Ways and Means Hearing

S-corporation taxation took center stage on the Hill last week.

Carrying the S-Corp flag before the House Ways and Means Committee was Association Advisor Tom Nichols of Meissner Tierney Fisher & Nichols S.C. Tom had been invited to represent the S Corporation Association and testify at a hearing entitled “Tax Treatment of Closely-Held Businesses in the Context of Tax Reform” along with five other witnesses representing other trade groups and academia. Tom’s testimony made clear to the tax writers what we’d like to see when they pursue tax reform:

“As much as possible, the business tax system in the United States should move toward a single tax structure, and away from the punitive double tax C corporation system. Especially for closely-held businesses, a single tax system substantially reduces complexity and eliminates the opportunity and incentive for non-productive tax planning and strategizing.”

“Second, broadening the tax base and lowering and flattening the tax rates would serve all segments of society. The lower the rate on a given amount of marginal income, the more likely it is that a business owner is going to expend the effort and take the risks in order to earn that income, and the less effort he or she will expend trying to defer or otherwise mitigate the tax consequences of having done so.”

“Third, it is important that whatever tax reform is implemented be comprehensive. Since pass-through business owners employ over half of the workforce in the country, lowering the tax rate for all taxpayers (rather than just the headline rate for C corporations) should be the goal of comprehensive tax reform.”

S-Corp’s perspective was reinforced by witnesses representing the National Federal of Independent Business (NFIB) and the Financial Executives International, both of whom made clear that comprehensive reform as the only means to making all businesses sectors more competitive. NFIB’s Dewey Martin also made the case for the shorter built-in gains holding period:

Finally, reducing the holding period for the built-in gains tax would do much to promote flexibility for small businesses. The built-in gains tax locks-in capital assets if a C-Corporation elects to change to S-Corporation status, and reduces economic efficiency. NFIB appreciates that the holding period has been reduced from 10 years to 5 years, and, at the very least, this should be extended.

During Q&A, Tom had a chance to highlight the importance of built-in gains relief during a back-and-forth with S Corporation Modernization sponsor Dave Reichert of Washington state:

With everything up in the air right now, it is more important than ever for business owners and their representatives in Washington D.C. to step up and be heard on these important issues. We appreciate Tom’s willingness to testify along with the other witnesses at last Wednesday’s hearing. We hope policymakers were listening.

Large Pass-Through Businesses and Double Taxation

There’s a small but vocal group of C-corporations arguing that Congress should force large pass-through businesses to pay taxes like C-corporations — i.e. pay two layers of tax on their business income rather than just one. Just exactly how raising taxes on large pass-through businesses in order to cut them for even larger C-corporations would encourage investment and growth here in the United States is left unexplained.

But what about the complexity of such a rule? Wouldn’t an arbitrary cut-off based on revenues or employment be difficult to administer and enforce? Tom’s testimony before the Ways and Means Committee last week is the best exploration we’ve seen of the overwhelming tax administration challenges such a policy would face.

It should be must reading for anybody involved in tax reform. Here’s what he said:

“There have also been proposals to force double tax C corporation treatment on large pass-through entities, say those having gross receipts over $50 million. In addition to imposing a substantial additional compliance and tax burden on the most productive members of the pass-through sector of our economy, such a provision would require a detailed and complicated system of inter-related rules. For example, how would an entity be treated that hovers both above and below the $50 million trigger point? Would the built-in gains tax apply when the entity re-elects S status after having been forced into C corporation status as a result of having extraordinarily good receipts during the testing period? Would an entity be trapped in C corporation status even though it no longer had $50 million of gross receipts, because of higher receipts during the testing period? If not, would closely-held business owners not be in a position to know whether they will be subject to a C corporation or S corporation tax regime until after the end of the year in question?

Also, I am assuming that there would have to be some type of aggregation rules so that closely-held business owners could not simply split their business into two or more entities and avoid the C corporation regime in that fashion. As you can imagine, such aggregation rules are extremely difficult to administer. For example, if various business entities were to constitute a series of overlapping aggregated control groups or affiliated service groups, how would that be handled? If one of the groups was below the threshold and another of the groups was above the threshold, would the owners of the group that was below the threshold be forced into double tax C corporation status, even though some of them owned only an interest in a relatively small business?

Even in the absence of multiple overlapping groups, how would you handle the numerous complexities that are involved when multiple entities are treated as a single unit? The consolidated return regulations span over 440 pages in the standard edition of the CCH Income Tax Regulations, dealing with issues such as inter-company transactions, stock investment accounts, calculation of credits, allocation of income tax liabilities and numerous other matters. These complexities are difficult enough for groups of business entities that voluntarily choose to treat themselves as a single affiliated group, but this level of complexity would be multiplied many times by forcing aggregate treatment for all tax purposes on an amalgamation of corporations, partnerships, limited liability companies and other entities that happen to be linked by common ownership or activities.

This forced amalgamation might also have the unintended consequence of opening up opportunities for aggressive tax planning and tax shelters. For example, if dividends are treated as coming from the aggregate earnings and profits of the amalgamated entity, could the C corporation owners of one of the amalgamated entities drain off all of the earnings and profits on a tax-preferred basis, while allowing the remaining individual owners to achieve the equivalent of S corporation treatment as a result of non-dividend distributions? If not, would the individual owners of one of the separate entities with separately treated earnings and profits be able to achieve S corporation-type treatment by carefully managing the operations of that entity?

In addition to these workability concerns, making an arbitrary and involuntary cutoff for pass-through tax treatment is simply not good tax policy. For the reasons indicated at the outset of this testimony, the double tax C corporation system is not preferred tax policy. Moreover, the $50 million trigger (or whatever number is chosen as the trigger) would clearly discourage growth in companies that are approaching that level, and such companies would be incentivized to engage in a great deal of sophisticated and expensive tax planning to avoid being involuntarily subjected to the double tax system. Such maneuvers might nonetheless be justified if such a proposal were enacted, because one additional dollar of gross receipts could literally trigger millions of dollars of federal tax consequences. Such cliff-like triggers are obviously not favored for policy purposes.

Finally, just because an entity has $50 million of gross receipts does not mean that it is profitable. There are many such entities (or amalgamations of such entities) that actually have losses, which, under current law, are appropriately taken into account (and if necessary carried over) at the individual level. Forcing individual owners at that level of activity to forego the ability to deduct these losses would unavoidably impact their willingness to continue to fund these enterprises, with the concomitant impact on the jobs and financial security of their employees. Even profitable entities would not seem to merit such draconian treatment. For example, a low-margin 1 percent-of-sales business could easily have $50 million of gross receipts, but have only $500,000 of actual taxable income. Triggering C corporation status in these circumstances seems entirely unwarranted.”

Backwards Tax Reform

So earlier this month, we warned that you might hear a new argument when it comes to tax reform: cut corporate tax rates but raise them on shareholders. The idea is that corporations are mobile, whereas shareholders are not. So cut the corporate tax to encourage more firms to locate here, and raise taxes on shareholders because they’re stuck and can’t go anywhere anyway.

Well, we didn’t have to wait long to hear this flawed argument again. At last Tuesdayb’s Senate Finance Committee hearing, Dr. Robert Atkinson he believed in corporate tax reform that raises taxes on high-income individuals and lowers them on the corporate side is the way to go, saying that while “rich people are not going to move to Mexico or Taiwan, corporations will do that.” He went on to say that the idea that we cannot raise taxes on the rich is a mistake, and that it is much more important to get this right on the corporate side.

Here’s the clip of his testimony:

Setting aside the corporate governance issues of further separating the interests of management from the interests of shareholders, the principle challenge with this argument is that it ignores the most mobile commodity of all: capital. Raising the overall tax burden on business investment in the United States is not going to encourage additional investment here, even if it’s done in a manner that reduces one tax rate while hiking another. As Alex Brill and Alan Viard wrote last week, the tax hike under consideration is remarkably large:

The president’s proposal would allow the 2003 dividend tax cut to expire for high-income households at the end of the year, pushing the top dividend tax rate up from 15 to 39.6 percent. That’s a dramatic increase in its own right. But, other provisions make the true increase even larger. The president also wants to bring back a provision phasing out deductions for high-income taxpayers, which will cause each additional dollar of dividends to trigger 1.2 cents of extra taxes. And, beginning next year, the president’s health care law will impose an additional 3.8 percent tax on dividends and other investment income of high-income households. Under the president’s proposal, the top all-in dividend tax rate will be 44.6 percent – almost triple today’s 15 percent rate.

You can pretend that shareholders are not the real owners of businesses organized as public corporations, and maybe those businesses behave like they have no shareholders for short periods of time, but eventually those shareholders makes themselves known by voting with their feet and capital will flow out the U.S. and into those countries with a lower overall tax burden on equity investment.

These days, that’s just about everybody else.

Tax Notes: Make S-Corps Pay C-Corp Taxes

The drumbeat to impose the double corporate tax on large pass-through businesses grows louder. This time, it’s Martin Sullivan at Tax Notes arguing that larger firms should all be subject to corporate-level taxes. At least that’s the headline. Read the actual article, however, and our impression is a tax-writer at war with his conclusions. Try these lines:

  • “true tax reform would completely eliminate the double taxation of corporate income.”
  • “After all, the corporate tax is our worst tax.”
  • “What should be the dividing line between businesses subject to corporate tax and those that should be exempt? That’s not an easy question given that there is no economic justification for the corporate tax in the first place. Economics says it should be repealed.”


  • “There is no better corporate tax loophole than complete exemption from corporate tax.”
  • “The causes of fairness and economic efficiency would be served by not allowing large businesses to escape corporate tax and using the revenue gained to relieve the double tax burden for all.”
  • “If some competitors in an industry are exempt from corporate tax and others are not, the tax treatment results in inefficient excess investment for the fortunate and inadequate levels of investment for everyone else. There is also inefficiency across industries. If the apple industry is filled with tax-favored investors and the potato industry is not, there are too many apples and too few potatoes.”
  • “If there must be a second layer of tax on business, economics would push us in the direction of making all business income subject to the tax, with a low rate.”

So Sullivan makes the point that double taxation is inefficient and unnecessary, but at the same time he argues that more businesses should be subjected to double taxes. It is a head-scratching kind of article that left us unsure of where to begin a response.

Beneath all of the contradictions, we believe his basic point is that a fair and efficient system is not realized by having some businesses taxed in a manner that discourages employment and investment, while subchapter S corporations and other pass-through businesses are taxed in a manner more beneficial to those activities.

So far, so good. Since the purpose of tax reform is to make American businesses more competitive, that would argue that we should move away from the inefficient system (the corporate tax) and towards the more efficient system (pass-through treatment, or at least a single layer of tax for all).

But Sullivan doesn’t go there. Instead, he creates a straw man argument for tax reform — to eliminate loopholes — and then argues that pass-through tax treatment is a loophole.

We wholeheartedly reject the idea that a business structure originally enacted by a Democratic Congress and strengthened by subsequent Congresses over the past fifty years is a “loophole.” Moreover, while it can be true that treating similar firms in a dissimilar manner may create economic inefficiencies, it is also true that subjecting more business activity to an additional layer of tax is also inefficient. Sullivan admits as much.

So then, where is the efficiency gain in imposing a new, second layer of tax on a medium-sized business while using the revenue to reduce the double tax on an even larger, multi-national firm? The double tax is increased here and reduced there, by the same amount. By our math, it’s a wash, efficiency-wise.

Further, he appears to have concluded that we are stuck with the double-tax model without providing any supporting arguments. Why are we stuck with the double tax? Why can’t we move away from it rather than towards it? Why is all the work done on integrating (not consolidating, but integrating) our taxation of business income — including the original 2003 Jobs and Growth tax proposal that completely eliminated the second layer of corporate tax and came within a whisker of passing both houses of Congress — so totally void of merit that he never mentions it?

Finally, consider this passage:

Not only are large corporations avoiding corporate tax, they are doing so while smaller competitors in the same industry pay significant tax. Compare the last two columns of the table. The cohort of 339 manufacturing S corporations with an average of $429.3 million in receipts pays no corporate tax. Meanwhile, 801 manufacturing C corporations — much smaller than their S corporation brethren, with an average of $99.3 million in receipts — pay an average of $3.3 million in corporate tax. What policy purpose is served by taxing small manufacturers more than large manufacturers?

Tax Notes‘ readers are steeped in tax policy, but this passage could have left even your S-Corp Team with the impression that S corporations pay no tax. That’s obviously not true. They pay lots of tax on their business income — just not on the corporate tax code and not twice. According to a study commissioned by the Small Business Advocate, S corporations under $10 million in revenues paid the highest effective tax — 27 percent of their income — compared to similar-sized C corporations that paid only 18 percent.

This study did not include the second layer of tax applied to C corporation income, so direct comparisons are not exact. The point is, it’s a long leap from Sullivan’s “no tax” to the reality that S corporation shareholders pay a substantial and competitive amount of tax on their business income.

So if imposing no more than a single layer of tax on business income is more economically efficient and the more desirable goal for tax reform, why move in the opposite direction? The cynic would point out that the current exercise is nothing more than a money-grab. As Sullivan notes:

This tax reform is not about principle. It is about power, so start flexing your muscles.

Unfortunately, we are seeing that for too many actors in this debate, economic efficiency and competitiveness are secondary considerations. If they are improved, great, but that is not the point. What is the point? It’s all about the money.

S-CORP and Congressional Small Business Advocates Continue Push for b�Sting Taxb� Relief

Congress has returned from a weeklong recess and once again will attempt to finish last year’s tax business: a $70 billion tax cut bill (the “reconciliation” bill) and a pension reform bill. The S Corporation Association (“S-CORP”) continues to work with congressional tax-writers to include a Senate-passed provision to provide “sting tax” relief for S corporations subject to double taxation at the highest corporate rate in the tax reconciliation bill. S-CORP salutes Senator Blanche Lincoln (D-AR) for leading a bicameral and bipartisan letter that was sent last night to the House and Senate conferees.

The letter urges House and Senate conferees to retain the Senate language that, among other things, modifies the current excess passive income rules by increasing the threshold for taxing excess passive income from 25 percent to 60 percent and eliminates the rule that would terminate a company’s Subchapter S status for having excess passive income for three consecutive taxable years. Members signing the letter include Senate Finance Committee members Orrin Hatch (R-UT) and Gordon Smith (R-OR); Senate HELP Committee Chairman Mike Enzi (R-WY); and, House Ways and Means Committee Members Jim Ramstad (R-MN) and Phil English (R-PA) in addition to Small Business Committee Chairman Don Manzullo (R-IL).

S-CORP Chairman Tom McMahon said, “We are deeply grateful for the work of Senators Lincoln, Hatch, and Smith to pass legislation that will free S corporations from outdated and obsolete rules that either double tax our business income or lock up our capital and place us at a competitive disadvantage.” He added, “We are pleased that this provision has garnered bipartisan support and hope that Congress will soon pass a final conference report that will help America’s small and family-owned businesses grow and prosper free of the risks and constraints of the “sting tax.”

Congress will be in session for two weeks of legislative business before a two-week Easter recess. It is unclear whether the House Senate Conference Committee working on the final tax bill will be able to complete action on the bill in this time. Immigration and lobbying reform top the Senate’s priority list for Senate Floor action during this time period. The House agenda is more open and would allow time for consideration of a conference report.

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