BRT Offers Up Higher Tax Rates on Pass-Through Businesses

The Business Roundtable (BRT), an association of some of Americabs largest multinational corporations, today sent a letter to congressional leaders and the President calling for comprehensive tax and entitlement reform, but also leaving the door open for higher tax rates on individuals and smaller businesses.

In response, Brian Reardon, Executive Director of the S Corporation Association issued the following statement:

bWe agree with the Business Roundtable that the only way to address our long-term fiscal challenge is through comprehensive reform of both the tax code and our entitlement programs, but we disagree that Congress should consider raising marginal rates on pass-through businesses as part of those reforms.b

bBoth the Congressional Budget Office and Ernst & Young have made clear that higher marginal rates will result in fewer jobs now and in the future.B The business community needs to unite behind comprehensive tax reform that lowers marginal rates on all businesses, not just multinational corporations.b

Fiscal (Slope) Cliff Forecast

While everyone in Washington waits for Tuesdaybs election results, this story in The Hill caught our eye:B bFiscal cliff already weighing on economy.bB According to the story:

While the expiring tax cuts and automatic spending cuts that make up the cliff do not take effect until the beginning of 2013, Pawlenty said he is hearing from financial firms that businesses are already halting business activity because they are not sure what will happen.

For example, 61 percent of JPMorgan’s U.S. clients are altering their hiring plans because of the cliff, and 42 percent of fund managers for Bank of America identify it as their greatest investment risk.

Thatbs consistent with what our S-CORP members are telling us.B Faced with higher tax rates, uncertain health insurance prospects, and lagging employment growth, the S corporations we hear from are choosing to forego hiring and investment decisions until they feel more confident about the future of public policy and the economy.

This suggests the so-called fiscal cliff is more of a downward slope, and webre already on it.B Employers are holding back, which is suppressing investment and hiring decisions right now, and thatbs reflected in the less-than-stellar jobs and GDP numbers webve been seeing for the past six months.

That also means that any signal that Congress is prepared to address the cliff and block these tax hikes would help the economy immediately– not just after January 1st.

So, whatbs at stake for S corporations?B Herebs a short list:

Tax Rates:B The best case is that current rates are extended for 2013.B The worst case is total gridlock in Congress and rates rise to their pre-2001 levels and beyond.B (Beyond because of the tax hikes included in health care reform).B Herebs a table summarizing the options:

Top Rates

Worst Case

Best Case

Wage & Salary

44.7%

37.9%

Cap Gains

23.8%

15.0%

Dividends

44.7%

15.0%

Interest

44.7%

35.0%

S Corp Income

44.7%

35.0%

Keep in mind, the best case scenario includes both extending current rates and repealing the new 3.8 percent investment tax imposed under Obamacare.B Not impossible if Romney wins and Republicans take the Senate, but not easy either.

AMT:B One of the findings in our E&Y study released this summer was the significant number of pass-through owners who pay the AMT.B According to E&Y, of the 2.1 million business owners who earn more the $200,000 annually, 900,000 pay the top two tax rates, while 1.2 million pay the AMT.B This suggests that the expiration of the so-called AMT patch last year may have more impact on pass-through business owners than the expiration of the lower rates.B Treasury estimates that 30 million additional taxpayers will be pulled into the AMT April 15th under the current rules (if the AMT patch remains expired).B The findings of E&Y suggest many of those taxpayers are business owners.B Business owners most at risk are those with dependent children and those living in high-tax states like New York and California.

Extenders:B B Congress has gotten into a [bad] habit of ignoring the expiration of all those tax provisions falling under the title of bextendersb — the R&E tax credit, the state and local tax deduction, the shorter built-in gains holding period, etc.B The Senate Finance Committee has passed a package of extensions, but the House has yet to act.B If and how these important issues are addressed during the lame duck are still to be determined, and unfortunately seem to have taken a backseat to dealing with the bmust-dob broader 2001/2003 extenders that are set to expire at yearbs end.

Those are the tax provisions directly impacting the S corporation community. Couple them with the spending cuts scheduled to begin January 1st, and the total makes up the $700-plus billion fiscal cliff.

What might happen?

Our friends at International Strategy & Investment in the past suggested that the choice before Congress is not ball or nothingb and we agree.B Rather than be constrained by the idea that we will either fall off the cliff or step back entirely, our view is that Congress will take a half-step back, avoiding the most damaging pieces of the cliff while allowing others to take effect.B Herebs a list with those cliff provisions most likely to be avoided starting at the top:

More LikelyB

  • AMT
  • Middle-Class Tax Relief
  • Sequestration
  • Doc Fix
  • Tax Extenders
  • Extended UI Benefits
  • Upper Income Tax Relief
  • Health Care Reform Tax Hikes
  • Discretionary Spending

Less Likely

Webve highlighted the tax rates on upper income taxpayers, including S corporations, since their extension depends almost entirely on who wins the White House.B The odds they get extended is close to zero under President Obama, and perhaps 50-50 under a new Romney Administration.B Romney has made clear he will push for them, as has the House — itbs the Democrats in the Senate that are the wild card.B As for the rest of the provisions, there may be some movement based on the elections, but not much.

In addition to the policies, therebs a question of timing.B The general notion is that any deal on the fiscal cliff must occur before the end of 2012, but several of the provisions listed above could just as easily be dealt with in the first few weeks of 2013 with little additional harm to the economy, particularly if Congress and the incoming Administration effectively signaled what they had in mind.B Moreover, with only a few weeks between the elections and the holidays, there may simply be insufficient time for the differing parties to come together.

But that doesnbt mean itbs okay to wait.B Action immediately after the election to address the entire fiscal cliff — including the top tax rates — would help improve peoplebs lives now through increased hiring and increased business investment.B Congress should act, and act quickly.

But will they?B Not if their recent behavior, particularly in the Senate, is any indication.B So our best pre-election guess is that Congress will act eventually, but only at the last minute, and that most of the fiscal cliff will be averted either prior to the end of the year or shortly thereafter.

Cliff Notes

House leadership has made clear they will take up legislation to extend the current tax rates and other policies through 2013, combined with expedited procedures for tax reform to be enacted in 2013.

This one-two punch is designed to address two challenges facing policymakers today.B The first is the tax component of the bfiscal cliffb we face at the end of the year.B The pending expiration of the lower rates on wages, business income, and investment income is having a tangible, negative impact on investment and job creation right now and, left unchecked, threatens to push the economy back into recession.B Businesses simply donbt know what the rules are going to be moving forward, and are reluctant to tax risks and hire new people as a result.

The second goal is to address the underlying instability in the tax code and its impact on jobs and investment through tax reform.B The code is rife with challenges, including:

  • The devolution of the Alternative Minimum Tax into a tax on millions of middleclass families;
  • The growth in the number of temporary tax provisions, including the estate tax rules, that need to be extended every year or so; and
  • The emergence of the U.S. tax rates on corporations and pass-through businesses alike as the highest in the developed world.

The purpose of the expedited process is to enable Congress to more easily develop and pass legislation addressing these challenges, while cutting overall marginal rates and improving incentives for work and investment.

While there is an element of bwait and seeb to the reform portion of this package, our view is that the legislation outlined by House leadership is the most promising and responsible path for Congress to take right now and it deserves our support.B A little clarity for employers coupled with the promise of reform would go a long way to improving the economic outlook now and into next year.

What are the billbs prospects?

The House appears to have the votes to pass the legislation described above — a strong bi-partisan majority is not out of the question — but what about the Senate?B Doesnbt the Democratic majority in that body have the votes to kill it?B Maybe not.

The Hill today highlights an emerging group of Senate Democrats who oppose raising taxes on anyone right now.B According to The Hill:

A growing number of Senate Democrats are signaling they are not prepared to raise taxes on anyone in the weak economy unless Congress approves a grand bargain to reduce the deficit.

At least seven Democratic senators have declined to rule out supporting a temporary extension of the Bush-era income tax rates, breaking with party leaders who have called for letting the rates expire for people earning more than $1 million per year.

Combined with the 47 Senate Republicans, those seven votes would give the proposed House bill majority support in the Senate, which is certainly good news.

That doesnbt mean the House bill will pass, however.B Itbs clear a minority of Senators are willing to stand aside and watch as tax rates on higher income taxpayers and businesses go up, and perhaps middle income Americans too.B Again, according to The Hill:

Some Senate Democrats in safe seats have even gone so far as to privately propose allowing all the Bush tax rates to lapse to maximize their bargaining power with Democrats.

Democrats in Republican-leaning states blanch at this idea. They do not want to have to explain an across-the-board tax hike to constituents when economic growth is sluggish and unemployment is high.

So the House will pass a one-year extension in the next month, and then this debate will shift to the Senate, where it appears a minority of Senators will work to block the legislation from passing that body.

What can the S Corporation Association and its members do?B Make clear to members in both the House and the Senate that allowing the current tax rates on business and investment income to expire is simply not an option.B They must be extended if the economy is to return to its normal growth rates.

Webve been on the Hill with that message for over a year now, and its beginning to gain traction.B The pending vote in the House is a big step in the right direction, and our goal is to get as many votes — Republican and Democratic — as possible to send a signal that the Senate needs to act.