S Corp Payroll Tax Hike Resurfaces

Last week, Senate Democrats released a paper highlighting a dozen tax increases they would like to use to offset spending cuts in the current budget negotiations. As Politico reported:

Tax expenditures topping the list include the deduction corporations take when they move operations overseas and the carried interest loophole, which allows private equity and some other investment advisers to pay the lower capital gains tax rate on some of their income.

Also on the list is our old nemesis, the S corporation payroll tax hike. Labeled the Edwards Loophole by Republicans and the Gingrich Loophole by Democrats, the issue is that some professionals are using the S corporation structure to avoid paying payroll taxes. According to the Democrats’ release:

Some wealthy business owners knowingly mischaracterize their income as business profits instead of salary to avoid Medicare and Social Security payroll taxes. Ending this loophole would save about $12 billion over the next ten years.

We have a number of objections to this characterization. First, using your S corporation to avoid payroll taxes is not a loophole, it’s tax avoidance. The current reasonable compensation rules are clear and the IRS has a history of going after offenders and winning.

Second, the proposals offered to date are worse than the existing rules. The JCT might score them as raising $12 billion over ten years, but it’s hard to see how the IRS would be able to come up with that level of enforcement.

For example, the provision defeated by the Senate back in 2012 would have replaced reasonable compensation with a “principle rainmaker” test where the IRS would have to determine whether 75 percent or more of the gross income of the S corporation is attributable to the service of three or fewer shareholders. Oh, that’s easy. As a letter signed by 38 business organizations observed:

This new approach, particularly the ”principal rainmaker” test, is neither clear nor more enforceable than existing rules. These rules have been in effect for over half a century, and the IRS has repeatedly and successfully used them to ensure that active S corporation shareholders pay themselves a reasonable wage, most recently in Watson v. US (2011).

The business community responded strongly in 2012 and that opposition remains today. We do not support the misuse of the S corporation structure to avoid payroll taxes, but any replacement to the current ”reasonable compensation” test must be easier for the IRS to enforce and for businesses to comply with.

For those who want more, here are links to the business community letter as well as a longer history of the issue:

SBA Weighs in on Corporate Tax Reform

A new study sponsored by the Small Business Administration adds to the case that corporate-only tax reform, as advocated for by the Obama Administration, would shift the tax burden on to smaller, private companies. As reported by Politico:

Cutting corporate tax rates by trimming costly breaks is a popular selling point for a tax code overhaul, but some small businesses could wind up unintended victims, an independent government agency on Wednesday said, lending support to Republican concerns.

New data from the Small Business Administration warn that the trade-off would be a double whammy to smaller businesses that file taxes as individuals.

These businesses get nothing from a corporate rate cut but they could still lose their tax breaks. The SBA study found that these businesses account for about $40 billion in tax benefits, or about one-third of the $161 billion spent each year on all business tax expenditures.

The top U.S. corporate rate is 35 percent, among the highest in the industrialized world. Although the code is riddled with breaks and loopholes that allow some companies to pay far less, others pay much more.

By contrast, the top rate for individuals, including these so-called pass-through entities, is more than 40 percent.

The study compared the value of tax expenditures for all businesses with those used by pass through and corporate businesses with annual receipts under $10 million. As the study notes:

Of the largest tax expenditure provisions utilized by all businesses in 2013, small businesses will utilize approximately $40 billion out of a total of $161 billion. The estimates indicate that small businesses will utilize approximately 25 percent of the largest business tax expenditure provisions in 2013.

So any effort to eliminate tax expenditures to pay for a lower corporate tax rate would also hit pass through businesses that pay at the individual rates. Not good. As our 2011 E&Y study made clear, such a policy would increase taxes on pass through businesses by $27 billion a year.

S Corporations and the Estate Tax

With a large fraction of the tax code expiring in the next couple of years, the big surprise may be the growing consensus for compromise over the estate tax. The estate tax is scheduled to go away in 2011 followed by its return in 2011 with a top rate of 55 percent and a $1 million exemption per spouse.

How did the estate tax, perhaps the most contentious and divisive of taxes, get to the head of the line of possible compromises? A couple of factors appear to be in play.

For legislators who support full repeal, the prospect of allowing the tax to rise from the dead in 2011 is simply unacceptable. These legislators could hold out for full repeal, but it’s highly unlikely they will get it. Any effort on their part to block a compromise would ensure a higher estate for their constituents, not a lower one.

For estate tax supporters, allowing the tax to go away entirely in 2010 is also problematic. It means any comprise agreed to in 2010 would be a step backward from current law. It also means that principals with sizeable estates in 2010 very well may choose death over taxes. It would only take one well-publicized estate tax suicide to highlight all the reasons the estate tax repeal effort was so successful before 2001.

The net result is that legislators on both sides of the issue have a strong incentive to compromise, and to do it sooner rather than later. The estate tax rules in place in 2009 ($3.5 million exemption with a 45 percent top rate) may form the basis for the compromise.

What does this mean for S corporations? As small and closely-held businesses, we have more than our fair share of family-owned businesses. And as much as tax simplicity, economic growth, and basic decency argue that the estate tax should be repealed, having some kind of certainty over the rules going forward is valuable too.

It also means the S corporation valuation issue that has been litigated in the courts over the past decade will become more of a priority.

For new readers, the issue is whether the value of an S corporation should be adjusted to reflect the future taxes paid by its shareholders on the business income.  Gross v. Commissioner held that these tax payments do not count. The result is that when an S corporation is part of an estate, the IRS may try to value it at a 60 percent or higher premium over similar C corporations.

Charging S corporations a higher estate tax merely because they pay taxes at the shareholder rather than corporate level is simply unacceptable. S corporations need to be aware that this discrimination exists, and be prepared to fight it out with the IRS.

Payroll Taxes and the Wage Cap

Former Presidential Advisor Larry Lindsey wrote in the Wall Street Journal earlier this week about Senator Obama’s proposal to raise the wage cap on Social Security taxes.

On several occasions, Senator Obama has suggested the Social Security payroll tax of 12.4 percent should apply to income above $250,000. This proposal would create a three-tiered payroll tax: workers would pay 12.4 percent on their first $102,000 of earnings, nothing on the next $148,000, and then 12.4 percent again on any income above $250,000.

Setting aside the nonsensical rationale of imposing this tax doughnut hole on wage income, Larry focuses on the economic implications of raising marginal rates by 12.4 percent. As Larry writes:

The economics of what Sen. Obama is proposing should be at least as troubling. A high-income entrepreneur would see his or her federal marginal tax rate rise to 53% from 37.7% under Sen. Obama’s tax plan. He proposes a 4.6 percentage point hike in the personal income tax rate, a loss of some itemized deductions, and a 12.4 percentage point hike in the Social Security payroll tax. This would take a successful entrepreneur’s effective marginal tax rate higher than what it was under Jimmy Carter or Richard Nixon, when the maximum tax on an entrepreneur was 50%.

As S Corp readers know, the S Corporation Association has fought the idea of raising payroll taxes on S corporation income for years. Eliminating the wage cap is just one means of raising Social Security taxes. Couple it with the Joint Committee on Taxation proposal to apply payroll taxes on all the S corporation income of certain shareholders, and you are looking at a tax hike of historic proportions on S corporations and their shareholders.

Congressional Tax Update

Another week, another vote on extenders. As we reported last week, the House was going to take up another package of tax extenders, this time extending the AMT patch through the end of 2008.

On Wednesday, the House adopted the package 233-189 and sent it to the Senate, where the Republican minority is expected to block its consideration. They object to the revenue raisers attached to the patch. The White House also objects. According to the Statement of Administration Policy issued during the debate in the House:

The Administration does not believe that the appropriate way to protect the 26 million Americans from higher 2008 AMT liability - including 22 million that would be newly exposed to the AMT - is to impose a tax increase on other taxpayers. The Administration urges Congress to reduce the risk of disruption to the 2009 tax filing season by eliminating tax increases from the bill.

This is just the latest in what has the potential to be a very long dance between those legislators who want to offset the extension of existing tax benefits with tax increases elsewhere, and those who do not. Last year, this debate lasted right up until Christmas.

Senator Clinton’s Tax Policies – Bad for S Corporations

Recently, we reviewed Senator Obama’s tax policies and how they might impact S corporations should he become President. What about Senator Clinton? If she becomes President, how would her tax policies impact small and closely-held businesses?

In general, Senator Clinton has opposed the rate relief and other tax reductions enacted over the past eight years. As she told one audience:

I want to restore the tax rates we had in the ’90s. That means raising taxes on corporations and wealthy individuals. I want to keep the middle-class tax cuts, and I want to start making changes that will save us money, save money in our Medicare budget, save money for the average American.

On the individual side, she advocates repealing the Bush tax cuts for those taxpayers making $250,000 or more. In practical terms, that would mean the two top income tax rates would rise from 33 and 35 percent to 36 and 39.6 percent.

While her position on reforming the Alternative Minimum Tax is unclear, she has advocated cutting the AMT and raising taxes on “billionaires”:

I’ll tell you something that we are going to have to deal with, the alternative minimum tax, which falls heavily on a lot of you and your families. You know, for six years I’ve been saying, with all due respect, do the billionaires in America need more tax cuts? Don’t you think we ought to cut the taxes of middle income people, in particular those who are going to be hit by the alternative minimum tax?

For investment income, dividends and capital gains, there’s no ambiguity. She supports raising the top tax rate on dividends from 15 to 39.6 percent, while raising the tax on capital gains above the old rate of 20 percent.

Regarding payroll taxes, she has expressed opposition to Senator Obama’s plan to eliminate the Social Security wage cap, but she has questioned why middle-income taxpayers are subject to Social Security taxes while wealthier taxpayers are not. As she stated in a debate last year:

Middle-class and working families are paying a much higher percentage of their income. [Billionaires like] Warren Buffett pay about 17%, because don’t forget, it’s the payroll tax plus the income tax. And when you cut off the contribution at $95,000, that’s a lot of money between $95,000 and the $46 million that Warren Buffett made last year. We’ve got to get back to having those with the most contribute to this country.

Finally, on the estate tax, Senator Clinton has advocated freezing the law as of 2009, when the top rate is 45 percent and the exemption is $3.5 million per spouse.

So what does all this mean for S corporations? On its face, it’s a mixed bag. Senator Clinton’s support for freezing the estate tax rules at 2009 levels is an improvement over current law, which would have the estate return to its old robust self in 2011. But all of her other positions represent a retrenchment back to pre-2001 tax policies or worse.

One challenge for Senator Clinton is how to pay for any AMT reform, middle class tax relief, or the numerous spending programs she has put forward. Keep in mind, the congressional baseline assumes all the Bush tax relief goes away in 2011, including family tax relief such as the refundable $1000 child credit and estate tax reform and repeal.

Extending any of those provisions, even freezing the estate tax at 2009 levels, will be considered revenue losers by the Congressional Budget Office and will have to be offset so as not to add to the deficit. Going beyond the Bush family tax relief by increasing the child credit for the child’s first year, as Senator Clinton advocates, would reduce revenues even more. Where will a Clinton presidency turn for those additional revenues?

Details aside, it is obvious that Senator Clinton’s priorities do not include keeping a lid on tax rates or the overall tax burden. She has other goals in mind. Given the budget pressures we will face over the next decade, a Clinton Presidency will likely mean significantly higher taxes on S corporations and taxpayers in general.

LIFO Under Attack, Again

Last-In, First Out accounting has been under fire for the past two years.

Part of the rationale for eliminating LIFO is budgetary-repealing LIFO would raise lots of money for the Federal government; by some estimates, more than $100 billion over 10 years. As you can imagine, numbers like that have caught the attention of policymakers desperate for new revenues.

Another reason is the on-going effort to conform U.S. accounting rules to those in Europe. These talks are part of a broad-based initiative to create a single, uniform set of world-wide accounting rules, something the accounting industry has sought for years.

The problem is the Europeans don’t use LIFO, so any effort to conform U.S. and E.U. accounting rules would require somebody to make a change. In some circles, the presumption is that the U.S. would repeal LIFO and conform to the Europeans.

Where does FASB (Financial Accounting Standard’s Board), the U.S. accounting standard maker, stand? In the past, they have been reluctant to weigh in on an issue as politically charged as LIFO.

So imagine our surprise when we saw their submission to the Securities Exchange Commission from last Fall on the topic of allowing U.S. issuers to prepare their financial statements under E.U. rules. In it, the chairmen of FASB and its Foundation advocate the U.S. adopting European rules:

Board members and Trustees strongly support the proposal described below that U.S. public companies transition to an improved version of international accounting standards; however, individual Board members and Trustees may have differing views on some of the other recommendations outlined in this letter.

Let us hope individual board members have lots of differing views, since part of the FASB recommendation is to eliminate LIFO.

It is unclear why the FASB would recommend for the United States to adopt the accounting rules of France, and not the other way around. Moreover, all the talks appear to be with Europe. The U.S. is talking with Europe. Japan is talking with Europe. The Chinese are talking with Europe. Perhaps the U.S. should talk to Japan instead, and reinforce our respective support for this important inventory accounting method. Unfortunately, Japan appears to be moving in the opposite direction.

LIFO is needed now more than ever. With inflation rearing its ugly head again after 25 years of disinflation, policymakers on Capitol Hill should be reluctant to repeal the one accounting method that protects businesses from paying taxes on the phony, inflated value of their inventory. Income taxes should apply to real income only, not phantom profits.

For companies using LIFO, there are two policy responses. First, we can and will defend LIFO before Congress.  There is no policy rational for repealing LIFO other than for its use as a revenue offset. Second, we should look into eliminating the conformity requirement for companies that use LIFO for tax purposes to also use LIFO for their book accounting as well. If FASB wants to abandon U.S. companies currently using LIFO, there is little reason the U.S. Congress and the tax code need to follow suit.

These issues will be debated and fought over the next year. If your company is on LIFO and wants to keep it that way, please let us know and we will help connect you with your congressional representatives.

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