that this new tax is going to hurt job creation and economic growth in future years. As the letter states:

Finally, while the tax has been described as applying to the “unearned” income of only a few taxpayers, it is actually a direct tax on the majority of taxable savings in this country. In 2007, households with incomes exceeding $200,000 accounted for 47 percent of all interest income, 60 percent of all dividends, and 84 percent of all capital gains reported on tax returns.

Businesses and workers rely on these savings to increase their productivity and wages. At a time when businesses are having a hard time accessing credit, millions of workers are unemployed, and the entire economy needs to recapitalize, raising taxes by this amount on that much capital is simply reckless.

Despite this harm, the House retained the provision. It now heads to the Senate. While we expect the Senate to adopt the tax as well, the tax itself doesn’t take effect until 2013, giving the S Corporation Association and our allies two years to educate policymakers on why this is a really bad idea.

The “3.8%” Tax and Future Tax Rates

Peter Cohn in CongressDaily has an interesting piece on where tax rates, especially the tax rate on dividends, are headed in the next couple years. Here’s the lead:

Democrats may be boxed in to letting the tax rate on dividends for upper-income earners top 40 percent in January — or coming up with tens of billions of dollars to pay for a lower rate — due to new budget rules signed into law in February.

The general assumption has been that Democrats will enact President Obama’s tax policies, averting that scheduled increase by capping it at 20 percent for wealthier earners. But the pay/go law only assumes the dividend rate will stay at its current 15 percent for middle-class taxpayers. For the wealthy, the rate would revert to its pre-2003 levels corresponding to ordinary income tax rates, unless Congress finds a way to pay for holding it to 20 percent.

With Federal deficits exceeding $1 trillion, we’re not holding our breath here that the same Congress that just imposed a new 3.8 percent tax on investment income would turn around and cut the base tax rates on that same category of income.

Which means, coupled with where the marginal tax rates are scheduled to go already, the new 3.8 percent tax has the potential to drive tax rates to their pre-1986 levels — capital gains rates would be 25 percent while the tax on interest, dividends, royalties, and other forms of investment income would be nearly 45 percent. More from Peter Cohn:

Observers outside the Beltway are baffled why the issue isn’t getting more attention. “I don’t think anyone is really focused on the dividend tax,” said Jeffrey Kwall, a professor of tax law at University of Loyola Chicago Law School. “And I don’t think people have really thought through what kind of impact it would have on the market” for the top rate on dividends to skyrocket by 165 percent.

Congress spent a year focused on expanding the Federal government’s obligations to health care while ignoring one of the most basic issues affecting the economy and job creation — the after- tax rate of return on investment. Outside observers should be baffled.

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