The Washington INsider

In search of Congressional 'payfors,' S corp tax comes back

Adviser advocate: "Bad tax ideas don't go away, they just get recycled"

May 18, 2012 @ 3:02 pm

By Mark Schoeff Jr.

In Washington parlance, the phrase “pay for” has become a noun, “payfor.”

This term trends during the legislative process, as lawmakers seek “payfors” to offset spending or tax cuts contained in bills. A payfor is necessary under paygo rules that don't allow legislation to be financed through deficit spending. Of course, the rule can be lifted whenever Congress wants to ignore it.

Investment advisers could feel the impact of one payfor popular with congressional Democrats. They have proposed financing student loan legislation by expanding payroll taxes on subchapter S corporations and partnerships.

Under the bill, Social Security and Medicare taxes would be levied on all business income if the firm is engaged in professional services, such as investment advice, or if 75% or more of the gross income of the firm is attributable to three or fewer shareholders. The provision is estimated to generate about $9 billion in federal revenue over 10 years.

Currently, S corporation shareholders are assessed payroll taxes only on wages paid to shareholders, not on the income that is distributed to them.

“The bill will be fully paid for by closing a tax loophole that some of the wealthiest Americans use to avoid taxes,” said a statement from House Democratic leaders.

Democrats emphasize that the tax would fall on a “subset” S corporations and would only apply to couples who earn more than $250,000 or individuals who earn more than $200,000.

Even though Senate Republicans filibustered the student loan bill, it's likely that the S corporation tax will become a staple Democratic “payfor” for the rest of the year – not only on the student-loan bill but also on other legislation.

“Bad tax ideas don't die, they just get recycled,” said Phillips Hinch, assistant director of government relations at the Financial Planning Association. “I don't see this going away.”

Mr. Hinch said that about 50% of FPA's 23,400 members work in firms that employ five or fewer people. About 4% of the approximately 3.4 million S corporations, based on 2003 tax returns, are in the finance and insurance sector.

Opponents maintain that the Democratic proposal would hurt small businesses.

“This provision represents a tax increase rather than a clarification of existing tax burdens,” stated a May 3 letter to Senate leaders from 37 business organizations. “Businesses engaged in service professions have employees and capital investments. [The bill] would apply payroll taxes to both, thus blurring the line between payroll taxes imposed on wages and salary and income taxes applied to other forms of income.”

The good news for small adviser shops set up as S corporations is that Washington gridlock works in their favor. The Senate standoff over the student loan bill is a harbinger of what will likely be consistent Republican resistance to the S corporation payfor.

“I would think it is not going to get enacted in the absence of some big overall tax bill,” said Clint Stretch, managing principal of Deloitte Tax LLP.

A trade group that lobbies for S corporations also is taking heart in this week's announcement by House leaders that the chamber will act before the election on a bill that would establish a fast-track process in 2013 for broad tax reform.

This increases the chances that corporate and personal tax reform will be done simultaneously. If Congress were to move on corporate reform first, it could leave behind small business owners who run their companies from their personal tax returns.

“Our message to the Hill is that you have to do comprehensive reform that recognizes the economic importance of pass-through businesses,” said Brian Reardon, executive director of the S Corporation Association.

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