Last week we previewed the Midterm elections and shared our thoughts about how things will likely shake out. Today we’ll take a look at how those results will impact tax policy in the lame duck and beyond, with a focus on what it all means for the S corporation community.

Lame Ducks Tend to be Lame

Let’s begin with the bottom line – we don’t expect much from this lame duck.  There’s been lots of chatter about a litany of bills and other priorities that could move in the weeks following the midterms, but that always seems to be case and it’s rarely followed by any real results.

Why is that?  We can think of three reasons:

  1. Truly pressing issues would have been addressed already.
  2. Many members of Congress will have just lost their jobs and those remaining will be focused on the next Congress. Issues include leadership elections and committee assignments, and moving offices and hiring staff.
  3. When there’s a change in control, the incoming majority is unlikely to see an advantage to moving bills during their last days in the minority. That’s not true for all issues, but generally it’s the case.

This time around, we know we’ll have lots of outgoing members (record retirements), and a middle-of-the-road prediction of incumbents who lose adds another 25-35 departing members.  Coupled with our prediction of new majorities in both houses and you have a recipe for lots of turmoil and very little legislating.

Possible Lame Duck Items

That said, it is not impossible for something to happen, even something significant. Here’s our list of possible items, in order of their likelihood of enactment.

Government funding is first on the list.  Current funding runs out on December 16th and Congress is faced with three options – continue existing funding levels into the New Year with another Continuing Resolution (most likely), pass what’s called an Omnibus that includes new, updated funding levels for all the parts of government that remain unfunded (less likely), or a combination of the two (somewhat likely).

There’s also the National Defense Authorization Act, which the business community will oppose if it continues to include the harmful ENABLERS Act that was snuck into the House bill at the last minute. The NDAA has been adopted every year for the past zillion years or so, rain or shine, so expect this to be on the floor in November and remember to read the fine print. As with the controversial Corporate Transparency Act two years ago, lots of unrelated items catch a ride on the NDAA, not all of them good.

There’s also a pending sequester which doesn’t seem to be getting sufficient attention.  Medicare payments face a 4-percent cut beginning in 2023 unless Congress acts to prevent it.  Congress has blocked sequesters in the past, but this time the PAYGO cut is the result of the increased deficit under the American Rescue Plan, so it’s carrying all sorts of baggage. The cuts have been postponed several times already and another postponement is likely, but they certainly complicate things, particularly as the chronic deficit and rising debt payments grab more attention.

On the tax front there are lots policies being promoted, including:

  • Section 174 which, as of the start of this year, requires companies to amortize – rather than fully expense – their research and development costs.
  • Similarly, a more stringent cap on interest expenses under Section 163(j) also went into effect in 2022. As you can imagine, there is a sizeable coalition of businesses (which S-Corp is part of) pushing for retroactive relief, or at the very least more favorable treatment of these expenses going forward.
  • There’s also the perennial issue of tax extenders; this JCT report from January is a good reminder that there’s no shortage of expiring tax provisions – each with their own constituencies on Capitol Hill – for Congress to address.
  • On the individual side, Democrats are still eying an extension of the enhanced Child Tax Credit, which was expanded as part of the 2021 covid relief bill and allowed to expire a year later.

Republicans are a strong favorite to take at least the House, so extending the credit is a long shot. However, Senator Mitt Romney has kept the issue alive by introducing his own plan to reform the provision, and Democrats may use it as a bargaining chip in negotiations over the business provisions above.

Other possible agenda items include the retirement-focused “SECURE Act 2.0,” trade adjustment assistance, Electoral Count Reform Act, Ukraine aid, and a permitting bill backed by Senator Joe Manchin. This is the bill Senator Manchin negotiated with Senator Schumer in exchange for his vote on the Deficit Reduction Act.  It has yet to pass the Senate (and may not) and if it does, it faces a strong challenge in the House.  That said, there’s lots of bipartisan support for increased domestic production and with rising energy prices playing a big role in the elections, who knows?

Could a package that includes spending, tax, and the Manchin permitting bill come together? Anything is possible, but we think Congress does the minimum here and then adjourns for the Holidays.  That means a CR into 2023, another PAYGO postponement, and an NDAA that includes non-controversial riders only.

New Congress

Assuming our election predictions play out, S corporations and the rest of the Main Street business community can expect divided government and a high degree of gridlock for the next two years. And while we expect both houses to flip, gridlock only needs the House to flip, an outcome the betting markets see as a virtual lock.

Gridlock means the chances of new tax hikes being adopted are just about zero. The business community has its plate full with rising prices, tight labor markets, and ongoing supply chain challenges, so gridlock should be a welcome respite, particularly on the tax front. For the first time in years, business owners will be able to ignore pandemics and devastating tax hikes and focus on running their companies instead.

Beyond gridlock, we see two major trends developing. The first is the reemergence of deficit politics.  The deficit has come down from its highs during the pandemic, but the core deficit remains above $1 trillion annually and it just goes up from there.  Meanwhile, higher interest rates mean the cost of servicing the debt is going to balloon.  Both parties did a good job of ignoring deficits over the past decade, but we’re not sure that will be possible in the coming years.  The budget numbers coming out of the CBO are just too scary.

These factors become even more important within the context of the debt limit, which is expected to be reached sometime in mid-2023. Battle lines are already being drawn – some Democrats recently called for doing away with the spending cap, while Republicans have signaled they plan to use it as a means of getting spending levels under control. With the potential for default on the table, we expect this fight to be one of the more contentious aspects of the next Congress.

Second, the battleground for the next two years should shift from legislation to investigations, executive actions and nominations, especially if the Senate flips. Gridlock means Congress will be unable to get its legislative priorities signed into law, and that the Biden administration will have to resort to non-legislative options if it wants to get anything done.

For pass-throughs, that means the policy risk shifts from the Ways and Means and Finance committees to the Office of Tax Policy over at Treasury.  We’ve seen this challenge in the past with the proposed Section 2704 regulations and other executive actions, so we’ll have to be on our toes.

Post-2024

Post-2024 is when the policy landscape will become especially challenging for pass-throughs, as the TCJA’s individual tax provisions are set to expire at the end of 2025, including:

  • The Section 199A pass-through deduction;
  • The lower individual rates, including the 37 percent top rate;
  • The increased child tax credit;
  • The employer credit for paid family leave;
  • The Work Opportunity Tax Credit;
  • The increased standard deduction;
  • The SALT deduction cap; and
  • Many other provisions.

As you can see, it’s a veritable fiscal cliff all targeted at individuals and pass-through businesses, much as we saw at the end of 2012.  That cliff was resolved when Senator McConnell and Vice President Biden successfully worked out a compromise that mitigated the most harmful aspects of the cliff.

Could we see another successful negotiation this time around? Ensuring a positive result in 2025 is going to be S-Corp’s primary focus moving forward.  The lower top rate and 199A deduction were 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 well above those paid by their C corporation competitors. Estimates from Treasury and the CBO say the same thing. The expiration of Section 199A will destroy that parity and make it all but impossible for millions of S corporations to stay competitive.

Exactly how Congress responds to the fiscal cliff will depend on many variables, including who controls the White House and Congress following the 2024 elections.  But under any scenario, Congress will need to take action in 2025 to address the expiration of these provisions.  S-Corp’s job will be to ensure those actions are fair to individually- and family-owned businesses, and that discussion starts right now.