S-Corp Comments on 2704

Monday was the close of the comment period for Treasury Notice 2017-38, and the S Corporation Association joined several other trade groups in submitting our final comments on the pending Section 2704 rules, including our study highlighting the threat these rules pose to family businesses and their employees.
This comment period is the latest in a long saga and we hope it marks the beginning of the end.  To recap:
  • August, 2016 – Treasury issues Notice 2017-38 targeting proposed rules under Section 2704;
  • November, 2016 – The official comment period closes, with Treasury receiving a record number of comments in opposition to the rule (read S-Corp’s comments here);
  • December, 2016 – Treasury and the IRS host a hearing on the proposed rules, which lasts a record six hours (read S-Corp’s testimony here);
  • April, 2017 — Release of Trump Executive Order 13789directing Treasury to review all rules published since January 1, 2016 and identify those that are financially burdensome, unduly complex, or exceed Treasury’s authority; and
  • June, 2017 – Treasury targets eight rules for revision or repeal out of the 105 studied, including the harmful Section 2704 rules.
The study we submitted in this most recent comment period was authored by former Clinton economist Dr. Robert Shapiro makes clear that the Section 2704 rules violate all three of the criteria established in the President’s EO – they are financially burdensome, they are unduly complex, and they exceed Treasury’s authority.   They would also hurt the ability of these family businesses to grow and create jobs.  The study finds that:
  • Limiting valuation discounts under the Proposed Rule would increase estate taxes for large family businesses by $633.3 billion, in present discounted dollars, over the next 46 years.
  • To prepare for this additional burden, these businesses would divert resources, equivalent to the additional tax they will owe, from their normal business investments.
  • The projected reductions in their investments in equipment and machinery would reduce GDP growth, in 2016 dollars, by $2,476 billion from 2016 to 2062.
  • This slower growth also would reduce job creation over the next decade by 105,990 jobs.
The study was sponsored by the S Corporation Association and several other groups, including the Real Estate Roundtable, the Associated Builders and Contractors, and the Independent Community Bankers of America.
So now with numerous publications and comment periods behind us, the record is clear.  The proposed Section 2704 rules are harmful to family businesses and the people who work for them and need to be withdrawn.  Soon!  It has been just over a year since these rules were first published and it’s time to put them to rest.

S-Corp in the News

The Washington Examiner published a piece Monday on the implications the failed health care reform effort has for tax reform.  First among those is the continuation of the so-call Net Investment Tax that applies to investment and pass through business income.  As the Examiner notes:
And one of the taxes in particular, a tax on investments for high-income earners, hits many of the small businesses that Republicans have been trying to create new provisions to help. 
 
That would be the net investment income tax, a 3.8 percent tax surcharge on capital gains, interest and dividends for families making more than $250,000.  Repealing the tax would cut revenue by $172 billion over 10 years, according to Congress’ Joint Committee on Taxation. 
Although the tax applies to individuals, it also falls on businesses that file through the individual side of the code, a category that Republicans are hoping to privilege with a new special tax rate.
 
“It hits a broad swath of family businesses,” said Brian Reardon, President of the 
S Corporation Association. 
 
Nonmanagement partners in S Corporation businesses get hit with the 3.8 percent tax on the companies’ earnings, Reardon noted.  “It drains money from active businesses,” he said. 
 
S-Corp has been leading the charge to repeal this harmful tax since its inception seven years ago, most recently organizing a letter supporting the tax’s repeal signed by 40 national business trade groups.  The tax was initially presented during the Obamacare debate as a “Medicare” tax on high income investors, but it has nothing to do with Medicare and its burden falls on a large percentage of pass through businesses, as well as a majority of annual savings.  It’s a surtax on savings, pure and simple.
Failing to eliminate this tax as part of health care reform was a huge miss for the economy, so it must be done within the tax reform debate instead.  The business community is united around the idea of bringing down all business tax rates and moving towards rate parity, but that can’t happen with this tax in place.  It has to go.

S-CORP Testifies

 

Ahead of the extender deadline, S-Corp was on the Hill testifying yesterday that Congress needs to act to end the extender roller coaster and make permanent these provisions, including the built-in gains relief that affects so many of our S corporations.  At a hearing hosted by the House Small Business Committee entitled “Tax Extenders and Small Businesses as Employers of Choice” S-Corp was represented by Tom Nichols, Chairman of our Board of Advisors.

Tom Nichols Testimony 12.3

Tom opened his remarks by highlighting the important role pass-through businesses play in employment and job creation, and then focused on a number of specific actions Congress could take this month to ensure they continue in this role, including making permanent the shorter, five-year holding period for the built-in gains tax.  As Tom noted:

Delaying confirmation of the five year built-in gains tax period has similarly destructive consequences. In the past several years, small business owners have asked me repeatedly whether the five-year or ten-year period will apply. The only response I could give them is that the final built-in gains period will “probably” be five years, but that they can’t count on it.

This has created a number of excruciatingly difficult situations for my clients. For example, several of my farming clients were attempting to sell agricultural land – either to raise capital or to finance their pending retirement – while farmland prices were at their peak. Unfortunately, for those in the critical 6 to 10-year “limbo” period, this uncertainty constituted a huge stumbling block, and now it appears that the optimal time for selling is gone.

I had another client who wanted to sell his business, but could ill afford to do so if the double-tax built-in gains regime was applicable. I recommended that he and the buyer reach agreement and have all the documents prepared, but wait until actual passage of the extenders legislation to sign and close the deal. His response was that he was in poor health and may not be able to wait.

As with expensing, a five-year period for the built-in gains tax is well supported by policy considerations. The built-in gains tax was originally enacted in the Tax Reform Act of 1986 and was intended to prevent C corporations from converting to S Corporation status and selling some or all of their business subject only to the single-tax S Corporation regime. To be honest, I have never understood why paying only one tax upon the sale of a business was considered a loophole to be closed. Regardless, it is generally recognized that a ten-year waiting period is much longer than necessary in order to achieve the initial policy goal. Given the uncertainties and vagaries of conducting business, business owners are extremely unlikely to elect S Corporation status with concrete plans to sell after waiting for a period of five or more years.

You can read Tom’s written analysis here.  Small and closely-held businesses play an invaluable role in creating jobs where they are most needed, despite all of the unnecessary obstacles imposed on them by Washington. But it doesn’t have to be so difficult. Failing to make business extender items like built-in gains permanent is a wholly unforced error that this Congress has the ability to fix.  Talks are going on right now.  Let’s hope they come to a happy conclusion.

 

Pass-Through Tax Rates

More on the effective tax rates pass-through employers pay.   Sitting next to Tom at yesterday’s hearing was Todd Kriegel, the CEO of Global Precision Parts. Todd’s company has a profile that many S-Corp members will find familiar—a family-owned, S corporation manufacturer with 200 employees split across three locations in Indiana and Ohio.

Also familiar to S-Corp readers is how the Fiscal Cliff resulted in a massive tax hike on Todd’s business:

GPPs current federal effective tax rate is 39.4%, far higher than our C-Corp counterparts, not to mention the Chinese companies who we really are competing against. In 2008, we had a 28.07% effective federal tax rate with the Alternative Minimum Tax. That 11.33% jump in our tax liability cost us hundreds of thousands of dollars we could have used to hire more workers for the machines we would have purchased.

Just last April, S-Corp Board member Dan McGregor of McGregor Metalworking gave similar testimony on how the effective rate on his metal-working business jumped from 33 to 42 percent as a result of the fiscal cliff!

Following the resolution of the fiscal cliff, the top tax rate on my shareholders increased to approximately 41.4 percent due to the higher 39.6 percent marginal rate plus, where applicable, the new 3.8 percent Affordable Care Act tax and the effect of the reinstatement of the Pease limitation on itemized deductions. As a result, today we have to distribute approximately 42 cents of every dollar earned so our shareholders can pay the federal, state and local S corporation tax.

Dan and Todd employ hundreds of well-paid manufacturing workers in communities — like Springfield, Ohio and Wabash, Indiana — that desperately need jobs.  And they are being forced to compete not only with Chinese companies that play by an entirely different set of rules, but also with domestic C corporations that enjoy significantly lower tax rates.  The CEO of Pfizer complains about his 25 percent effective rate?  We’re guessing Dan and Todd would swap with him in a second.

Any reform of how we tax business income needs to begin with Main Street businesses.

President Signs BIG Relief!

In a capital-starved economy, what makes more sense than allowing firms access to their own capital? For one year beginning in 2011, hundreds of thousands of S corporations around the country will be able to do just that, thanks to the efforts of the S Corporation Association and its allies in Congress, particularly Senators Grassley, Lincoln, Hatch, and Snowe and Representatives Kind and Reichert.

On September 27th, President Obama signed into law the Small Business Lending Fund Act of 2010 (HR 5297). Among other business friendly provisions, the bill includes one of the S Corporation Association’s tax priorities, a reduction in the built-in gains holding period. The provision is for 2011 only, but it allows firms that converted as few as five years ago to sell appreciated assets without paying the punitive built-in gains tax.

This success builds on last year’s reduction in the holding period to seven years, and we hope it signals a move towards permanently reducing the holding period below the old ten-year requirement. Ten years is a long time, and in a world where capital is dear, it only makes sense for firms planning new investments to begin by accessing their own capital.

 

Latest on Tax Outlook

House Speaker Nancy Pelosi (D-CA) has lost control of the tax debate headed into the November elections. Last week, 31 House Democrats signed a letter supporting extending all the individual tax rates, including the top two rates. Then, 47 Democrats wrote Speaker Pelosi calling for keeping dividend and capital gains rates at their current 15 percent. As The Hill reports:

Forty-seven House Democrats have signed a letter calling on Speaker Nancy Pelosi (D-Calif.) to extend the current tax rate on capital gains and dividends. “By keeping dividends and capital gains tax rates linked and low for everyone, we can help the private sector create jobs and allow seniors and middle-class households to save and invest more,” the letter states. Under current law, beginning next year capital gains will be taxed at 20 percent while dividends will be taxed at ordinary income rates that go as high as 39.6 percent.

As a result, a majority of House members now support extending all the current rates, at least temporarily. How is it possible that an issue that’s been 10 years in the making is still unresolved eight weeks before the election? Keith Hennessey has a very good entry on his blog outlining the steps Congress took to get here. As Keith points out:

The sequence of events was:

1. The President picks a big fight on the tax extension and highlights the partisan split;

2. a handful of Senate Democrats signal they’re not onboard; (first warning)

3. the Speaker says “the Senate will go first;” (second warning)

4. the President doubles down on the fight and elevates the conflict by making it the centerpiece of his election-cycle argument;

5. the President’s just-resigned budget director guts the President’s argument in his first New York Times column; (third warning)

6. (same day as #5) the President proposes “new” policies that are ignored by both sides; (confusion reigns)

7. Members return from August recess;

8. 30 House Democrats bail on the President’s position; (final blow)

9. Senate Democrats delay the vote until after the election.

That’s not poor coordination, it’s a total absence of coordination. Going into a highly partisan conflict on the other team’s turf, you either make sure your team is unified first, or when you figure out they’re not, you concede or switch topics quickly. We have seen a strategy and an alliance slowly collapse over a several month period. I don’t understand how the blue team [Democratic] leaders could allow that to happen.

So that’s how we got here. How does the Speaker respond? Last month, we listed the possible outcomes of the rate debate. Congress could:

  • Extend all current tax policies (except the estate tax rules) for one or two years;
  • Extend just those policies benefiting families making less than $250,000; or
  • Do nothing and leave this issue to the next Congress.

The events of the last week have killed option two. There may be a way for the Speaker to move a middle-class-only bill through the House, but we are unable to think of how. There’s talk they may consider the bill under the Suspension Calendar, but suspensions need two-thirds support in order to pass, and the Speaker doesn’t control a simple majority on this issue. Once you lose the majority on an issue in the House, you generally lose.

Option one is becoming increasingly likely, but it would require the Speaker to allow a vote on blocking all the tax hikes when Congress returns in November. She may not control a majority on this issue, but she does control the floor. It would also require an emboldened Republican conference to accept a temporary fix to an issue they probably would like to fight next year.

So while “extending all” is moving up on the options list, we continue to believe the most likely outcome is that this issue will remain unresolved through the end of the year and would be the first order of business for the new Congress.

 

More on “Big” vs. “Small”

Meanwhile, the debate over how higher rates might impact business continues. On Meet the Press Sunday, Representative Chris Van Hollen (D-MD) made the following point about extending all the tax rates:

They have tried to mask this as an issue with small businesses. Well, it turns out that only 2 percent of small businesses are affected. And when you look at the definition of small businesses, you find that they’re big hedge funds, big Washington lobbying firms, KKR, Pricewaterhouse. Because, under the definition of tax code, anything that’s an S corporation qualifies. So I want Mike to tell us whether he really believes that KKR, whether Pricewaterhouse, whether those are the kind of small businesses that need help? Because that’s the folks that they’re trying to help out.

S-CORP ally and AEI economist Alan Viard warned policymakers about this argument earlier this month. As he wrote in an AEI research piece:

A common argument is that the high-income rate reductions lower taxes on small business. The valid form of this argument, recently explained by Kevin A. Hassett and myself, is that the rate reductions lower marginal tax rates on investment by all firms, including small businesses. Unfortunately, the more common forms of the argument adopt an exclusive focus on small business and obscure the growth implications.

To begin, the argument is often founded on the mistaken premise that small firms are inherently better than large firms, which suggests that the government should interfere with market forces to promote the former over the latter. In a previous Outlook, Amy Roden and I explained that firms of all sizes contribute to national prosperity and demonstrated that small firms do not play a disproportionately large role in job creation. By focusing only on small (more precisely, pass-through) firms, the argument ignores the adverse effect of letting the high-income rate reductions expire on investment by big business. The data cited above suggest that the affected high-income households finance a greater fraction of corporate investment than pass-through investment. The potential tax-rate increase on corporate investment is also larger, at least if the dividend tax cut fully expires.

While in the past we’ve disagreed with Alan on the job creating capabilities of smaller businesses, we agree wholeheartedly with him that allowing the rate debate to devolve into a fight over the size of the businesses affected is simply a distraction. This is a debate about jobs and not raising taxes on employers, regardless of how many people they employ.

On the question of large S corporations, the IRS does a nice job of breaking down the S corporation community by size and industry in its SOI reports. The most recent numbers can be found in the IRS data book while more in-depth figures date back to 2007. Here’s a quick profile we pulled from the numbers:

  • There are 4.5 million S corporations (2009);
  • The average S corporation has $1.5 million in revenues and $100,000 in income (2007); and
  • Assuming a wage of $40,000, the average S corporation has five employees (2007).

These are simple averages, but they provide a general sense of the S corporation world. In terms of revenues, the majority of S corporations can be found in wholesale and retail, followed by construction, manufacturing, and then professional services.

In short, S corporations are large and small. They are active in every industry and in every community, and they provide millions of much-needed jobs to families across the country — even the big ones.

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