Senate Eases Impact of Bill’s Tax Increases on Small Businesses

Senate Democrats trying to pass a bill that extends many popular but expired tax breaks have softened two tax increases that had aroused concerns among some small-business supporters. But that was not enough to save the revised measure from a threatened Republican filibuster on Thursday night, The New York Times reported.

The American Jobs and Closing Tax Loopholes Act of 2010 also resuscitated temporary stimulus measures to improve Small Business Administration lending, financed some infrastructure investment, and extended unemployment programs. To pay for these, the bill, as its title suggests, closed some loopholes. As The Agenda reported last week, one provision would tax much of investment fund managers’ carried interest, or their share of their investors’ profits, at ordinary income rates rather than at much lower capital gains rates. Another would subject all the income of certain “professional service” S corporations to unemployment taxes.

Some critics said the carried interest change would choke off investment funding for start-ups. And opponents of the S corporation provision quickly found an ally in Senator Olympia Snowe of Maine, the ranking Republican on the Senate Small Business Committee. “Laudably, the provision is aimed at reducing gaming that can take place by S Corp. owners shifting income away from compensation and to ‘dividends’ that are not subject to payroll tax,” Ms. Snowe said in a statement. “However, this is a substantial new tax on the income whether or not it is distributed, thus imposing payroll taxes at a 15.3 percent rate on the retained earnings of S corporations.”

Last Thursday Ms. Snowe, along with another Republican, Senator Mike Enzi of Wyoming, submitted an amendment to remove the S corporation provision from the bill, which Ms. Snowe called a “poison pill in this tax bill.”

After the bill failed to clear a procedural obstacle on Tuesday — in which 11 Democrats and independent Joe Lieberman of Connecticut joined 40 Republicans in a vote against the measure — Senator Max Baucus of Montana, chairman of the Senate’s tax-writing committee, relented. On Wednesday, a new version of the bill made changes to both provisions, along with some spending cuts.

The new carried-interest provision actually raises the share of carried interest taxed at ordinary income rates from 65 percent in the previous bill to 75 percent — the same share as in the version of the bill that passed the House — and it implements the change earlier, in 2011 rather than 2013. (The remaining 25 percent would be taxed at the capital gains rate.) However, gains on long-held assets are treated more generously: the profits on assets sold after five years would be evenly split between ordinary income and capital gains.

The revisions do not significantly reduce tax revenue to the Treasury — according to a preliminary estimate (pdf) from the Senate Finance Committee, the new version would raise $13.9 billion over a decade, compared to $14.5 billion initially — but it may reallocate who will pay those taxes.

“The main objective was to have a meaningful distinction between short-term investment and longer-term investment, such as venture capital funds, which create jobs — as opposed to hedge funds and private equity, which are more asset plays,” said Nathan Steinwald, an aide to Senator Mark Warner, the Virginia Democrat who helped broker the compromise.

Venture firms, he added, tend to hold on to assets for five to 10 years, while private equity funds tend to keep them for just two to four years. However, according to a 2008 global survey of private equity deals by the World Economic Forum, in nearly 60 percent of these transactions, the acquired companies were held for at least five years.

By comparison, the Finance Committee merely tweaked the S corporation provision. Where the earlier version was vaguely aimed at professional services corporations whose “principal asset” is “the reputation and skill of three or fewer employees,” the new version restricts its sights to firms where “80 percent or more of the gross income of such business is attributable to service of three or fewer shareholders.”

The new language might satisfy the critics who complained to The Agenda that the original was too ambiguous and would require small companies to undertake expensive valuations to determine what constitutes their principal asset. However, it would not appear to meet Snowe’s objections to taxing retained earnings. Messages left at Snowe’s office seeking comment were not returned.

But Snowe voted against the measure, along with 37 other Republicans. Lieberman and Senator Ben Nelson, Democrat of Nebraska joined them. Fifty-five Democrats and one independent, Senator Bernie Sanders of Vermont, voted for it. While this left the Democrats closer to the 60 votes needed to end debate, they remain four votes short. One Democrat and three Republicans did not vote.