With a large fraction of the tax code expiring in the next couple of years, the big surprise may be the growing consensus for compromise over the estate tax. The estate tax is scheduled to go away in 2011 followed by its return in 2011 with a top rate of 55 percent and a $1 million exemption per spouse.

How did the estate tax, perhaps the most contentious and divisive of taxes, get to the head of the line of possible compromises? A couple of factors appear to be in play.

For legislators who support full repeal, the prospect of allowing the tax to rise from the dead in 2011 is simply unacceptable. These legislators could hold out for full repeal, but it’s highly unlikely they will get it. Any effort on their part to block a compromise would ensure a higher estate for their constituents, not a lower one.

For estate tax supporters, allowing the tax to go away entirely in 2010 is also problematic. It means any comprise agreed to in 2010 would be a step backward from current law. It also means that principals with sizeable estates in 2010 very well may choose death over taxes. It would only take one well-publicized estate tax suicide to highlight all the reasons the estate tax repeal effort was so successful before 2001.

The net result is that legislators on both sides of the issue have a strong incentive to compromise, and to do it sooner rather than later. The estate tax rules in place in 2009 ($3.5 million exemption with a 45 percent top rate) may form the basis for the compromise.

What does this mean for S corporations? As small and closely-held businesses, we have more than our fair share of family-owned businesses. And as much as tax simplicity, economic growth, and basic decency argue that the estate tax should be repealed, having some kind of certainty over the rules going forward is valuable too.

It also means the S corporation valuation issue that has been litigated in the courts over the past decade will become more of a priority.

For new readers, the issue is whether the value of an S corporation should be adjusted to reflect the future taxes paid by its shareholders on the business income.  Gross v. Commissioner held that these tax payments do not count. The result is that when an S corporation is part of an estate, the IRS may try to value it at a 60 percent or higher premium over similar C corporations.

Charging S corporations a higher estate tax merely because they pay taxes at the shareholder rather than corporate level is simply unacceptable. S corporations need to be aware that this discrimination exists, and be prepared to fight it out with the IRS.

Payroll Taxes and the Wage Cap

Former Presidential Advisor Larry Lindsey wrote in the Wall Street Journal earlier this week about Senator Obama’s proposal to raise the wage cap on Social Security taxes.

On several occasions, Senator Obama has suggested the Social Security payroll tax of 12.4 percent should apply to income above $250,000. This proposal would create a three-tiered payroll tax: workers would pay 12.4 percent on their first $102,000 of earnings, nothing on the next $148,000, and then 12.4 percent again on any income above $250,000.

Setting aside the nonsensical rationale of imposing this tax doughnut hole on wage income, Larry focuses on the economic implications of raising marginal rates by 12.4 percent. As Larry writes:

The economics of what Sen. Obama is proposing should be at least as troubling. A high-income entrepreneur would see his or her federal marginal tax rate rise to 53% from 37.7% under Sen. Obama’s tax plan. He proposes a 4.6 percentage point hike in the personal income tax rate, a loss of some itemized deductions, and a 12.4 percentage point hike in the Social Security payroll tax. This would take a successful entrepreneur’s effective marginal tax rate higher than what it was under Jimmy Carter or Richard Nixon, when the maximum tax on an entrepreneur was 50%.

As S Corp readers know, the S Corporation Association has fought the idea of raising payroll taxes on S corporation income for years. Eliminating the wage cap is just one means of raising Social Security taxes. Couple it with the Joint Committee on Taxation proposal to apply payroll taxes on all the S corporation income of certain shareholders, and you are looking at a tax hike of historic proportions on S corporations and their shareholders.

Congressional Tax Update

Another week, another vote on extenders. As we reported last week, the House was going to take up another package of tax extenders, this time extending the AMT patch through the end of 2008.

On Wednesday, the House adopted the package 233-189 and sent it to the Senate, where the Republican minority is expected to block its consideration. They object to the revenue raisers attached to the patch. The White House also objects. According to the Statement of Administration Policy issued during the debate in the House:

The Administration does not believe that the appropriate way to protect the 26 million Americans from higher 2008 AMT liability - including 22 million that would be newly exposed to the AMT - is to impose a tax increase on other taxpayers. The Administration urges Congress to reduce the risk of disruption to the 2009 tax filing season by eliminating tax increases from the bill.

This is just the latest in what has the potential to be a very long dance between those legislators who want to offset the extension of existing tax benefits with tax increases elsewhere, and those who do not. Last year, this debate lasted right up until Christmas.