Everyone in Washington knows Congress will have to address the growth of the Alternative Minimum Tax (AMT) and the expiration of popular tax provisions over the next three years. Just how they will go about it, however, is very much up in the air.

Both the House and the Senate are considering their respective budgets this week. Lots goes into a federal budget, as you can imagine, but nothing is more important for S corporations than how this budget will address the AMT and expiring tax provisions.

On this question, the House and Senate are moving in opposite directions. The House wants to offset the full revenue impact of extending the AMT patch and related expiring tax provisions while the Senate does not.

This difference is reflected in their budgets. The House budget calls for enacting a revenue neutral tax package with a simple majority vote in both the House and the Senate, while the Senate budget would require this package to gain 60 votes in order to pass.

As CongressDaily reported this morning, this fight is a replay of the challenge that confronted Congress last year:

On the tax side, Spratt said House Democrats would stand with the Blue Dog Coalition and insist that a one-year patch to the alternative minimum tax be fully offset. Last year, the Senate was unable to muster the votes for a fully offset AMT patch, and House Democrats were forced to allow an unfunded fix to be enacted. “We’re very insistent on seeing that this time, when we do the AMT extension, the AMT patch, it be offset,” Spratt said. “On the other hand,” he added, “Since Conrad has some problems mustering the votes for that in the Senate, we’ll have to wait and see how it comes out.”

Your S Corp team would point out that while this battle is very serious in its own right, it is merely a precursor to a much larger tax fight that will take place when an increasing share of the tax code expires in coming years.

How big is this impending challenge? The Congressional Budget Office has conveniently put together a table of all the expiring tax provisions between now and 2018 and how much revenue would be lost by their extension.

A few comments are in order. First, just extending the so-called family tax relief – the new 10-percent bracket, the marriage penalty relief, and the refundable $1,000 child credit – will reduce revenues by nearly $650 billion between now and 2018.

Second, the full scope of total expiring provisions is staggering – nearly 100 tax provisions expire between now and 2018. Measured by their revenue, that’s nearly $4 trillion in current tax benefits that will go away between now and then, or about 10 percent of total projected revenue.

Third, the expiration of these provisions is taking place within the context of a rising tax burden, as projected federal revenues take an increasing share of our total national income. According to the CBO, the total tax bite will rise from 17.9 percent this year to 20.3 percent in 2018.

If Congress lives up to its intention to use Pay-As-You-Go budgeting (Paygo), where the extension of any expiring tax provision must be offset with tax increases elsewhere, then we’re looking at an effective real tax increase on families and businesses of unprecedented proportions in coming years.

Paygo and Tax Increases

As you may have noticed, a real concern of the S corporation community these days is the combination of multiple expiring tax provisions and the application of Paygo budgeting.

Consider how this works in practice. In 2010, S corporation shareholder Jim is subject to the top tax rate of 35 percent on both his salary and his business income. In that business, he takes advantage of Section 179 expensing. He also uses LIFO (Last-In, First-Out) inventory accounting and has an IC-DISC (Interest Charge Domestic International Sales Corporation) for his growing export business.

Absent congressional action, in tax year 2011 Jim’s tax rate will rise to 39.6 percent and his ability to write-off new capital investments will decline from more than $125,000 per year to $25,000. In other words, Jim is facing a sharp increase in his federal taxes in 2011.

Under Paygo, Congress can extend Jim’s lower rate and preserve current levels of expensing only by raising taxes elsewhere. (Technically, Congress could cut spending as an offset too, but to date has refrained from using that option.)

So to comply with Paygo, Congress could temporarily extend the lower tax rates and higher expensing limit by, among other offsets, permanently repealing LIFO accounting and the IC-DISC. This being Congress, they would then send out a press release letting Jim know how they prevented his taxes from going up.

But Jim’s taxes did go up. Yes, he retains the lower 35 percent tax on his income and the ability to write-off $125,000 of his capital investments, but he no longer has the ability to use LIFO accounting nor the IC-DISC.

As this example demonstrates, the combination of expiring tax relief and Paygo budgeting has tag-teamed Jim into a significant tax increase.

What’s particularly pernicious about Paygo is Congress’ ongoing habit of making tax relief provisions temporary while making their offsetting tax increases permanent. This combination ensures that tax collections in the future will rise above current projections.

As we mentioned earlier, the total federal tax bite is estimated to increase to record levels in the next decade. The combination of expiring temporary tax relief, permanent offsets, and Paygo will only serve to raise that burden even higher.