We’ve had numerous conversations in the past couple of weeks with S corporation owners about the tax outlook for the next couple of years, and it’s becoming apparent that the S-Corp community is underestimating the threat of higher tax rates on the horizon. With that in mind, here’s our best assessment of what to worry about, and when to worry about it.

First, in case you have not heard, all the major tax relief provisions enacted since 2001 will expire at the end of 2010 unless Congress acts to extend them. For S corporations, that means higher tax rates on your business income. The top rate will revert back to 39.6 percent, while all the other rates will rise as well. It also means higher tax rates on your investments. The capital gains rate will revert to 20 percent, while the tax on dividends will return to 39.6 percent.

Second, proposals to eliminate the AMT currently include the provision of a 4 percent surtax applied to the adjusted gross income over $150,000 for individuals and $200,000 for couples. This surtax would apply to wages, capital gains, dividends, and flow-through business income alike.

Third, both Congress and the Treasury Department are actively looking at a budget-neutral reduction in the corporate income tax. What this means in general terms is to lower the marginal tax rate on C corporations – currently 35 percent – by broadening the tax base on which it is imposed.

What sort of base broadening are they looking at? Eliminating the R&E tax credit, the manufacturing deduction, LIFO accounting rules, ESOP rules, etc. For C corporations, the trade-off would depend on their particular profile. Generally speaking, corporations with high effective tax rates would benefit, those with low effective rates would not. For S corporations, however, there is no upside. S corporations take advantage of all these tax benefits and will face higher effective tax rates if they are eliminated.

What’s the worst case scenario?

  • Congress allows the lower income tax rates to expire in 2011;
  • Congress imposes a new, 4 percent surtax on all income above a certain threshold to pay for eliminating the Alternative Minimum Tax;
  • Congress cuts C corporation rates and broadens the business tax base by eliminating tax provisions used by C and S corporations alike;
  • Congress expands the application of Social Security and Medicare taxes on S corporation income; and
  • Congress, as part of a Social Security fix, repeals the current income cap on Social Security payroll taxes.

For an S corporation whose shareholders pay the top rate, the net effect of these five tax events – which are either already included under current law or have been proposed by senior policy makers in Congress and Treasury – would raise the top potential tax rate on some S corporations from 35 percent to 58.9 percent!

That’s obviously the worst case scenario, and we’re not predicting that outcome. But all five of those changes to the tax code are being actively considered and some are more than likely to become law between now and 2011.

Do we have your attention?

Estate Tax Hearing in Senate

Warren Buffet will headline a hearing in the Senate Finance Committee next week on the future of the estate tax.

Mr. Buffet is the second wealthiest advocate of the estate tax. Bill Gates, of course, is the first. Both gentlemen have argued strongly in favor of retaining a significant tax on estates when people die, yet both have committed to donate most, if not all, of their personal wealth to the Bill & Melinda Gates family foundation, thus avoiding paying the estate tax.

As S-Corp readers know, the current estate tax rules are in flux over the next couple of years. The exclusion will rise from $2 million in 2008 to $3.5 million in 2009 with a tax rate of 45 percent that year. The tax goes away entirely in 2010, but then returns to its former glory of a $1 million exclusion and a 55 percent top tax rate the following year.

So, if Congress does nothing, the estate tax will revert back to its old, miserable self in the year 2011.

Odds are that Congress will take some form of action between now and then. Even Senator Clinton has endorsed making permanent the 2009 rules as part of a broader savings package. When, how, and what actions are taken, however, remains very much up in the air.

The small business community will be represented at the hearing next week. We’ll let you know who the rest of the witnesses are when they are announced.