Here’s a bit of good news for the S corporation community – Treasury has exempted them from the newly published rules under Section 385.
This is a huge relief to the S corporation community. The rules would have hit S corporations the hardest, despite them having no skin in the “base erosion” game. S corporations would have suffered through the new reporting requirements and limitations on cash pooling and related party loans just like their C corporation counterparts, but they also would have faced the prospect of losing their S corporation status, together with the multitude of tax and penalty implications associated with that.
The final rules released yesterday, however, made major changes to the original draft, including exempting S corporations and other entities not likely to practice base erosion from the entire rule. Other important changes include easing the documentation requirements and eliminating the entire so-called “bifurcation rule” that threatened smaller domestic businesses. Those are significant improvements.
As Politico made clear this morning, however, concerns with the rule remain in the broader business community:
But by and large, the response from business was more cautious, and filled with concerns like this from the Organization for International Investment. “We will continue to analyze the final regulations, but remain concerned that they may harm the ability of the United States to attract global investment and limit opportunities for American workers,” said OFII President Nancy McLernon.
More concerns: The effective date for the regulations will still be early April, and there are still some worries that the cash pooling and foreign-to-foreign exemptions might not have enough teeth.
For S corporations, Treasury made the right decision and we applaud them for listening. As our comments from July made clear, S corporations have little or no opportunity to game the system using debt. As with consolidated groups (also exempted from the rule), S corporation income and loss all flow up to the same US tax returns, so deductible interest should always be paired up with taxable income. Here’s what we said back in July:
Application in the S corporation context, however, is inappropriate as the rules relating to S corporations likewise eliminate the possibility of tax arbitrage, making the income reported on Form 1120S analogous to the income reported by a consolidated group on Form 1120 for federal income tax purposes. Therefore, S corporations should be exempted, the same as consolidated group members.
And here’s what Treasury said yesterday when releasing the rule:
Because an S corporation cannot be owned by persons other than U.S. resident individuals, certain trusts, and certain exempt organizations, an S corporation cannot be controlled by members of an expanded group in a manner that implicates the policies underlying the final and temporary regulations. S corporations are therefore excluded from the definition of an expanded group member for all purposes of the final and temporary regulations.
Exempting S corporations allows Treasury to focus their efforts on those entities more likely to engage in base erosion practices, and it allows S corporation owners to focus more on running their businesses. For all those Members of Congress, S corporation experts, and Main Street businesses who weighed in on this, thanks!
Now on to the Section 2704 rules!
It looks like the IRS and Treasury have made their revisions to the proposed 385 regulations and are just waiting for sign-off from the White House. According to our friends at Politico:
Tax lawyers just held a big confab in Boston, and, not surprisingly, it was rife with speculation about just what the Treasury Department’s final Section 385 rules might contain. Tax Analysts sifted through some of the unanswered questions and predictions now that Treasury has sent final rules to the White House, including whether the department would only finalize part of the extensive anti-inversion rules it rolled out in April. (If so, one lawyer asked, why wouldn’t the department have sent the White House both proposed and final rules last week?) Also of concern: Will the rules still be retroactive, a particular concern of business? “They’ve got enough fights to pick here,” said David Garlock of EY. “If it’s something that’s clearly expanding the scope of the rules and making it tougher, I can’t imagine that they’re going to risk the validity of the whole package by saying that it’s retroactive to April 4.”
Now that Treasury is done redrafting the rules, the White House (the Office of Information and Regulatory Affairs, really) has up to 90 days to review them and suggest revisions. With the Obama Presidency in its waning days, an extended back and forth here is highly unlikely, and we expect to see something posted in the Federal Register before the end of the year.
The S corporation community needs to pay attention here, because the 385 rules as previously drafted have the potential to blow up S elections. As our comments to Treasury back in July made clear:
As a result, if S corporations were subject to the Proposed Regulations, recharacterization of related party indebtedness as stock would result in the loss of S corporation status in nearly all circumstances. The requirement that qualified subchapter S subsidiaries be 100% owned by the S corporation parent would similarly result in “Q-Sub” disqualification in the vast majority of circumstances. Internal Revenue Code Section 1361(b)(3)(B)(i).
The loss of S corporation and/or “Q-Sub” status, in turn, would result in costs far in excess of the increased taxation resulting from any recharacterization of debt as equity, including the payment of IRS and professional fees necessary to seek restoration of S corporation status, the need to change how the business is financed in order to avoid future disqualifying events, and back taxes and penalties related to the disqualification if the corporation is unable to “cure” the loss of S corporation status with IRS consent.
Will the revisions address the concerns of the S corporation world? The answer is unclear. Tax Notes attended the Boston ABA meeting and had this to report on the S corporation question.
Although a Treasury official said recently that the government is considering changes to the proposed debt-equity regulations to address passthroughs, including S corporations specifically, comments from two IRS officials September 30 left the impression that S corporations might want to prepare for final regs that won’t give them a specific carve-out…
Michael Gould, branch 5 attorney, IRS Office of Associate Chief Counsel (Corporate), acknowledged that when there’s a bifurcation in the case of debt issued between two related S corporations (a brother-sister S corporation scenario), that would cause the S corporation election to be invalidated. “At first blush, yes, it does look that way,” he said, adding that it puts pressure on the question “How far does the second class of stock rule go?”
Those hoping for sympathy from the government left largely empty-handed.
“Ultimately . . . what [section] 385 is saying is: Is it debt? Is it equity? And if it’s equity, the proposed regs say it’s equity for all tax purposes,” Jacobs said. “That’s where we are. We’re saying it’s equity for tax purposes, and what happens from there is all of the other results of all the other provisions.”
So no love for S corporations here, but it is not clear if the lack of understanding was a reflection of the draft sitting over at the White House, or the fact that Treasury officials are necessarily constrained in what they can say about a rule before it’s made public. Only time will tell, but once again the tax world gets a really good example of why Congress needs to legislate carefully. Give the Treasury Department some discretion, and it will use it, even if it takes 47 years.
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.