As we reported last week, a bipartisan group of tax writers in the House and Senate have introduced this year’s version of the S Corporation Modernization Act. The bills (H.R. 1696 & S. 711) are sponsored by Senators John Thune (R-SD) and Ben Cardin (D-MD) and Representatives Dave Reichert (R-WA) and Ron Kind (D-WI).
This week, a group of eighteen Main Street business groups wrote to Congress in support of the legislation, including the National Federation of Independent Business, the Associated Builders and Contractors, the Independent Community Bankers, and the American Council of Engineering Companies. As the letter states:
Main Street businesses are the growth engine of America’s economy and S corporations are the cornerstone of the business community. There are more than 4.7 million S corporations nationwide. They are in every community and every industry and they employ one out of every four private sector workers.
Yet many of the rules that govern the day-to-day management of S corporations date back more than half a century. These outdated rules hurt the ability of S corporations to grow and create jobs. Many family-owned businesses would like to become S corporations, but the rules prevent them from doing so. Other S corporations are starved for capital, but find the rules limit their ability to attract investors.
This year’s legislation is the ninth Congress in a row that the S Corporation Modernization Act has been introduced. Over the years, we have had great success getting many of the bill’s provisions enacted into law. Just last Congress, we saw the shorter built-in gains recognition period and the charitable basis provisions made permanent.
This year’s bill includes provisions that increase access to capital by reducing S corporation ownership restrictions, ease punitive restrictions that apply to converted S corporations and punish the unwary, and level the rules between S corporations and partnerships when their assets are passed on from one generation to the next.
With tax reform on the table, we are hopeful that these provisions can be included in the broader effort. The S Corporation Modernization Act has a strong history of seeing its provisions enacted into law and we’d like to keep that momentum going!
Good news on a hot day in July! The 2016 version of the “S Corporation Modernization Act” has been introduced the House and the Senate. Led by Senators Thune (R-SD) and Cardin (D-MD) and Representatives Reichert (R-WA) and Kind (D-WI), the bill includes a half-dozen provisions designed to improve the rules that govern S corporations.
- You can see the entire bill here
- You can see the section-by-section analysis here
- You can see the S-Corp press release here
Yesterday’s introduction of companion bills is the first time in a while that the S corporation community has had this important legislation being championed in both bodies, and we really appreciate the hard work the members and their staffs put in to get the provisions just right.
Of particular note is the fact that Senator Thune is taking on the leadership of the bill from Finance Committee Chair and longtime S corporation advocate Senator Orrin Hatch (R-UT). South Dakota has a ton of S corporations and ranks second nationally in pass-through employment, so this effort is important to Senator Thune and his state and we look forward to his enthusiastic leadership. As he noted at the introduction:
Family owned small businesses are the backbone of the U.S. economy and can be located in every corner of the country. Small towns and rural communities are oftentimes the ideal location for these small- and medium-sized businesses, which is why making these common-sense reforms to S corporations is so important to South Dakota.
Senator Ben Cardin added:
S corporation businesses are critical to the well-being of the Maryland economy and account for more than half of our state’s private-sector workforce. Unfortunately, our federal tax code has not kept up with the increasingly important role that these types of companies play,” said Cardin. “The S Corporation Modernization Act contains much-needed changes to the tax treatment of S corporations, allowing them to better attract capital, create jobs, and make charitable investments in their communities.
Key changes in this version relative to past efforts include:
- Dropping the two provisions – BIG and charitable – that were made a permanent part of the Tax Code last December
- Moving the Nonresident Alien provision up to the top slot – it is time for direct foreign investment to be available to S corporations; and
- Including the new internal basis adjustment provision to ensure that S corporation assets receive similar treatment as partnerships.
So your S-Corp team has a new bill, new champions, and new priorities to accomplish in the coming months and years. The legislative outlook is uncertain, with Congress preparing to break for the party conventions and then, after a short fall session, the November elections. That doesn’t leave us much time, but as always we will be looking for opportunities to get something done. With a terrific bipartisan set of advocates on the Hill, we are in a good position to do just that.
S-Corp Concerns Dominate 385 Comments
The comment period is closed and the verdict is in – just take S corps out. That’s what numerous trade associations and other groups recommended to Treasury regarding the pending section 385 regulations. Here’s what the National Association of Manufacturers had to say:
The proposed regulations also significantly impede the ability of businesses organized as subchapter S corporations to utilize their cash effectively. In particular, the bifurcation rule in the proposed regulations, which allows the IRS to treat a debt instrument as part debt and part stock, could cause a subchapter S corporation to lose its S status and become taxed as a C corporation.
In order to qualify as an S corporation, an entity must have only one class of stock (identical rights to distribution and liquidation proceeds) and must be owned only by eligible shareholders (examples of ineligible shareholders include C corporations, foreign corporations, partnerships, insurance companies and non-resident aliens). The reclassification to stock, or part stock, could inadvertently create an ineligible S corporation shareholder (e.g., if the debt reclassified to stock was held by a C corporation, the C corporation would become an ineligible S corporation shareholder); and/or the reclassification to stock could create a second class of stock via preferred return consideration on the debt instrument….
The proposed regulations do not apply to corporations filing a consolidated tax return. S corporations under common ownership, however, are not permitted to file a consolidated tax return and thus, the proposed regulations apply to commonly-owned S corporations, even those with solely domestic activity. The NAM strongly recommends that subchapter S corporations be exempted from the final regulations.
Other groups made similar arguments and their conclusions were just as strong. Here’s just a sample:
Exclude S corporations from the expanded group.
We recommend that S corporations be exempted from the application of the regulations.
Provide exceptions to ensure that S corporations do not inadvertently terminate their status when debt is reclassified as equity.
The rules should exempt S corporations which clearly cannot be a focus for the issues of concern regarding the Proposed Rules.
Exclude S corporations, as well as certain other entities, from the ambit of the proposed regulations (i.e., revise Prop. Treas. Reg. § 1.385-1(b)(3)(i)(A) so that it only “turns off” paragraph (3) of section 1504(b)).
The IRS is holding a public hearing on the proposed rules today. Of the 18 speakers listed, many of them are from groups that support excluding S corporations from the rule. We’ll be watching closely to what, if any, reaction there is from the Treasury and IRS officials in attendance. More to come.
As our members know, S-Corp wears two hats when it comes to advocacy – one is defensive where we protect S corporations from bad tax policy. The other is proactive and seeks to improve the S corp rules.
Both hats were on display this week before the House Ways & Means Committee. First, Rep. Dave Reichert (R-WA) discussed his S Corporation Modernization Act which makes a number of improvements to the S corporation rules, including opening the door to foreign investment into S corporations. As Rep. Reichert told the Committee:
“I’ve heard from a seventh-generation family-owned company and the struggles it has faced based on the nationalities of the spouses of the family members, including family members who have had to sell their stock in the company because of current restrictions. With the number of burdens our business owners face, does it make sense to maintain yet another hurdle simply based on who someone decides to marry?”
Allowing S corporations to attract foreign investment has been an S-Corp priority for years. The current restrictions simply make no sense, particularly if the fix is done through an ESBT structure in which the Treasury can be certain taxes will be paid. We’ve come close to getting this policy enacted in the past, and with Rep. Reichert’s leadership, we look forward to seeing it move through Congress soon.
Second, Rep. Vern Buchanan (R-FL) was able to educate the committee on the importance of tax rate parity. For a decade – between 2003 and 2012 – all forms of business paid the same top rate. Today, as a result of the Fiscal Cliff and Obamacare, C corporations continue to pay the same 35 percent top rate, but the rate on pass throughs is nearly 45 percent!
In response, Rep. Buchanan has introduced legislation – the Main Street Fairness Act – which would restore rate parity by capping taxes on pass-through businesses at the top C corporation rate:
“Today, the average business in Florida, a pass through, [pays] 43 percent, big corporations are at 35 percent. In many places in the country, state and federal is over 50 percent. My bill simply says lower those tax rates to nothing higher than corporate rates going forward.”
What’s the prognosis for these efforts? Shortly after the hearing, Ways and Means Chairman Kevin Brady (R-TX) announced that he was committed to restoring regular order in the Committee, stating:
“Today’s hearing demonstrates that we are serious about considering tax legislation through an open and transparent process. We’re committed to introducing bills, considering them and moving them to the floor. The fact that over 30 Members are sharing their ideas today is a testament to our new process – and to our return after so many years to regular order.”
Does this mean a markup of member-driven proposals is in our future? That remains to be seen, but the fact that the Committee is giving members an opportunity to speak about their respective efforts is promising, and we will continue to work with our friends on the Committee both to protect S corps from bad policies and to fight for improved rules.
Business Community Unites Against 385 Regs
Speaking of bad policies, some of the largest business trade groups in the world have sent Treasury a letter calling on the agency to rethink the proposed section 385 regulations it released last April 4th. You can read the whole letter here, but the core of the letter’s message is contained in these two paragraphs:
Based on Treasury’s April 4 press release, the proposed 385 regulations are designed “to further reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping.” Nonetheless, even a cursory review of these regulations clearly indicates that they go far beyond cross-border mergers and apply to a wide range of ordinary business transactions by global and domestic companies both in and outside the United States.
Indeed, the proposed 385 regulations affect all aspects of both a company’s capital structure and the funding of its ordinary operations and fundamentally alter the U.S. tax rules on intercompany debt by overturning the well-established facts and circumstances analysis used by the courts and the Internal Revenue Service (IRS) to determine whether an instrument is debt or equity. Whether an instrument is debt or equity has significant, collateral consequences to business operations that go well beyond the interest deduction on the instrument and include the legal classification of an entity, eligibility for withholding tax exemptions under tax treaties and the ability to file a consolidated tax return. These issues present a severe impediment to the use of intercompany financing for even normal operations and will significantly increase the cost of capital and limit the amount of capital available to invest in the United States.
We noted in a previous post that these regulations pose a particularly acute threat to S corporations. All the concerns listed above apply to S and C corporations alike, but S corporations also face the possibility that they could lose their classification and be forced back into the C corporation world.
The comment period for these proposed regulations ends on July 7th. We intend to submit extensive comments and hope that others do as well. Our message is simple – these regulations were not well thought out and need to be pulled.