Senate Democrats plan to advance a budget reconciliation bill in the coming weeks, but it will not include the $300-400 billion in Main Street tax hikes originally planned.

The decision to scrap the tax provisions – an expansion of the 3.8 percent Net Investment Income Tax and Loss Limitation rules – was made after Senator Joe Manchin presented Democratic leaders with a deal: pass a smaller bill without tax hikes now or continue negotiations into September with the hopes that the inflation and economic outlook improves.  As Yahoo reported:

Joe Manchin is forcing Democrats into a brutal choice: Take a deal now to lower the costs of health care premiums and prescription drugs, or try to negotiate a larger bill in September that includes climate and tax reform with no guarantee it will pass.

The West Virginia Democrat said Friday that he wants to see another month of inflation numbers before considering legislation that might increase taxes on some higher-income Americans and plow hundreds of billions of dollars into the energy sector. On Thursday Manchin “unequivocally” rejected July or August approval of Democrats’ proposed energy investments and tax increases in a meeting with Senate Majority Leader Chuck Schumer, according to a person briefed on the meeting.

Manchin made that offer after more than 200 trade associations – the entire business community really – came out in opposition to the tax hikes.

Confronted with a classic “bird in hand” scenario, it appears Senator Schumer is preparing a skinny reconciliation bill built around Medicare and ACA provisions:

…Schumer and other top Senate Democrats [are] also working on a reconciliation package…. The Senate parliamentarian is expected to hold a key meeting on Thursday with GOP and Democratic staff to review the Democrats’ Medicare prescription drug pricing proposal. The other big Democratic provision would provide two more years of premium support for Obamacare enrollees. 

This decision represents a huge victory for America’s Main Street employers.  After 18 months of being in the crosshairs, they can stop worrying about tax policy and go back to running their businesses. Between inflation, tight labor markets, and continued supply chain disruptions, they already have their hands full without Washington piling on.

The NFIB Small Business Optimism Index dropped 3.6 points in June to 89.5, marking the sixth consecutive month below the 48-year average of 98. Small business owners expecting better business conditions over the next six months decreased seven points to a net negative 61%, the lowest level recorded in the 48-year survey. Expectations for better conditions have worsened every month this year.

With the BBB behind us, what’s next for tax policy? Main Street should expect three distinct stages in the coming months/years:

Stage 1: Tax Extenders-Plus: With tax hikes off the table, businesses should expect an extender-plus package to be considered as part of a Lame Duck session this year.  This JCT report from January outlines all the possible extender items, plus several other items that might appeal to Congress at the end of the year:

  • The stricter rules around deducting research and development expenses, which went into effect at the start of this year, are likely to drive a lot of the action. Companies that could previously write off all their R&D expenses immediately now must amortize them over five years. As Senator Chuck Grassley recently told Tax Notes: “That provision on R&D expensing — that’s probably the thing that’s going to drive getting 25 extenders done or none of them getting done.”
  • Also in play is the Section 163(J) cap on interest deductibility. The amount of interest a business could write off was previously limited to 30 percent of its EBITDA, as of this year that cap applies just to EBIT, a much more stringent limitation, particularly for capital-intensive businesses like manufacturers.
  • Finally, with the economy slowing, some sort of recovery package may be considered either at the end of this year or the beginning of next. Congress usually adopts relief allowing businesses to more quickly write-off losses in these circumstances, but those provisions became an unexpected political football during the CARES Act debate.  Here’s hoping rational heads prevail in the next slow-down, and NOL and Loss Limitation relief resumes its traditional role as bipartisan recession relief.

So lots of items for a possible extender package.  Will it happen?  Hard to say.  Lame Ducks tend to over promise and under deliver which means the odds are against it, but there’s lots of motivated members and taxpayers out there too, so we will see.

Stage 2: Divided Government & Gridlock: Beginning 2023, Main Street can plan on divided government and gridlock for two years.  The House will almost certainly flip to Republican control next year – the evidence supporting Republican gains this year is historically compelling.  So might the Senate, although it’s a closer call.  Either way, we will have divided government where the chances of any new tax hikes being adopted are just about zero.  The business community already has its hands full, so gridlock should be a welcome source of stability, particularly on the tax front.  Focus on business and don’t worry about any tax changes.

Stage 3: Son of Fiscal Cliff:  Those folks who missed all the fun during the 2012 Fiscal Cliff will have a chance for a re-do in 2025, as nearly all the TCJA’s individual tax provisions, good and bad, expire at the end of that year. Exactly what Congress passes will depend on who controls the White House and Congress, but under almost any scenario, we see Congress taking some form of action at the end of that year. Otherwise, taxes will rise for families and businesses alike.

The most important tax issue for the pass-through business community is the 20-percent Section 199A deduction. S-Corp readers are well aware that 199A was enacted to establish rough parity between C corporations and pass-throughs. Our EY study from 2019 shows that absent 199A pass-throughs would face effective tax rates up to 13 percentage points higher than their C corporation competitors, so its expiration will destroy that parity.  You can bet we will be spending the next two year preparing the ground for a positive outcome in 2025.

Wrap-Up

S-Corp has won many victories in its twenty-five years but defeating the BBB tax hikes has to rank at the top. The BBB presented Main Street with a triple threat – higher taxes when they earned income, sold the business, and passed it on to the next generation.  It would have destroyed the prospects of many of these family businesses and made worse the economic consolidation already taking place in this country. If you care about Main Street, you should be rejoicing that the BBB tax hikes are behind us.

With that, it’s time to focus on what’s next, starting with a possible extender-plus package this fall and ending with the Fiscal Cliff taking place in 2025.  S-Corp is going to be engaged in all these fights, as well as the many other challenges that pop up along the way. We appreciate your support in defeating the BBB tax hikes, and we look forward to your continued support in the battles to come.