S-Corp Testifies

S-Corp President Brian Reardon testified yesterday before the Senate Small Business Committee in a hearing entitled “Tax Reform: Removing Barriers to Small Business Growth.”  As Inside Sources reported:

The hearing primarily focused on ensuring small businesses are considered in the current push to lower corporate tax rates. The Small Business Administration found that small businesses make up a sizable portion of the national economy at 49.2 percent of private-sector employment.

“As we all know, our tax code is in need of reform,” New Hampshire Democratic Sen. Jeanne Shaheen, the ranking member of the committee, said at the start of the hearing. “As Congress considers tax reforms, we need to make sure small businesses are at the table.”

The S-Corp testimony focused on themes familiar to S-Corp readers, including the fact that pass through businesses like S corporations employ the majority of private sector workers, so that any effort to reform the tax code should start with those businesses in mind.

Testifying

You can watch the full hearing here

In addition to tax reform, the testimony touches on other important consistent S-Corp priorities like the S Corporation Modernization Act and the withdrawal of Treasury’s proposed 2704 regulations.  Asked about how we ended up with one of the worst tax codes in the world, Brian made the case for action:

Back in 1986, when we last reformed the code, we brought the corporate rate down from the high 40s down to 35 percent. At the time that was one of the lower tax rates in the developed world. I think the average for the OECD at that time was about 44 percent. Today the average for the OECD is down in the low 20s while we’re still at 35 percent. 

So we’ve been sitting still, both on rates and also this idea of a worldwide tax system. We tax our businesses on their earnings wherever they are made. Most countries in the last 10-15 years have moved to a territorial system. England did. You know, 10 years ago, England (UK) had the same problems we did — they had inversions, companies were moving overseas, they were losing to other countries…they completely revamped their rates, they cut the rates down, they moved to territorial, and now companies are moving to the UK not away from the UK.

You can read Brian’s full written remarks here.

Pass Thru Rates & Enforcement

As Congress returns to tackle tax reform, one area of consensus continues to be ensuring that Main Street is treated fairly by establishing a new, low top rate on pass through businesses.  But separating business and individual rates brings its own challenges.  As BNA reported last week:

Economists and tax accountants note that taxing pass through income at rates distinct from the individual income scale would open up incentives for taxpayers to route their income through the lowest rate path. Treasury Secretary Steven Mnuchin recently said tax reform legislation would include rules to prevent people from gaming the tax rate meant to spur business investment.  

From S-Corp’s perspective, creating a unique rate for pass through businesses requires two essential steps:

  • First, you have to define the new pass through tax base correctly.
  • Second, you have to include enforcement rules to reduce or eliminate the opportunity for individuals to recharacterize their wage and salary income as business profits in order to access the lower tax rate.

The first of these challenges is fairly straightforward.  A rate applying to pass through businesses should mirror the tax base for corporations and be broadly defined, embracing all the active business income earned by businesses organized as pass throughs.  H.R. 116 from Representative Vern Buchanan (R-FL) is a nice example of how this should be done.

The second challenge is more problematic and has been with us since Congress eliminated the wage cap on Medicare taxes back in 1993.   Exactly how do you distinguish returns from an owner’s personal labor from returns on his/her investments in capital and employees?  It’s not easy and, more importantly, getting it wrong has the potential to completely undo the benefits of tax reform to Main Street businesses.

By way of example, a provision in the Camp tax reform draft would have established a strict, 70/30 ratio of wages to business profits for all pass through businesses.  S-Corp and the rest of the Main Street business community pushed back hard, arguing that a fixed ratio recharacterizing business profits as wages was unfair and would hurt pass through businesses with lots of employees and capital investments.

This same argument applies if the Committee would add the 70/30 rule to the House Blueprint.  Ostensibly, the Blueprint has a top rate structure of 33 percent for wages, 25 percent for pass through businesses, and 20 percent for C corporations.  But applying the 70/30 test broadly to active owners means in reality the top rate for S corps and partnerships would be closer to 31 percent, 11 percentage points higher than the C corp rate.  We’re not perfectionists when it comes to rate parity, but having an effective rate more than 50 percent higher than competing C corps isn’t rate parity in anybody’s book.

Moreover, the strict 70/30 rule has the potential to turn the Blueprint from a tax cut to a tax hike for many pass through businesses.  To understand the threat, look at how coupling the Blueprint with the 70/30 rule would affect this particular S corporation manufacturer.

Tax Reform Example

As you can see, not only does the 70/30 rule result in this manufacturer paying significantly more than a similar C corporation, it means the Blueprint could be an actual tax hike on this manufacturing company.  Under current law, they pay $1.16 million in taxes.  Under the Blueprint, they would pay $60,000 more.  The Blueprint’s lower rate is fully offset by the loss of state and local tax deductions, Section 199, and the ability to write-off interest expenses.

You can see a full discussion of these issues in this presentation, but the simple fact is that if Congress is going to establish a separate rate for pass through businesses, it needs to get the enforcement challenge right.  Getting it wrong means completely undoing the benefit of lower rates and the other pro-business provisions in the Blueprint.  More on this to come.

 

2704 Study Highlights Threat from Proposed Rule

This week, the S Corporation Association along with several other trade groups released a new study highlighting the threat the pending Section 2704 rules pose to family businesses and their employees.

Authored by former Clinton economist Dr. Robert Shapiro and entitled “An Economic Analysis of Proposals to Limit the Recognition of Valuation Discounts for Transfers of Interests in Large Family Businesses,” the study finds that family-controlled businesses are a significant source of earnings and employment in the US economy.  According to the study:

  • Large family businesses account for 31.8 percent of U.S. business revenues, 30.7 percent of U.S. private employment, and 31.1 percent of U.S. payrolls.
  • Large family businesses have less employee turnover, leaner cost structures, and smaller debt burdens; they also invest at higher rates and over longer time horizons than comparable non-family businesses.

Meanwhile, the pending section 2704 rules would 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, with a goal of highlighting the threat these pending rules pose to family businesses and their employees.

With the Trump Administration actively seeking ideas on how Treasury can reduce red tape and encourage investment and growth, withdrawing these 2704 rules should be job one.  A record number of opponents weighed in during the official comment period last fall, yet the rules continue to perplex family businesses and their advisors as they make succession plans.  This one is easy, and S-Corp will be working on it until it’s done.

S-CORP Testifies at IRS

Last month’s elections so dramatically changed the outlook for tax policy in 2017 that we’re still trying to catch up.  The outlook for the proposed 2704 regulations in particular has done an about-face, going from appearing almost inevitable to having the Chairman of the Ways and Means Committee, along with others, targeting them for elimination quickly next year.

But they are not dead yet, and the regulatory process moves on.  Today, the IRS hosted its public hearing on the proposed rules, and the family business community arrived in force—S-CORP in particular. We submitted our formal comments back on October 17th, which you can read here, while today we had four witnesses address the panel – S-Corp President Brian Reardon, Board Member Clarene Law, and Board Advisors Chris Treharne and John Porter.

Nearly 40 tax attorneys, CPAs, and other tax experts weighed in on the rules, but the real star was Clarene Law.  She was one of the few business owners to make the trip to DC to testify, and her story of building a successful hotel business in Jackson, Wyoming over the past half century got directly to the challenge these rules pose to real business owners.  As she told the panel:

 

clarene-irs-testimony

 

I started Elk Country Motels as a 28-year old back in 1962.   My funding came from my mother and father — a housewife and blue collar road construction worker – who had little money but lots of pride.  They trusted me with their life savings of $10,000 and enabled me to purchase a small, 17-room motel- 12 cabins and rooms above the office…,

Over 50 years later, our small business has grown and provided my extended family and employees with a stable living.  Today we manage 450 rooms, all in Jackson and employ over 100 people.

Continuing this family business is of the utmost importance to me. I have high hopes of passing it onto my children and grandchildren.  I feel we can only accomplish my wish for succession with favorable tax consideration which acknowledges legacy businesses such as ours…. 

The proposed regulations under Section 2704 have the potential to severely disrupt these plans. Ownership of Elk Country Motels and our other limited liability companies is divided between my 3 children, myself, my husband and our trusts—all minority interests.

The IRS’ application of family attribution could result in all these interests being valued as if they were controlling, preventing the use of legitimate valuation discounts and leading to estate tax increases that the next generation would have to bear.

This could force my descendants to sell the business in order to pay the taxes. After 55 years of operation, this family would like to stay in business and not just sell out to corporate America.

Longtime S-Corp advisor Chris Treharne of Gibraltar Business Valuations focused his remarks on the technical challenges the rules would pose to appraisers:

“While I understand Treasury’s perception of abuses associated with third-party owners inasmuch they may affect the inability to liquidate an ownership interest or the entity, I am again concerned that inflexible, “bright-line” rules may be potentially abusive, too… I encourage Treasury to identify and adopt alternate, more flexible language that accomplishes its goals of preventing taxpayer abuse without imparting inflexible constraints on legitimate ownership structures and strategies.”

The remainder of comments were almost universally opposed, with a number of speakers recommending that Treasury radically revise and then reissue the proposed rules in order to give stakeholders another opportunity to weigh in with comments.

 

br-at-irs

 

For his part, S-Corp President Brian Reardon focused his comments on what happens next year:

“Looking forward, it is clear these rules need to be withdrawn.  Over 28,000 comments have been received by Treasury during the comment period, and with few exceptions, they all were opposed.  That is an extraordinary outpouring of opposition by the business community and Treasury needs to be responsive. 

It is also clear that Congress needs to rewrite section 2704.  Family attribution is a fatally flawed concept, whether it’s applied broadly, per our reading of these rules, or narrowly, as written into the underlying 2704 statute. 

The S Corporation Association intends to continue to work with stakeholders and tax writers to achieve both of these goals, and we appreciate the willingness of both Treasury and the Congressional tax writers to listen to our concerns.”

With the comment period officially over, Treasury is now tasked with wading through the 28,000 comments and either adjusting the rules to reflect the concerns raised, or explain in detail why they went in a different direction.  It’s a laborious process that could literally take years, which is a frightening notion.  Meanwhile, the new Administration is expected to kill these rules quickly upon taking office.  We hope so.  Innumerable hours and dollars already have been wasted trying to protect family businesses from an unwarranted change in how they are valued.  It’s time for closure and moving on.

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