As we have noted, the stars appear to have aligned for a big estate tax compromise later this year, most likely to be focused on freezing the 2009 rules for at least a year. This means the current top tax rate of 45 percent and $3.5 million exclusion will stay the same for a while. But there’s lots of mischief that can take place under those broad levels.

As tax reformers will tell you, the base is just as important in determining your tax burden as the rates.

With that in mind, several S-Corp allies have pointed out legislation introduced by Congressman Pomeroy (D-ND) earlier this year — H.R. 436 — and asked us whether the base broadening included in this bill might get considered later this year. The answer is a definitive “Yes.” According to our quick read, H.R. 436 would do the following:

  • Freeze the tax rate and exclusion at 45 percent and $3.5 million;
  • Restore the step-up in basis;
  • Restore the recapture of graduated rates; and
  • Limit the use of minority discounts for family businesses.

To put the total impact of these provisions in perspective, here’s a simplified example of a family business where current rules would value the business at $7 million, but under H.R. 436 the value would be $10 million. For comparison’s sake, we included the tax burden on that estate under the rules in place in 2000, this year, in 2010 when the estate tax repeal takes place, and under the Pomeroy bill.

2000 2009 2010 H.R. 436
Top Rate 55% 45% 0 45%
Exclusion $1 million $3.5 million NA $3.5 million
Estate Tax Base/Basis $7 million $7 million $650,000 $10 million
Estate/Capital Gains Tax $2.9 million $1.45 million $1.4 million $2.8 million

As you can see, eliminating planning techniques used for closely-held businesses results in an estate tax under H.R. 436 that is nearly the same as the estate tax under the pre-2001 rules, and about twice as much as the current tax.

This is obviously a simplified example that doesn’t include many of the nuances associated with estate planning. Moreover, a smaller estate would experience less of an impact from changes to the valuation rules whereas larger estates would see a substantial increase.

For both, however, changing the rules under which estates are valued seriously threatens the ability of family-held businesses to survive one generation to the next, and should be treated very carefully by policymakers.

So while business groups are focused on the rates and exclusion, we should be just as worried about proposals that would affect the base. Be prepared to see this issue gather more ink in coming months.

So What’s Next?

With Washington focused like a laser on the stimulus package for the past few months, a natural question is: “What’s next?” Your S-CORP team has been asking around, and here’s what we’ve come up with:

Energy Bill: Both the House and the Senate will consider energy legislation this year that, among other items, will include a tax title extending and modifying expiring energy tax items like the Section 45 production tax credit. Many of these popular provisions are scheduled to expire at the end of the year and need to be extended. The Senate may move as early as March on a stand-alone bill, while the House looks like it will pair traditional energy issues — a renewable electricity standard, energy efficiency standards, and tax items — with a carbon cap-and-trade bill.

Housing & Financial Services: Congress is geared up to take up President Obama’s housing plan this spring together with a rewrite of the rules governing what’s left of Wall Street and the mortgage markets. The housing plan will cost money, so we expect a tax title to offset the revenue loss.

Rangel “Mother Bill”: Remember the “Mother of All Tax Bills” introduced in 2007? It swapped the AMT for higher income tax rates, cut the corporate rate while broadening the business tax base, and targeted benefits at low and middle-income families. Word is Mr. Rangel has been redrafting and could reintroduce the package sometime this spring. Once again, his goal would be to encourage an active discussion over the future of tax code. Actual action will likely wait until 2010 or later.

Middle-Class Tax Relief: Senator Baucus has made noises about moving legislation to provide permanent middle-class tax relief. Such relief could include an effort to permanently extend the middle-income tax rates, the child tax credit, and marriage penalty relief.

Estate Tax: An estate tax compromise is on the table and likely to be considered before the kids go back to school next fall. (See above)

Health Care Reform: We expect a push to provide Americans with more health insurance options at some point this summer. While most of the bill will be focused on Medicare, Medicaid, and an expansion of health coverage, we expect changes to the current tax treatment of health benefits to be included. Swapping the current health care deduction with a tax credit would not only balance the tax treatment of health care consumption, it would also raise lots of money that could be used to expand coverage.

As you can see, Congress’ plate is full. Even if only half of these items get addressed this year, it is a full agenda with lots of opportunities for mischief.

Moreover, with the deficit approaching $2 trillion and Congress done with the $800 billion stimulus package, its focus should shift to budget neutral reforms and deficit reduction, placing even more pressure on the tax code and taxpayers.

We’ll keep watch and make sure closely-held businesses are represented.