Senate leadership has committed to taking up a Jobs bill next week. The details of the package are still being worked out, but the list released by the Senate Democrats includes:
- Job Creation tax credit
- UI and Cobra Extensions
- Bonus depreciation and 179 expensing
- Highway funding
- Build America Bonds
- SBA loans
- Export Promotion
- Some energy related tax items
Although it’s not mentioned, we do expect the tax extenders to also be part on the mix. On the other hand, an estate tax fix is not likely to be included. Senator Reid told reporters that he still plans to move legislation restoring the estate tax, just not now. Meanwhile, policymakers are increasingly worried that time is slipping by. As BNA reported earlier:
Proponents of making the estate tax retroactive to Jan. 1 say case history is on their side, although they admit it will be more complicated because the longer they wait to enact legislation, the more people will attempt to game the tax system.
We are not exactly sure how one would “game” the current system. You have to pass away, after all, to take advantage of the current rules. Final jeopardy, indeed. Takeaway: more chatter about getting something done, but no clarity on when they would do it, what it would look like, whether the House is on board with the retroactive application, or whether they have better guidance on the constitutionality question.
Also, we are hearing from folks that a possible solution would be to offer estates the option of using the 2009 rules or the repeal rules. Point of this would be to protect those mid-sized estates (around $7 million) from paying more under repeal than they would have under last year’s rules. That would certainly get around the retroactive question, but it would also raise the cost of acting.
Rep. Paulsen Weighs in on Marginal Rates
The battle over tax rates is heating up. This week, Congressman Erik Paulsen (R-MN) sent the President a letter asking him to focus on proposals that would hold down marginal tax rates and spur small business growth.
The letter refers to a bill introduced by Rep. Paulsen (H.R. 2284) in May that would allow individual taxpayers an exclusion from gross income for certain items of partnership and S corporation pass-through income up to $250,000 ($500,000 for married couples filing joint returns). As Rep. Paulsen notes, this ability to defer taxes on reinvested income “ensures that small business owners are taxed only on the profits taken out of their business, and also allows for the deferment of taxes on income that was placed back into developing their business. By encouraging reinvestment and incentivizing job creation, we can reach our shared goal of economic growth.”
Paulsen also discusses the possibility of creating “an alternative rate schedule for income stemming from small business activity, including sole proprietor, partnership, and S corporation income” in order to “ensure that marginal tax rates would not rise for America’s job creators during a weak economy.”
Amen to that. America has a vibrant, active Main Street business sector because past Congresses have proactively adopted policies to encourage small business creation and growth. Creation of the S corporation was one of those policies. Now is not the time to reverse course.
John Edwards and S Corporations
One of our allies asked us, “How did John Edwards come to be the poster child for S corporations?” He’s featured prominently in a recent CongressDaily story and, frankly, it’s not an association we’re eager to continue.
The Edwards issue first emerged during the 2004 presidential campaign when we learned that, prior to be elected, Senator Edwards operated his law practice as an S corporation. According to reports — recapped by CongressDaily — Edwards took most of his earnings in the form of S corporation distributions which are not subject to payroll taxes.
As you can imagine, this use of the S corporation caught everybody’s attention and the “John Edwards Issue” was born. We still hear “Oh, is this that John Edwards thing?” when we talk to staff about payroll taxes.
While the payroll tax issue continues to be difficult for policymakers and tax collectors alike, the rules governing when S corporation shareholders pay payroll taxes have been in place for long time. Since the IRS released Revenue Ruling 59-221 back in 1959, S corporation shareholders have been required to pay payroll taxes, but only if they work at their business and only on the wages they pay themselves. Revenue Ruling 74-44 made clear that “dividends” paid to shareholders will be recharacterized as wages when the dividends are in lieu of reasonable compensation for services performed for the S corporation.
Despite these clear rules, when Congress lifted the cap on the Medicare payroll tax back in 1993, it created an arbitrage opportunity for business owners whose income exceeds the Social Security wage base. Organize as an S corporation, pay yourself little or no salary, and avoid paying the Medicare tax.
The S Corporation Association’s position on this is three-fold. First, people should pay the taxes they legally owe — we don’t support tax avoidance. Second, while it is admittedly time-consuming, the IRS has the tools necessary to deal with this issue and collect the money owed. As the IRS wrote one taxpayer back in 2003:
Generally, under the rules described above, if a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services. An S corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed.
Third, every legislative proposal we have seen to date to “fix” this issue has been overly broad and would raise taxes on shareholders already fully complying with the law.
As we mentioned, applying the “reasonable compensation” standard is difficult and time-consuming, but the standard is well established and ensures that payroll taxes only apply to shareholder income derived from their services, as opposed to income stemming from their investments in the business and its employees. As you can imagine, capital-intensive industries like manufacturers and others are keenly interested in making certain this line of demarcation is preserved.
The GAO spent the last year looking into S corporations and the tax policy challenges they present. On the payroll tax issue, the GAO recognized that the IRS has the tools in place to enforce current law. Its recommendation:
To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed.
We understand the current rules are not a perfect solution to the “John Edwards Issue.” But then, nothing else is either. We hope the IRS follows the GAO’s recommendation and works to improve its guidance and enforcement of reasonable compensation. Effective enforcement would take the pressure off policymakers to codify new rules, and remove from the S corporation community the threat that fifty years of tax policy will be turned on its head.