Your S-CORP team has been busy hitting the Hill in opposition to this payroll tax provision in recent days. Late last week, the House Ways and Means Committee released its package of tax extenders, partially offset by an expansion of the S corporation payroll tax to firms in service industries.
While the S corporation community knew the payroll tax hike was under consideration, this was the first time we had seen an actual proposal and it took us a couple days to get a read on who would be affected.
The provision is much broader than advertised. It begins by defining the population of firms targeted — professional or personal services firms in the area of law, engineering, architecture, performing arts, etc. The Committee’s choice to create a new definition for “Professional Services Business” was, we believe, predicated on the desire to target financial services firms as well as athletes, movie stars and other highly compensated individuals who might use an S corporation to block payroll tax obligations.
Once you fall into the “Professional Services Business” pool of S corporations, the provision asks, is your firm the partner in a service partnership and does that partnership consume substantially all of the activities of the S corporation? This test is targeted directly at the “John Edwards case” where a successful lawyer used the S corporation to block payroll taxes on his legal fees. Our members have raised few concerns about this test.
The second test, however, is more troubling. It would apply to “any other S corporation which is engaged in a professional services business if the principal asset of such business is the reputation and skill of 3 or fewer employees.” It took us a couple reads to realize this provision is not nearly as narrow as it first appears.
First, the test is not limited to firms with three or fewer employees. Firms with numerous employees could be affected, as long as only three are “key.”
Second, “principal asset” does not mean their skill and reputation comprises the majority of the value of the firm. Instead, that asset just has to be bigger than all the other assets of the firm. So, a business at which the largest asset is equal to 10 percent of the firm’s value would be affected if the “skill and reputation” of three employees are worth 11 percent.
With that as background, here is a list of concerns we’ve shared with the Committee over their new, never-before-seen provision to tax service S corporations:
- The provision would require a “disqualified” small business to determine whether its principal asset is the “skill and reputation” of fewer than three employees. This would require every “disqualified” small business to get a valuation of each of its significant assets every year in order to determine which asset is its “principal” asset.
- The provision arbitrarily discriminates against small businesses. It taxes businesses with three key employees at higher tax rates than businesses that are identical in every respect, except they have four key employees.
- The provision tests for highly-skilled “employees” rather than shareholders. Why? Is there evidence that indicates that highly-skilled employees are underpaid by S corporations?
- The provision requires difficult legal conclusions about uncertain areas, such as whose asset is an employee’s “skill and reputation”– the employee’s? Or the company for which the employee works?
- The provision provides no definition of “asset”– it isn’t clear, for example, whether all of a corporation’s computers and furniture are aggregated into a single “asset” for purposes of determining the “principal asset” of a company.
- The provision would discriminate against family-owned S corporations by applying payroll taxes to family members not active in the business. This provision would reduce the ability of S corporations to raise capital from family members.
- And finally, how exactly does one go about establishing the value of “skill and reputation” of employees on a widespread basis? This, and the other undefined terms used in this provision are simply inviting litigation.
All of these technical challenges beg the question: What problem is the second test designed to solve? The first test, after all, captures the “John Edwards case” that everybody, including S-CORP, would like to address. What is the magic value of “three or fewer” employees? 60 90 percent of S corporations are owned by three or fewer shareholders. Is it just a money grab?
Beyond the policy, the lack of process or public review should be enough to bring about this provision’s defeat. No specific hearings on the proposal, no markups, no floor debate, not even a draft bill to comment on, and yet this $11 billion tax hike is supposed to be considered by the House and the Senate before the Memorial Day recess.
The IRS already has the tools to go after John Edwards and others like him. It has successfully litigated cases where taxpayers have taken compensation that was less than reasonable. Spicer Accounting Inc. v. US, 918 F2d 90 (9th Cir. 1990); Dunn & Clark, PA v. US, 853 F. Supp. 365 (D. Idaho 1994); Radtke v. US, 712 F. Supp. 143 (ED Wis. 1989) , aff’d per curiam, 895 F2d 1196 (7th Cir. 1990) Veterinary Servs. Corp., PC, 117 TC 141 (2001) . Veterinary Surgical Consultants, P.C., 117 TC 141 (2001) , aff’d, 54 Fed. Appx. 100, 2003-1 USTC B6B 50,141 (3d Cir. 2002).
We’re not in the business of proposing tax hikes on our members, but if the problem resides with single shareholder S corporations in the service sector, why not start with that population and whittle it down from there? And what about an employee threshold? Who is going to hire lots of people at market salaries in order to reduce their personal tax rate by a little more than 2 percent?
We understand Congress needs revenue to offset its priorities, but to try to raise $11 billion on the backs of closely-held businesses without having one public review of the policy strikes us as a little much. Take a little time, engage the public, and you might get a better product.
Extender Package Stalls in the House
On a related note, timing for consideration of the “extender plus” package is very much up in the air. It was supposed to go to Rules earlier this week with floor consideration today or tomorrow, but that might not happen.
Although members are concerned with the offsets in the package, it is the number of extraneous items and their cost to taxpayers that is slowing any progress at this point. In addition to extenders, the package includes a UI extension, Cobra benefits, the Doc Fix, and other expensive items. The size of the package is causing moderate members concern:
“I’m concerned about it,” said Sen. Ben Nelson, D-Neb. When combined with “emergency”-designated extensions of unemployment insurance and COBRA health benefits for laid-off workers, Medicaid assistance to states and perhaps Temporary Assistance for Needy Families funds, the unpaid-for cost of the bill could top $170 billion. “Obviously, my preference is to have offsets, and look hard at nonemergency issues. Everything can’t be called an emergency to avoid having offset requirements,” Nelson said.
Sen. Kent Conrad, chairman of the Senate Budget Committee, said Tuesday he has concerns with the size of a large tax and benefit bill Democratic leaders hope to pass this week, casting doubt on the chances of the legislation being approved. Mr. Conrad (D., N.D.) said the current net cost of the measure to public finances – $141 billion over a five-year period – was too high.
So the package is getting larger, but only those provisions extending tax benefits for families and employers are going to be offset, and those provisions will be offset with tax hikes on families and employers.
To put this discussion into perspective, the current extender package extends provisions that expired last year. The extension is only twelve months, which means Congress will have to come back later — most likely in a Lame Duck session — and pass another extension if all these tax provisions are not to expire at the end of 2010. The tax hikes, on the other hand, are permanent.
Groups targeted for tax hikes in this bill need to be wary. Taxwriters will be on the hunt for another $30 billion in just a few months, so any deal cut today will be revisited tomorrow.
Estate Tax Update
The inability of any estate tax proposal to garner 60 votes in the Senate is becoming increasingly apparent. There’s still a chance for a breakthrough, but time is getting short and opposition is getting more vocal.
As reported in numerous publications, estate tax negotiators have hit a wall in crafting a compromise plan that can pass. As Dow Jones reported last week:
Senators that want to reduce estate tax rates even further have in the past two weeks closed in on a compromise that would not add any more to the deficit, at least in the short-term, than Obama’s plan. The plan would start at Obama’s proposed levels in 2011, but gradually phase down to a 35% rate and a $5 million exemption level.
But Tuesday they said that a proposed compromise is in limbo. “Nothing is clear about how the estate tax will be considered,” said Sen. Jon Kyl (R., Ariz.), the lead Republican in the negotiations. “Last week I believed there was an agreement on what the details were going to be. That may not be the case now.”
“There’s no agreement on estate tax, neither on substance nor on process. None whatsoever,” said Senate Finance Committee Chairman Max Baucus (D., Mont.), who is one of two Democrats involved in the talks, the other being Sen. Blanche Lincoln (D., Ark.).
Meanwhile, the lack of progress and the short calendar is emboldening the opposition. According to CongressDaily:
That would be fine with Sen. Bernie Sanders, I-Vt., who said reverting to pre-2001 law would only affect about 2 percent of the nation’s estates. When asked about a plan to reduce the tax to 35 percent and lift the exemption to $5 million, Sanders replied: “I will do everything I can to stop that.”
CongressDaily goes on to quote another Senator as estimating that up to 80 percent of the Democratic conference is opposed to any sort of estate tax compromise. While he quickly backed off that estimate, anywhere near that level of opposition would doom an estate tax compromise this year and allow the pre-2001 rules to take effect beginning in 2011.
This stalemate also is blocking the Senate small business tax package, including built-in gains relief, from moving forward. The package has been negotiated between Finance Committee Democrats and Republicans and was ready to be marked-up last week until the estate tax roadblock emerged.
At this point, the path forward is unclear. Taxwriters could resolve their differences on the estate tax or they could agree to set that issue aside and let the small business package proceed (perhaps directly on the Senate floor). A third option would be to resolve nothing and let both estate tax relief and the small business package die. Let’s hope it’s not option three.