With the Republican convention behind us and the Democratic one this week, we thought it would be worthwhile to assess what the business community can expect on taxes in the next six months. We break the outlook into three buckets:

  1. First, the need to extend the tax policies set to expire on January 1;
  2. Second, the need to make more fundamental changes to the tax code; and
  3. Third, what to do about those pesky tax “extenders?”

2001 & 2003 Tax Cuts

Bucket one is easiest, since both sides have outlined their positions. The Republican House adopted legislation to generally extend all the 2001 and 2003 tax policies for one year (together with expedited consideration of broader tax reform). One big deviation from previous Republican actions was the decision to extend current estate tax rules ($5 million and 35 percent top rate) rather than the repeal included in the original 2001 legislation.

Senate Democrats countered with legislation (which failed to muster the necessary 60 votes) to extend the middle-class portions of the 2001 and 2003 tax relief only. Investors, business owners, and income-earners making more than $250,000 ($200, 000 for single filers) would see their taxes go up. An exception in the Senate bill was the dividend rate, which would rise to 20 percent rather than the 39.6 percent rate called for under current law. Also, current estate tax rules were not extended, meaning the top rate would revert back to 55 percent next year coupled with a lower, $1 million exemption.

(Neither the House nor the Senate bill addressed the pending new 3.8 percent tax on investment income enacted as part of the health care reform, by the way.)

As to the outlook, the odds of either side prevailing in this fight depend heavily on the election outcome. The election won’t change any votes before next year — the President and Congressional leadership will stay the same — but moral authority plays a key role in moving legislation in lame duck sessions, so, if either side can declare a conclusive electoral victory, their respective position will gain momentum. That’s the positive outlook for action.

Inaction is also possible, however, and should be taken seriously. Several Senate Democrats are already on record arguing against taking any action this year — they say the fiscal cliff is more of a fiscal slope and that there will be time to address these issues in early 2013. Meanwhile, it’s difficult to see how House Republicans accept the Senate position and proactively vote for legislation that raises tax rates on anyone in this political and economic environment.

It’s also difficult to see how President Obama pivots off his current position and signs into a law a comprehensive extension. Finally, the inability or unwillingness of Senate Majority Leader Harry Reid to successfully move large, complex bills in the Senate is a particular challenge and should not be discounted.

For those reasons, we believe a Republican victory in November will signal that Congress will adopt something very close to the House bill — a one-year extension of everything coupled with some sort of expedited reform process — or, if the Senate and President stand firm, do nothing at all. If Democrats prevail, then the likely outcomes shift to either the Senate-debated position of extending just the middle-class relief or, if the House refuses to go along, nothing at all. So, regardless of who wins in November, there’s an even chance nothing gets done.

Additional variables that could affect the outcome include the pending sequestration cuts to defense and the strength of the economy. The worse the economy does, the more likely it is that Congress takes action, and vice versa. Meanwhile, the push by hawks and conservatives to stop the pending cuts to defense could result in them giving in other areas, including tax policy. Something to keep an eye on.

Tax Reform

Bucket two includes tax reform or changes to the tax code broad enough that they look like tax reform. We believe there’s a good chance Congress will act on such a package beginning early next year for the following reasons:

  • It will need to raise the debt limit (again);
  • There’s broad agreement that the deficit needs to be addressed;
  • There’s agreement that our corporate rate is too high; and
  • The annual game of extending all these tax provisions, including rates, the AMT patch, estate tax parameters, and traditional extenders is simply unsustainable and needs to end.

Put another way, Congress will need to raise the debt ceiling sometime early in 2013. To get the House on board, significant spending cuts will need to be part of the package, just like in 2011. To gather additional support, particularly in the Senate, taxes will also need to be part of the package. This tax package could be budget neutral, or it could raise significant levels of revenue. The elections will largely determine that mix.

Let’s say the President and Congressional leaders agree to raise the debt limit coupled with $4 trillion in deficit reduction over the next ten years. An Obama Administration and Democrat-run Senate might seek a 50-50 package of spending cuts and tax increases. A Romney Administration coupled with a Republican Senate might shoot for 100 percent spending cuts. Compromises necessary to move the package through the Congress under either scenario would argue that the final package will fall somewhere in between.

What sort of base-broadening might apply? Likely groupings include:

  • Previously targeted business tax items like LIFO, Section 199, and carried interest;
  • Traditional extenders that fail to gain sufficient support; and
  • Individual tax expenditures, including at least some portion of the exemption for employer-provided health insurance.

So, broad tax changes are likely to be on the table in 2013. A revenue-neutral package would broaden the tax base by eliminating certain tax expenditures and unpopular provisions and use all those revenues to cut rates, while a tax-increasing package would do the same, but cut rates to a lesser degree. As long as the House remains in Republican hands, a package that actually raises headline rates is highly unlikely.

Could Congress get through 2013 without considering broad tax legislation? It’s unlikely but possible, particularly if the Senate remains under Democratic control. The Senate has refused to act in other critical areas in recent years, like doing a budget. But just as the debt ceiling fight forced the Senate’s hand in 2011, we expect the same dynamic to play out in 2013. A budget resolution is optional; raising the debt ceiling is not.

Tax Extenders

Bucket three is the large list of tax extenders, many of which already expired at the beginning of the year. Both the Ways and Means and Finance Committees have taken action to define and adopt a package of tax extenders in recent months, but the ultimate outcome remains unclear.

Just prior to the August break, the Senate Finance Committee adopted legislation to extend a package of expired or expiring tax extenders through 2013. The $205 billion package includes a two-year AMT patch together with an extension of the state sales tax deduction, the higher Section 179 expensing amounts, the R&E tax credit, and the energy production credit and other energy incentives, among other items. Importantly for Washington Wire readers, the package also extends built-in gains tax relief and the basis adjustment for S corporations making charitable contributions of property. The Committee report and legislative language were released last week.

In a foreshadowing of the fight to come this fall, Committee leaders noted that their extender package deleted 20 provisions from extender packages of prior years, while several dissenting Republicans argued that the Committee should have gone further and that they look forward to further reducing the list as part of comprehensive tax reform. Senate leaders are hopeful to consider this legislation on the Senate floor in the few remaining legislative days before the November election, but it’s a full schedule already with only a few days of session.

On the House side, the Ways and Means Committee began their examination of tax extenders back in April, when members had the opportunity to advocate on behalf of their favorite extenders. In June, a panel of tax experts testified on which is the best framework to test each extender provision and eliminate those that fall short. It is unclear if the Select Revenue Subcommittee will hold another hearing in September, but Subcommittee Chairman Pat Tiberi (R-OH) was reported as noting that the House will not act on its version of an extender package until after the November elections, not before.

At that point, the tension between considering an extenders package separately this year or rolling these decisions into a broader tax reform package will have to be addressed. Given that Congress also will face the broader issues of the 2001/2003 tax cuts, sequestration cuts, the FY2013 appropriations process and the rest of the congressional kitchen sink, there’s not a lot of time and continued broad disagreement over direction.

For that reason, we believe it is fifty-fifty that Congress acts on extenders this year, with success most likely tied not to policy, but rather to whether Congress is able to move on some of these other fiscal matters. Movement in those areas would suggest an agreement over extenders is also possible, while a stalemate on the 2001/2003 cuts, spending and sequestration might bleed into the extender debate.

Just to be clear, this is our outlook, but it’s not our preference. Here at S-CORP, our fingers are crossed that Congress returns after the election and resolves all of these critical tax questions. For the business sector, action and clarity are better than inaction and uncertainty, so let’s hope this year’s lame duck session does not live up to its name and is instead positive and productive.