Congress is set to return for its lame duck session the week after next. With Thanksgiving in the middle and Christmas at the end, Congress has maybe three weeks to fund the government and figure out what to do with tax policy.

Before the election, we believed two outcomes were possible on extending the tax rates: either Congress adopts a one-year extension of everything (with some middle ground for the estate tax), or Congress does nothing and the new Republican House takes the issue up first thing in January.

The President’s original preference of extending only the middle-class tax relief does not enjoy majority support in the House and is not an option. His more recent offer of extending the upper income relief for one year and making permanent all the rest — so-called decoupling — has a better chance to pass, but we think it’s simply too complicated to construct and pass quickly. So the choice is between everything and nothing.

Our metric of which option might prevail was yesterday’s results — if Republicans had a big day, then the odds of Option 1 increased and action in the lame duck would be most likely. Well, Republicans had a big day and we now expect to see Congress and the Administration come together on a one-year deal before the New Year.

Why one year? Because the Administration does not want this issue to hang over into 2012 and their reelection. How certain are we? Not very — maybe two in three that Congress passes a one-year extension. There is still a serious risk that nothing gets passed and rates go up.

S Corporation Reform

Champions of S corporation reform had a mixed day yesterday. On the positive side, S-Corp champion Representative Ron Kind (D-WI) withstood a serious challenge and won reelection in western Wisconsin. Representative Kind was the lead sponsor of our S Corporation Modernization Act (H.R. 2910) this Congress, and helped shepherd through built-in gains relief this year. His cosponsor, Dave Reichert (R-WA), also survived a tough reelect up in Washington State. With the reelection of Representatives Kind and Reichert, S-Corp’s reform team remains intact in the House.

On the other hand, Senator Blanche Lincoln (D-AR) lost her reelect bid in Arkansas. Each election cycle seems to have at least one member who, despite representing their state well, loses out to the broader wave. In 2008, it was S-Corp champion Gordon Smith (R) who lost a close election in Oregon. This time around, it was Senator Lincoln. Lincoln was our lead sponsor in the past two congresses, spearheaded our Sting Tax success in 2007, and has been a tireless advocate for private businesses. Her leadership on these issues will be missed.

Another S-Corp Champion, Senator Chuck Grassley (R-IA) easily won reelection to the Senate. Senator Grassley was instrumental in moving built-in gains relief last summer — his five-year holding period became law this fall — and he partnered with Senator Olympia Snowe (R-ME) to defeat the ill-advised payroll tax hike last summer. Senator Grassley will be stepping aside from his position as Ranking Member on the Finance Committee, though he will remain a senior member of the Committee, and his replacement will be another S-Corp champ, Senator Orrin Hatch (R-UT). Senator Hatch has sponsored our modernization bill for over a decade, and we’re looking forward to his leadership on the Committee.

Improving the rules governing how S corporations are structured and operate continues to be the central role of the S Corporation Association and, with our remaining champions, we’re eager to build on this year’s successes and get the new Congress started off on the right foot

Macro Policy Outlook

It’s never too early to look towards the next election, and this cycle in particular could play a significant role in how Congress — specifically the Senate — acts over the next two years.

Our basic view is there will be three distinct entities vying for control over the next two years: the Republican House, a largely ungovernable Senate, and the Obama Administration.

The House is designed to be the body of the majority, and with a 20-plus seat advantage, future Speaker John Boehner (R-OH) should have a relatively easy time constructing and passing Republican-oriented legislation. On most issues, we expect the House to produce clear statements of policy consistent with their majority and the underlying political landscape.

In the Senate, on the other hand, two key factors stand out. First, the Democratic majority is reduced. They went from 60 to 52 or 53 seats in less than a year. Second, of the remaining Democratic members, more than 20 are up for reelection in 2012. Having that many members up for reelection at the same time is a challenge, and the combination of a small majority and lots of nervous members means that Majority Leader Reid has his work cut out for him. Given these challenges, predicting what legislation emerges from the Senate, and what alliances form to pass it, is simply beyond our forecasting ability. The Senate is a wild card.

We are also likely to see a high level of distrust between Senate Democrats and the Obama White House. The President’s policies — particularly the health care bill and his cap-and-trade efforts — played a significant role in Democratic losses, while successful Democratic candidates largely ran away from those policies, a trend that’s been noted up on the Hill. (West Virginia’s Democratic Senator-elect Joe Manchin literally shot a bullet through the cap-and-trade bill.) So for the next two years, the Democratic caucus will be made up of a handful of Senators who ran opposing the Obama agenda and a larger group of Senators in cycle and running similar campaigns. Under such circumstances, a stable alliance between the Obama Administration and the Democratic Senate is unlikely to emerge.

All of which suggests we’re going to have a three-headed government beginning next year, and two possible macro policy trends. One possibility is the tri-headed government proves unworkable and gridlock prevails. As we observed yesterday, gridlock is not our friend. Current law includes a number of negatives — expiring tax provisions, pending tax hikes, the growth of the AMT, costly 1099 reporting requirements, pending greenhouse gas regulations, etc.

If gridlock prevails, we will see higher taxes and increased regulation, so the business community loses.

The second possibility is that the pressures of deficits, a weak economy, and expiring tax policies will force the tri-headed government to come together and address these issues. That would mean legislation on spending and deficits, permanent tax policies going forward, and clarity on how the EPA is going to move forward (or not) on greenhouse gas regulation. With a divided government, any legislation in these areas inevitably means compromise. Given the alternative, however, a little clarity packaged in a mixed bag might be better than the status quo.

The President’s press conference today signaled more gridlock. It’s possible he was just avoiding negotiating with himself on taxes and health care, but at no point in the back-and-forth with reporters did he indicate a willingness to step back from his current policies. Time will tell, but the American people elected a divided government yesterday, and division is just what they might get.