The economic fear that gripped folks in the Fall of 2008 has resulted in a historic collapse of federal revenues.
Revenue collections since 1960 have stayed in a relatively tight pattern centered around 18 percent of our GNP. Considering the range of tax policies we’ve imposed on taxpayers during that time, the steadiness of the 18 percent mean is remarkable and suggests some sort of political or economic boundary is in effect.
That steadiness was broken last year when federal collections fell to their lowest level since 1950. Meanwhile, Washington’s response to the crisis has driven federal spending to levels not seen since World War II.B Record low revenues and record high spending means record high deficits.
While record high deficits are obviously a negative, what your S-CORP team finds most troubling is the long-term outlook. For the next decade, the trend is definitely not our friend.
Once we get past the immediate effects of the “fear” and revenues move back to their historic mean, deficits of 4 or 5 percent GNP will persist. And when revenues move well above their historic mean? Deficits of 4 or 5 percent will persist.
And this is the baseline! It doesn’t include expensive policies that are either set to expire or those that are simply politically unsustainable.
Obama 2009 Tax Proposals vs. CBO Baseline Deficit
The chart above takes CBO’s September deficit estimates and superimposes CBO’s June estimates of President Obama’s 2009 tax proposals. Not exactly kosher, but the underlying point is undiminished: even the President’s modest policies to extend just part of the Bush tax relief would add hundreds of billions to the deficit each year.
“Unsustainable” is the word that comes to mind. Herb Stein once observed that unsustainable trends will not be sustained, which suggests these projected deficits are unlikely to become a reality, but that just means something has to give. Stuck between a rock (record deficits) and a hard place (a weak economy), there are simply no easy answers.
For S corporations, the challenge is to spend the next year demonstrating to taxwriters the economic importance of our community, especially as Congress grapples with the “too big to fail” concept for financial services.
S corporations were created to fight economic consolidation. They move economic power and decision-making away from Wall Street and on to Main Street. If policymakers want proactive policies that reduce the incidence of systemic risk, empowering closely-held businesses is a sure-fire means of doing so.
Health Care Pay-Fors
Health care reform is in the final stages of its legislative journey — last half of the fourth quarter perhaps? — and while the pro-reform team has plenty of momentum, exactly what tax items make it into the final package remain undecided.
Of most concern to S corporations are the marginal rate increases included in both bills. In the House, it is the 5.4 surtax applied to individual incomes above $500,000, while in the Senate it is the 0.9 percent HI tax increase applied to individual incomes over $200,000.
Moreover, recent stories on possible compromises should raise S corporation eyebrows. As first reported in CongressDaily, negotiators are considering expanding the Medicare HI tax beyond wages to include all types of income, including S corporation income.
According to JCT, applying the existing 1.45 percent payroll tax to investment income, including capital gains, taxable interest, dividends, estate and trust income and income from rents, royalties, S corporations and passive partnership income, to those earning above the $200,000/$250,000 thresholds would raise $111 billion over a decade.
S-CORP has a long history of fighting efforts to expand payroll taxes beyond, well, payrolls. Payroll taxes like the HI tax were designed to resemble private insurance premiums on the premise that Medicare and Social Security were “earned” benefits. This proposal would blur the line beyond taxes on labor and taxes on capital, undermine the notion that Medicare is an “earned” benefit, and should be of considerable concern to the business community.
GAO Releases S Corporation Report
In response to a request by Senators Max Baucus (D-MT) and Charles Grassley (R-IA), the Government Accountability Office spent the last year looking into tax compliance by the S corporation community. The GAO presented its findings in a report released yesterday.
Reports like this always carry with them a large degree of headline risk. Words like “noncompliance” and “misreported” jump off the first few pages. Look beyond the first couple pages, however, and the GAO has compiled a comprehensive review of the challenges S corporation face when calculating their taxes.
Questions covered by the GAO include why some businesses choose to be S corporations, what are the types of S corporation non-compliance, and what are the options for improving S corporation compliance. To answers these questions, the GAO interviewed numerous stakeholders, including the S Corporation Association, and, in their just-released report, came to the following conclusions:
- Congress should require S corporations to calculate and report the basis for their shareholders’ ownership shares;
- The IRS should research options for improving the performance of professional tax preparers;
- The IRS should provide additional guidance to new S corporations on calculating basis and compensation; and
- The IRS should require examiners to document analysis of compensation, and provide more guidance on compensation.Having given the report a first read, what is our reaction? First, the S corporation was created to encourage private enterprise, not avoid lawfully-owed taxes. We don’t support or help those taxpayers who knowingly avoid paying their taxes.
Second, the legislative recommendation included in the report is for Congress to require an entity-level basis calculation. According to the GAO, this proposal would help address the problem of shareholders claiming losses beyond their basis in the firm. This recommendation is new to S-CORP and we have asked our advisors to weigh-in on its merits.
Third, we’re glad to see the GAO agrees with us that the IRS has tools to address one of the larger areas of non-compliance. Some S corporation owners who work in their business underpay their salaries in order to reduce their payroll tax obligations. As the GAO notes, the IRS needs to do a better job of both defining the existing “reasonable compensation” standard in its guidance, and applying the standard in its examinations.
As to the headline risk, last summer the IRS reported that tax compliance by S corporations likely was as good, and possibly better, than taxpayers’ compliance in general. Meanwhile, the SBA reported last year that S corporations shoulder the highest effective tax burden of any business type. As an investor, as an employer, and as a taxpayer, S corporations are a valuable component of America’s business community. The GAO has given us some suggestions on how we can do better.