The Ways and Means Committee Subcommittee on Select Revenue Measures heard from Members last week on the tax extenders they care most about. Given the relative dearth of legislative opportunities this year, there was lots of interest in the session and lots of member involvement. Twenty-seven Members showed up to state their case for the tax breaks they believe should be made permanent and would create jobs and help the economy.

From our perspective, they saved the best for last, as the final witness of the day was S-Corp champ Congressman Dave Reichert (R-WA), who made the case for the common-sense provision that reduces the holding period for converted S-Corporation built-in gains. He highlighted the bill that he introduced with Representative Ron Kind (D-WI) to help businesses access their own capital, especially in these times when business capital is much-needed and so hard to come by.

Here’s the case Representative Reichert made to the Subcommittee:

I know many Members will join me in expressing support for long-standing, “traditional” incentives like the research tax credit that help American businesses innovate and grow. But I want to emphasize today two extensions of current tax law that I authored that have a demonstrated ability to leverage private capital and create jobs: the renewable energy production tax credit (H.R. 3307) and the five-year holding period for built-in gains for small businesses organized as S corporations (H.R. 1478).

The reduced five-year holding period for built-in gains in small businesses organized as S corporations is another tax provision that leverages private capital and creates American jobs. This common sense measure that I authored as part of a broader package with Congressman Ron Kind (D-WI) enables S corporations to access their own capital sooner. An April 2011 study by Dr. Robert Carroll (Ernst &Young) found that businesses organized as flow-through entities account for more than half of all private sector jobs in the United States, and 56% in Washington State. One out of every four of these workers is employed by an S corporation.

Enabling scores of these businesses to continue unlocking their own capital sooner is one of many actions Congress can take to help small businesses access the resources needed to grow their businesses and create jobs. The holding period for built-in gains reverted to 10 years with the expiration of this provision in 2011 - meaning that if Congress fails to act, businesses that converted to S corporation status must wait a decade to access their own capital or face a punitive tax.

I am grateful that Subcommittee Chairman Tiberi cosponsored my S Corporation Modernization Act, and I would also like to submit for the hearing record a letter from 13 organizations representing millions of small businesses across America who support an extension of this provision.

Congressman Reichert’s testimony was reinforced by a letter signed by 13 business trade groups, including S-Corp, NFI, and the U.S. Chamber, arguing for a permanent extension of the five-year holding period. As the letter states:

Unlike public companies, these closely-held businesses have little or no access to the public capital markets. They rely on banks, they rely on relatives, and they rely on their own assets for investment and working capital. An overly long built-in gains tax exacerbates this disadvantage by preventing converted S corporations from putting the capital they already control to better use.

Many thanks to Congressman Reichert and the business groups for helping to bring this provision to the Ways and Means Committee’s attention.

More on the Payroll Tax Hike

When the Senate returns next week, it will consider the student loan bill that includes a $9 billion tax hike on S corporations.

The bill, S. 2343, was introduced last week and placed directly on the Senate Calendar without any consideration from the committee of jurisdiction. On Thursday night, Majority Leader Harry Reid made a motion to proceed to the bill and file cloture to end debate on the motion. The Senate will vote on that motion on Tuesday, May 8th. It takes 60 votes to close out debate, and while the student loan issue appears to have broad bipartisan support, few people think Majority Leader Reid has nearly that many votes on the bill to raise taxes by $9 billion on Main Street businesses.

Here at S-Corp, we are relieved the Senate is expected to reject the Reid payroll tax language. It’s bad policy put forward without any legislative review or history, and it shows. The minority staff at the Senate Finance Committee put out talking points Friday night to highlight some of those deficiencies, including this apparent drafting error:

An S Corporation is owned 1/3 by a father, 1/3 by his son, and 1/3 by his daughter. The father does not contribute substantial services to the business, but both the son and daughter do. The S Corporation has $900,000 of income. Under current law, for income tax purposes, $300,000 of income would be attributed to the father, $300,000 to the son, and $300,000 to the daughter.

However, for payroll tax purposes, under the Democratic proposal, the father’s $300,000 of income would be entirely attributed to the son and entirely attributed to the daughter. In other words, the son will have $600,000 subject to payroll tax and the daughter will have $600,000 subject to payroll tax. Therefore, a total of $1.2 million will be subject to payroll tax, even though S Corporation’s income was only $900,000. The father’s $300,000 of income would be subjected to payroll tax twice.

But there’s more. Due to the adoption of the Affordable Care Act, the father’s S corporation income is already subject to the new 3.8 percent investment tax starting next year. And the ACA raised the Health Insurance (HI) tax rate from 2.9 percent to 3.8 percent. So under the Reid bill, the father’s $300,000 in non-active S corporation income next year would be subject to regular income taxes (39.6 percent), plus the HI tax twice (7.6 percent), plus the 3.8 percent investment tax, for a total tax hit of 51 percent, all to close a “payroll tax loophole” on a guy who doesn’t work at the business and is earning a return on capital, not labor.

Another challenge highlighted in the minority talking points is the $250,000 threshold. This new threshold creates a couple of challenges. First, it creates a rate cliff for S corporation owners as their incomes approach $250,000. This cliff would not only include the extra HI taxes owed by the active shareholder on their S corporation dividends, but also HI taxes on the S corporation income of any related, non-active shareholders. As the minority talking points make clear, one dollar of extra income could result in tens of thousands in extra payroll taxes. Not exactly how you want to structure the tax code if your goal is simplification, job creation and economic growth.

Second, the threshold undermines the argument that the provision is just a “loophole closer.” If we are closing a loophole here, why do we need a threshold? Shouldn’t a loophole be closed regardless of the taxpayer’s income? The simple fact is that this isn’t a loophole, and the Reid bill will raise taxes on business owners already fully compliant with the law.

The argument for the threshold also isn’t helped by the fact that the most recent IRS enforcement in this area, Watson v. US, involves a case where the defendant had overall S corporation income below $250,000. The Eighth Circuit decision against the defendant teaches us a couple of things: (1) the IRS already has the tools in place to go after taxpayers who underpay themselves in order to avoid payroll taxes — its tax avoidance, not a tax loophole; and, (2) since the defendant’s income was less than $250,000, it shows that new Reid provision will be less than effective at going after future Watsons and other taxpayers abusing the S corporation rules.

The Reid payroll tax hike has many flaws beyond those listed above — it uses Medicare funding to pay for non-Medicare spending, it uses permanent tax hikes to pay for temporary spending programs, it applies payroll taxes to the return on capital as well as the return on labor, it replaces an imperfect but thoroughly vetted “reasonable compensation” standard with an even more imperfect and wholly untried “principal rainmaker” test, etc. — and it deserves to fail.

Just how to apply payroll taxes to S corporation income is a serious challenge and it deserves a serious discussion. We hope that discussion could take place as part of a larger debate over tax reform and the future direction of the tax code where a thorough review will be part of the process.