Tax Outlook

With the Republican convention behind us and the Democratic one this week, we thought it would be worthwhile to assess what the business community can expect on taxes in the next six months.B We break the outlook into three buckets:

  1. First, the need to extend the tax policies set to expire on January 1;
  2. Second, the need to make more fundamental changes to the tax code; and
  3. Third, what to do about those pesky tax bextendersb?

2001 & 2003 Tax Cuts

Bucket one is easiest, since both sides have outlined their positions.B The Republican House adopted legislation to generally extend all the 2001 and 2003 tax policies for one year (together with expedited consideration of broader tax reform).B One big deviation from previous Republican actions was the decision to extend current estate tax rules ($5 million and 35 percent top rate) rather than the repeal included in the original 2001 legislation.

Senate Democrats countered with legislation (which failed to muster the necessary 60 votes) to extend the middle-class portions of the 2001 and 2003 tax relief only.B Investors, business owners, and income-earners making more than $250,000 ($200, 000 for single filers) would see their taxes go up.B An exception in the Senate bill was the dividend rate, which would rise to 20 percent rather than the 39.6 percent rate called for under current law.B Also, current estate tax rules were not extended, meaning the top rate would revert back to 55 percent next year coupled with a lower, $1 million exemption.

(Neither the House nor the Senate bill addressed the pending new 3.8 percent tax on investment income enacted as part of the health care reform, by the way.)

As to the outlook, the odds of either side prevailing in this fight depend heavily on the election outcome.B The election wonbt change any votes before next year — the President and Congressional leadership will stay the same — but moral authority plays a key role in moving legislation in lame duck sessions, so, if either side can declare a conclusive electoral victory, their respective position will gain momentum.B Thatbs the positive outlook for action.

Inaction is also possible, however, and should be taken seriously.B Several Senate Democrats are already on record arguing against taking any action this year — they say the fiscal cliff is more of a fiscal slope and that there will be time to address these issues in early 2013.B Meanwhile, itbs difficult to see how House Republicans accept the Senate position and proactively vote for legislation that raises tax rates on anyone in this political and economic environment.

Itbs also difficult to see how President Obama pivots off his current position and signs into a law a comprehensive extension.B Finally, the inability or unwillingness of Senate Majority Leader Harry Reid to successfully move large, complex bills in the Senate is a particular challenge and should not be discounted.

For those reasons, we believe a Republican victory in November will signal that Congress will adopt something very close to the House bill — a one-year extension of everything coupled with some sort of expedited reform process — or, if the Senate and President stand firm, do nothing at all.B If Democrats prevail, then the likely outcomes shift to either the Senate-debated position of extending just the middle-class relief or, if the House refuses to go along, nothing at all.B So, regardless of who wins in November, therebs an even chance nothing gets done.

Additional variables that could affect the outcome include the pending sequestration cuts to defense and the strength of the economy.B The worse the economy does, the more likely it is that Congress takes action, and vice versa.B Meanwhile, the push by hawks and conservatives to stop the pending cuts to defense could result in them giving in other areas, including tax policy.B Something to keep an eye on.

Tax Reform

Bucket two includes tax reform or changes to the tax code broad enough that they look like tax reform.B We believe therebs a good chance Congress will act on such a package beginning early next year for the following reasons:

  • It will need to raise the debt limit (again);
  • Therebs broad agreement that the deficit needs to be addressed;
  • Therebs agreement that our corporate rate is too high; and
  • The annual game of extending all these tax provisions, including rates, the AMT patch, estate tax parameters, and traditional extenders is simply unsustainable and needs to end.

Put another way, Congress will need to raise the debt ceiling sometime early in 2013.B To get the House on board, significant spending cuts will need to be part of the package, just like in 2011.B To gather additional support, particularly in the Senate, taxes will also need to be part of the package.B This tax package could be budget neutral, or it could raise significant levels of revenue.B The elections will largely determine that mix.

Letbs say the President and Congressional leaders agree to raise the debt limit coupled with $4 trillion in deficit reduction over the next ten years.B An Obama Administration and Democrat-run Senate might seek a 50-50 package of spending cuts and tax increases.B A Romney Administration coupled with a Republican Senate might shoot for 100 percent spending cuts.B Compromises necessary to move the package through the Congress under either scenario would argue that the final package will fall somewhere in between.

What sort of base-broadening might apply?B Likely groupings include:

  • Previously targeted business tax items like LIFO, Section 199, and carried interest;
  • Traditional extenders that fail to gain sufficient support; and
  • Individual tax expenditures, including at least some portion of the exemption for employer-provided health insurance.

So, broad tax changes are likely to be on the table in 2013.B A revenue-neutral package would broaden the tax base by eliminating certain tax expenditures and unpopular provisions and use all those revenues to cut rates, while a tax-increasing package would do the same, but cut rates to a lesser degree.B As long as the House remains in Republican hands, a package that actually raises headline rates is highly unlikely.

Could Congress get through 2013 without considering broad tax legislation?B Itbs unlikely but possible, particularly if the Senate remains under Democratic control.B The Senate has refused to act in other critical areas in recent years, like doing a budget.B But just as the debt ceiling fight forced the Senatebs hand in 2011, we expect the same dynamic to play out in 2013.B A budget resolution is optional; raising the debt ceiling is not.

Tax Extenders

Bucket three is the large list of tax extenders, many of which already expired at the beginning of the year.B Both the Ways and Means and Finance Committees have taken action to define and adopt a package of tax extenders in recent months, but the ultimate outcome remains unclear.

Just prior to the August break, the Senate Finance Committee adopted legislation to extend a package of expired or expiring tax extenders through 2013.B The $205 billion package includes a two-year AMT patch together with an extension of the state sales tax deduction, the higher Section 179 expensing amounts, the R&E tax credit, and the energy production credit and other energy incentives, among other items.B Importantly for Washington Wire readers, the package also extends built-in gains tax relief and the basis adjustment for S corporations making charitable contributions of property.B The Committee report and legislative language were released last week.

In a foreshadowing of the fight to come this fall, Committee leaders noted that their extender package deleted 20 provisions from extender packages of prior years, while several dissenting Republicans argued that the Committee should have gone further and that they look forward to further reducing the list as part of comprehensive tax reform.B Senate leaders are hopeful to consider this legislation on the Senate floor in the few remaining legislative days before the November election, but itbs a full schedule already with only a few days of session.

On the House side, the Ways and Means Committee began their examination of tax extenders back in April, when members had the opportunity to advocate on behalf of their favorite extenders.B In June, a panel of tax experts testified on which is the best framework to test each extender provision and eliminate those that fall short.B It is unclear if the Select Revenue Subcommittee will hold another hearing in September, but Subcommittee Chairman Pat Tiberi (R-OH) was reported as noting that the House will not act on its version of an extender package until after the November elections, not before.

At that point, the tension between considering an extenders package separately this year or rolling these decisions into a broader tax reform package will have to be addressed.B Given that Congress also will face the broader issues of the 2001/2003 tax cuts, sequestration cuts, the FY2013 appropriations process and the rest of the congressional kitchen sink, therebs not a lot of time and continued broad disagreement over direction.

For that reason, we believe it is fifty-fifty that Congress acts on extenders this year, with success most likely tied not to policy, but rather to whether Congress is able to move on some of these other fiscal matters.B Movement in those areas would suggest an agreement over extenders is also possible, while a stalemate on the 2001/2003 cuts, spending and sequestration might bleed into the extender debate.

Just to be clear, this is our outlook, but itbs not our preference.B Here at S-CORP, our fingers are crossed that Congress returns after the election and resolves all of these critical tax questions.B For the business sector, action and clarity are better than inaction and uncertainty, so letbs hope this yearbs lame duck session does not live up to its name and is instead positive and productive.

Payroll Tax Hike Taken Up in the Senate

The Senate began debate on the bloated tax extender package today. The House passed its version 215-204 shortly before leaving for the Memorial Day recess on May 28th.

That vote was supposed to take place earlier in May, leaving time for the Senate to take action, but opposition to the tax hikes and higher deficits called for in the bill delayed consideration until the Leadership was able to cobble together the votes. As a result, the Senate had already left town and is just now taking up the bill today.

Regarding the schedule, Senator Reid faces a tight window to get the bill done: he needs every Democrat plus at least one Republican to move this, but Senator Lincoln (D-AR) is back in Arkansas for today’s run-off tomorrow and won’t be available until tomorrow.

Meanwhile, there are no votes on Friday or next Monday and debate on Senator Murkowski’s Resolution of Disapproval (climate change) is set to consume much of Thursday.

That basically leaves Wednesday as the only day this week where Senator Reid might have the votes to move the process along, and it’s apparent from the news today that he’s not there yet. Senator Snowe (R-ME), a long-time S-CORP champion, indicated as much to CongressDaily:

Snowe said on Monday she was still waiting to see details. But she said the combination of deficit spending and tax increases, such as a new 15 percent payroll tax on small services-providers organized as “subchapter S” corporations, were giving her pause. “Pretty far from it at this point,” Snowe said, when asked about her comfort level with the bill, adding that it was unlikely to pass this week.

On the policy side, the delay in the House has been a boon for good tax policy, since the longer this payroll tax provision is out there, the worse it appears. Swapping a “reasonable compensation” standard for a “principal asset” test is not an improvement to the Tax Code. Exactly how is the IRS supposed to enforce an annual valuation of the “skill and reputation” of a firm’s three key employees?

Tom Nichols, a long-time S corporation attorney and head of the ABA’s Tax Section on S Corporations penned a letter to Congress making this point and many others. Meanwhile, the blogs of tax practitioners across the country are beginning to weigh in, raising numerous concerns that should have been dealt with through the normal legislative process — except there wasn’t one. The blog Tax Prof has links to a long list of critical commentators. As one observed:

But even assuming that you should hit service providers with self-employment tax on all of their K-1 income, you should do so in a way that is fair, understandable to taxpayers, and enforceable by the IRS. The S corporation provision in H.R. 4213 is none of these.

The Senate being the Senate, we expect this issue to be debated into the next week at least, and we plan to use that time to educate policymakers and improve the bill. There are taxpayers out there that use the S corporation to block payroll taxes they otherwise owe, and we support going after them, either through increased use of the reasonable compensation standard by the IRS or though a well-thought and well-targeted statutory provision. The provision before the Senate right now doesn’t meet that test.

Reasonable Compensation Standard in Action

 

Speaking of the reasonable compensation standard, the following post showed up in BNA this morning–as it makes clear, the IRS can and does go after payroll tax scofflaws using the reasonable compensation standard:

The U.S. District Court for the Southern District of Iowa May 27 held that David E. Watson P.C. must pay employment taxes on all remuneration for employment. David Watson incorporated an accounting firm as an Iowa professional corporation and chose to be taxed as an S corporation. Watson authorized himself a salary of $24,000 a year and he paid federal employment taxes on that amount. In addition to his salary, Watson received more than $200,000 in what he claimed were dividend payments. The Internal Revenue Service determined the dividend distributions should be recharacterized as wages, subject to employment taxes. (David E. Watson PC v. United States)

A fair reading of the House-passed bill is that the new, untested principal asset test for S corporations would be much more difficult for the IRS to enforce than the existing standard being used here. It would also be more costly for firms, as they would be required to value all their assets every year to determine if they are subject to the new tax. In order to enforce this new rule, the IRS would need to do the same.

The bill is now before the Senate, which has a reputation for debate and deliberation. We are hoping they expend a little deliberation on this provision. It could use it.

Health Care Update

The idea of taxing high cost plans is relatively new, and there are many outstanding questions about how it would work.B For example, how exactly how would this excise tax raise revenue?B The Senate plan imposes a 40 percent excise tax on high value plans with a cumulative cost of more than $21,000.B But medical loss ratios for private health insurance plans easily exceed 60 percent of premiums, so insurance companies confronted with a 40 percent excise tax will simply stop issuing those plans.B B B

At the employer level, that means if an employer used to offer his employees a $30,000 package of health benefits, he will now offer them a $21,000 plan and pay the remaining $9,000 to them in the form of wages and non-health benefits.B These extra wages, in turn, are subject to income and payroll taxes, resulting in higher tax collections by the federal government.B The revenues raised from the excise tax come from higher income and payroll taxes on employees, not from excise taxes on insurance companies.B B B B

Itbs this aspect of the Senate plan that has unions united in opposition.B The excise tax is coupled with a refundable tax credit available to families making less than 400 percent of the federal poverty level (about $88,000 for a family of four).B But many union members make more than that while most union members enjoy health insurance benefits that exceed the Baucus threshold. So for many union members, the Baucus plan would reduce their health benefits and raise their income and payroll taxes, but exclude them from the refundable tax credit.B B B B B

What about S Corporations?B How would they be impacted? B Herebs chart we put together:B B B

B Earns More than 400% FPLB B Earns Less Than 400% FPLB B
Has High Cost PlanB B Taxes Are HigherB B MixedB B
Has Low Cost PlanB B Not Affected*B B Taxes Are Lower*B B
We put an asterisk by the blow cost planb results because of another quirk in the excise tax that deserves review, the indexing for its thresholds.B As we mentioned, the Baucus bill sets the initial threshold for a familybs high cost plan at $21,000.B This threshold includes all forms of health care spending — premiums, preventive care, flexible spending accounts — and is indexed not to health care inflation (about 8 percent), but to regular inflation plus one percent (about 3-4 percent).B That means over time, the value of your low cost insurance plan is going to catch up to the threshold and become subject to the tax.B
B
This aspect of the Baucus plan would have been fixed had it not been essential to the procedural challenges facing health care reform.B Simply put, both the House and the Senate are attempting to offset health care spending, which grows at 8 percent per year, with tax increases, which rise at five percent per year.B The costs of the plans grow faster than the offsetting taxes, resulting in deficits in the out years.B
B
B
By comparison, the Baucus tax, because of the indexing details, grows faster than health care spending and produces surplus revenues in the out years.B As much as the unions complain, coming up with an offset that keeps the Presidentbs and congressional leadershipbs promise not to make the deficit picture worse is going to be hard to find.B
B
Thus, the friction between the House and Senate tax offsets, and yet another obstacle between healthcare reform and a signing ceremony.B The House surtax targets closely held businesses while the excise tax targets union workers.B Nobody said raising taxes by half a trillion dollars would be easy.B B B B B B

Estate Tax UpdateB B B

We expect Round 1 in the great estate tax battle to take place this fall/winter.B The tax goes away in 2010, and then returns in full form in 2011, giving just about everybody a reason to come to the table.B B B B

In preparation for this debate, forty-six trade associations, including your S Corporation Association, the Chamber of Commerce, NIFB, and the National Association of Manufacturers sent a letter to Congress urging them to support a permanent estate tax fix that includes a 35 percent top rate and a $5 million per spouse exclusion.B B B B

As Martin Vaughn of Dow Jones reported:B B B

The groups said they will support a permanent rate of 35%, with the first $5 million of wealth exempted, and up to $10 million in the case of married couples. Those are the terms that are being pushed in the Senate by Sens. Jon Kyl, R-Ariz., and Blanche Lincoln, D-Ark.B B B

On timing, the expectation continues to be that Congress will take up legislation to extend certain expiring tax provisions before the end of the year, and that the estate tax fix will be made part of that bill.B B B

Tax Reform Panel Report UpdateB B B

Remember the Presidentbs Economic Recovery Board headed by Paul Volcker?B The President announced its creation at the beginning of the year but itbs been quiet since then.B The principle reasons for this silence are federal sunshine laws that require any gathering to be open to the public.B It is hard to provide the President with critical insights into how to fix the economy when the whole worldbs watching. B B B B

One offshoot of the Board that has been active is the White House Tax Reform Panel.B They had their first (and last?) public meeting last week, chaired by CEA Member Austan Goolsbee.B During the meeting, Goolsbee made clear that the Panel was not seeking to create a new tax system but rather would focus its recommendations on three specific areas — tax simplification, enforcement and corporate tax reform.B The panel is accepting public comments through October 15th and then will make its own recommendations known to Treasury Secretary Geithner by December 4th.B B B B B

In the past, it has been easy to dismiss the work of presidential or congressional tax reform panels.B They tend to come and go, after all, with little to show for their efforts.B This time, however, the combination of huge deficits and an expiring tax code make some sort of dramatic changes to the tax code almost a certainty.B Given the landscape, we intend to follow the efforts of this group closely.B B B B