S Corporations Featured in Presidential Debate

This week’s Presidential debate featured both of our recent S-Corp studies — the first highlighting how many Americans work for pass-through businesses, and the second making clear that the pending higher tax rates will result in fewer jobs, lower wages, and less capital investment.

On pass-through jobs:

Governor Romney: But let’s get to the bottom line. That is, I want to bring down rates. I want to bring the rates down, at the same time, lower deductions and exemptions and credits and so forth, so we keep getting the revenue we need. And you think, well, then why lower the rates? And the reason is, because small business pays that individual rate. 54 percent of America’s workers work in businesses that are taxed not at the corporate tax rate, but at the individual tax rate. And if we lower that rate, they will be able to hire more people.

On the impact of higher rates:

Governor Romney: Now, I talked to a guy who has a very small business. He’s in the electronics business in St. Louis. He has four employees. He said he and his son calculated how much they pay in taxes — federal income tax, federal payroll tax, state income tax, state sales tax, state property tax, gasoline tax. It added up to well over 50 percent of what they earned. And your plan is to take the tax rate on successful small businesses from 35 percent to 40 percent. The National Federation of Independent Businesses has said that will cost 700,000 jobs.

Washington Wire readers will recognize those statistics as coming from the two studies we’ve commissioned by Ernst & Young in the past two years. You can access these studies here:

The point of these studies was to arm policymakers with good information about how pass-through businesses like S corporations are a key source of jobs. Based on this week’s debate, we’d say they worked.

Small Business Sector Afraid of Fiscal Cliff

More evidence that the current environment of increased regulatory activity and looming higher tax rates are hurting private businesses and job creation: according to a new poll by the Tax Foundation, 55 percent of business owners and manufacturers would not have started their businesses in today’s economy, while 69 percent say that President Obama’s regulatory policies have hurt their businesses. Here’s the summary from Roll Call:

Of 800 small business and manufacturers surveyed, 55 percent said the national economy is in a worse position for them to succeed than it was three years ago.

The survey, which was released today, was commissioned by the National Federation of Independent Businesses and the National Association of Manufacturers and was conducted by Public Opinion Strategies.

The study showed that two-thirds of the respondents believe economic uncertainty in the market makes it hard for them to grow and to hire more workers, for which they hold the Obama administration or Congress responsible.

The finding that entrepreneurs would refrain from starting new businesses or hiring new workers in this lousy economy is reinforced by new research by Tim Kane at the Hudson Institute. According to Kane’s research:

  1. Startup businesses have historically been the source of all net new job creation; Startups create an average of 3 million new jobs a year, while established companies lose on average one million per year.
  2. Since 2006, startup job creation has fallen sharply, declining each year through 2011; and
  3. Startup job creation under President Obama is the lowest of any President in the last 24 years.

You might recognize this point from the Presidential debate. Governor Romney cited Tim’s work too:

Governor Romney: It’s small business that creates the jobs in America. And over the last four years, small business people have decided that America may not be the place to open a new business, because new business startups are down to a 30-year low. I know what it takes to get small business growing again, to hire people.

Obviously, the two studies are connected. Faced with an uncertain level of taxation and regulation, entrepreneurs are holding back on hiring and investment decisions. That’s what these studies are telling us, and that’s what we hear from our membership. Hopefully, Congress and the Administration will hear them as well and do something about it in the Lame Duck.

Business Community Opposes Tax Hike

Following yesterday’s comments by President Obama, the S Corporation Association joined together with more than 30 other business associations to make the case for action by Congress to avoid the massive tax hike on private enterprise looming next year. As the letter states:

Main Street businesses are America’s job creators. They are responsible for 60 percent of the net new jobs created in the last decade. But uncertainty about the economy and looming tax hikes have kept this sector from hiring new workers, resulting in a weak economic recovery and slow to nonexistent job growth. Until Main Street begins to hire, we fear the unemployment rate will remain unacceptably high.

Congress returns next week and the first order of business will be the much-delayed package of small business tax provisions. This legislation is the perfect vehicle for extending the tax rates and Congress should jump at the chance. According to the Joint Committee on Taxation, failure to take action would mean that taxes next year will rise on families and businesses by $227 billion.

Despite the President’s opposition, momentum for extending all the expiring rates appears to be growing. In recent weeks, senators Ben Nelson (D-NE), Kent Conrad (D-ND) and Evan Bayh (D-IN) have all expressed support for extending all of the rates. Meanwhile, former OMB Director Peter Orzag wrote in the New York Times earlier that, given a choice between doing nothing and extending everything next year, Congress should extend everything.

Each of these Senate defections is significant since any effort to extend current tax policy will need 60 votes, and the Democrats only control 59 prior to the elections. As The Hill noted today:

Senate Democrats would need all 59 Democrats and at least one Republican to pass the Obama administration’s plan to extend tax cuts for the middle class while allowing the tax breaks for the highest-income tax brackets to expire. That plan could be a non-starter in the Senate without Nelson’s support, since another GOP vote would be needed for passage.

Moreover, the Democrat’s majority may shrink immediately after the November elections. Three states — Delaware, Illinois, and West Virginia — will immediately seat their new Senators after the elections in November rather than wait until January, which means if any of those seats change parties, support for a full extension would grow.

As before, we continue to believe the most likely outcome is continued stalemate on extending the rates and no action by Congress this year, followed closely by Congress choosing to extend all of the rates for at least a year. Each additional defection, combined with any Republican victories in Delaware, West Virginia, and Illinois, increases the odds that the latter option becomes law.

S-CORP on Fox Business News

S Corporation Association Executive Director Brian Reardon appeared on Fox Business News last week to discuss the Obama Administration’s newest stimulus proposals.

As discussed above, if the Obama Administration wants to see some real stimulus, it should seek to remove the policy uncertainty hanging over the private sector and support extending all of the current tax provisions that either expired last year or are scheduled to expire next year.

While some of the specific tax items offered up — particularly expensing and a permanent R&E tax credit — are attractive to members on both sides of the aisle, finishing the existing “honey-do” list of tax items is more important.

The amount of capital available to the private sector — and currently buried in money market funds and ridiculously low-interest Treasuries — completely dwarfs the $180 billion package proposed by the President, even without the offsetting tax hikes that are planned to accompany the package. Getting that capital off the sidelines is the first step towards helping the job market recover.

Tax Policy on the Table for September

Members of Congress are back home and set to return mid-September for a final three week session before the November elections. Add in two or three weeks of possible “lame duck” session, and that’s the extent of time available to tax writers to address the numerous items on their honey-do list:

  • Preventing the 2011 tax hikes (including AMT);
  • Adopting the small business tax bill;
  • Extending the extenders that expired last year;
  • Extending the extenders that will expire this year; and
  • Something on the estate tax.

Given that these issues have been before Congress the entire year, it’s difficult to conceive how Congress would suddenly jump into action on all these items before the clock runs out. And while recent statements by leadership suggest they will make a concerted effort to address most of these items before adjourning for good, the Senate continues to be hamstrung in its ability to move anything. Here’s our take on the where we go from here:

  • Small Business Tax Bill: The bill itself is non-controversial and has bipartisan support. What’s holding it up is a fight over the process — will amendments be allowed and, if so, how many — and on-going debates over extraneous tax items like the future of the estate tax. Majority Leader Reid was very close to a deal with  Minority Leader McConnell just prior to the break. We expect further progress and ultimate adoption of this package in September.
  • Tax Hikes: Last week, Finance Committee Republicans issued a statement calling on the Committee to hold a markup on extending current rates “as soon as possible to bring certainty of continued tax relief.” Meanwhile, House Majority Leader Steny Hoyer is calling for extending only those provisions for taxpayers making less than $200,000. And several Senate Democrats — notably Senators Kent Conrad (D-ND) and Evan Bayh (D-IN) — have expressed support for a one-year extension of everything. No clear path out of this challenge, but we continue to believe a one-year extension of everything is most likely, followed by failure of Congress to pass anything. A one year extension of the middle-class relief is a close third.
  • Extenders: Extenders will likely move as part of the small business tax bill in September, which is good news for manufacturers and families living in states with no state income tax. The bad news is the extension would last just until the end of this year, so another bill would have to follow soon.
  • Estate Tax: We’re now four months away from seeing the estate tax rise from the dead (55 percent top rate and $1 million exemption) with no apparent solution in view. Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) are pressing for lower rates and a higher exemption (35 percent and $5 million) while others support adopting the rules in place in 2009 (45 percent and $3.5 million). Still a third camp is happy to see the estate tax return in full force. Time is short, and no side appears to have the 60 votes necessary to prevail, which means current law has the upper hand.

Regarding the floor situation, Senate Majority Leader Reid set up the small business bill to be pending business as soon as they get back on September 13th. He introduced yet another substitute before they left and filled the amendment tree to block other amendments. He then filed cloture on several democratic amendments to the bill as well as the underlying legislation, setting up a series of 60-vote threshold cloture votes in the first couple days when they return.

While it’s possible these votes take place and fail along party lines, it’s more likely the two leaders come to an agreement on allowing a limited number of amendments — including adding the extender package to the mix - for the bill to move forward. At least that’s what we hope, since there are some very good provisions in the small business bill that should help investment and job creation.

Regarding the other items, including Extenders v. 2011, we’re expecting the rest of the to-do list to get pushed into a lame duck, with some sort of omnibus bill that includes federal funding and tax provisions presented to members in November or December. No idea how that battle royale turns out, but we’ll be sitting in the front row to watch.

More on S Corporations and Employment

The ongoing battle over the pending tax hikes has a tendency to devolve into a debate over the definition of “small” business and other random characteristics a firm needs before it be considered “real” by some policymakers. For example, proponents of the tax hike appear to believe a manufacturer is more “real” than a law firm, even though both are taxed as flow-through entities and both might be defined by the SBA as small.

But this debate over which types of business activity are “real” is silly and misses the point. The point is that a large percentage of the pending tax hike will be imposed on employers and investment. One half of all business income is taxed at the individual tax rates. One quarter to one-third of all business income is subject to the top two rates. That’s a lot of economic activity subject to the pending tax hikes.

Consider this debate from the perspective of the employee: whether your job comes from a large S corporation or a small S corporation makes no difference to you; both are employers, and your job is your job. So why should policymakers care whether you work at a 500 employee manufacturing plant or a 12 person law firm? Why do some policymakers believe one job worth saving but the other not?

One challenge we face in this debate is that while the folks at the Statistics of Income break down firms by structure, they don’t include employment numbers, so it’s difficult to tell how many employees work for S corporations. One way to back out an estimate is to look at their payroll and executive compensation numbers. If we assume the average compensation of an American worker is $40,000 (admittedly a rough estimate) then it appears S corporations employed about 21 million workers back in 2007.

Moreover, S corporation employment gets bigger the more revenue and income a firm makes (as you’d expect). Firms with more than $50 million in revenues employed about 4.5 million workers, while firms with $10 to $50 million in revenues employed 4.4 million workers.

Firms that size have average business income per shareholder exceeding $335,000, which means more often than not, their business income is taxed at the top two rates. Are the nine million employees who work at these firms less deserving than the employees who work at the local coffee shop? Obviously not, but for some reason the other side of this debate spends an enormous amount of time trying to minimize the value of those employees and the firms they work for.

Again, these numbers are just rough estimates, but the point they make is valid nonetheless: flow-through businesses — including S corporations — represent the majority of employers in this country and raising their taxes is not going to help the economy or the job picture.

Joint Committee Estimates Tax Hikes

In response to a request from the Ways and Means Committee, the Joint Committee on Taxation released some estimates last week on who would benefit from foregoing the rate hikes and other tax increases next year. You may have seen related stories focusing on how much “millionaires” would benefit. A couple thoughts:

First, while the JCT estimates that taxpayers earning over $1 million would see an average tax break of $103,834, they also estimated this break would reduce their tax burden by only 11 percent, suggesting that these taxpayers will pay nearly $1 million in income taxes next year on average.

Second, the revenue “cost” of avoiding all the tax hikes next year is not substantially more than the cost of avoiding those for taxpayers making less than $200,000 — $227 billion versus $202 billion.

That’s not as much as we would have expected, and in our view raises the odds that Congress extends for one year all the 2001 and 2003 tax cuts. It’s not a done deal, of course, and total inaction by Congress is also possible, but with the weak job market and pending elections, the legislative equivalent of a punt — a one year extension of everything — is looking increasingly likely.

President Releases 2011 Budget

The president released his FY2011 budget yesterday. According to the Office of Management and Budget (OMB), the administration begins with a ten year baseline deficit of $5.5 trillion dollars. Simply put, if Congress and the administration left current laws in place, the deficit would average over $500 billion per year for the next decade.

The president’s proposed policies would raise this deficit to $8.5 trillion. As a result, debt held by the public would increase from $5.8 trillion (41 percent of GDP) in 2008 to $17.5 trillion (76 percent of GDP) in 2019.

It always helps to look at the really big numbers — there aren’t any bigger than when you’re discussing federal budgeting — to put things in perspective. Under the president’s proposed budget:

  • Total spending over ten years would be $45.8 trillion. Spending is scheduled to move from 24.7 percent of GDP in 2009 to 23.7 percent of GDP in 2020. The historical average is around 21 percent.
  • Meanwhile, total revenue collections would be $37.3 trillion. Taxes are scheduled to rise from 14.8 percent of GDP in 2009 to 19.6 percent by 2020. The historical average is 18 percent.

On the revenue front, the president proposes just over $4 trillion in tax relief — most of which comes in the form of extending the 2001 and 2003 tax relief packages which targeted folks making less than $250,000. On the other side of the ledger, the president proposes a large “grab bag” of tax increases — LIFO repeal, carried interest, black liquor, etc. With the odd baseline the administration is using (see below), we’re not sure exactly what the tax increases total, but it’s somewhere in the neighborhood of $1 to $1.5 trillion.

As expected, the budget calls for allowing taxes on upper-income families (and businesses) to rise back to their pre-2001 levels. As the Wall Street Journal reports this morning,

The two top income-tax brackets would rise to 36% and 39.6%, from 33% and 35% respectively. For families earning at least $250,000, capital gains and dividend tax rates would rise to 20% from 15%. All told, upper-income families would face $969 billion in higher taxes between 2011 and 2020.

For other big ticket items — health care reform and cap-and-trade — the budget includes only cursory references. These placeholders are consistent with the administration’s approach to date of delegating these policy decisions to Congressional leadership.

As we have observed in previous posts, the president’s budget is always an odd duck. The president has no tangible authority to tax or spend — the Constitution reserves that right for Congress, after all — yet there is a leadership quality to any presidential budget that can effectively set the tone for the budget decisions to be litigated through the legislative process.

In the case of this budget, that leadership appears wholly absent. No details on his biggest policy priorities. No meaningful proposals for holding down spending or bringing down the deficit/ No hints at entitlement reform. There is a proposed deficit reduction commission, but it has no teeth.

Congress this year will face as difficult a budgeting challenge as any in recent memory. The economy has stabilized and a continued financial meltdown is no longer imminent. The biggest threat to economic growth now is the federal deficit and its impact on interest rates and prices. As this budget release makes clear, Congress will be addressing these challenges alone.

Estate Tax Update

On the estate tax front, the president continues to call for making permanent the estate tax rules from 2009 — a 45 percent top rate and a $3.5 million exemption — but you’d be hard-pressed to find much discussion of this policy in the budget. That’s because the administration is using something other than the usual “Current Law” baseline. As Treasury’s Green Book notes:

The Administration’s primary policy proposals reflect changes from a tax baseline that modifies current law by “patching” the alternative minimum tax, freezing the estate tax at 2009 levels, and making permanent a number of the tax cuts enacted in 2001 and 2003. The baseline changes to current law are described in the Appendix. In some cases, the policy descriptions in the body of this report make note of the baseline (e.g., descriptions of upper-income tax provisions), but elsewhere the baseline is implicit.

In other words, they have taken a projection of current policy and modified that baseline to accommodate changes to AMT, Medicare Physician Payment policy and the estate tax. In budget world, no mention of the estate tax in the budget means an extension of current policy. A footnote on page 158 of the budget makes clear the “current” policy they’re referring to for the estate tax is the 2009 policy, not the 2010 policy currently in place. Not exactly a strident endorsement for the 2009 rules, but it’s there nonetheless.

The second set of estate tax proposals in the budget looks similar to last year’s budget proposals. There are three, the headings are the same, and the revenue estimates are similar:

1. Require consistent valuation for transfer and income tax purposes: Ten Year Estimate — $1.8 billion (2010 budget); $2.1 billion (2011 budget);

2. Modify rules on valuation discounts: Ten Year Estimate — $19.0 billion (2010 budget); $18.7 billion (2011 budget);

3. Require a minimum term for grantor-retained annuity trusts (GRATS): Ten Year Estimate — $3.3 billion (2010 budget); $3.0 billion (2011 budget).

We spent the past year working on issues related to provision 2 — the valuation discounts. While the write-up of the administration’s proposal refers to “estate freezes” rather than the “family attribution”, we remain wary that restoration of the old “family attribution” approach is part of the policy mix being discussed at Treasury and on Capitol Hill.B B B With that in mind, we will continue our work to educate policymakers on why family attribution is a really bad idea.

Regarding work on an estate tax compromise, the Finance Committee has been working with key offices to come up with some sort of process to move a compromise forward in the next couple months. They appear to be still working on what that compromise might look like, even at this late date. Possible policies range from restoring 2009 rules to implementing a more business-friendly compromise centered around a 35 percent top rate and $5 million exemption.

The bottom line question for everyone involved remains the same — is there a proposal out there that can garner 60 votes? If not, expect to see the current repeal stay in place through the rest of the year, followed by the restoration of the old pre-2001 rules. The longer this process takes, the more likely that is the final outcome.

S Corporations and Payroll Taxes are Back in the News

A couple weeks ago, House-Senate health care negotiators raised the idea of paying for health care reform by expanding the types of income subject to the Medicare payroll tax. Payroll taxes are limited to wages at the moment, but this proposal would also tax cap gains, dividends, interest, rents, and limited partners. Oh, and S corporation income.

S-CORP has a long history of advocacy on these issues and, while the future of health care reform is wholly uncertain following the special election in Massachusetts, we felt it was important for the business community to weigh in on this issue with strong opposition. The result is a letter signed by 20 trade associations opposing this concept. As the letter notes:

Expanding the application of the Medicare payroll tax to non-wage income is an unprecedented policy that would undermine the principle that Medicare is an earned entitlement, damage the integrity of the Medicare Trust Fund, and hurt Main Street businesses and jobs. We strongly urge you to reject this misguided policy.

This morning, a CongressDaily article makes clear that this idea continues to be actively discussed between House and Senate negotiators. While the prospects for health care reform are dim, leadership continues to press for some sort of resolution and apparently this payroll tax item is part of those talks. Peter Cohn reports that the House and Senate are divided on how to expand the Medicare tax:

Senate negotiators want to keep active S corporation income — other than income from passive investments — exempt from the payroll tax, fearing their chamber’s fragile voting math can ill afford what could be seen as a new small business tax, aides said. House lawmakers disagree, citing the revenue loss, relatively few actual small-business employers that would be affected, and potential to game the system — such as opting for S corporation status simply to avoid the tax.

We’ll keep you apprised on any new developments on this front. As we’ve mentioned before, our assessment is health care reform will be talked about for the next month or so and then just fade away as other priorities take center stage. There won’t be a funeral or closure, but the votes simply do no exist to move forward right now. That said, no bad idea ever goes away and we fully expect to see this payroll tax expansion to be raised on other bills.

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