Treasury Hits Family Businesses!

The verdict is in, and Treasury’s proposed rules on estate tax valuations of family-owned businesses are broad – very broad indeed. They are, simply put, a direct assault on America’s family-owned businesses.

Here’s the take of WealthManagement.Com:

Although the details are significant, the bottom line is that the proposed regulations would appear to eliminate almost all minority (lack of control) discounts for closely held entity interests, including active businesses owned by a family. To accomplish that, restrictions under the governing documents and even those under state law would be disregarded for valuation purposes.

And Steve Leimberg’s Estate Planning Email Newsletter:

In short, it may appear that, outside of the new three year rule, that not much is being proposed with respect to the valuation of minority discounts.  One might, therefore, conclude… that minority discounts remain largely intact with a narrow exception for transfers made within three years of death.  That reading would not, however, be accurate.  As will be discussed, the proposed regulations under Section 2704(b), in particular based upon a new concept referred to as “Disregarded Restrictions,” are a frontal attack on the concept of discounts in the context of family entities.  Given the failure the IRS has sustained in the courts in terms of its argument favoring a family-attribution principle and given its resulting frustration, it must be conceded that the new Disregarded Restrictions approach seems masterfully drafted.  

So so-called “minority interest” discounts are at risk under the proposed rules. What does that mean?  It means that family owned businesses will be valued, and taxed, at significantly higher rates than businesses owned by non-related parties.  How much more depends on the facts and circumstances of each case, but minority discounts of 20, 30, 40 percent and higher are common and have been approved by the courts.

But aren’t these discounts just a loophole? No, not at all.  Minority interest or “lack of control” discounts reflect the underlying economic reality that ownership without control – control to sell, control to make management decisions, control to distribute profits — is worth significantly less than ownership with control.  If you own 30 percent of a company, but have no say in how the business is run or when it is sold, then your share of the company is worth significantly less than 30 percent of the total value of the company.

For examples of minority discounts, look no further than the stock exchanges. Every stock on the New York Stock Exchange is traded with a minority discount imbedded in the price.  That is why investors seeking to buy a controlling interest in a publicly traded company are willing to offer a premium over the traded price.  Unlike retail investors, they expect to have a controlling interest at the end of the day, so they are willing to pay more.

So when Treasury calls this a “loophole”, what they are really upset about is the underlying economic reality of control. One might as well complain that the sky is blue.

This is not a new fight. The IRS has been waging, and losing, the battle over these discounts for decades.  But the newly proposed rule represents a whole new tact on the part of Treasury that needs to be taken seriously by the business community.  This is the first time in the long battle over discounts that Treasury has hung its efforts on an existing, albeit 26-year old, statute.

So does section 2704 give Treasury the authority to eliminate minority interest discounts for family-owned enterprises? Probably not.  But we won’t have the ultimate answer to that question until these rules are fully litigated in the press, the comments to Treasury, the elections, the Congress, and finally the courts.

For next steps, there’s the 90-day comment period ending in early November, a public hearing in early December, and then the bums rush by Treasury to get these regulations out the door before the end of the Obama Administration.

In the meantime, the business community, including your S Corporation Association, will be up in arms once again. This proposed rule combines the two signature trademarks of this Administration – a jaded view of private enterprise coupled with a willingness to push the envelope on legal authority. We expect to ultimately win this battle, but it will take a long time and waste innumerable resources that could otherwise be used to invest and create jobs.  What’s the point in that?

Volcker Report Released. On a Friday. In August.

The headline says it all. The long-awaited Volcker Tax Reform Commission report was released last Friday and was immediately put on a shelf someplace in the basement of the Ways and Means Committee. According to the Commission members:

The Board was asked to consider various options for achieving these goals but was asked to exclude options that would raise taxes for families with incomes less than $250,000 a year. We interpreted this mandate not to mean that every option we considered must avoid a tax increase on such families, but rather that the options taken together should be revenue neutral for each income class with annual incomes less than $250,000.

In general, the report’s authors sought to provide “helpful advice to the Administration” on “options for changes in the current tax system to achieve three broad goals: simplifying the tax system, improving taxpayer compliance with existing tax laws, and reforming the corporate tax system.” The Board was not asked to consider major tax reforms.

Just how helpful this advice is remains to be seen, but the low-key manner in which the report was released suggests the Administration does not see the report itself as a useful message vehicle. Proposals to raise taxes seldom are.

For S corporations, two recommendations stand out:

Payroll Tax Provision: The report suggests that payroll tax policy could be changed so that all active S corporation shareholders, LLC members and limited partners pay payroll taxes on all distributions from their businesses. Under the heading of “Disadvantages,” the report states:

The revenues raised from the proposal would come primarily from owners of small businesses. Moreover, it would impose employment taxes on income that is partially a return on capital rather than a return on labor.

Our point exactly.

Business Structure Neutrality: As a part of corporate tax reform, the report states that “a goal of reform in this area is tax neutrality with respect to organizational form” including these two options:

One option would be to require firms with certain “corporate” characteristicsb – publicly traded businesses, businesses satisfying certain income or asset thresholds, or businesses with a large number of shareholders “to pay the corporate income tax. In effect, this would broaden the corporate tax base by applying the corporate tax to more businesses.”

An alternative option would eliminate the double taxation of corporate income and harmonize tax rates on corporate and non-corporate income through “integration” with the individual income tax. In one example of such a system, individual investors would be credited for all or part of the tax paid at the corporate level against their individual taxes.

 

In other words, you could harmonize the tax treatment of business income by either imposing the corporate tax on more entities or by reducing the double tax currently paid by C corporation shareholders. Again, the disadvantages of option one highlighted by the Commission speak volumes:

Achieving neutrality between corporate and non-corporate businesses by subjecting more businesses to the corporate tax would increase the cost of capital and thus decrease investment in those businesses.

Yep.

More on Pending Tax Hikes

 

Our friends on the Hill pointed out a new survey of the National Association of Business Economists membership on the pending tax hikes. The survey found that more than half of NABE economists support extending all the marginal tax rates (including the upper brackets) while six out of ten support keeping the rates on capital gains and dividends at 15 percent. Other interesting results:

  • Three quarters support promoting economic growth over reducing the deficit;
  • Three quarters oppose further fiscal stimulus; and
  • A large plurality support “clarity on future regulation and tax policy” over other ways in which the government can best “encourage increased employment.”

 

We are hearing this last point repeatedly these days — the best thing Congress can do is provide a little policy certainty to the markets. Congress is not doing the things it is supposed to (budgets, tax extenders, etc.) while it is considering and adopting dramatic changes to rules by which businesses relate to their employees, their customers, and their government. Markets do not like uncertainty, yet the current policy climate here in D.C. is rife with it. CNN points out that in the area of tax policy alone, more than 100 tax relief provisions affecting just about everybody are waiting to be extended.

 

Finally, on the National Commission on Fiscal Responsibility and Reform, four out of five respondents did not believe the Commission would produce a credible plan that could pass Congress. On that one, we’re not so sure.B A growing number of smart folks around town are suggesting the Commission may be the best chance we have in the next couple years to get the federal deficit under control. Maybe; but either way, we’re guessing that report won’t be released on a Friday.

Small Business & Extender Tax Bill Update 2.0

After reappearing briefly last week, the latest version of the tax extenders package (Baucus IV) has now disappeared. The plan was for the latest version to garner sufficient support and then be attached to the small business tax bill, but the small business bill was pulled, ending the chances of the extender package getting adopted before the August break.

That means all those tax provisions that expired at the end of last year, including the R&E tax credit and the state sales tax deduction, will have to wait until September at the earliest before getting another shot. That’s too bad, as it now appears the package has the votes to move through the Senate.

As we noted last week, one of the modifications Chairman Baucus made to the package was to eliminate the S corporation payroll tax provision. Dow Jones reported this on Friday:

Senate Finance Committee Chairman Max Baucus (D., Mont.) has removed a controversial proposal that would force lawyers, accountants and other professionals to pay more in payroll taxes from a broader bill to extend expired tax cuts. The payroll tax provision, which would have raised $9 billion to help pay for tax cut extensions, had drawn strong criticism from business advocacy groups and Republicans including Sen. Olympia Snowe (R., Maine).

Coupled with other changes, striking this provision should give Baucus the 60 votes he needs to move forward. We will find out in September.

On the small business bill, negotiations continued over the weekend and there’s a very slight chance the bill could come back up before the end of the week. As CongressDaily reported yesterday:

This week will determine if the chamber passes the small-business bill, which stalled last week in a dispute over amendments. Reid on Thursday urged members to “cool down” over the weekend as aides said they hoped for a deal that would set up a quick series of votes and passage of the bill by Wednesday. Republicans have sought votes on four amendments, while Reid last week offered three. Aides said completion could wait until September if they do not reach a deal, which will have to include Republican agreement to limit debate time.

Majority Leader Reid would also need to find extra time in a very crowded week. He intends to take up three other controversial matters before Friday — the Kagan nomination, extra money for states under FMAP, and competing energy bills designed to respond to the Gulf oil spill. All of these items will likely be debated at length, so fitting in yet another bill would be a challenge. With the tight calendar, we’re expecting this issue to get kicked into September as well.

Small Business and 1099 Reporting

Some good news on the small business paperwork front: a majority of House members support repealing from the health reform bill the 1099 reporting requirement that has the small business community up in arms. CNN Money has a nice summary of what’s at stake:

Right now, the IRS Form 1099 is used to document income for individual workers other than wages and salaries. Freelancers receive them each year from their clients, and businesses issue them to the independent contractors they hire.

But under the new rules, if a freelance designer buys a new iMac from the Apple Store, they’ll have to send Apple a 1099. A laundromat that buys soap each week from a local distributor will have to send the supplier a 1099 at the end of the year tallying up their purchases.

The bill makes two key changes to how 1099s are used. First, it expands their scope by using them to track payments not only for services but also for tangible goods. Plus, it requires that 1099s be issued not just to individuals, but also to corporations.

Taken together, the two seemingly small changes will require millions of additional forms to be sent out.

One item that caught our eye was the revenue estimate. The Joint Committee on Taxation believes repealing this paperwork mandate would reduce revenue collections by $2 billion per year! Since filing 1099s does not increase tax levies by itself, the JCT is assuming the IRS will be able to use the payment information to increase enforcement and collections. We’re skeptical. It’s just as likely that collecting, organizing, and putting to use the millions (billions?) of new 1099s would cost the federal government more than it saves.

But back to the good news. Last Thursday, House leadership pulled legislation from the House floor rather than lose a vote on repealing this 1099 requirement. Then on Friday, leadership attempted to adopt this provision with $20 billion in offsetting tax hikes, but failed again to garner the requisite votes. Apparently a sufficient number of House members recognized that trading a poorly-conceived paperwork mandate for higher taxes was not in fact a good bargain and should be rejected.

So there’s hope yet for the small business community. A majority of House members recognizes that imposing yet another paperwork requirement on Main Street businesses is a bad idea and should be repealed. Let’s hope House leadership listens to its members and lets them vote on a clean repeal.

More on Extending Tax Rates

The debate over extending tax rates also is getting kicked into September, but the rhetorical battle is heating up now. The Washington Post in particular is staking out the “let’s tax the rich” position. The paper’s online “Research Desk” feature highlighted the following question from reader Ross Cohen:

Republicans keep fighting for the Bush tax cuts with a talking point about small business owners filing as individuals. I’ve heard 50 and 75% quoted as the number of $250k filers that are actually small businesses. Any truth to this? It seems to be their strongest case against letting the cuts expire.

Post researcher Dylan Matthews responds:

As far as I can tell, this argument originated with Grover Norquist in this column. Norquist cites IRS data to say that two-thirds of income from sole proprietorships, partnerships and S corporations was reported by filers making over $250,000 a year. Although true, this is almost totally irrelevant. Norquist looks at the proportion of income, not filers, which inevitably results in a bigger portion for high-earners.

Really? The only source the Post researcher could find was Grover Norquist? We agree with Grover on this issue and many others, but he does tend to be a lightning rod. Had Ross asked S-CORP his question, here are a couple citations we would have provided him with:

The Joint Committee on Taxation projects that $1 trillion in business income will be reported on the individual income tax returns in 2011. Notably, of that $1 trillion, nearly one-half, $470 billion, will be reported on returns that will be subject to the top two rates of 36 percent and 39.6 percent if EGTRRA and JGTRRA are allowed to sunset.

Testimony of Doug Holtz-Eakin, July 14, 2010

Top bracket taxpayers received a disproportionate share of flow-through business income and paid an even larger share of the tax on it; taxpayers in the highest two tax brackets made up 8 percent of all taxpayers receiving any flow-through income or loss, but they received 72 percent of the net flow-through income and paid 82 percent of the taxes on this flow-through income (Table 3.3).

United States Treasury Report, July 23, 2007

The Joint Committee on Taxation and the United States Treasury are good sources, no? Moreover, how many of our Washington Wire readers noticed that Dylan misread the question? The question asked what percentage of high-rate taxpayers own small businesses. There’s a lot of good data out there, too, including this one:

Because flow-through income is concentrated in the top tax brackets, the reductions enacted in 2001 and 2003 in the highest two marginal income tax rates have important consequences for the recipients of this income - typically owners of small and entrepreneurial businesses. For 2007, the Treasury Department estimates that about 75 percent of the taxpayers who will benefit from lowering the top rate from 39.6 percent to 35 percent are flow-through business owners, and that 84 percent of the tax reduction from the top rate reduction will go to flow-through business owners.

United States Treasury Report, July 23, 2007

So, to summarize: yes, Ross, it is true that small businesses are overrepresented among taxpayers who pay the top two income tax rates, and those businesses will see their tax rates go up under the pending tax increases.

Finally, why is it irrelevant that a large percentage of business income — somewhere between one-quarter and one-third of all business income — is taxed at the top two rates? From our perspective, that is the heart of the issue. If a single taxpayer is responsible for a large amount of economic activity and employment, raising his or her taxes in the middle of a weak recovery makes little sense.

As the Tax Foundation noted several years ago:

So why should we pay attention to the way our tax code treats small businesses? They are an important source of innovation and risk-taking, creating between 60 and 80 percent of net new jobs, employing over half the labor force, and generating more than one half of the nation’s gross domestic product. Higher income tax rates reduce the investment spending of entrepreneurs and the likelihood that they invest at all, discouraging the growth or expansion of small businesses.

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