Susan Collins and other senators are toying with a 'carve-out' to benefit small businesses. GOP Plan B: Protect business owners

It may be time to add another phrase to the fiscal cliff lexicon: carve-out.

Republicans in the Senate are brainstorming ways to shield small businesses from tax hikes should they be unable to persuade President Barack Obama to extend the Bush tax rate cuts for everyone.


Maine Republican Susan Collins and other GOP senators are toying with what they’re calling a “carve-out” to benefit small businesses that pay their taxes through the individual side of the Tax Code.

A sort of GOP Plan B, a carve-out could give Republicans — and some red state Democrats — a way to save face if they’re faced with a choice between allowing the government to go over the fiscal cliff or swallow some sort of marginal tax rate increases.

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Collins, for her part, is reprising her proposal to impose a 2 percent surtax on the wealthiest earners, with a carve-out. But the concept could also apply to a broader marginal rate increase. The idea is to exempt those profits, from S-corporations, partnerships and other passthrough entities, from the income tax increases Obama wants for top earners.

But it’s far from clear whether a carve-out would pass muster with the White House and congressional Democrats, whose official preference is a full expiration of the Bush-era rates for top earners. It would be messy and take a big chunk out of the revenue that Obama is seeking to generate from marginal rate hikes. It would also run into long-standing partisan divisions over what constitutes a “small business” — and how many of them, exactly, would be hurt by increasing upper-income tax rates.

But discussions reflect the difficult position Republicans face in the fiscal cliff talks, after an election in which Obama made the expiration of the top Bush-era tax rates a central rallying cry.

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“It’s more of a break-the-glass-type proposal if we can’t get the deal we want to prevent the rates from going up,” said one senior GOP aide who has talked with several Republican offices about the idea. “There’s definitely been talks of this type of carve-out, but the hope still is that Obama and congressional Democrats will agree to the framework that Boehner and McConnell have laid out.”

Republicans have conceded that revenues will have to be put on the table, but have been pushing to avoid actual rate increases — a position shared by at least a few Democrats. Some top Democrats have discussed a rate increase short of the Clinton-era rates, while some House Republicans have signaled a willingness to raise taxes on millionaires.

Still, few Republicans are willing to budge off of their strict no-tax-rate-increase position at this stage in the fiscal cliff negotiations.

Asked whether the House Ways and Means Committee is considering a carve-out, panel spokesman Sage Eastman noted that the committee majority is still not even considering rate increases, so it’s “kind of tough to even get to the second step.”

GOP opposition to Obama’s pitch to allow rate hikes on households making more than $250,000 has focused heavily on the potential risks to small businesses. They say tax increases on the top 2 percent will crush startups, often citing an Ernst & Young study — authored by former top Treasury official Robert Carroll — that says the increases would result in more than 700,000 fewer jobs and stifle economic growth.

That’s because about 75 percent of businesses, and almost all companies classified as small businesses, file their profits individually rather than through the corporate tax code.

“The problem with raising tax rates on wealthy Americans is that more than half of them are small-business owners,” Boehner said in a press conference last week.

Democrats often counter that only about 3 percent of those small businesses would actually be affected by the rate increases, and that Republicans are hiding behind small businesses in their efforts to protect the wealthy. They say that the GOP is including in its calculations people not normally thought of as small-business entrepreneurs: celebrities who receive income from speaking engagements, people who invest in stock, best-selling authors who get royalties for book sales and partners in law firms and hedge funds.

“In reality, only a tiny fraction of the top earners actually own, control and manage a business that is small and has hired anyone,” Senate Finance Committee Chairman Max Baucus (D-Mont.) said on the Senate floor in July.

A small-business carve-out, GOP aides say, might look like one Collins introduced last December during the standoff on the payroll tax holiday.

The Maine Republican introduced legislation to extend the payroll cut and several other expiring provisions, and offset it with a 2 percent surtax on millionaires. The surtax included an exemption of sorts for businesses that had less than 500 employees.

Collins said in a statement Tuesday that her proposal “offers a potential middle ground to resolve the differences on the revenue side of the ledger. We propose a 2 percent surtax on the very wealthy but with a carve-out to protect small businesses.”

Collins said that “Multimillionaires and billionaires who are not running businesses could pay more of their income to help reduce the $16 trillion federal debt. But I feel strongly that we must ensure that small-business owners who pay taxes through the individual income tax system are protected.”

Her bill would distinguish people who actually operated and ran businesses from those with other business income earned from dividends, stocks or bonds — a distinction that tax experts label as “active-income” versus “passive-income.”

Collins wants her colleagues to consider this approach in fiscal cliff negotiations. She’s been talking with Republicans and Democrats about how this might work, including Claire McCaskill (D-Mo.), who co-sponsored the proposal last year.

“Sen. McCaskill has always been willing to work on a bipartisan basis, with Senator Collins and others, to achieve the goal of improving our long-term financial outlook,” said Drew Pusateri, a McCaskill spokesman.

But Pusateri stopped short of saying whether McCaskill would support Collins in her efforts, saying only that “she believes that avoiding the ‘fiscal cliff’ needs to be done through a balanced compromise.”

The GOP aide gauging Republican thoughts about the idea said a new carve-out would probably be classified as an “exclusion” from the rate increase for companies that have fewer than 500 employees, since that’s how the Small Business Administration defines some, though not all, “small businesses.”

The aide says the carve-out wouldn’t be too hard to implement since all companies have to issue W-2 forms to all their employees already, so the IRS could identify firms with fewer than 500 employees.

“I wouldn’t think that that would create any real, new headaches,” the aide said. “Our tax code is so complicated already that that additional complication doesn’t seem to add too much.”

But tax writers from the other end of the political spectrum are skeptical. They say a carve-out is easier said than done.

For one, critics say it gives taxpayers another opportunity to game the system.

“This type of bill would take the most complex parts of the code — definitions of active income, passive income, ordinary income and capital gains, as well as incentives to structure a business as a corporation versus a pass-through — and add yet another layer of complexity on top,” said one Democratic aide that works on tax policy. “More complexity always means more ways to game the system.”

The same staffer also took issue with defining “small businesses” as companies that have up to 500 employees.

“That actually includes more than 99 percent of businesses across the country,” the staffer said. “It’s like defining small business as ‘smaller than General Electric.’”

At least one House Republican has expressed interest in a carve-out.

“The thing that we want to do is have the small businessmen, single-filers filtered out; there has to be a good comfort level on that,” Rep. Jack Kingston said last week.

As of Monday evening, the Georgia Republican hadn’t endorsed a specific proposal but he was eyeing a measure introduced by Iowa Democrat Dave Loebsack in August, spokeswoman Mary Frances Carpenter said in an email.

The Loebsack bill would extend the Bush cuts for families making under $250,000 as well as current investment and estate tax rates and the child tax credit. It also would exempt small businesses and family farm income from the rate hike on top earners.

“The congressman thought that is a good starting point for a compromise on the fiscal cliff,” said Joe Hand, a Loebsack spokesman. “It’s not everything that Democrats want, it’s not everything that the Republicans want, but it’s a good starting point to get people talking about it and to get people onboard for a compromise and actually getting something done.”

This article first appeared on POLITICO Pro at 2:47 p.m. on November 20, 2012.