More on 385

S-Corp continues its efforts to educate policymakers about the pending Section 385 rules and the harm they will cause to domestic employers and American jobs starting…well, now.

That’s the dirty little secret about the 385 rules.  Released as part of a package of “anti-inversion and base erosion” tools, much of their impact will be on normal domestic business practices instead.  All that is necessary to be subject to the rule is 1) a group of investors that controls two or more corporations and 2) a loan or cash pooling between members of the group.

That’s it.  No international component required.  And the portion of the rule that could damage S corporations the most – the so-called “bifurcation rule” — has no de minimis threshold, so businesses of all sizes could be subject to the new rule depending on how they are organized.  As the Wall Street Journal noted on Tuesday:

… Treasury aims to solve this alleged problem by overturning decades-old interpretations of tax law and forcing many loans between related businesses to be treated as equity instead of debt. Businesses commonly pool the cash from various subsidiaries in one account, or they may fund one business with loans from an affiliate that has available cash. Recasting these transfers within a corporation as equity investments will trigger higher taxes for many firms unless they hire outside banks to provide the financing they used to do internally.

To give an example, the “Brother-Sister” company illustration below from our 385 Power Point is an extremely common means of organization, where the business operations are housed in one S corporation while the real estate assets are housed in another.  How common?  Impossible to say at this point, but with 4.5 million S corporations out there, our advisors tell us that such brother-sister arrangements are likely to number in the hundreds of thousands, or more.

385 Graphic

Under the proposed rule, this business would need to end any cash pooling between the two companies or give up its S election.  Neither is an attractive option, and to what purpose?

Base erosion is the practice of shifting profits overseas through loans and other pricing strategies.  But S corporations, by definition, have to be domestic businesses with domestic ownership, and all S corporation income must be taxed here in the United States.  Non-resident aliens are not permitted to own S corporation stock. Nor are foreign companies.

Moreover, unlike a C corporation, an S corporation that has foreign subsidiaries does not get a US tax credit for the foreign taxes the subsidiary pays.  For this reason, the vast majority of S corporations use branches for their overseas operations, not separate corporations, which means that all of their income, whether earned here or overseas, is taxed immediately in the United States.

So if the Treasury wants to go after base erosion practices, looking at S corporations is simply the wrong place to start.  There’s no there there.

Despite these realities, the draft rules include S corporations, putting them at risk along with the rest of the business community to having their debt converted into equity.  But S corporations face an additional risk not shared by the broader business community.  That is because S corporations are unique in the tax code in that they can lose their S election if they violate any of the following restrictions:

  1. S corporations may have only one class of stock;
  2. They are limited to 100 or fewer shareholders; and
  3. S corporation shareholders are restricted to US residents, estates and certain trusts and exempt entities.

Converting debt into equity could cause an S corporation to violate some or all of these requirements, which means years of additional fees, penalties, taxes, and reconfigured finances.  It’s a very serious threat and one S corporation owners need to focus on now.

What should Treasury do to fix this?  Based on outreach to our membership and feedback from meetings with the Hill and the relevant agencies, we have developed the following asks:

  1. Treasury should slow down the process and delay the effective date of the final rule. This rule is expansive and would in many cases force businesses to reconfigure how they finance their day-to-day operations.  That would impose significant costs on them and take time to execute. Treasury should take time too and ensure it avoids any “innocent bystander” damage here.
  2. Treasury should make sure these regulations do not apply to S corporations. For the reasons articulated above, S corporations are the wrong place to look if you’re trying to clamp down on base erosion practices.
  3. Treasury should ensure that S corporations do not lose their S corporation status. Cash pooling and related party loans are not crimes, but losing an S election would impose criminal-level costs on these companies. Treasury needs to make clear that no S corporation will lose its election because of this rule.

The comment period for the proposed rules closes on July 7th, and the IRS has announced it will hold hearings on the matter the following week on July 14th.  We plan to submit extensive comments and we encourage other business groups and S corporations to do the same.  Treasury has made clear it intends to finalize these rules this year, so it is extremely important that S corporations act now to ensure the rules are fixed before they are made final.

Treasury’s Section 385 Regs and S Corps

The business community is beginning to recognize that Treasury’s new Section 385 regulations published on April 4th have a much broader reach than anybody thought.  S corporations in particular need to pay attention.

How broad are they?  Here’s how Tax Notes described a meeting of the ABA Section of Taxation here in DC last week:

Practitioners who specialize in the taxation of S corporations said they’re concerned that many S corps may end up gratuitously losing their S corp status if the new related-party debt rules are applied as written without exception.

Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC said that as he reads the new rules— in particular the bifurcation rule of prop. reg. section 1.385-1(d), which enables the
government to divide a purported debt instrument into part debt and part stock — they could apply to debt issued by an S corp in a way that could automatically invalidate an S corp election.

Released April 4, the proposed section 385 regulations (REG-108060-15) generally treat
related-party debt as equity unless it facilitates new net investment in the borrower’s operations.

Although the regs were released along with a set of new anti-inversion rules, the section 385
regs can apply to transactions that have no connection at all to foreign acquisitions of U.S.
companies. Nichols said May 6 at the S Corporations session of the American Bar Association Section of Taxation meeting in Washington that the rules could turn debt into stock that could potentially violate the S corp single class of stock requirement or the eligible shareholder rule.

The disconnect appears to be that while the Treasury regulations were advertised as targeting corporate inversions, the actual policy would apply to the related party debt of all US companies, not just those moving overseas or seeking to shift income from one tax jurisdiction to another.

The bottom line is the proposed rules appear to give the IRS the ability to re-characterize the related party debt of a large percentage of S corporations.  As S corporation owners know, the downside of having your debt remade into equity is not limited to the loss of an interest deduction.  S corporations are only allowed to have a single class of stock.  If they have more than one class of stock, they revert back to C corporation status.

Existing tax rules provide S corporations a safe harbor to ensure that different forms of debt are not misconstrued as equity and threaten their status.  The proposed 385 regulations appear to override those existing rules.

A final point to make is that the effective date for the proposed regulations is April 4, 2016.  So unless they are pulled entirely, or revised significantly, the proposed regulations already threaten the normal business practices of S corporations across the country.

The business community is gathering its forces to communicate its response to this massive regulatory proposal.  It will be interesting to see if this Treasury Department listens.

Extenders – The Post-Thanksgiving Update

Lots of noise on the extender front, but is there progress being made?  Hard to tell.  Last week, a list of potential items made the rounds that would have made some provisions permanent, some extended for 5 years, and some extended for 2 years. Specifically, the list included:

  • Permanent: All the House passed permanent provisions, including small business expensing and the shorter built-in gains recognition period but not bonus depreciation, plus changes to the American Opportunity tax credit, child tax credit, the earned income tax credit.
  • 5-Year: Bonus depreciation, the Production Tax Credit and Investment Tax Credit, and the Work Opportunity Tax Credit.
  • 2-Year: All the other extender provisions that were previously included in the Senate Finance Committee-report bill.

In other words, the package looked a lot like the starting point Ways & Means Republicans would choose for negotiations.  Then this week a competing list was circulated that kept the basic structure but added some extraneous provisions, including:

  • Indexing the refundable tax credits;
  • A 2-year delay on the Affordable Care Act “Cadillac Tax”; and
  • A 2-year holiday from the medical device tax in exchange for additional funding for the ACA risk corridors.

These items, in particular the risk corridor proposal, are highly controversial and would require concessions on the part of Republicans to move.  In other words, this package looks like something the House Democrats might put together in response to the initial list.

Regardless of who put the lists together, they give outsiders like S-Corp a sense of where the sides line up.  What’s unclear is how active these talks are, and who’s involved.  At various times in the past couple days, we’ve heard that that the real talks have yet to begin, that a proposed deal was already submitted to the White House, and that the tax writers had taken it as far as they could and it was up to congressional leaders now. Finally, Bloomberg reported yesterday that talks between congressional leaders have stalled, at least for the moment, over the indexing issues.

The big picture here is that Congress may (finally) be getting serious about ending the multi-year roller coaster ride of extenders.  These provisions expired at the end of last year, and while we’re running right up against the end of the tax year for most families and businesses, it’s gratifying that at the very least “permanence” and “multi-year extensions” are still on the table.  Let’s hope they get off the table and on to the President’s desk.


Treasury’s Move to Stop Inversions

The recent wave of Inversions and related corporate buyouts are yet another reminder that the US tax code is broken. The Pfizer and Allergan announced deal is the largest buyout in pharmaceutical history and, as the Wall Street Journal notes, the US corporate tax rate was a leading motivator:

[Pfizer CEO] Mr. Read has railed against high U.S. corporate tax rates, which he says puts American-based companies like Pfizer at a competitive disadvantage to their overseas rivals. Pfizer’s tax rate is about 25%, the highest among its Big Pharma peers, according to Evercore ISI.

Of course, many pass throughs and domestic corporations pay effective tax rates exceeding 30 percent, so 25 percent looks pretty good to them.  But we digress.  In an attempt to stem the tide, Secretary Lew announced new Treasury guidance last week. According to Politico and the Financial Times, these rules won’t do much:

Treasury officials think the third country rule is likely to have the most teeth. And administration officials swear up and down that Pfizer’s talks with Allergan aren’t why we’re seeing the new rules now. “We’re really not focused on particular companies or particular transactions,” one Treasury official said.

Fair enough, because experts like Steve Rosenthal at the Tax Policy Center say the new rules wouldn’t be much of an impediment to a Pfizer deal. “These measures are technical changes around the edges,” Rosenthal told The Financial Times. “It’s a welcome mat for Pfizer to combine with Allergan and strip its earnings.”

In fairness, Secretary Lew conceded that the limited scope of the rules comes from the fact that Congress, not the Treasury Department, is in the best position to curb inversions by reforming how we tax businesses.  That’s true, but it’s also true that the largest obstacle to tax reform continues to be the White House, which refuses to consider lowering the rate for individuals and pass-through businesses.  Did we mention that many of these businesses already pay higher rates than Pfizer?

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