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Legislative Outlook: Lame Duck and Beyond
Last week we previewed the Midterm elections and shared our thoughts about how things will likely shake out. Today we’ll take a look at how those results will impact tax policy in the lame duck and beyond, with a focus on what it all means for the S corporation community.
Lame Ducks Tend to be Lame
Let’s begin with the bottom line – we don’t expect much from this lame duck. There’s been lots of chatter about a litany of bills and other priorities that could move in the weeks following the midterms, but that always seems to be case and it’s rarely followed by any real results.
Why is that? We can think of three reasons:
- Truly pressing issues would have been addressed already.
- Many members of Congress will have just lost their jobs and those remaining will be focused on the next Congress. Issues include leadership elections and committee assignments, and moving offices and hiring staff.
- When there’s a change in control, the incoming majority is unlikely to see an advantage to moving bills during their last days in the minority. That’s not true for all issues, but generally it’s the case.
This time around, we know we’ll have lots of outgoing members (record retirements), and a middle-of-the-road prediction of incumbents who lose adds another 25-35 departing members. Coupled with our prediction of new majorities in both houses and you have a recipe for lots of turmoil and very little legislating.
Possible Lame Duck Items
That said, it is not impossible for something to happen, even something significant. Here’s our list of possible items, in order of their likelihood of enactment.
Government funding is first on the list. Current funding runs out on December 16th and Congress is faced with three options – continue existing funding levels into the New Year with another Continuing Resolution (most likely), pass what’s called an Omnibus that includes new, updated funding levels for all the parts of government that remain unfunded (less likely), or a combination of the two (somewhat likely).
There’s also the National Defense Authorization Act, which the business community will oppose if it continues to include the harmful ENABLERS Act that was snuck into the House bill at the last minute. The NDAA has been adopted every year for the past zillion years or so, rain or shine, so expect this to be on the floor in November and remember to read the fine print. As with the controversial Corporate Transparency Act two years ago, lots of unrelated items catch a ride on the NDAA, not all of them good.
There’s also a pending sequester which doesn’t seem to be getting sufficient attention. Medicare payments face a 4-percent cut beginning in 2023 unless Congress acts to prevent it. Congress has blocked sequesters in the past, but this time the PAYGO cut is the result of the increased deficit under the American Rescue Plan, so it’s carrying all sorts of baggage. The cuts have been postponed several times already and another postponement is likely, but they certainly complicate things, particularly as the chronic deficit and rising debt payments grab more attention.
On the tax front there are lots policies being promoted, including:
- Section 174 which, as of the start of this year, requires companies to amortize – rather than fully expense – their research and development costs.
- Similarly, a more stringent cap on interest expenses under Section 163(j) also went into effect in 2022. As you can imagine, there is a sizeable coalition of businesses (which S-Corp is part of) pushing for retroactive relief, or at the very least more favorable treatment of these expenses going forward.
- There’s also the perennial issue of tax extenders; this JCT report from January is a good reminder that there’s no shortage of expiring tax provisions – each with their own constituencies on Capitol Hill – for Congress to address.
- On the individual side, Democrats are still eying an extension of the enhanced Child Tax Credit, which was expanded as part of the 2021 covid relief bill and allowed to expire a year later.
Republicans are a strong favorite to take at least the House, so extending the credit is a long shot. However, Senator Mitt Romney has kept the issue alive by introducing his own plan to reform the provision, and Democrats may use it as a bargaining chip in negotiations over the business provisions above.
Other possible agenda items include the retirement-focused “SECURE Act 2.0,” trade adjustment assistance, Electoral Count Reform Act, Ukraine aid, and a permitting bill backed by Senator Joe Manchin. This is the bill Senator Manchin negotiated with Senator Schumer in exchange for his vote on the Deficit Reduction Act. It has yet to pass the Senate (and may not) and if it does, it faces a strong challenge in the House. That said, there’s lots of bipartisan support for increased domestic production and with rising energy prices playing a big role in the elections, who knows?
Could a package that includes spending, tax, and the Manchin permitting bill come together? Anything is possible, but we think Congress does the minimum here and then adjourns for the Holidays. That means a CR into 2023, another PAYGO postponement, and an NDAA that includes non-controversial riders only.
New Congress
Assuming our election predictions play out, S corporations and the rest of the Main Street business community can expect divided government and a high degree of gridlock for the next two years. And while we expect both houses to flip, gridlock only needs the House to flip, an outcome the betting markets see as a virtual lock.
Gridlock means the chances of new tax hikes being adopted are just about zero. The business community has its plate full with rising prices, tight labor markets, and ongoing supply chain challenges, so gridlock should be a welcome respite, particularly on the tax front. For the first time in years, business owners will be able to ignore pandemics and devastating tax hikes and focus on running their companies instead.
Beyond gridlock, we see two major trends developing. The first is the reemergence of deficit politics. The deficit has come down from its highs during the pandemic, but the core deficit remains above $1 trillion annually and it just goes up from there. Meanwhile, higher interest rates mean the cost of servicing the debt is going to balloon. Both parties did a good job of ignoring deficits over the past decade, but we’re not sure that will be possible in the coming years. The budget numbers coming out of the CBO are just too scary.
These factors become even more important within the context of the debt limit, which is expected to be reached sometime in mid-2023. Battle lines are already being drawn – some Democrats recently called for doing away with the spending cap, while Republicans have signaled they plan to use it as a means of getting spending levels under control. With the potential for default on the table, we expect this fight to be one of the more contentious aspects of the next Congress.
Second, the battleground for the next two years should shift from legislation to investigations, executive actions and nominations, especially if the Senate flips. Gridlock means Congress will be unable to get its legislative priorities signed into law, and that the Biden administration will have to resort to non-legislative options if it wants to get anything done.
For pass-throughs, that means the policy risk shifts from the Ways and Means and Finance committees to the Office of Tax Policy over at Treasury. We’ve seen this challenge in the past with the proposed Section 2704 regulations and other executive actions, so we’ll have to be on our toes.
Post-2024
Post-2024 is when the policy landscape will become especially challenging for pass-throughs, as the TCJA’s individual tax provisions are set to expire at the end of 2025, including:
- The Section 199A pass-through deduction;
- The lower individual rates, including the 37 percent top rate;
- The increased child tax credit;
- The employer credit for paid family leave;
- The Work Opportunity Tax Credit;
- The increased standard deduction;
- The SALT deduction cap; and
- Many other provisions.
As you can see, it’s a veritable fiscal cliff all targeted at individuals and pass-through businesses, much as we saw at the end of 2012. That cliff was resolved when Senator McConnell and Vice President Biden successfully worked out a compromise that mitigated the most harmful aspects of the cliff.
Could we see another successful negotiation this time around? Ensuring a positive result in 2025 is going to be S-Corp’s primary focus moving forward. The lower top rate and 199A deduction were enacted to establish rough parity between C corporations and pass-throughs. Our EY study from 2019 shows that absent 199A, pass-throughs would face effective tax rates well above those paid by their C corporation competitors. Estimates from Treasury and the CBO say the same thing. The expiration of Section 199A will destroy that parity and make it all but impossible for millions of S corporations to stay competitive.
Exactly how Congress responds to the fiscal cliff will depend on many variables, including who controls the White House and Congress following the 2024 elections. But under any scenario, Congress will need to take action in 2025 to address the expiration of these provisions. S-Corp’s job will be to ensure those actions are fair to individually- and family-owned businesses, and that discussion starts right now.
Election Outlook
The elections are less than a month out, and the implications for S corporations are huge. If Democrats retain control, we can expect two more years of policy risk, with the threat of higher rates and increased estate tax levies looming large. If Republicans take either the House or the Senate, we can expect two years of divided government, with limited opportunities for tax policy to move and the focus shifting to the policy cliff taking place at the end of 2025.
So what will it be? Here’s how we think things will play out.
Macro Trends
Let’s start with macro trends. Earlier this month, the New York Times ran a piece entitled, “It’s Time to Take Democrats’ Chances in the House Seriously.” Their thesis centered on a couple generic congressional ballots showing that voters in the aggregate slightly prefer Democrats over Republicans for Congress. But those ballots appear to be an outlier. Real Clear Politics publishes an average of three key metrics – the generic ballot, Presidential approval, and right track/wrong track, with each showing Republicans are ahead:
So the macro outlook favors Republicans. So does the history of mid-term elections, where the President’s party has gained seats in the House only twice in the last century. As NPR observed during the 2014 elections, “History tells us that midterm elections are bad — sometimes very bad — for the party that controls the White House.” There are exceptions, but this year doesn’t appear to be one of them.
House
In the House, Democrats face a challenging landscape and will need to significantly outperform the current outlook if they are to hold on to the majority. Here’s the latest summary from Cook Political Report:
According to Cook, 211 seats at least “Lean Republican,” including 9 Democratic seats. Compare that to the 193 seats that at least “Lean Democrat,” only two of which are Republican seats. That suggests the Democrats would need to win 80 percent of the 31 “Toss Up” races (24 out of 30) in order to hold onto their current majority.
FiveThirtyEight offers similar projections, with their model generating the following odds of a Republican majority come next year:
So their model says there’s a 80 percent chance Republicans take the House, with the most common scenario resulting in Republicans controlling between 225 and 230 seats.
Finally, Real Clear Politics shows an even larger Republican advantage. They start with 221 solid or Republican-leaning seats, with 38 toss-ups. Split those down the middle and you have Republicans with somewhere between 235 and 245 seats next year. If this is a wave election (as many predicted earlier this year), then the toss up seats will mostly break one way, meaning 245-250 seats for Republicans.
The bottom line here is that even absent a “Red Wave”, it’s hard to plot out a scenario where Democrats emerge with their majority intact. The betting markets agree, showing the odds of Republican control at 88 percent.
Our take: Republicans net 33 seats, for a 245-190 majority
The Senate is where things get a little more interesting. Cook lists four seats as “Toss Ups,” split evenly between both parties: Pennsylvania and Wisconsin for the Republicans and Georgia and Nevada for the Democrats. Cook also ranks the three battleground races in Arizona, Colorado, and New Hampshire as “Lean Democrat” with two races – North Carolina and Ohio – as “Lean Republican.”
That’s about as close as it gets. Yet FiveThirtyEight puts the Democrats’ odds of holding onto their 50-seat majority at nearly six-in-ten:
We think that’s a stretch, and that 538 is in danger of repeating its misses in recent cycles. Instead, our view is more consistent with the RCP outlook, showing Republicans starting with 47 safe, likely or leaning seats and winning 5 more, resulting in a three-seat gain overall.
How does RCP get there? They start with their average of current polls, but then adjust those results to reflect polling misses in the past three cycles. For example, Pennsylvania polls at this point showed presidential candidate Hillary Clinton with a 6.2 percentage point lead over Donald Trump, but Trump eventually won the state by 0.7 percent. Similar misses occurred in 2018 and 2020, suggesting the Pennsylvania polls are off by an average of 4.8 percent. That adjustment would give Dr. Oz a 2.4 percent lead on election day.
The table above shows similar adjustments in other battle ground states. What’s interesting is that while the polls laughably undercounted Republicans in North Carolina and Ohio, the math works the other way in Nevada, where recent polls have tended to undercount Democrats. After the adjustment, challenger Laxalt still shows a small lead, but it’s going to be very close.
If the RCP analysis is accurate, and we think it is, then expect Republicans to have a good election night and come away with a comfortable Senate majority.
Our take: Republicans net a total of 3 seats, for a 53-47 majority
So that’s our outlook for the upcoming elections. We’re three weeks out and lots could change, but our base case for now is Republicans win the majority in both bodies and we have divided government for the next two years. We’ve been wrong before, so you never know, but for Democrats to retain control they would have to overcome recent polling, the current macro outlook, and the history of mid-terms. That’s a tall order, and it doesn’t appear likely.
Our next update will focus on the policy implications of the elections, and what divided government might mean to Main Street.
Talking Taxes in a Truck Episode 22: Tax Girl
Our latest podcast guest is Kelly Phillips Erb, managing shareholder at the Erb Law Firm, Team Lead for Insights and Commentary at Bloomberg Tax and Accounting, and the face behind the excellent @TaxGirl Twitter account and taxgirl.com blog. Kelly kicks things off with an overview of the ENABLERS Act, and explains how the broadly-written bill could put millions of law-abiding businesses and employees in the Treasury Department’s crosshairs. Later, Kelly and Brian do a deep dive on the $80 billion in new IRS funding, discuss the issues keeping Kelly’s clients up at night, and lay out the prospects for a lame duck tax package.
This episode of Talking Taxes in a Truck was recorded on October 5, 2022, and runs 55 minutes long.
Main Street Opposes ENABLERS Act
The S Corporation Association joined with dozens of associations today to oppose the ENABLERS Act, legislation that would adversely affect millions of businesses, charities, and foundations, as well as their employees and investors. More than 75 organizations signed onto the effort, including NFIB, the American Farm Bureau Federation, the U.S. Chamber of Commerce, and the Real Estate Roundtable.
The ENABLERS Act seeks to dramatically expand the reporting requirements put in place by the Corporate Transparency Act, despite the fact that final regulations under the CTA were just released today with a delayed effective date of 2024.
S-Corp initiated this effort after the ENABLERS Act was snuck onto the National Defense Authorization Act in the House. If that process sounds familiar, it’s how the initial Corporate Transparency Act was adopted two years ago. They hid it on the NDAA and the business community was unable get the security-minded staff and members of the defense committees to pay attention.
Today’s letter is an effort to make certain the same process gambit doesn’t result in yet another assault on the privacy of Main Street businesses. As with the CTA before it, today’s letter points out that the ENABLERS Act would do little to combat illicit activity and instead targets a broad swath of law-abiding business owners, charity executives, and foundation trustees with new and intrusive reporting requirements. How broad a swath?
While the bill’s stated goal is to increase reporting by “professional service providers who serve as key gatekeepers to the U.S. financial system,” its broad language would cover the owners, board members, and senior executives of most businesses and charities. Anyone engaged in an entity’s formation, acquisition, or disposal would be covered, as would owners and employees engaged in nearly every financial activity of the business, including money management, payment processing, wire transfers, or buying and selling currencies.
The ENABLERS Act appears to lack the energy and bipartisan support of its predecessor, but it’s still just one conference and two votes away from enactment, so the business community needs to remain vigilant all the way through the end of the year. We’ll be taking today’s letter up to key Senate offices to educate them on the history of this issue and how these bills are being used to target private businesses and their owners.
A full copy of the letter can be accessed by clicking here.
For additional background on the ENABLERS Act, please click here.
Tax Gap Claims Come Up Short, Again
We’ve been skeptical of grandiose promises to close the so-called tax gap for years (here, here, here). Part of that skepticism stems from the blatant self-interest of those making the estimates – we could raise billions, trillions, quadrillions if only you gave us more money! (Perhaps the CRS or JCT could be in charge of making these estimates in the future?)
Last week’s piece from The Hill is a perfect example. Under the breathless headline, “Lucrative IRS program targeting wealthy tax cheats is withering from a lack of funds,” the article reveals many things, none of which are consistent with the headline.
First, far from lucrative, the program’s returns stink. Here’s The Hill:
The Finance Committee report found that since 2007, the whistleblower program has brought in almost $6.5 billion while paying out just over $1 billion in rewards.
Despite those soaring returns, the number of investigations opened by the IRS as a result of the program has fallen from 43 in 2014 to just six in 2020, according to the report.
Revenues from the program have also been falling, down to $245 million collected from noncompliant taxpayers in 2021 from $1.4 billion in 2018.
Six-and-a-half billion in 15 years? Oooh. Cuing Dr. Evil. Seriously, that’s less than $500 million a year, or enough to fund the federal government for about an hour.
Second, notice the cherry-picked statistics? We are told collections in 2021 were only one-sixth of those in 2018. But 2018 was a banner year for the program and an obvious outlier. When you compare 2021 collections to the program’s average (again, around $500 million annually), the reduction is much more in line with normal variations. Moreover, the budget cuts to the IRS began a decade ago – shouldn’t the reduced funding have depressed 2018 collections, too?
Third, where’s the meat? This program encourages Americans to snitch on their neighbors, colleagues, and employers with really substantial rewards and all they can gin up is a few billion over 15 years? What happened to all those billionaire tax cheats the IRS has promised?
As we’ve noted in the past, the reality of the tax gap is much more complicated than the Marvel Comic version being peddled by the IRS and its supporters. First, much of the gap is from taxpayers who are broke and unable to pay anything, let alone a large tax debt. Second, much of the debt is owed by lower-income Americans and would require lots of enforcement to collect relatively small amounts.
And third, a not insubstantial amount is the result of disputes between the IRS and taxpayers. In those cases, they count the amounts in dispute as part of the tax gap, even when the taxpayer prevails. Let that sink in for a second: in cases where the IRS is wrong, they still add that amount to the tax gap estimates.
All of which is why former Finance Committee staffer Dean Zerbe’s comment should have been the story’s headline:
I don’t think people realize how much the IRS kind of shoots blanks, meaning that they audit folks and it just kind of comes up to zero or next to a zero. The whistleblower program is much better at really targeting the bad actors,” he said.
The program itself is designed to go after the big-dollar folks. The way that the law is structured, it kicks in for major corporations, for wealthy individuals and very wealthy individuals,” he added.
How are those comments consistent with the rest of The Hill’s story, or the recent tax gap narrative? If most IRS audits turn up little or nothing, how will more audits produce the windfall promised by the Inflation Reduction Act?
And if the whistleblower program is so much better at targeting the cheats than random audits, why does it produce relatively miniscule amounts of revenue? Either it’s not that great of a program, or the tax cheats aren’t really that rich or prevalent.
None of this makes any sense and it all points to the ultimate futility of all that new IRS funding. The US tax code relies on Americans paying their taxes in good faith and, with some exceptions, it works very well. Our compliance rate is among the highest in the world, after all.
But good faith works in both directions. It requires a tax code that’s fair and understandable, and an enforcement agency that helps taxpayers comply with the rules – rather than targeting them as tax cheats.
With that in mind, we’ll go out on a limb here and predict that more whistleblowers and thousands of new, poorly trained auditors are not going to result in the predicted revenue windfall. It will, however, severely undermine the good faith necessary to make it all work.