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Main Street Tax Certainty Act
Good news for Main Street! Long time S-Corp champion Senator Steve Daines from Montana plans to introduce his “Main Street Tax Certainty Act” later today. Cosponsored by more than a dozen of his colleagues, the bill would prevent rate hikes on America’s individually and family-owned businesses by making permanent the Section 199A 20-percent deduction. This deduction was created by the Tax Cuts and Jobs Act but is scheduled to sunset at the end of 2025.
The introduction of this legislation was widely anticipated in the business community, with more than 140 trade associations representing millions of Main Street businesses, including NFIB, the National Restaurant Association, and the American Farm Bureau Federation, adding their names to a strong letter of support. As the letter states:
Individually- and family-owned businesses organized as pass-throughs are the backbone of the American economy. They employ the majority of private-sector workers and represent 95 percent of all businesses. They also make up the economic and social foundation for countless communities nationwide. Without these businesses and the jobs they provide, many communities would face a more uncertain future of lower growth, fewer jobs, and more boarded-up buildings.
Despite this, Section 199A is scheduled to sunset at the end of 2025, even as the businesses it supports continue to recover from the COVID-19 pandemic and the price hikes, labor shortages, and supply chain disruptions that followed.
199A permanence is necessary to balance out the tax treatment of pass-through businesses with the lower, 21-percent tax rate paid by C corporations. As our work with EY comparing effective rates demonstrates, absent the 199A deduction, pass-through businesses would be subject to tax rates nearly one-third higher than comparative C corporations.
Making 199A permanent has implications for jobs and growth too.. At a time when businesses of all sizes are confronting rising prices and interest rates, supply chain disruptions, and a possible recession later this year, ensuring that these businesses are not going to see higher rates in the future will help them plan for growth with more certainty. As the letter notes:
Making the Section 199A deduction permanent will help Main Street during this very difficult time, leading to higher economic growth and more employment. Separate studies by economists Barro and Furman, the American Action Forum, and DeBacker and Kasher found that making the pass-through deduction permanent would result in significantly improved parity and lower rates for Main Street businesses.
So congratulations to Senator Daines and his cosponsors on the bill’s pending introduction. This legislation is necessary for Main Street businesses and the communities they serve, and we look forward to working with him and our other allies in Congress to see it enacted.
A Post-Disinflationary World
Today’s meeting between Congressional leaders and the President is the first of many to come in what might be termed the post-disinflationary world.
Interest rates peaked at 16 percent in the early 1980s and, following the Volker rate hikes and a nasty recession, the US embarked on an unprecedented 40-year disinflationary period where rates went from record highs to record lows.
Well, that’s over. Rising prices and record deficits are back and, absent a change of course, they are not going to get better. Hence the importance of today’s meeting.
Debt and Interest Rates
The debt situation is not good. Debt held by the public is right at 100 percent of our GDP and scheduled to grow sharply in the coming decade, up to 118 percent by 2033, which is right about the time the Social Security trust fund runs out of money. Meanwhile, the cost of interest on that debt is growing even faster, as rising interest rates compound the effect of rising debt levels.
The debt limit standoff is not helping. Last week’s Treasury auction of 30-day notes that mature after the current debt limit deadline demanded a record rate of 5.84 percent. It’s difficult to conceive of rates that high on short-duration bonds given that just a few years ago, 30-year mortgage rates were less than 3 percent.
We also need a new way to describe the inverted yield curve. The nearly 200-basis-point differential in yields is unlike anything we’ve seen in the past.
Can Congress use the next decade to constructively address our fiscal imbalance and the pending bankruptcy of Social Security?
Deficit Politics
What’s interesting politically is that when interest rates were high and monetary policy was tight, the deficit had some political punch. Voters – not all but some – voted based on the fear that unchecked deficits threaten our future. They could see how federal deficits impacted them directly through higher borrowing costs and taxes.
That potency went away with the financial crisis, as the monetary and fiscal response to the collapse of the mortgage markets was so massive it rewrote the books on what was possible. And it stayed away as we spent the next ten years not raising rates, not reducing the Fed’s balance sheet, and not cutting deficits, all without any apparent repercussions. The more the budget scolds warned about deficits and rising prices, the lower prices went. It is hard to be Chicken Little when the sky’s not falling.
But now the sky is falling. We have ten years to get our budget house in order. Expect to see deficits and rates take center stage again. From our perspective, today’s meeting is the first to test the resolve not of those who want to address the challenge, but those who deny there’s anything to worry about. Whatever cautionary tale is the opposite of Chicken Little, that’s where we are at.
Debt Limit
Where do things stand? House Republicans defied expectations two weeks ago and successfully adopted a package to 1) raise the debt limit sufficiently to keep things running for another year, and 2) reduce the deficit by nearly one-half trillion dollars though a package of spending caps, recissions of unspent COVID funds, and repeal of the electric vehicle tax credits from the Inflation Reduction Act. (There’s been lots written about just how expensive those credits will be – here, here, and here – way more than Congress originally estimated.)
The Administration, on the other hand, has repeatedly called for adopting a clean debt ceiling increase, arguing that the country’s finances should not be held hostage to a procedural vote. As White House Press Secretary Karine Jean-Pierre put it:
Business leaders and economists have warned that the threat of a default risks the livelihoods of American small businesses, retirees, and working families and would hand a massive win to China — and recent events underscore the need for Congress to address the debt limit as soon as possible. It’s time for Republicans to stop playing games, pass a clean debt ceiling bill, and quit threatening our economic recovery. The President welcomes a separate conversation about our nation’s fiscal future.
If we are right that deficit politics have regained their potency, then the fact that the House successfully passed a credible deficit reduction package increases the odds the ultimate package will include deficit reduction provisions. Survey results from the Winston Group back this up:
“Similar to what we saw in March, 48% of voters believe the President should negotiate with Congressional leaders while only 14% support the President in refusing to negotiate and insisting on a “clean increase” without conditions.”
The ball now is in the Senate’s court and all eyes are looking to the White House to see what President Biden will support.
Implications for S Corporations
For the business community, the challenge is clear. We have a ten-year window to address this and the earlier Congress acts, the less pressure there will be to raise taxes. In an environment where tax policy is driven by a misguided desire to target large employers and family businesses, there’s never been a more important time to get our fiscal house in order. A clean debt limit might make Wall Street feel better, but it only makes our ten-year challenge worse.
Talking Taxes in a Truck Episode 26: “Testifying Ain’t Easy”
Fresh off of her triumphant visit to Capitol Hill we’re joined by Lynn Mucenski-Keck, an S-CORP Advisor and Principal at top-25 public accounting firm Withum. Lynn recaps her appearance before the House Small Business Committee, including the specific tax provisions discussed, her back and forth with some of the panel’s members, and her thoughts on the whole experience. Later we discuss IRS funding, advice for aspiring CPAs, and how Artificial Intelligence might shape the accounting profession in the years to come.
This episode of the Talking Taxes in a Truck podcast was recorded on April 21, 2023, and runs 27 minutes long.
S-CORP Testifies
The S Corporation Association took center stage on Capitol Hill yesterday at a Tax Day hearing before the House Small Business Committee.
Lynn Mucenski-Keck, an S-Corp Advisor and Principal at the national accounting firm Withum did a great job representing the pass-through community at the hearing focused on business tax issues and the impact they have on the small business community.
As S-Corp readers know, Lynn is a long-time advocate for, and prolific writer on good tax policy. She is also a past (excellent) guest on our “Talking Taxes in a Truck” podcast, raising awareness regarding the dangers posed by the now-defunct Build Back Better Act.
You can read her full testimony here but from its beginning, Lynn focused on the high notes of S-CORP advocacy:
While business owners understand the need to pay their “fair share” of federal income taxes, there is an overriding concern that coupling an already expanded tax base with the proposed increases in tax rates could cause a crucial tipping point where businesses are no longer be able to invest back into the economy and secure growth. The significant increase in federal tax payments will continue to cause negative effects on savings, investment, and entrepreneurship that could ultimately have a much broader impact on the United States economy. The challenge for Congress is to determine what is indeed a “fair share” of taxes while not negatively impacting a teetering economy and exhausted business community.
Lynn went on to highlight several recent changes to the tax code that hamstring Main Street businesses, including the cap on interest expenses, the punitive capitalization regime for research and development costs, and the tiered decrease of bonus depreciation.
Starting with Section 163(j), which limits the amount of interest expense businesses can write off, Lynn’s written testimony shows how the more stringent cap – which went into effect this year – coupled with higher interest rates can severely limit small business’ access to much-needed capital:
As we pointed out last week, the pain is even worse for businesses going through a rough patch, as any decline in revenue necessarily increases the bite of the cap.
Another change Lynn highlighted was the requirement that companies amortize their research and experimentation expenses over five years, rather than write them off immediately. Here’s how she put it:
For the 2022 taxable year, domestic R&E expenditures are not only required to be amortized over a 5-year period, but taxpayers can only begin at the midpoint of the taxable year, resulting in a 10% deduction…This is in drastic contrast to many OECD countries that provide for a “super-deduction,” allowing businesses an additional fictitious deduction for eligible research expenses.
Finally, Lynn emphasized the importance of the 199A small business deduction and the need to make it permanent:
If taxpayers are no longer allowed the pass-through deduction their effective tax rates will increase by as much as 7 percentage points. For small business owners who are immediately paying tax on their earnings (though not necessarily receiving a distribution of the cash from the pass-through entity), a 7 percentage point increase in an effective tax rate is severe. In addition, the original intention to provide some equality between small business owners and C corporation would no longer exist. I strongly encourage the committee to remember the reasoning for the pass-through deduction implementation and continue to ensure that pass-through businesses can retain this benefit to ensure closer parity to C corporations.
Witnesses (also members of our Main Street Employers Coalition!) Warren Hudak of NFIB and Russell Boening of the Texas Farm Bureau, an affiliate of the American Farm Bureau, also focused on the threat posed by the tax policies included in the President’s recent budget and how they move in the wrong direction.
The hearing was standing room only and included more back-and-forth than usual for these types of meetings, signaling the importance of this topic and the seriousness of the debate. This exchange between Lynn and Ranking Member Velazquez at 1:12:00 in the hearing is a likely precursor of the debate to come.
Yesterday’s hearing in the House of Representatives is the first of what we hope and expect will be many meetings raising awareness of the challenges faced by the Main Street employers and how Congress and tax policy can play a role in helping them succeed and grow. More to come.
IRS Plan Light on Details
Last week, the IRS released a 150-page document outlining how it will spend some $80 billion in new funding authorized in the Inflation Reduction Act. The good news is that the report places a heavy emphasis on improving customer service. That includes processing returns faster, increasing the number of forms that can be filed electronically, improving its telephone service, and other important steps. It also includes a host of new initiatives and milestones designed to ensure those objectives are met.
Beyond that, however, the plan is positively obtuse when it comes to “enforcement activities” or how the agency will leverage the new funding to bring in additional tax revenue. The basic premise behind the funding boost was that more enforcement dollars would allow the IRS to more effectively chase down tax cheats, yielding $180 billion in new revenue according to Congressional scorekeepers.
How many more auditors will the IRS hire? The report doesn’t say, which is odd given it is the most contentious aspect of the funding increase. As others have pointed out, a document released by Treasury last year projected that the new funds would enable the IRS to hire an additional 87,000 employees by 2031, with most of those new hires working on enforcement.
Treasury pushed back, arguing that many of these new employees would simply replace retiring ones, and claiming that the actual increase in workers would be just 25 or 30 percent. That estimate, however, is inconsistent with the Congressional Budget Office’s analysis, which forecasts a doubling of the workforce:
Spending would increase in each year between 2021 and 2031, though the highest growth would occur in the first few years. By 2031, CBO projects, the proposal would make the IRS’s budget more than 90 percent larger than it is in CBO’s July 2021 baseline projections and would more than double the IRS’s staffing. Of the $80 billion, CBO estimates, about $60 billion would be for enforcement and related operations support. [emphasis added]
The CBO also made clear that most of the funding increase – and presumably new hires – is in enforcement, not customer service.
IRS Commissioner Danny Werfel justified leaving out overall employment numbers by promising the release of additional estimates in the future. According to Bloomberg Tax:
Werfel said the agency plans to soon release employment estimates for fiscal 2025 but said a lot is involved in projecting staffing levels, particularly as the agency implements new technologies.
“I hope that we can get better and better at forecasting, but I just think it’s good management and leadership practice to look at these things in a three-year window and provide that type of precision,” Werfel said.
So the new plan fails to estimate headcounts, but it does emphasize that audit rates on taxpayers earning less than $400,000 will not increase. But in parsing the language, we find here the report is just a little obtuse too. The word “historical” is doing some heavy lifting:
Pursuant to Treasury’s directive, small businesses and households earning $400,000 or less will not see audit rates increase relative to historical levels. We will increase our focus on segments of taxpayers with complex issues and complex returns where audit rates are minimal today, such as those related to large partnerships, large corporations, and high-income and high-wealth individuals.
Under the Inflation Reduction Act, the IRS needs to raise an additional $180 billion from somebody. Increased audits of high-wealth individuals and large corporations may provide some of that additional funding, but those taxpayers are already highly scrutinized and unlikely to provide all of it.
As this data from the GAO attests, the IRS already focuses its enforcement efforts on higher income taxpayers. Moreover, these rates are annual, so they understate the odds of being audited over a period of years. If a taxpayer makes more than $5 million a year from four separate taxable entities, their chance of getting audited over a decade is not 2.35 percent but rather many times that percent.
The GAO also found that the IRS’s record of collecting additional tax stems mostly from lower income taxpayers. From 2010 through 2021, most of the additional tax recommended by the IRS was from taxpayers making less than $200,000. For the Inflation Reduction Act to be successful, some of the $180 billion will have to come from those taxpayers. How do you raise revenue from taxpayers making under the $400,000 threshold while keeping to the promise outlined above? Here’s CBO again:
The proposed increase in spending on the IRS’s enforcement activities would result in higher audit rates than those underlying CBO’s baseline budget projections. Between 2010 and 2018, the audit rate for higher-income taxpayers fell, while the audit rate for lower-income taxpayers remained fairly stable. In CBO’s baseline projections, the overall audit rate declines, resulting in lower audit rates for both higher-income and lower-income taxpayers. The proposal, by contrast, would return audit rates to the levels of about 10 years ago; the rate would rise for all taxpayers, but higher-income taxpayers would face the largest increase.
So apparently “current” audit rates are less than “historical” audit rates, which means they will be going up. The CBO’s analysis also allows for enforcement activities other than audits:
Activities other than audits—such as collections and automated screening and document matching—are not constrained by the Secretary’s directive, and under the 2022 reconciliation act, the amounts they generate will be greater for taxpayers with all amounts of income, CBO projects.
All of this assumes the IRS will stick to the Secretary’s directive. Will it? The directive reflects a political promise made by the President and his Treasury Secretary. When they are gone, we expect the directive will go too. This is a ten-year plan, after all.
Where does that leave us? For taxpayers, including S corporation owners, making more or less than $400,000 a year, the chances of getting audited are going up. Way up. Funding for IRS enforcement increased by 69 percent under the Inflation Reduction Act. That new funding will allow the IRS to hire thousands of new agents/auditors/enforcement personnel (choose your descriptor, it doesn’t matter) and those employees are going to be on the hook to increase collections by $180 billion over the next ten years.
None of that is made clear in the IRS report released last week, but it’s still the plan.