Last week, the S corporation community was put on high alert when we received word that an S corporation payroll tax increase similar to the provision from the old Rangel Mother bill (H.R. 3970) was being discussed as an offset to the extender package. The “Mother” provision (see Sec. 1211) would apply payroll taxes to all the service-related income of active shareholders of S corporations primarily engaged in service businesses. While we anticipate that the language of any new provision will differ somewhat from its 2007 predecessor, the general concept remains the same. As CongressDaily noted:

Sources familiar with the House Ways and Means and Senate Finance discussions said applying payroll taxes to certain S corporation profits could raise anywhere from $10 billion to $15 billion, depending on how it is structured. Revenues in that ballpark would go a long way toward closing a $30 billion gap tax-writers need to fill to pay for extensions of numerous expired provisions.

An earlier proposal floated in 2007 was estimated to raise $9.4 billion over a decade by subjecting S corporation and partnership income earned from providing services to payroll taxes, although the new healthcare law would raise the Medicare portion of the tax beginning in 2013 for wealthier earners. The 2007 proposal was scaled back from an earlier option outlined by the Joint Committee on Taxation that would have applied the payroll tax to all S corporation income, estimated to raise $57.4 billion over a decade.

Team S-CORP has had to fight this battle in the past, and we have been in to discuss this provision with Ways and Means on several occasions to get a better idea what they have in mind. Letters sent back in 2007 on behalf of S-CORP as well as our allied trade associations should give you a better sense of the history of this issue.

The future of this particular effort is still very much up in the air. Our communications with the Hill suggest there continues to be strong interest in legislating on this issue — you could characterize this as just one more legacy item left to us by former Senator John Edwards and his law practice — albeit it may take place on a bill other than extenders.

We have pledged to work constructively with taxwriters on a resolution to this issue, but unless they are willing to dramatically pare back the Mother provision to target only bad actors, it is going to be very difficult for business groups to support yet another tax increase on their members.

Stay tuned. More to come.

Latest on Dividends

Whither Tax Rates? The Hill’s On the Money Finance & Economy Blog had an excellent discussion this month on the topic, focusing on the future of dividend rates.
As On the Money notes, “President Barack Obama has proposed that the current rate of 15 percent on dividends be extended for most taxpayers. He’d raise the tax on dividends for individuals making $200,000 or more and families making $250,000 or more to 20 percent. There are several reasons to think wealthier taxpayers will get hit with a much higher tax.”

Meanwhile, The Hill mentions that one possible outcome would be for the dividend tax to fall somewhere between the current 15 percent rate and the top rate on ordinary income. Any divergence from the baseline, however, would require positive action by Congress. As The Hill observes, that’s not something to be taken for granted:

Finally, the lesson of the expired estate tax also has dividend-tax watchers nervous. Congress was expected to extend the estate tax last year, but instead let it expire when Republican and Democratic senators could not reach a compromise. The estate tax is set to kick in again in 2011 at a much higher rate if no action is taken this year.

Also at play is a possible House-Senate dynamic. Our impression is Senate leadership would like to keep capital gains and dividends taxed at the same rates, while their House counterparts are more comfortable seeing the rate on dividends go back to 39.6 percent.

In the end, we believe process will dictate outcome here. The recently enacted ”pay-go” rules require Congress to offset any reduction in the dividend tax rate below 39.6 percent for 2011. Exactly what tax increases would Congress use to offset dividend tax cuts for folks making more than $200,000? We don’t know either, and expect the tax hikes already imbedded in current law will take place as scheduled.

Long To-Do List

Tax policy is in danger of becoming that honey-do list that never gets done. The traditional tax extenders — R&E tax credit, state sales tax deduction, etc. — all expired at the end of last year and, almost five months later, are still expired. Legislation to extend them is stuck between the House and Senate without a pay-for, yet (see above).

Meanwhile, the estate tax fix that was supposed to be done last year — before the tax took its one-year sabbatical — remains stalled in the Senate. Efforts to negotiate some sort of permanent fix are actively taking place in the Senate, so there’s hope. As with the extender package, however, the hold-up is primarily over offsets.

There’s also the most recent in the growing line of “jobs” bills being considered by Congress this year. The latest one passed the House under the banner of a “small business jobs” bill, despite the fact that most of its benefits went to Build America Bonds. We expect the Senate to take up a bill that’s more small-business oriented soon.

Finally, there’s the burning issue of all those tax cuts expiring at the end of the year.

With that as background, reasonable folks might ask themselves: “What’s the plan?” Ways and Means Committee Chairman Sander Levin (D-MI) addressed this question earlier this month, stating he hopes to complete work with the Senate on both tax extenders legislation and the House-passed small business bill by the end of May, telling reporters, “These bills are a critical priority for the leadership of this Congress and the president. These are jobs bills and we need to get these done.”

According to BNA, Levin met with Senate Finance Committee Chairman Max Baucus (D-MT) to discuss the two bills, but the two “did not discuss efforts to address the estate tax, which expired at the start of 2010, and no detailed plans have been set for how lawmakers will deal with the middle-class tax cuts of 2001 and 2003 that are set to expire at the end of the year.”

Your S-CORP team has numerous member companies who are intently interested in Congress moving forward on both the estate tax and the expiring tax provisions. We are five months into 2010 already. It’s time for Congress to act.

Built-In Gains in Play

Team S-CORP spent the last couple weeks on the Hill, educating members and staff on the virtues of reducing the built-in gains (BIG) holding period.

When a company converts to an S corporation, it must hold onto any appreciated assets for 10 years or face a punitive level of tax. This tax effectively locks up these assets, preventing the company from selling them and putting the resources to better use. We’ve raised this issue before, but allowing private companies access to their own capital makes lots of sense in an economy where capital is scarce. It also reflects the reality of today’s shorter lifespan for key business investments.

Last year, Congress agreed and included a shorter, seven-year holding period in the stimulus package. That seven-year period expires at the end of 2010 and needs to be made permanent. A five-year period would work, too. Last summer, Senator Grassley (R-IA) introduced legislation to reduce the BIG tax holding period to five years which we view as tremendously valuable to S corporations struggling to raise capital.

With the Senate actively considering provisions to help small businesses grow and create jobs, a shorter BIG holding period is going to give you more job-creating umph than any other tax provision we know. It would benefit Main Street firms located in every state and every sector of the economy and should be included in the final package.