In a capital-starved economy, what makes more sense than allowing firms access to their own capital? For one year beginning in 2011, hundreds of thousands of S corporations around the country will be able to do just that, thanks to the efforts of the S Corporation Association and its allies in Congress, particularly Senators Grassley, Lincoln, Hatch, and Snowe and Representatives Kind and Reichert.

On September 27th, President Obama signed into law the Small Business Lending Fund Act of 2010 (HR 5297). Among other business friendly provisions, the bill includes one of the S Corporation Association’s tax priorities, a reduction in the built-in gains holding period. The provision is for 2011 only, but it allows firms that converted as few as five years ago to sell appreciated assets without paying the punitive built-in gains tax.

This success builds on last year’s reduction in the holding period to seven years, and we hope it signals a move towards permanently reducing the holding period below the old ten-year requirement. Ten years is a long time, and in a world where capital is dear, it only makes sense for firms planning new investments to begin by accessing their own capital.


Latest on Tax Outlook

House Speaker Nancy Pelosi (D-CA) has lost control of the tax debate headed into the November elections. Last week, 31 House Democrats signed a letter supporting extending all the individual tax rates, including the top two rates. Then, 47 Democrats wrote Speaker Pelosi calling for keeping dividend and capital gains rates at their current 15 percent. As The Hill reports:

Forty-seven House Democrats have signed a letter calling on Speaker Nancy Pelosi (D-Calif.) to extend the current tax rate on capital gains and dividends. “By keeping dividends and capital gains tax rates linked and low for everyone, we can help the private sector create jobs and allow seniors and middle-class households to save and invest more,” the letter states. Under current law, beginning next year capital gains will be taxed at 20 percent while dividends will be taxed at ordinary income rates that go as high as 39.6 percent.

As a result, a majority of House members now support extending all the current rates, at least temporarily. How is it possible that an issue that’s been 10 years in the making is still unresolved eight weeks before the election? Keith Hennessey has a very good entry on his blog outlining the steps Congress took to get here. As Keith points out:

The sequence of events was:

1. The President picks a big fight on the tax extension and highlights the partisan split;

2. a handful of Senate Democrats signal they’re not onboard; (first warning)

3. the Speaker says “the Senate will go first;” (second warning)

4. the President doubles down on the fight and elevates the conflict by making it the centerpiece of his election-cycle argument;

5. the President’s just-resigned budget director guts the President’s argument in his first New York Times column; (third warning)

6. (same day as #5) the President proposes “new” policies that are ignored by both sides; (confusion reigns)

7. Members return from August recess;

8. 30 House Democrats bail on the President’s position; (final blow)

9. Senate Democrats delay the vote until after the election.

That’s not poor coordination, it’s a total absence of coordination. Going into a highly partisan conflict on the other team’s turf, you either make sure your team is unified first, or when you figure out they’re not, you concede or switch topics quickly. We have seen a strategy and an alliance slowly collapse over a several month period. I don’t understand how the blue team [Democratic] leaders could allow that to happen.

So that’s how we got here. How does the Speaker respond? Last month, we listed the possible outcomes of the rate debate. Congress could:

  • Extend all current tax policies (except the estate tax rules) for one or two years;
  • Extend just those policies benefiting families making less than $250,000; or
  • Do nothing and leave this issue to the next Congress.

The events of the last week have killed option two. There may be a way for the Speaker to move a middle-class-only bill through the House, but we are unable to think of how. There’s talk they may consider the bill under the Suspension Calendar, but suspensions need two-thirds support in order to pass, and the Speaker doesn’t control a simple majority on this issue. Once you lose the majority on an issue in the House, you generally lose.

Option one is becoming increasingly likely, but it would require the Speaker to allow a vote on blocking all the tax hikes when Congress returns in November. She may not control a majority on this issue, but she does control the floor. It would also require an emboldened Republican conference to accept a temporary fix to an issue they probably would like to fight next year.

So while “extending all” is moving up on the options list, we continue to believe the most likely outcome is that this issue will remain unresolved through the end of the year and would be the first order of business for the new Congress.


More on “Big” vs. “Small”

Meanwhile, the debate over how higher rates might impact business continues. On Meet the Press Sunday, Representative Chris Van Hollen (D-MD) made the following point about extending all the tax rates:

They have tried to mask this as an issue with small businesses. Well, it turns out that only 2 percent of small businesses are affected. And when you look at the definition of small businesses, you find that they’re big hedge funds, big Washington lobbying firms, KKR, Pricewaterhouse. Because, under the definition of tax code, anything that’s an S corporation qualifies. So I want Mike to tell us whether he really believes that KKR, whether Pricewaterhouse, whether those are the kind of small businesses that need help? Because that’s the folks that they’re trying to help out.

S-CORP ally and AEI economist Alan Viard warned policymakers about this argument earlier this month. As he wrote in an AEI research piece:

A common argument is that the high-income rate reductions lower taxes on small business. The valid form of this argument, recently explained by Kevin A. Hassett and myself, is that the rate reductions lower marginal tax rates on investment by all firms, including small businesses. Unfortunately, the more common forms of the argument adopt an exclusive focus on small business and obscure the growth implications.

To begin, the argument is often founded on the mistaken premise that small firms are inherently better than large firms, which suggests that the government should interfere with market forces to promote the former over the latter. In a previous Outlook, Amy Roden and I explained that firms of all sizes contribute to national prosperity and demonstrated that small firms do not play a disproportionately large role in job creation. By focusing only on small (more precisely, pass-through) firms, the argument ignores the adverse effect of letting the high-income rate reductions expire on investment by big business. The data cited above suggest that the affected high-income households finance a greater fraction of corporate investment than pass-through investment. The potential tax-rate increase on corporate investment is also larger, at least if the dividend tax cut fully expires.

While in the past we’ve disagreed with Alan on the job creating capabilities of smaller businesses, we agree wholeheartedly with him that allowing the rate debate to devolve into a fight over the size of the businesses affected is simply a distraction. This is a debate about jobs and not raising taxes on employers, regardless of how many people they employ.

On the question of large S corporations, the IRS does a nice job of breaking down the S corporation community by size and industry in its SOI reports. The most recent numbers can be found in the IRS data book while more in-depth figures date back to 2007. Here’s a quick profile we pulled from the numbers:

  • There are 4.5 million S corporations (2009);
  • The average S corporation has $1.5 million in revenues and $100,000 in income (2007); and
  • Assuming a wage of $40,000, the average S corporation has five employees (2007).

These are simple averages, but they provide a general sense of the S corporation world. In terms of revenues, the majority of S corporations can be found in wholesale and retail, followed by construction, manufacturing, and then professional services.

In short, S corporations are large and small. They are active in every industry and in every community, and they provide millions of much-needed jobs to families across the country — even the big ones.