The conventional wisdom in the press is that the agreement on the fiscal cliff killed tax reform. By making permanent so many tax policies — including the AMT treatment and estate tax rules — the deal deprived policymakers of catalysts for doing something big on taxes later this year.
That view may prove correct, but there remain several good reasons to believe taxes will be a big part of the policy conversation moving forward, including:
- Debt Limit: The debt limit fight hasn’t been avoided, just delayed. Congress will need to raise the limit prior to the August break, setting up a redo of the 2011 negotiations that resulted in $2 trillion in deficit reduction over ten years.
- Budget Season: By delaying the debt limit fight, Congress put the focus back where it should be — on budgets and the long-term fiscal imbalance. The House, Senate, and White House will all need to produce their vision for federal spending and taxes this spring, helping to set the table for the debt limit fight to follow.
- Sequestration: The odds of sequestration will take effect as written beginning March 1st ($85 billion in total cuts this year with $43 billion from defense and $11 billion from Medicare) are rising every day. Republicans are determined to keep the focus on spending, and alternatives that replace some or all of the cuts with tax hikes stand no chance in the House. That said, one or two months of sharp cuts to defense spending may be enough to convince Congress that it needs to replace the across-the-board cuts with more targeted ones.
- The CR: And finally, Congress needs to extend funding for the government when the current continuing resolution expires on March 27th.
Congress will have to deal with each of these items, either individually or in some combination, before the start of summer, which begs the question: How does Congress get past all these fiscal hurdles without dragging tax policy into the discussion? Add in the fact that both the Ways and Means and Finance committees have made clear that reforming the tax code is a priority for 2013, and we’re confident that tax policy will be part of the mix one way or another this year.
What does that mean for S corporations? We see two distinct challenges moving forward.
The first challenge is to ensure that any broad-based changes to the tax code are a net positive for S corporations and other Main Street businesses. As our coalition letter from last year made clear, tax reform needs to be comprehensive, it needs to keep rates on corporate, individual, and pass-through income uniform and low, and it needs to continue to reduce the double tax on corporate income.
Any tax reform that claims to make American businesses more competitive will need to embrace those three goals.
Second, we need to continue to fight ad hoc efforts to raise taxes outside of tax reform. Congress is always hungry for revenues, and in recent weeks policymakers and left-leaning groups have released long lists of “revenue raisers” that include numerous threats to Main Street businesses, including:
- Increasing payroll taxes on S corporation income;
- Increasing the effective tax on inventories; and
- Hiking the estate tax by increasing valuations of family-owned businesses.
As long as federal spending is out of control, this thirst for new revenues will continue and will follow the predictable path from press conference to signing ceremony — target a group of taxpayers, marginalize their legitimacy, and then push to raise their taxes.
Which means the response to challenges 1 and 2 is the same — we need to educate policymakers and the tax press on the economic and social value of S corporations. From our past studies, we know that one out of four workers wakes up every morning and goes to work at an S corporation. We also know that S corporations are in every state, every district, and every industry. Meanwhile, other studies show that S corporations already pay a very high effective tax.
Add it all up, and S corporations are a key and vital part of the local employment base in just about every community in America. Far from being marginal actors in the economy, they are one of its cornerstones.
S-Corp Payroll Tax
Speaking of ad hoc efforts to raise taxes, the S corporation payroll tax hike is raising its head again.
In the past couple weeks, several left-leaning groups and policymakers have put forward wish lists of whose taxes to hike and by how much. Reports from the Senate Budget Committee Democrats, Citizens for Tax Justice (last year), and the Center for American Progress all encourage Congress to raise taxes on S corporations by making more of their income subject to payroll taxes.
Here’s the write-up from the Center for American Progress report:
Certain highly paid professionals sometimes take advantage of a tax loophole made infamous by former Speaker of the House Newt Gingrich (R-GA) and former Sen. John Edwards (D-NC). These professionals – lawyers, accountants, doctors, consultants, and entertainment professionals -form “S corporations,” whose profits are not subject to Medicare taxes and who characterize much of their income as profits of the business instead of salaries. Regular wage-earners can’t do this, and neither can the owners of other kinds of small businesses. Government watchdogs have flagged the S corporation loophole as an area of rampant abuse. Legislation introduced in the House and Senate in recent years would shut down this loophole, requiring these well-heeled professionals to pay their fair share into Medicare, which would raise $11 billion over 10 years.
Those who follow our efforts will understand that the issue before Congress is not one of loopholes but rather avoidance where the IRS has existing tools to fight it. The IRS already requires the owner/operators of S corporations to pay themselves reasonable compensation for their work at the business. Shareholders who underpay themselves in salary in order to avoid Medicare taxes can be and are successfully challenged.
For example, just last year the Eighth Circuit Court of Appeals ruled in favor of the IRS and against an Iowa CPA who was paying himself a minimal salary compared to his experience and efforts. According to the Court:
Here, the district court found that DEWPC understated wage payments to Watson by $67,044 based on the following evidence:(1) Watson was an exceedingly qualified accountant with an advanced degree and nearly 20 years experience in accounting and taxation; (2) he worked 35-45 hours per week as one of the primary earners in a reputable firm, which had earnings much greater than comparable firms; (3) LWJ had gross earnings over $2 million in 2002 and nearly $3 million in 2003; (4) $24,000 is unreasonably low compared to other similarly situated accountants; (5) given the financial position of LWJ, Watson’s experience, and his contributions to LWJ, a $24,000 salary was exceedingly low when compared to the roughly $200,000 LWJ distributed to DEWPC in 2002 and 2003; and (6) the fair market value of Watson’s services was $91,044. Based on the record, the district court did not clearly err.
So the IRS already has the authority and the tools to go after Gingrich and Edwards if they choose. Admittedly, these tools are “facts and circumstances based,” but so are the fixes proposed in Congress. The version that failed to pass the Senate last year is illustrative of the problem. For example, the proposal applies to:
Any other S corporation which is engaged in a professional service business if 75 percent or more of the gross income of such business is attributable to service of 3 or fewer shareholders of such corporation.
Exactly how is the IRS supposed to determine if 75 percent or more of the gross income is “attributable” to the “service” of three or fewer shareholders? Even if the test were made clearer, this standard might not bring in the revenue its authors claim. In the court decision referenced above, it’s doubtful the CPA would have tripped this test — according to the court record, he came nowhere near generating 75 percent of his firm’s gross revenues.
So the Senate was attempting to fix a problem by giving the IRS less effective tools than it already has, and this was going to raise $11 billion. Sure.
Which brings us back to the M.O. of tax-raisers listed in the first entry — identify a group of taxpayers, challenge their legitimacy, and then raise their taxes. They’ve spent the last decade trying to apply payroll taxes to more S corporation income. Too bad they didn’t spend more time getting the policy right.