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 Payroll Tax Hike Resurfaces

Last week, Senate Democrats released a paper highlighting a dozen tax increases they would like to use to offset spending cuts in the current budget negotiations. As Politico reported:

Tax expenditures topping the list include the deduction corporations take when they move operations overseas and the carried interest loophole, which allows private equity and some other investment advisers to pay the lower capital gains tax rate on some of their income.

Also on the list is our old nemesis, the S corporation payroll tax hike. Labeled the Edwards Loophole by Republicans and the Gingrich Loophole by Democrats, the issue is that some professionals are using the S corporation structure to avoid paying payroll taxes. According to the Democrats’ release:

Some wealthy business owners knowingly mischaracterize their income as business profits instead of salary to avoid Medicare and Social Security payroll taxes. Ending this loophole would save about $12 billion over the next ten years.

We have a number of objections to this characterization. First, using your S corporation to avoid payroll taxes is not a loophole, it’s tax avoidance. The current reasonable compensation rules are clear and the IRS has a history of going after offenders and winning.

Second, the proposals offered to date are worse than the existing rules. The JCT might score them as raising $12 billion over ten years, but it’s hard to see how the IRS would be able to come up with that level of enforcement.

For example, the provision defeated by the Senate back in 2012 would have replaced reasonable compensation with a “principle rainmaker” test where the IRS would have to determine whether 75 percent or more of the gross income of the S corporation is attributable to the service of three or fewer shareholders. Oh, that’s easy. As a letter signed by 38 business organizations observed:

This new approach, particularly the ”principal rainmaker” test, is neither clear nor more enforceable than existing rules. These rules have been in effect for over half a century, and the IRS has repeatedly and successfully used them to ensure that active S corporation shareholders pay themselves a reasonable wage, most recently in Watson v. US (2011).

The business community responded strongly in 2012 and that opposition remains today. We do not support the misuse of the S corporation structure to avoid payroll taxes, but any replacement to the current ”reasonable compensation” test must be easier for the IRS to enforce and for businesses to comply with.

For those who want more, here are links to the business community letter as well as a longer history of the issue:

SBA Weighs in on Corporate Tax Reform

A new study sponsored by the Small Business Administration adds to the case that corporate-only tax reform, as advocated for by the Obama Administration, would shift the tax burden on to smaller, private companies. As reported by Politico:

Cutting corporate tax rates by trimming costly breaks is a popular selling point for a tax code overhaul, but some small businesses could wind up unintended victims, an independent government agency on Wednesday said, lending support to Republican concerns.

New data from the Small Business Administration warn that the trade-off would be a double whammy to smaller businesses that file taxes as individuals.

These businesses get nothing from a corporate rate cut but they could still lose their tax breaks. The SBA study found that these businesses account for about $40 billion in tax benefits, or about one-third of the $161 billion spent each year on all business tax expenditures.

The top U.S. corporate rate is 35 percent, among the highest in the industrialized world. Although the code is riddled with breaks and loopholes that allow some companies to pay far less, others pay much more.

By contrast, the top rate for individuals, including these so-called pass-through entities, is more than 40 percent.

The study compared the value of tax expenditures for all businesses with those used by pass through and corporate businesses with annual receipts under $10 million. As the study notes:

Of the largest tax expenditure provisions utilized by all businesses in 2013, small businesses will utilize approximately $40 billion out of a total of $161 billion. The estimates indicate that small businesses will utilize approximately 25 percent of the largest business tax expenditure provisions in 2013.

So any effort to eliminate tax expenditures to pay for a lower corporate tax rate would also hit pass through businesses that pay at the individual rates. Not good. As our 2011 E&Y study made clear, such a policy would increase taxes on pass through businesses by $27 billion a year.

Payroll Tax Update

Congressional taxwriters, especially in the House, continue to express interest in raising payroll taxes on active S corporation shareholders as an offset to the tax extender package under consideration, and the business community has responded.

Nineteen groups penned letters to Chairmen Levin of Ways and Means and Baucus of Senate Finance, highlighting their concerns with the proposal. As BNA reported:

Small business groups urged in an April 28 letter that House Ways and Means Committee Chairman Sander Levin (D-Mich.) abandon a proposal that would raise payroll taxes paid by S corporation shareholders. The proposal is being considered as a possible way to raise additional revenues to pay for the annual tax extenders legislation (H.R. 4213) that includes $31 billion in extensions of popular tax cuts that expired at the end of 2009.

Setting aside the politics of raising taxes on small employers during an economic downturn, another significant challenge confronting tax-writers is the lack of an actual proposal. This idea has been around for years, yet the number of bills introduced with some form of this provision included is few — maybe only the Rangel Mother bill introduced in the fall of 2007. The association letters focused on that provision because it’s the only one out there.

A member of the American Institute of Architects had a chance to speak to this issue yesterday when he testified before the House Small Business Committee:

Although the details of the proposal currently under consideration are unclear, it is my understanding that the proposal would expand the application of payroll taxes to active shareholders of S corporations primarily engaged in the performance of services. I understand that there is concern that some S corporations misclassify salary compensation as earnings distributions in order to avoid paying payroll taxes. However, my fear is that the proposal will entrap millions of small business owners who are legitimately and correctly classifying salary and earnings distributions, with limited public policy benefit.

Yesterday’s hearing was unique in that, to the best of our knowledge, it was the first public testimony on this topic in years. The head of the Joint Committee on Taxation outlined a proposal to apply self-employment taxes to all partnership, LLC, and S corporation income before the Senate Finance Committee, but that was five years ago! We are unaware of any other legislative activity on this topic before last month, when the concept was floated to Ways and Means Members as a possible pay-for for extenders.

Overturning fifty years of tax policy should be a big deal and approached in an orderly fashion, not done at the last minute and on the run.

Payroll Taxes and the 3.8 Percent Investment Tax

With the S corporation payroll tax issue front and center, we’ve been revisiting the adoption of the 3.8 percent investment income tax as part of healthcare reform. There are a number parallels that deserve to be pointed out.

First, both taxes were introduced into the process at the eleventh hour. The 3.8 percent tax was introduced into the debate after both the House and Senate had passed their respective health reform bills and barely a few weeks before the whole package was signed into law. In terms of size and speed, the 3.8 percent investment tax is the LeBron James of the tax world. It’s likely nothing that size ($210 billion over ten years) has moved from introduction to law that quickly in the history of democracy.

Meanwhile, the S corporation tax is under consideration for the extender package. That package has already passed both the House and the Senate and the S corporation provision was not part of either bill. As with the 3.8 percent tax, it hasn’t actually been introduced in any legislation — it’s just a concept. And, like the 3.8 percent tax, this concept has never been subject to hearings or review.

Second, while both taxes are described generically as payroll taxes, they aren’t. The 3.8 percent tax is a tax on savings and investment only. It does not apply to wages or other forms of labor income. The same is true for the S corporation tax. For law-abiding shareholders, it’s a tax on returns from business investment.

Third, one of our arguments against the S corporation payroll tax is that it would, for the first time, fund Medicare with taxes on capital rather than labor. Some have suggested that the 3.8 percent tax broke that barrier already — not true.

There is no connection between the 3.8 percent investment tax and Medicare. The House struck the Medicare connection in the manager’s amendment filed the day before the package was adopted. So, while the tax still has “Medicare” in its title, none of the revenues raised by the tax go to the HI or related Medicare trust funds. Calling the 3.8 percent tax a Medicare tax, or even a payroll tax, is simply incorrect.

Finally, the 3.8 percent tax applies to just about all forms of investment income — rents, royalties, annuities, partnership income, etc. — except for business income earned by active shareholders of S corporations. Active shareholders of S corporations were explicitly exempted. Yet, the new S corporation payroll tax currently under consideration for the extenders package would effectively reverse this policy decision by applying a 3.8 percent tax to the business income of active shareholders!

Americans Love Small Business

The American economy’s reliance on small, closely-held businesses is unique in the developed world. Most other major economies focus their economic energies on large public corporations, but not the United States. Notwithstanding the financial crisis, the Jeffersonian concept of the yeoman farmer is alive and well and lives on Main Street.

As we’ve pointed out before, this emphasis on small and independent didn’t happen by accident. It was the result of conscious efforts by past Congresses — both Republican and Democratic — to empower Main Street business.

A recent poll by the Pew Research Center suggests this reliance on private enterprise is in synch with the American people. As reported in USA Today:

According to the just-released study by the highly respected Pew Research Center, small business is the most trusted institution in America. More than churches. More than colleges. More than technology companies. And certainly more than labor unions or large corporations.

The results were “striking,” according to Carroll Dougherty, Pew’s Associate Director. “At a time when a lot of institutions are viewed negatively, small business is viewed very positively. What’s really interesting is that large corporations are viewed almost as negatively as Wall Street. The contrast between large corporations and small business is enormous.”

“So much of this survey is partisan,” Dougherty continued. “In this case, it’s bipartisan. It crosses party lines.” 72% of Republicans, 70% of Democrats and 73% of independents say small businesses have a positive effect on the way things are going in the country.

Now if we could only translate those positive vibes into positive legislation.

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