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.

The Washington Post Discovers Small Employer

The Washington Post this week reported on an issue that shouldn’t come as a surprise for S-CORP readers: President Obama’s tax plans could hurt many of America’s small businesses. Small business owners who report their business profits on their personal income returns (like most small business owners do) are suddenly finding themselves classified as the “richest” Americans, and thereby subject to Obama’s tax increases. The Post explains:

Across the nation, many business owners are watching anxiously as the President undertakes expensive initiatives to overhaul health care and expand educational opportunities, while also reining in runaway budget deficits. Already, Obama has proposed an extra $1.3 trillion in taxes for business and high earners over the next decade. They include new limits on the ability of corporations to automatically defer U.S. taxes on income earned overseas, repeal of a form of inventory accounting that tends to reduce business taxes, and a mandate that investment partnerships pay the regular income tax rate instead of the lower capital gains rate.

The Washington Post is catching up to what S-CORP and its friends have been pointing out for a while now — if your goal is to reinvigorate the economy, placing additional burdens upon the very business that can help pull us out of this crisis is the wrong way to go. The example used by the Post — Gail Johnson of Richmond, Virginia — should give S corporation shareholders pause:

Johnson declined to say whether she voted for Obama. But she said she ignored his tax plans until her husband, who handles real estate and construction for the schools, mentioned it one day. “I’ve since talked to my accountant,” she said. “And, oh, my gosh!”

In a typical year, Johnson’s federal tax bill would be about $120,000. But starting in 2011, the higher marginal rates would add about $13,000 a year, Hurst said. Capping the value of itemized deductions at 28 percent would add another $10,000, for a total increase of $23,000.

And Johnson’s tax bill stands to grow dramatically if Obama were to revive a plan to apply Social Security tax to income over $250,000 instead of capping it at the current $106,800. Because Johnson is an employee and an employer, she would have to pay both portions of the tax, Hurst said, tacking another $30,000 onto her bill.

That’s a potential $50,000 tax increase for a small employer whose family earns about $500,000 a year, including the income from her business. It’s hard to see how increasing her federal tax bill (this does not include state and local taxes) from around $120,000 to $170,000 would not harm Gail’s plans to invest in her business and hire additional employees.

Budget Plan Finished

On that note, perhaps the most frustrating aspect of the tax increases outlined above is that they simply will not be enough. Federal deficits are going sky-high and higher taxes on the middle-class are all but inevitable. House and Senate negotiators this week put the final touches on the budget outline for next year. For S corporations, three major items stand out: total deficit estimates, the estate tax and the inclusion of reconciliation instructions for health care.

The Congressional Budget Office estimates that the Obama budget, if enacted, would result in deficits of $1.8 trillion, $1.4 trillion, $1 trillion, $658 billion, $672 billion, and $749 billion over the next five years. That’s a cumulative of $4.4 trillion over five years, or $1.7 trillion more than if we simply did nothing over the next five years and maintained current law.

The U.S. government has never run deficits of that magnitude and exactly how the debt will be financed is an open question. To put these five-year numbers in perspective, over eight years of President Bush — who is rightly criticized for not paying more attention to holding down spending — debt held by the public increased by $2.4 trillion.  The budget offered up by conferees this week has deficit estimates that are smaller than the Obama budget, but not enough to address the question of who is going to finance all that debt.

Regarding the estate tax, the budget agreement calls for maintaining the 2009 rates and exemption levels of 45% and $3.5 million per spouse. While the Senate’s original budget allowed for higher exemption levels and a lower rate, the House ultimately prevailed and stuck with freezing the 2009 rules.

On the reform front, the resolution will include “reconciliation instructions” for health care reform. As S-CORP readers know, reconciliation is valuable to the majority in the Senate because it allows for controversial items to pass the Senate with a simple majority rather than the usual 60 votes.

There are limitations, however, because bills brought to the Senate floor under reconciliation may not increase the deficit outside of the budget window, which means whatever they enact under this budget would have to be sunset after five years.

S corporation shareholders know how these sunsets work — we have been dealing with the uncertainty of the estate tax repeal sunset for a decade now. How effective could broad-based health care reform be if it goes away in just five years?

Moreover, reconciliation bills may not include provisions with no or little impact on revenues and spending. The core provision in most health reform plans is to create a health insurance “exchange” similar to the Connector up in Massachusetts. This may or may not be a good idea, but it doesn’t have a significant impact on either revenues or spending and would likely fall outside of reconciliation. For a full review of these issues, we recommend reading the analysis of S-Corp ally Keith Hennessey.

Bottom line: Attempting to reconcile health care reform could cost the majority more than it’s worth,  especially with Senator Specter now aligning himself with the Democratic Caucus.

Small Business and Tax Rates — The Debate Continues

The advocates over at the Center for Budget and Policy Priorities (CBPP) issued a new study last week demonstrating, once again, how few “real” small businesses would be adversely affected by raising the top two income tax rates back to their old 39.6 and 36 percent levels. As their study states:

“Some critics of the President’s budget charge that his proposals to roll back tax breaks for taxpayers with incomes over $250,000 would harm small businesses. In fact, only 8.9 percent of people with any small business income have incomes of over $250,000 and, thus, would even potentially be affected by these provisions.”

As S-Corp readers know, this is old ground. One side says only a tiny portion of small business owners pay the top two rates. The other side says that small business owners make up a large percentage of those affected. Back and forth, over and again.

Missing from the debate is a sense of scope. For example, there are only six million or so employers in the United States while there are about 30 million businesses. Under the CBPP’s approach, then, a policy to raise taxes on every single employer in America could be dismissed because it “only” affects twenty percent of all businesses. It’s not the number of taxpayers affected that matters, but rather the amount of total economic activity being taxed.

The reality is, as we’ve pointed out before, an enormous amount of business activity is subject to the top two rates. More than half of all business income is taxed at the individual rates (S corporations, partnership, and sole proprietorships), and more than two-thirds of that income is taxed at the top two rates, which means more than one-third of all business income earned in the United States will be subject to higher tax rates under the President’s plan. As the Tax Foundation points out, more than half the new revenues collected from the higher rates would come from business income.

Moreover, those higher rates are going to be applied to a larger tax base. Under proposals put forward by the President and/or the Chairman of the House Ways and Means Committee, the business tax base will be broadened by eliminating or restricting deferral, LIFO accounting, Section 199 deductions, and many other deductions used by business.

Finally, the President’s budget proposes to reinstate the old PEP and Pease rules. These rules phased out the personal exemptions and capped itemized deductions, respectively. Their net impact is to raise the base on which tax rates apply and would increase the number of taxpayers subject to the top two rates, including those who are small business owners.

So the cumulative result of these proposals would be to dramatically raise both the tax rate and tax base for a large percentage of business income earned in the United States. There’s no way to minimize the negative effect of that.

Obama Budget Limits LIFO

Speaking of base broadening, the budget outlined last week by the Obama Administration calls for repealing LIFO. Exactly how he would structure this repeal is unclear — the only reference to the policy is back in the revenue tables.

According to the revenue score, the proposal would increase tax collections by $61 billion beginning in 2012, or just about half of the projected tax increase from the provision included in the 2007 Rangel -Mother of All Tax Bills’ legislation ($105 billion).

The Rangel provision applied to all businesses — large and small — using LIFO inventory accounting rules and gave them an eight year period to pay taxes on their accumulated LIFO reserves. (Keep in mind, repealing LIFO is a double whammy for LIFO businesses — their annual taxes go up moving forward but they are also on the hook to pay back-taxes on their accumulated LIFO reserves.)

Until the Treasury Department issues its “Blue Book” to describe all the tax provisions in the Administration’s budget, we won’t know for sure how the Obama repeal differs from the Rangel repeal. They might have limited the change to publicly-held companies, or eliminated the retroactive tax on LIFO reserves.

At this point, however, such differences are meaningless, since whatever President Obama proposes will have to go through Chairman Rangel’s committee anyway.

The headline here, which should be noted by every LIFO business and their accountants, is that the President of the United States, the Chairman of the Ways and Means Committee, the Securities and Exchange Commission, the Financial Standards Accounting Board, and the Joint Committee on Taxation have all weighed in recently against LIFO in one form or another.

The case against LIFO is a wholly contrived money-grab, but with that lineup against us, you might want to begin making contingency plans.

Obama’s Tax Plans Take Shape

President Obama released a 140-page outline of his budget today that reflects his revenue and spending priorities for the next couple of years.

Chief among these is a major change in federal health care policies. As made clear in his speech to Congress the other day, health care reform is first among the several big reforms on the table and his budget sets aside $634 billion of the estimated $1 trillion he plans to spend on the plan.

To raise the $634 billion, Obama calls for: 1) limiting itemized deductions for families earning more than $250,000, starting in 2011; 2) cutting payments to Medicare Advantage plans; and 3) reducing Medicaid payments to hospitals and drug makers.

Other key proposals include:

  • Beginning in 2011, increasing the top two income tax rates to 39.6 and 36 percent respectively while raising rates on capital gains and dividends to 20 percent, consistent with President Obama’s promise to raise taxes on families earning over $250,000.
  • Raising $353 billion through the elimination of so-called business loopholes including limiting the ability of firms to defer tax payments on overseas income and LIFO repeal.
  • Raising the tax rates applied to so-called “carried interest” earned by hedge fund managers and other professionals.
  • Calling for a cap-and-trade program to limit carbon emissions with 100 percent of the credits auctioned off. The resulting revenue would be used to fund clean energy programs and be returned to families and small businesses.
  • Locking into place the 2009 estate tax rate and exemption levels.

We will have more reports in coming days, but suffice it to say that the Obama outline, if enacted intact, would result in significantly higher tax rates for many S corporations that would be imposed on a significantly larger income base.

The one piece of good news is that the budget, reflecting the current economic climate, does not attempt to accelerate the rate increases on upper-income families, but rather allows the current rules to take effect whereby the lower rates expire beginning in 2011.

As students of government know, the President’s annual budget submission is required by Congress and is just the first step in the year-long process of establishing the governmentb’s spending and revenue limits. Given the current make-up of Congress, however, we expect the plan outlined today to be the presumptive starting place for congressional deliberations — especially in the House. For S corporations, that means we will be playing a lot of defense for the next few months.

Do Marginal Rates Matter?

Perhaps the biggest tax debate in the next couple years will be over President Obama’s proposal to raise top tax rates back to their pre-2001 levels. Tax cutters argue that higher marginal tax rates will hurt small businesses and the economy as a whole.

Increasingly, we are hearing the counter argument that marginal rates don’t matter. Policymakers on the Hill have told us that and President Obamab’s budget outline appears to endorse that notion as well. A back-and-forth on CNBC this morning does a nice job of outlining the debate.

Your intrepid S-CORP team was around in 1993, and we recall that the Clinton rate increases took place in an extremely positive economic and global climate — the Cold War was over, the Thrift Bailout had run its course, and much of the developed world was moving towards market-based policies. Attributing any effect of higher tax rates to economic performance in that climate is a stretch at best.

In many ways, the climate today is just the opposite of what Bill Clinton inherited in 1993, and we are not at all comfortable that higher tax rates applied to a broader tax base will have limited or minimal impacts on economic activity.

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