Permanent Built-In Gains in Extender Package

Negotiators agreed to a package of tax and a package of spending provisions last night, and the big news (pun intended) is that the 5-year recognition period for built-in gains (BIG) – something S-Corp has been championing for more than a decade – is made permanent in the tax package!  We’re also happy to see that another priority, a basis adjustment to ensure S corporation owners can receive full charitable deductions on contributions, is also made permanent in this package!

The process from here is that the packages introduced last night will be held over for a couple days so members can review them, and then vote on them separately in the House.  We understand that a vote on the extender package will occur tomorrow, and the spending bill on Friday.

Then, in a move not wholly unusual for this time of year, the House would combine the two packages into one “message” and send them to the Senate.  The combo message accomplishes two things – it means there’s no debate on the motion to proceed (since messages from the House are privileged) and it means there’s only one bill to filibuster, not two.

As a result, the Senate could receive the bill on Friday and vote that day if everyone cooperates, or run the clock on cloture and vote on final passage Sunday or early next week if they don’t.

That’s the process.  What’s in the package?  As we reported several weeks ago, the tax extenders portion has been divided into three parts – those provisions made permanent (R&E tax credit, small business expensing, built-in gains, etc.), those extended for five years (bonus depreciation, CFC look-through, etc.) and those extended for 2015 and 2016 only (everything else).   You can read the full list here.

We don’t do spending here at S-Corp, so we won’t bore you with those details, but both the tax and spending package include a number of extraneous provisions that may be of interest to the business community, including:

  • Lifting the long-standing ban on oil exports;
  • A two year suspension of the medical device tax, as well as the two year delay in the Cadillac tax and annual fee on health insurance providers;
  • REIT-related provisions based on items included in Ways and Means Chairman Brady’s recent proposal, but with further modifications and a transition rule; and
  • Technical changes to the recently adopted partnership audit rules.

Left out of the package were efforts to roll back the Labor Department’s pending fiduciary duty rule or to raise the SIFI threshold for regional banks.  We expect a number of these provisions to raise concerns with specific groups, so it will be interesting to see how the leadership in the House and the Senate cobble together majorities for both the tax and the spending bills.

That said, the tax package represents a major step forward for tax policy and how S corporations are treated.  It gets the business community off the extender rollercoaster we’ve been on for the past three decades while setting the table for broader tax reform in 2017.  We’ve been asking for permanence for years, and now it appears we’re just a couple of days away from getting it.  You can bet S-Corp and our allies will be on the Hill with a message of just how important it is for Congress to enact this package.

Legislative Update: The Pre-Thanksgiving Edition

We’re tracking two key tax items at the moment – tax extenders and international reform.  Here’s our outlook for both.

For extenders, Congress has once again ignored the needs of American businesses by delaying adoption of a multi-year extender package until the last possible moment.  What’s the point of encouraging businesses to invest in new equipment if those provisions are enacted only retroactively?  Not only does it undermine the policy, it creates a dynamic where pass through owners are required to overpay their taxes over the course of the year, draining money from their businesses and reducing their ability to hire new workers and invest in new equipment.

The most recent word from the Hill suggests these concerns may be resonating, and that there’s a vigorous effort afoot to:

  1. Make as many of the extender provisions permanent as possible, including the R&E tax credit, small business expensing, and built-in gains relief;
  2. Extend the other provisions for two years; and
  3. Include EITC and child credit reforms important to the Administration.

In other words, we may see a reprise of the deal they nearly closed last fall.  If true, this development would represent a significant early accomplishment in Ways & Means Chairman Brady’s tenure and help to set the table for more significant tax policies to come.

If the broader package fails, we’re hearing the Administration will push for a one-year extender package (2015 only) to give them one more chance to work on tax policy prior to the 2016 elections.  Obviously, a one-year extension of policies that have already expired would simply prolong the extender roller coaster ride that we’ve been on for the past several years and should be vigorously rejected by Congress.

On the international front, we reported in October that Chairman Ryan had officially put on hold his efforts to fix our international tax code by attaching it to the highway bill.  Ryan was unable to come to terms with Senator Chuck Schumer (D-NY) over highway funding levels and he faced a reform skeptic in Speaker Boehner.

Now that he’s Speaker, that effort may have new life.  New Ways & Means Chair Kevin Brady’s remarks in the Wall Street Journal, where he adopted Ryan’s “step one, step two” approach to pursing international reform in 2016, suggest Ryan has an ally at the head of the Committee.  Add to that Pfizer’s announced merger with Allergan in the largest inversion ever, the continued vocal support of Senator Rob Portman and other key policy makers for targeted international reforms, and the G-20’s endorsement of base erosion recommendations that are likely to hit US companies, and it all builds the case that something has to be done on the international front.

On the other hand, Speaker Ryan’s “60 Minutes” interview (see below) demonstrates he understands on-going tax rate disparity faced by pass through businesses.  Successful pass through businesses currently pay tax rates significantly higher than their corporate and foreign competitors.  That disparity would likely be made worse by reforms that focus on corporate concerns only.  Meanwhile, the innovation box draft that was designed to stop corporate inversions has failed to garner widespread support in the corporate community (see below), reinforcing the perception that the business community is far from unified over exactly what international reform should look like.

So that pretty much leaves us where we’ve been for several months now – the need for reforming how we tax business income is obvious, but the path to getting there is not, particularly with a President who opposes restoring rate parity for pass through businesses.

 

Innovation Box Support

A coalition of large corporations has emerged to support the innovation box approach proposed by Ways & Means member Charles Boustany (R-LA).  We offered comments on that draft last summer and have been waiting along with the rest of the tax community for a redraft.  Rumor has it that the release of a new, improved innovation box draft is imminent, which explains the timing of this week’s announcement.  As Politico reports:

BUSINESS RESPONDS TO BEPS: A corporate coalition featuring Apple, Boeing, Cisco and Intel is using the G-20’s adoption of the OECD BEPS recommendations to ramp up their international tax reform efforts. The group, American Innovation Matters, is releasing a statement this morning pushing for an innovation box, even in the heightened gridlock of a presidential election year.

American Innovation Matters (AIM) joins at least three other coalitions out there pushing corporate tax reform, including RATE, LIFT, and ACT.  That’s a lot of corporate muscle in favor of reform.  Now if they could just agree on what it looks like.

 

Speaker Ryan on “60 Minutes”

On Sunday, House Speaker Paul Ryan appeared on “60 Minutes” to discuss his new job and the challenges he faces:

I think you can walk and chew gum at the same time. I think you can oppose the president on some issue that you fundamentally disagree with, but also work with the other party on issues you do agree with. That’s what I’ve been doing. Look, if we can find common ground, we can on highways, we will on funding the government, hopefully we can on tax policy. Those are three things that will produce certainty in this economy in the next few months. Let’s go do that.

Our friends at Politico focused on the “next few months” line and what that might mean:

The “next few months” line there is interesting. A Ryan spokeswoman said the speaker was specifically referring to extenders, an area where practically everyone expects some sort of deal by the end of 2015. But Ryan has also left open the idea that international tax reform could happen in 2016, even though plenty of people see that as quite the longshot.

During the interview, Speaker Ryan also had the opportunity to lay out his vision for comprehensive tax reform:

Scott Pelley: You have proposed having only two tax brackets, 10 percent and 25 percent. That still your position?

Paul Ryan: Yeah, I’ve always liked that plan. And our tax code really punishes our small businesses, which is where most of our jobs come from. I mean, look, we’re sitting here in Wisconsin, overseas, which to us means Lake Superior. You know, the Canadians are taxing their businesses at 15 percent. The top tax-rate on successful small businesses in America, here in Wisconsin, is 44.6 percent. How can you compete like that? How can you have jobs? How can working families get ahead with a tax system like that?

Scott Pelley: Give me three things you would do on tax reform. Very specifically.

Paul Ryan: Well, I’d simplify the code dramatically. I would collapse the rates down to two or three. And I would change the way we tax ourselves internationally, so businesses can take their money and bring it back home so American businesses stay American businesses. And we have to drop our rates on our businesses. I think those three things right there are what I would do.

Paul Ryan has always been a vocal advocate for Main Street businesses and he understands the challenge S corporations and partnerships face with top marginal tax rates of over 40 percent.  The vision he outlined on “60 Minutes” meets the criteria outlined in our Pass Through Principles Letter signed by 120 of the largest and most active business trade groups in Washington DC.  Now that he’s the Speaker, he has an opportunity to move tax reform the fits that vision through the House.

S-Corp Comments on Innovation Box

The S Corporation Association submitted comments today to Ways and Means Committee Members Rep. Charles Boustany (R-LA) and Rep. Richard Neal (D-MA), sponsors of the draft “Innovation Promotion Act of 2015.”

As you’ll recall, the two members released a “discussion draft” of their innovation box idea back in July and asked stakeholders to weigh in.  The box itself offers US firms a lower tax rate on some income derived from the use of patents, inventions, formulas, etc.  Our friends at the Tax Foundation identified three motivating factors in the introduction of the box:

  • The U.S. tax code has become increasingly uncompetitive;
  • Lawmakers are concerned that under the BEPS project, U.S. companies will be pressured to move related R&D to foreign countries to satisfy new foreign tax laws; and
  • Lawmakers want to encourage the creation of more research and development and the related jobs in the United States by providing a lower rate on its income.

Regarding our comments, you can read the whole letter here, but the two essential points are 1) the best means of encouraging innovation is to reduce tax rates on all business activity and 2) a more targeted effort to reduce rates on “innovative” activity should be drafted as broadly as possible, including applying it to S corporations and other pass through businesses.  As we noted previously, the innovation box draft currently applies to C corporations only.

A cornerstone of tax reform is to apply rules and rates evenly, so that investment and hiring decisions aren’t unnecessarily distorted.  An innovation box, by definition, targets a more narrow set of activities than across-the-board marginal rate cuts, but it doesn’t need to pick and choose among business types too.  Innovation takes place within C corps, S corps, and other pass through entities alike, so all these business should be included in the box.

 

Tax Extenders on Fall Agenda

Congress returns to a full legislative plate for September and beyond, including the following deadlines for action:

  • Iran nuclear deal (September 17th)
  • Government funding (September 30th)
  • Internet Tax Freedom Act (October 1st)
  • October 29th (Highway authorization)
  • December (Debt Limit)
  • Tax Extenders (December or January)

Add in the controversy over Planned Parenthood’s funding and it’s difficult to see how Congress manages to wade through all these deadlines unscathed.  Should be an interesting few months.

On the tax policy front, Congress needs to extend the so-called “extenders” before tax season officially begins next year.  As readers know, this batch of 50-plus tax provisions (including business-friendly provisions like the R&E tax credit, the shorter built-in gains (BIG) recognition period, higher limits on small business expensing, etc.) officially expired at the end of last year, but everyone in DC expects Congress to act this fall to extend them, both for the current year and for 2016.  There should also be an aggressive effort to make some of the provisions, including BIG relief, permanent.

We’ve commented previously on the adverse impact this on-again, off-again approach to tax policy has on businesses and their investment decisions.  As Jody Fledderman of Batesville Tool and Die testified earlier this year, the temporary expiration of these tax provisions has the effect of draining resources from his company, resources he can’t get back even when Congress retroactively extends the provisions.

This dynamic is one reason over 2000 businesses and trade groups wrote to Congress calling on them to act on extenders quickly.  As the letter, led by the National Association of Manufacturers, states:

Failure to extend these provisions is a tax increase. It will inject instability and uncertainty into the economy and weaken confidence in the employment marketplace. Acting promptly on this matter will provide important predictability necessary for economic growth.

The expired provisions should be renewed as soon as possible this year. We urge all members of Congress to work together to extend seamlessly on a multiyear basis, and where possible enhance or make permanent, these important tax provisions.

So Congress’ plate is full, but early action on extenders would be greatly appreciated by the business community.  It would instill a higher degree of certainty while representing an important step towards the reformed tax code everybody would like to see.

 

Pass Throughs and Bracket Creep

Add “bracket creep” to the list of tax challenges specific to pass through businesses.  According to the Congressional Budget Office, individual tax collections are expected to rise sharply over the next decade, in part due to wages rising faster than inflation.  As the TaxVox Blog noted:

The expected rise in individual income taxes is largely due to a phenomenon known as real bracket creep. Income tax rates are mostly indexed for inflation so nominal increases in income don’t boost effective rates. But when incomes rise faster than the rate of inflation, as CBO projects in a growing economy, that income is pushed into higher tax brackets. As a result, CBO figures individual income taxes will rise by 0.6 percent of Gross Domestic Product by 2025.

An increase of 0.6 percent of GDP doesn’t sound like much, but it works out to more than $150 billion in additional annual tax collections by the end of the decade.

Missing from the CBO report is any commentary on the impact bracket creep has on Main Street businesses.  While the vast majority of C corporation income is already taxed at the top corporate rate of 35 percent and is therefore immune to bracket creep if it occurs at all — does business income rise faster than inflation? – a sizable amount of pass through income is taxed at rates below the top 39.6 percent top rate.  Combined with the fact that pass through income is added on top of wage and salary income and it means that many S corporation shareholders will have their business income subject to higher effective tax rates over time.

So “bracket creep” joins the Alternative Minimum Tax, foreign tax credit treatment, and other tax policies and interactions that present particular challenges to the pass through business community.

 

 

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