The Wall Street Journal featured S-Corp Board member Clarene Law last week in a story focused on the new tax rates for pass through businesses in the House tax reform plan. As the story notes:
Clarene Law said a lower tax rate on pass-throughs would free up capital to add rooms to her hotels in Jackson, Wyo. or buy new air conditioners and washing machines.
“25% if it’s pure, not all cobbled up with a bunch of surtaxes, it would be a great benefit,” said Ms. Law, chief executive officer of Elk Country Motels Inc. Her businesses own more than 400 hotel rooms and generate revenue of more than $10 million a year, she said.
What does Clarene mean by a “pure” 25-percent rate? The priority of the pass through community is making certain that the new, 25-percent rate is real and robust. It should apply to all forms of active pass through business income just as the new 20-percent rate applies to all forms of active corporate income.
The concern here is twofold. First, when Congress has considered special rates for closely-held businesses in the past, they typically have limited the application of the new rate or deduction based on industry and income. For example, back in 2012, the House considered a special, 20-percent deduction for small business income, something you would expect the Main Street community would support.
However, the legislation included several carve-outs – various versions of it imposed limit on revenues, a cap on the number of employees, and excluded certain industries from the deduction. In the end, most of the business community chose not to support the effort.
So for the new, 25-percent rate, how Congress defines the tax base is extremely important. In our communications with Members of Congress, we have emphasized that the pass through tax rate base should:
- Target active business income, rather than active shareholders. Previous efforts to create a separate, pass through tax rate defined the tax base by looking at the shareholder, rather than the business. That’s the wrong approach. If a business makes income manufacturing steel, the income is the same regardless of whether the shareholder is active or passive. The base needs to be broad, and focused on the income, not the shareholder.
- Not be limited by industry or income. Some early versions of a lower pass through rate would have excluded financial services companies from the lower rate. This approach is also wrong – there is no valid policy reason to exclude pass through businesses operating in the financial services area. The tax base for the pass through rate should mimic the C corporation tax base, avoid excluding certain industries, and be as broad as possible.
The second challenge is how does Congress prevent cheating without undermining the value of the new 25-percent rate? Under the Brady plan, the top tax rate on salaries and wages will be 33 percent, while the top rate for pass through businesses will be 25 percent. For owners that also work at the business, there will be an incentive to allocate as much of their total income as possible as business profits rather than wages and salaries.
This is an old issue – it dates back to 1993 when Congress removed the salary cap on Medicare Payroll taxes – and we have addressed it many times in the past. The larger rate differential in the House plan, however, raises the stakes, and lawmakers are eager to find a solution.
The challenge is how exactly do you distinguish between business income and wage income for active business owners? Here’s the JCT on the existing rules:
A shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages, but generally is not subject to FICA tax on amounts that are not wages (such as distributions to shareholders). Nevertheless, an S corporation employee is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wages.
A significant body of case law has addressed the issue of whether amounts paid to shareholders-employees of S corporations constitute reasonable compensation and therefore are wages subject to the FICA tax, or rather are properly characterized as another type of income that is not subject to FICA tax.
In the past, S-Corp has maintained that any attempt to legislate in this area should pass a simple test – are the new rules clearer, more accurate at differentiating wages from profits, and more enforceable than the existing rules? If not, then the new approach should be rejected. To date, all the proposed solutions have failed this test.
So, as the Committee is working through these issues, the S Corporation Association and its allies are up on the Hill, educating members about the importance of addressing both these challenges fully and appropriately. With lower rates, estate tax repeal, AMT repeal, expensing, and territorial on the table, the Brady bill has the potential to completely re-craft how pass through businesses pay tax, so it’s definitely worth the pass through business community’s time to help get this right.
Expect lots more on this in the coming weeks.
The August recess has given the S-Corp team a little more time to review the pending valuations rules out of Treasury. Recall that 23 years after the IRS surrendered and stopped using their flawed “family attribution” approach to valuing family-owned businesses, Treasury is trying to resurrect the concept using Section 2704. Below are some additional thoughts about why this is a particularly bad and fatally flawed idea.
Scope: Eliminating the application of “lack of control” and possibly “lack of marketability” discounts – the rule is unclear on those — to family business valuations may sound technical and immaterial, but it’s a big deal. Here’s one way to look at it.
Consider a 20 percent interest in a family-owned business transferred from a father to a daughter. The fair market value for the whole company is $500, so the pro-rata value of a 20 percent stake would be $100.
The 20 percent stake is not controlling, however, so its value needs to be adjusted for lack of control – the daughter has no ability to compel the company to buy the shares, nor can she compel the liquidation of the company. Add on the lack of marketability, since the company is closely held and there is no ready, liquid market outside the company to sell the shares.
If those discounts are worth 30 percent, then a 20 percent stake in the business would be valued at $70, and the estate tax would be $28. Under the new Treasury approach, however, there would be no recognition of lack of control and possibly marketability, and the estate tax would be $40 – a 43 percent increase in tax!
Worse, if the daughter seeks to sell her 20 percent stake, any arm’s-length buyer is going to offer her fair market value, which takes into account lack of control and lack of marketability. So the business interest she received from her father is worth $70 to an arm’s-length investor, but under Treasury’s new rules the estate tax would be $40. That’s more than half the value of the inheritance!
Keep in mind that this new rule applies to family-owned enterprises only. If the 20 percent interest were passed on to a non-family member, then the estate would be allowed to take lack of control and lack of marketability into account when valuing the stake, and the estate tax would be $28.
That’s how significant this proposed rule is. It’s a backdoor means of legislating significantly higher estate taxes on family businesses nationwide.
Treasury v. IRS: Perhaps the best case against adjusting the value of business assets in an estate by looking at who is receiving the property is made by our friends at the IRS. Here’s what the IRS Valuation Guide for Income, Estate, and Gift Taxes says:
“[t]he willing buyer and willing seller are hypothetical persons, not actual persons. See United States v. Simmons and Estate of Bright v. United States [citations omitted]. Accordingly, it is irrelevant who the real seller and buyer are. The important thing to remember is that valuation must consider both the willing seller and the willing buyer. …”
Here’s what the IRS says about the appropriate way to value property in Revenue Ruling 93-12:
The value of the property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.
And here’s what it says about discriminating against family members:
After further consideration of the position taken in Rev. Rul. 81- 253, and in light of the cases noted above, the Service has concluded that, in the case of a corporation with a single class of stock, notwithstanding the family relationship of the donor, the donee, and other shareholders, the shares of other family members will not be aggregated with the transferred shares to determine whether the transferred shares should be valued as part of a controlling interest.
The reason valuation science starts with a hypothetical buyer and seller is because that’s the only way to ensure a similar and balanced approach to all valuations. Once you start adjusting valuations based on who is receiving the property, you create an unworkable mess and opportunities for arbitrage. Tax advisors are going to have a field day with this one.
Statutory Authority: President Obama’s Treasury Department has been notable for its willingness to stretch the bounds of legal authority, and these rules are no exception. Treasury cites Section 2704 as the basis for this new rule. That provision, adopted back in 1990 as part of the Omnibus Budget Reconciliation Act, included a change to estate tax rules targeting so-called “lapsing restrictions” that artificially lower the value of family business assets. Here’s what the provision says:
The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee. (emphasis added)
Notice how the provision makes clear that the restriction has to go away at some point? However, “lack of control” and “lack of marketability” are not restrictions, and they don’t go away. They are real and exist in all forms of ownership inside and outside estate tax law. An ownership stake is simply worth less if you don’t enjoy all the rights – including the right to sell – that traditionally come with ownership.
Oh, and here’s the Conference Report that accompanied OBRA90:
The conference agreement modifies the provision in the Senate amendment regarding the effect of certain restrictions and lapsing rights upon the value of an interest in a partnership or corporation. These rules are intended to prevent results similar to that of Estate of Harrison v. Commissioner, 52 T.C.M. (CCH) 1306 (1987). These rules do not affect minority discounts or other discounts available under present law. (emphasis added)
Oops. Keep in mind that if Congress had wanted to go after lack of control and marketability with Section 2704, they could have clearly drafted the provision to do so. But just the opposite is true – Congress clearly did not want to go after those valuation rules. Their desire to preserve them is obvious in both the statute and the accompanying committee report.
The courts are going to have a field day with this one too.
Money Loser? So here is a question – will the proposed rule put forward by Treasury raise revenue, or lose it?
On its face, increasing the value of business interests passed on from one family member to another would increase estate tax collections. Certainly Treasury thinks so. They scored previous proposals along these lines as raising $18 billion over ten years.
But what about stepped up basis? Most estates are too small to pay the estate tax, but they do get stepped up basis. As Treasury noted in its blog post announcing the proposed rule:
Estate and gift taxes, or transfer taxes, are taxes on the transfer of assets from one person to another either by gift during his or her lifetime or by inheritance at death. Only transfers by an individual or their estate in excess of $5.45 million are subject to tax. For married couples, no tax is collected on the first $10.9 million transferred. These generous exemption amounts mean that fewer than 10,000 of the largest estates are subject to any transfer tax at all in a year.
Setting aside just how “generous” it is to let people keep their own property, the bottom line is that even with the new valuation rules in place, the vast majority of family enterprise assets transferred at death will likely fall under the estate tax thresholds. However, they may receive an increased step up in basis which should reduce future capital gains tax collections when the business is sold. As noted by one estate tax firm:
Another potentially positive, and likely also unintended, effect if the new Proposed Regulations are made final may exist for taxpayers who have a family business entity, but who do not have a large enough estate to cause a federal estate tax or state estate or inheritance taxes. For these taxpayers, disallowing valuation discounts that would normally apply when the family business entity interests are valued at an owner’s death can mean that the family receives a larger income tax basis step-up at that time, even though the increased value does not produce any increased estate or inheritance taxes.
So does this mean the new Treasury rules would reduce overall tax collections? Not sure. There seems to be uncertainty whether Treasury’s new valuation approach would apply to family business interests that are not part of a taxable estate. Consistency would argue that they should, but we stopped expecting consistency from this Treasury Department a long time ago.
Moreover, the same advocates who support punishing family businesses with higher valuations also support raising the overall estate tax rate and reducing the exemption amount. They want those higher valuations to lead to higher estate taxes for everybody, so any tax benefit for smaller estates is likely to be short-lived.
S Corp Gap Revisited
The Trump tax plan has renewed concerns that taxing income at different top rates leads to tax evasion.
Under the Trump plan, salary and wage income is taxed at 33 percent while business income is subject to a top rate of only 15 percent. So what’s to stop taxpayers from shifting income from wages to business to take advantage of the lower pass-through rate? Here’s Politico on the question from a couple of weeks back:
The Agenda’s Danny Vinik examines a big issue that wonks from both sides of the aisle have with both the Trump and House GOP plans – a higher top rate for individuals than pass-through businesses, which gives workers all the incentive to make themselves independent contractors rather than run-of-the-mill wage earners.
Moore – who’s been answering all sorts of questions about Trump’s tax ideas this week – told Danny that there’d have to be some fairly stout rules to block the sort of gaming that has plagued Kansas, which implemented a similar framework in 2012. But how exactly would that work? The wonk set has its doubts that tough-enough rules could be crafted, noting that there’s already an incentive for workers to classify themselves as freelancers to avoid payroll taxes. A Trump-like plan would only accelerate that rush, experts say.
We agree. Anytime you have different top rates, you’ll create an incentive for taxpayers to shift income into the lower tax bucket.
That is why we support establishing the same top rate for all forms of income – wage and salary, pass through, and C corp. Rate parity is not only a matter of tax fairness, it is also a matter of good tax administration. So much of the IRS Code is focused on distinguishing one form of income from another. Tax reform should seek to establish the same, reasonable top rates on all forms of income to increase fairness, reduce complexity, and make the Tax Code easier to enforce.
Doesn’t that mean that capital gains and dividends should be taxed at regular income rates? Absolutely not. Keep in mind that most dividends and capital gains have already been subject to the corporate tax, so the lower rate reflects the fact that tax has already been paid on that income. That’s why we support integrating the corporate code as suggested by Finance Chairman Orrin Hatch. The Hatch plan would establish a single layer of tax for all business income, pass through and corporate alike.
Couple integration with rate parity, and you’ve got the makings of real tax reform.
You have to feel for the House tax writers. They spent months putting together a plan to reform the tax code and now all anybody wants to talk about is Brexit and Section 385. That’s too bad, because the plan outline released last week is pretty good.
You can read the whole outline here, plus there’s been lots of discussion among the tax experts on how it would help to simplify tax collections while encouraging more business investment and job creation:
- Tax Foundation: “Details of the House GOP Tax Plan”
- Tax Policy Center: “Ryan Proposes Big Tax Cuts for Business and Investors, Moves Towards a Cash Flow Tax”
- Deloitte: “House GOP tax reform blueprint proposes across-the-board rate cuts, move to territorial tax system”
- Forbes: “House GOP Tax Plan Combines Pro-Growth and Pro-Family Elements in Common Sense Package”
From the S-Corp perspective, the headline is the plan would make progress on all three of the key “pass-through principles” we’ve been championing since 2011 – that is, it takes a comprehensive approach to reform, it reduces both the corporate and pass-through rates to more reasonable and similar levels, and it makes progress on reducing the harmful double tax imposed on corporations. It also gets rid of the dreaded estate tax, which hits private companies much more acutely than publicly-owned ones.
And while some folks are concerned about the fact that the initial tax on C corporation income is 20 percent while the pass-through tax rate is 25, the simple fact is that the tax imposed on successful S corporations and partnerships will be almost 20 points lower under this plan than it is under current law. That’s a huge rate cut and one that would be welcomed by S corporations across the country. As Tax Notes reported yesterday:
At the briefing, House Republican taxwriters insisted that their plan offers parity for the various types of businesses, with a 25 percent rate for small business and passthrough income and a 20 percent rate for C corporation income.
Double taxation on corporations’ paid dividends accounts for their lower rate under the plan, Nunes said.
“It’s not based on small or large. It’s based on how you’re legally set up. I could be a one-man C-corp and get a 20 percent rate,” Nunes said. “Because of the double taxation on C-corp is why it’s necessary to have a little lower rate than the individual. But any company can create an LLC or C-corp no matter what size you are.” The blueprint labels the two rates as applying to “small businesses” and “large businesses,” respectively.
Brady emphasized that the GOP plan’s rate for small businesses is a dramatic drop from the current tax structure.
“Don’t let that myth continue. You know right now that our passthroughs are paying the top rate of 44.6 percent as individuals, not just 39.6 percent. That’s the dramatic cut to 25 percent,” Brady said.
Regarding next steps, the Committee views this white paper as a discussion draft and is soliciting comments from stakeholders. We like the broad parameters outlined last week, but there are lots of details that go unexplored. For example, the 25 percent rate on pass-through businesses is structured as a rate cap rather than a separate tax rate schedule. That approach may work similar to a top rate in principle, but in practice it seems to be susceptible to being limited either by size or by industry (see our comments on the Buchanan bill). The authors of this plan need to resist the temptation to limit the pass-through rate in any way, and treat it just the same as the top rate on corporations.
We intend to comment further on this and other key aspects of the blueprint. There’s lots here to like, and much more that needs to be clarified. Our goal will be to ensure that the plan continues to be something Main Street can support as it moves through the process.
House R’s and D’s Weigh In on 385
Speaking of Section 385, in separate letters to Treasury Democrats and Republicans on the Ways and Means Committee have communicated their respective concerns about the pending regulations.
First, eleven Ways and Means Democrats sent a letter to Secretary Lew last week that applauded his agency’s efforts to crack down on inversions and base erosion practices, but also raised concerns that the proposed regulations implementing Section 385 go too far:
However, there may be a number of unforeseen circumstances in which the regulations could adversely affect ordinary course business transactions between related parties in the absence of tax avoidance motives. It has been raised that certain business sectors, including financial services, insurance, and utilities, may encounter industry-specific challenges to implementing these regulations due to various regulatory requirements unique to those industries. We also have been informed that there are broader concerns related to various internal cash management practices, such as cash pooling, and appreciate that Treasury is continuing to examine the effect of the proposed regulations on those practices. For these and other limited circumstances, we ask that you give careful consideration to whether exceptions or special rules, including transition rules, are appropriate.
Next, all the Republicans on the Committee signed a letter to Secretary Lew today that takes a much more aggressive and critical tone regarding the rule. As the letter notes:
We believe any finalization of the proposed regulations in present form will have a profound and detrimental impact on business operations nationwide. If not significantly altered, they will undoubtedly reduce overall investment and economic activity to the detriment of the United States and its business community. Since the release of these proposed 385 regulations, strong concerns have been raised with our offices by constituent companies and business groups representing every economic sector and industry in the United States. …
Furthermore, the proposed regulations represent a dramatic departure from current policy and practice, overturning more than a half century of well-established jurisprudence based upon analysis of an instrument’s actual substance … the proposed regulations are broadly applicable to a wide array of ordinary business transactions, creating unacceptably high levels of uncertainty and adverse collateral consequences for non-tax motivated business activity.
So, in addition to the broad concerns raised by the business community to date (here and here), we now have bipartisan concerns raised by Republicans and Democrats alike regarding the 385 rule. Let’s hope Treasury is in listening mode.