What tax compromise will actually mean

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Roughly two weeks ago, President Obama announced that he had reached a compromise with the Republicans in Congress to extend the “Bush tax cuts” passed in 2001 and 2003.

The compromise is the result of both Republicans and Democrats having listened to what the economists have been saying: we risk falling back into a recession if the tax rates increase and everyone’s paycheck is smaller next year. At the time this article was written, the legislation has been approved by the Senate but has not yet passed through the House of Representatives. Unless the House unexpectedly accomplishes a change to the deal’s framework, the act signed into law will include:

• An extension of the 2001 tax rate reductions for all taxpayers for two years.
• An Alternative Minimum Tax patch for two years.
• Cutting the employee share of social security tax two percentage points for one year.
• 100 percent depreciation for any capital expenditure made in 2011.
• An extension of long-term unemployment benefits for another 13 months.
• An extension of the reduced capital gains tax rate (15 percent) for another two years.
• The establishment of the estate tax rate at 35 percent with a $5 million exemption.

The compromise stems from the Republicans wanting the tax cuts to be made permanent and the Democrats wanting to temporarily extend all of the cuts for “middle class” taxpayers and to raise the tax rates on the “rich” (i.e. individuals making more than $200,000 and couples making $250,000). The compromise? Extend most things for two years. A compromise on this issue was inevitable because nobody in Washington wanted to be responsible for raising everyone’s taxes as of Jan. 1.

Politically, however, both the Republicans and Democrats are setting the country up for another epic showdown based on tax cuts, policy and deficit reduction for our next presidential election. The compromise essentially codifies this as the cornerstone issue in the next presidential campaigns.

Assuming the economy continues the reserved growth it is currently experiencing over the next two years, we will be hearing the exact same arguments amidst the next round of political campaigns. The words and phrases “sacrifice,” “tax cuts for the rich,” and “passing the price tag to our children” being shouted from Capitol Hill today will echo back in 2012.

Amidst this rhetoric and political positioning, however, hopefully people will gain a better understanding of how some of these tax cuts work and why it was a good idea to reach this compromise. A substantial percentage of small and midsize businesses operate as pass-through entities (i.e. partnerships, S corps or default classification LLCs), in which the income of the business itself flows through to the tax return of the owner or owners of the business. This has the potential to cause the income of an owner to exceed $250,000 without the owner actually receiving this much money. As a result, the business owner becomes one of the “rich” people with a higher tax burden even though he does not necessarily have the wealth to show for it. Imprecise legislation failing to acknowledge this fact would have increased the tax rates on these business owners and financially squeezed those on whom we hope to rely to fuel the economy and solve the unemployment problem. Therefore, increasing the tax rates on these “rich” people would have been counterproductive to the goals of the legislation coming out of Washington in the past few years.

Cutting the employee share of Social Security is a more generous replacement for the Making Work Pay tax credit which will expire at the end of this year. The cut is intended to encourage additional spending by employed consumers. Allowing a 100 percent depreciation deduction will encourage additional capital expenditures in 2011 by accelerating a tax deduction that businesses would otherwise receive over time. The extension of the reduced capital gain rates should increase investment and will help retain entities called IC-DISCs as a lucrative export incentive. The extension of the unemployment benefits will help some, but not all, of those currently out of work. The reinstatement of the estate tax at a lower rate than would have occurred if the tax cuts had lapsed is a hat tip to the increased control the Republicans have in the legislative branch of government.

While the extension of the tax cuts will add to the deficit, it is generally agreed that a current increase in tax rates across the board could tip the fragile economy back into recession. Therefore, this compromise had to happen. What must also happen, however, is that tax rates will have to increase to address the long-term economic issues. The interesting part will be hearing how our hopeful representatives frame their calls for sacrifice in the 2012 election cycle.

Robert Teuber is a tax attorney with Weiss Berzowski Brady in Milwaukee. He works with individuals and businesses in resolving tax audits, appeals, litigation and collection actions brought by the IRS and Departments of Revenue. Rob can be reached at 414-270-2538 or [email protected].