Armed with nothing more than the better policy argument, team S-CORP successfully rallied business groups and our friends on the Hill to defeat a proposed $9 billion payroll tax hike on S corporations last week.

The proposal, included in a larger package of so-called tax extenders, would have applied payroll taxes to all the income of service-oriented S corporations if they met a couple of tests. As your S-CORP allies observed, the new tests envisioned were more complicated and less enforceable than current law, meaning we would have taken a step backward had Congress enacted them.

The biggest ally we had in this fight was Senator Olympia Snowe (R) of Maine, who took the Senate floor shortly prior to the key vote last Thursday and made the following comments:

Finally, I had suggested that the provision that imposed that $9 billion in additional taxes on our small businesses, or Subchapter S corporations, be removed while we work diligently on legislation to close existing loopholes in the law that have resulted in abuses. And last week, I was told these new taxes would, in fact, be removed. Yet, just last night, the tide turned once again, and I was informed they would in fact remain.

These are revenue provisions that had never been the subject of hearings, had never been seen by the public, and would significantly damage the business environment for businesses both large and small just as we ought to be creating jobs, not curtailing them. This egregious provision would harm millions of small businesses and their ability to create jobs.

Under Section 413, a new, burdensome payroll tax of 15.3 percent is imposed on S corporations on the dividend distributions paid to employee-owners, to family members who are shareholders or partners, and unbelievably – on retained earnings in the business when distributions are kept in the business for reinvestment. At a time of festering high unemployment, this is exactly the wrong prescription for job creation.”

In the end, Senator Snowe’s opposition combined with the opposition several other swing votes resulted in the failure of the overall bill and a respite for service sector S corporations. Exactly how long this respite lasts depends on many factors, and we do expect additional action on this front in the future.

As we’ve made clear, we don’t support using the S corporation structure to block payroll taxes. This practice is tax avoidance (not a loophole as is so often claimed) and the IRS already has the ability to go after shareholders using the S corporation in this manner. If the IRS needs new tools, then a simple rule is the new tools should be targeted at tax avoiders only, and they should be more effective and enforceable than current law. The tax hike defeated last week failed both tests.

Finally, Something on Expiring Tax Cuts

A friend of ours has taken to saying that Congress has a secret plan to raise taxes on the middle-class. What’s the plan? Do nothing.

Absent congressional action, the Bush tax cuts are set to expire at the end of the year, and a large majority of them are targeted directly at the middle class. Despite this looming tax hike, Congress has taken no concrete steps to extend them–no budget, no hearings, no markups, not even a whole lot of talk in the press.

This lack of action (or at least talk) appears to be ending this week. As CongressDaily reported earlier:

House Ways and Means Democrats are discussing a roughly $270 billion, one-year extension of the tax cuts enacted under President George W. Bush in 2001 and 2003 for everyone except households earning more than $250,000, or $200,000 for individuals, according to sources familiar with the discussions.

That cost includes a two-year “patch” for the alternative minimum tax, preventing more middle-class taxpayers from being ensnared when they file their 2010 and 2011 tax returns. Congress has not yet patched the AMT for 2010.

According to Democratic officials, House leaders have instructed Ways and Means Chairman Sander Levin to develop consensus among Democrats on the tax-writing panel, and based on early discussions, the one-year plan seems to be the most viable. But sources stressed that no decisions have been made, and that movement on the Bush tax cuts, which expire Dec. 31, could wait until September.

And DowJones:

House Democratic tax-writers are discussing a one-year extension of tax cuts for middle-income Americans, which would prevent a tax increase for most but put off long-term decisions until next year.

The extension through the end of 2011 would avoid a tax increase for married couples with income of less than $250,000, or individuals with income of less than $200,000. Democrats would also include a provision shielding most taxpayers from the alternative minimum tax in 2010 and 2011 under the option discussed by House Ways and Means Committee Democrats in a Tuesday closed-door meeting.

Those items together would add $270 billion to the deficit, said a House aide with knowledge of discussions. The aide said the one-year option did not include any proposal on the estate tax, which, if Congress does not act, will return next year to tax estate wealth in excess of $1 million at 55%. Also discussed were a two-year option to extend the middle-class tax cuts through 2012, or an option to make those tax cuts permanent.

Meanwhile, The Hill is reporting that any middle-class tax cut extension will not be offset:

Rep. Chris Van Hollen (D-Md.), the Assistant to Speaker Nancy Pelosi (D-Calif.), on Wednesday said dire budget predictions by the Congressional Budget Office will not alter Democratic plans to extend middle-class tax cuts enacted under President George W. Bush and not pay for their cost.

“Our plan is to continue with that portion of the tax cuts that provide relief to people under $250,000,” he said, adding that “not at this time” was there a plan to offset the cost of extending these provisions.

Van Hollen also said there is currently no plan to offset the cost of protecting the middle-class from the alternative minimum tax and extending the 2009 estate tax law.

“The economy is still climbing out of a ditch,” he said, adding, “The problem is if you suck that much money out of the economy at the same time you get an anti-stimulative effect.”

So where there was nothing, at least now there is talk. But don’t get too excited.  If there is an extension, it will be limited to taxpayers making less than $200,000, which means that Congress plans to raise taxes on everybody else. What impact would that have on the struggling economy? About one-third of all business income in the United States is taxed at the top two rates. A massive amount of other investment income is, too. You do the math.

Even a limited tax cut extension might not happen–Congress was supposed to deal with the estate tax last year, too. And what about the other chamber of Congress? All the talk this week has been limited to the House side.

Another S-CORP friend has repeatedly pointed out that the first approach House leaders take when addressing any policy challenge is pretending the Senate doesn’t exist. They then proceed from there. Just because the House may take action on stemming tax hikes in the next six months doesn’t mean they are coordinating with the Senate, or that the Senate can or will take similar action.

Even with a massive political football like middle-class tax hikes, with the current congressional leadership, you just never know…