S-CORP Testifies

 

Ahead of the extender deadline, S-Corp was on the Hill testifying yesterday that Congress needs to act to end the extender roller coaster and make permanent these provisions, including the built-in gains relief that affects so many of our S corporations.  At a hearing hosted by the House Small Business Committee entitled “Tax Extenders and Small Businesses as Employers of Choice” S-Corp was represented by Tom Nichols, Chairman of our Board of Advisors.

Tom Nichols Testimony 12.3

Tom opened his remarks by highlighting the important role pass-through businesses play in employment and job creation, and then focused on a number of specific actions Congress could take this month to ensure they continue in this role, including making permanent the shorter, five-year holding period for the built-in gains tax.  As Tom noted:

Delaying confirmation of the five year built-in gains tax period has similarly destructive consequences. In the past several years, small business owners have asked me repeatedly whether the five-year or ten-year period will apply. The only response I could give them is that the final built-in gains period will “probably” be five years, but that they can’t count on it.

This has created a number of excruciatingly difficult situations for my clients. For example, several of my farming clients were attempting to sell agricultural land – either to raise capital or to finance their pending retirement – while farmland prices were at their peak. Unfortunately, for those in the critical 6 to 10-year “limbo” period, this uncertainty constituted a huge stumbling block, and now it appears that the optimal time for selling is gone.

I had another client who wanted to sell his business, but could ill afford to do so if the double-tax built-in gains regime was applicable. I recommended that he and the buyer reach agreement and have all the documents prepared, but wait until actual passage of the extenders legislation to sign and close the deal. His response was that he was in poor health and may not be able to wait.

As with expensing, a five-year period for the built-in gains tax is well supported by policy considerations. The built-in gains tax was originally enacted in the Tax Reform Act of 1986 and was intended to prevent C corporations from converting to S Corporation status and selling some or all of their business subject only to the single-tax S Corporation regime. To be honest, I have never understood why paying only one tax upon the sale of a business was considered a loophole to be closed. Regardless, it is generally recognized that a ten-year waiting period is much longer than necessary in order to achieve the initial policy goal. Given the uncertainties and vagaries of conducting business, business owners are extremely unlikely to elect S Corporation status with concrete plans to sell after waiting for a period of five or more years.

You can read Tom’s written analysis here.  Small and closely-held businesses play an invaluable role in creating jobs where they are most needed, despite all of the unnecessary obstacles imposed on them by Washington. But it doesn’t have to be so difficult. Failing to make business extender items like built-in gains permanent is a wholly unforced error that this Congress has the ability to fix.  Talks are going on right now.  Let’s hope they come to a happy conclusion.

 

Pass-Through Tax Rates

More on the effective tax rates pass-through employers pay.   Sitting next to Tom at yesterday’s hearing was Todd Kriegel, the CEO of Global Precision Parts. Todd’s company has a profile that many S-Corp members will find familiar—a family-owned, S corporation manufacturer with 200 employees split across three locations in Indiana and Ohio.

Also familiar to S-Corp readers is how the Fiscal Cliff resulted in a massive tax hike on Todd’s business:

GPPs current federal effective tax rate is 39.4%, far higher than our C-Corp counterparts, not to mention the Chinese companies who we really are competing against. In 2008, we had a 28.07% effective federal tax rate with the Alternative Minimum Tax. That 11.33% jump in our tax liability cost us hundreds of thousands of dollars we could have used to hire more workers for the machines we would have purchased.

Just last April, S-Corp Board member Dan McGregor of McGregor Metalworking gave similar testimony on how the effective rate on his metal-working business jumped from 33 to 42 percent as a result of the fiscal cliff!

Following the resolution of the fiscal cliff, the top tax rate on my shareholders increased to approximately 41.4 percent due to the higher 39.6 percent marginal rate plus, where applicable, the new 3.8 percent Affordable Care Act tax and the effect of the reinstatement of the Pease limitation on itemized deductions. As a result, today we have to distribute approximately 42 cents of every dollar earned so our shareholders can pay the federal, state and local S corporation tax.

Dan and Todd employ hundreds of well-paid manufacturing workers in communities — like Springfield, Ohio and Wabash, Indiana — that desperately need jobs.  And they are being forced to compete not only with Chinese companies that play by an entirely different set of rules, but also with domestic C corporations that enjoy significantly lower tax rates.  The CEO of Pfizer complains about his 25 percent effective rate?  We’re guessing Dan and Todd would swap with him in a second.

Any reform of how we tax business income needs to begin with Main Street businesses.

S-CORP Testifies on Built In Gains

Long-time S Corporation Association advisor Jim Redpath testified Tuesday before the Ways and Means Committee in support, among other items, of making permanent the 5-year recognition period for built in gains.

The hearing focused on making permanent a handful of so-called “extenders” that were part of Chairman Camp’s Discussion Draft released earlier this year, including the shorter built-in gains recognition period plus increased deductions for S corporations making charitable contributions.

Jim’s testimony, along with that of the four other witnesses, is available here.  You can watch Jim’s testimony by clicking below:

 

 

The hearing adds to the building momentum in Congress to act on extenders this year.  Just last week, the Senate Finance Committee reported out legislation that would extend nearly all the 50-plus tax provisions that expired at the end of 2013.  As with the Camp Draft, this package includes our BIG tax fix and the basis adjustment for charitable giving by S corporations.

S corporation provisions aside, however, the two packages are significantly different.  The Finance Committee package includes nearly all the expired provisions and extends them through the end of 2015.  The Camp package includes only seven provisions and makes them all permanent.

Their respective plans for moving forward are different as well.  Majority Leader Harry Reid (D-NV) has indicated he would like to consider extenders first thing when the Senate returns after Easter.  Meanwhile, Camp has made clear he intends to move individual provisions through his Committee and to the House floor, starting with legislation to make the higher limits on Section 179 expensing permanent, then the R&E tax credit, and then others.  His goal is to have a package of permanent House-passed provisions to compete with the broader, but temporary, Wyden package.

Given our druthers, we’d take permanent over temporary.  As Mr. Redpath testified Tuesday:

Although much better than the 10 year recognition period, the temporary extension results in tax motivated transactions as the expiration date approaches that may not be in the best interest of the company or its stakeholders.  Making the 5-year recognition period permanent would preserve the original intent of the 1986 Tax Act and provide S corporations stability and certainty, so they can make business decisions that are best for the company, its owners and stakeholders.

Either way, just having Congress take action on these expired provisions is a positive sign.  We’re hoping to see further progress soon.

Ways and Means Hearing

S-corporation taxation took center stage on the Hill last week.

Carrying the S-Corp flag before the House Ways and Means Committee was Association Advisor Tom Nichols of Meissner Tierney Fisher & Nichols S.C. Tom had been invited to represent the S Corporation Association and testify at a hearing entitled “Tax Treatment of Closely-Held Businesses in the Context of Tax Reform” along with five other witnesses representing other trade groups and academia. Tom’s testimony made clear to the tax writers what we’d like to see when they pursue tax reform:

“As much as possible, the business tax system in the United States should move toward a single tax structure, and away from the punitive double tax C corporation system. Especially for closely-held businesses, a single tax system substantially reduces complexity and eliminates the opportunity and incentive for non-productive tax planning and strategizing.”

“Second, broadening the tax base and lowering and flattening the tax rates would serve all segments of society. The lower the rate on a given amount of marginal income, the more likely it is that a business owner is going to expend the effort and take the risks in order to earn that income, and the less effort he or she will expend trying to defer or otherwise mitigate the tax consequences of having done so.”

“Third, it is important that whatever tax reform is implemented be comprehensive. Since pass-through business owners employ over half of the workforce in the country, lowering the tax rate for all taxpayers (rather than just the headline rate for C corporations) should be the goal of comprehensive tax reform.”

S-Corp’s perspective was reinforced by witnesses representing the National Federal of Independent Business (NFIB) and the Financial Executives International, both of whom made clear that comprehensive reform as the only means to making all businesses sectors more competitive. NFIB’s Dewey Martin also made the case for the shorter built-in gains holding period:

Finally, reducing the holding period for the built-in gains tax would do much to promote flexibility for small businesses. The built-in gains tax locks-in capital assets if a C-Corporation elects to change to S-Corporation status, and reduces economic efficiency. NFIB appreciates that the holding period has been reduced from 10 years to 5 years, and, at the very least, this should be extended.

During Q&A, Tom had a chance to highlight the importance of built-in gains relief during a back-and-forth with S Corporation Modernization sponsor Dave Reichert of Washington state:

With everything up in the air right now, it is more important than ever for business owners and their representatives in Washington D.C. to step up and be heard on these important issues. We appreciate Tom’s willingness to testify along with the other witnesses at last Wednesday’s hearing. We hope policymakers were listening.

Large Pass-Through Businesses and Double Taxation

There’s a small but vocal group of C-corporations arguing that Congress should force large pass-through businesses to pay taxes like C-corporations — i.e. pay two layers of tax on their business income rather than just one. Just exactly how raising taxes on large pass-through businesses in order to cut them for even larger C-corporations would encourage investment and growth here in the United States is left unexplained.

But what about the complexity of such a rule? Wouldn’t an arbitrary cut-off based on revenues or employment be difficult to administer and enforce? Tom’s testimony before the Ways and Means Committee last week is the best exploration we’ve seen of the overwhelming tax administration challenges such a policy would face.

It should be must reading for anybody involved in tax reform. Here’s what he said:

“There have also been proposals to force double tax C corporation treatment on large pass-through entities, say those having gross receipts over $50 million. In addition to imposing a substantial additional compliance and tax burden on the most productive members of the pass-through sector of our economy, such a provision would require a detailed and complicated system of inter-related rules. For example, how would an entity be treated that hovers both above and below the $50 million trigger point? Would the built-in gains tax apply when the entity re-elects S status after having been forced into C corporation status as a result of having extraordinarily good receipts during the testing period? Would an entity be trapped in C corporation status even though it no longer had $50 million of gross receipts, because of higher receipts during the testing period? If not, would closely-held business owners not be in a position to know whether they will be subject to a C corporation or S corporation tax regime until after the end of the year in question?

Also, I am assuming that there would have to be some type of aggregation rules so that closely-held business owners could not simply split their business into two or more entities and avoid the C corporation regime in that fashion. As you can imagine, such aggregation rules are extremely difficult to administer. For example, if various business entities were to constitute a series of overlapping aggregated control groups or affiliated service groups, how would that be handled? If one of the groups was below the threshold and another of the groups was above the threshold, would the owners of the group that was below the threshold be forced into double tax C corporation status, even though some of them owned only an interest in a relatively small business?

Even in the absence of multiple overlapping groups, how would you handle the numerous complexities that are involved when multiple entities are treated as a single unit? The consolidated return regulations span over 440 pages in the standard edition of the CCH Income Tax Regulations, dealing with issues such as inter-company transactions, stock investment accounts, calculation of credits, allocation of income tax liabilities and numerous other matters. These complexities are difficult enough for groups of business entities that voluntarily choose to treat themselves as a single affiliated group, but this level of complexity would be multiplied many times by forcing aggregate treatment for all tax purposes on an amalgamation of corporations, partnerships, limited liability companies and other entities that happen to be linked by common ownership or activities.

This forced amalgamation might also have the unintended consequence of opening up opportunities for aggressive tax planning and tax shelters. For example, if dividends are treated as coming from the aggregate earnings and profits of the amalgamated entity, could the C corporation owners of one of the amalgamated entities drain off all of the earnings and profits on a tax-preferred basis, while allowing the remaining individual owners to achieve the equivalent of S corporation treatment as a result of non-dividend distributions? If not, would the individual owners of one of the separate entities with separately treated earnings and profits be able to achieve S corporation-type treatment by carefully managing the operations of that entity?

In addition to these workability concerns, making an arbitrary and involuntary cutoff for pass-through tax treatment is simply not good tax policy. For the reasons indicated at the outset of this testimony, the double tax C corporation system is not preferred tax policy. Moreover, the $50 million trigger (or whatever number is chosen as the trigger) would clearly discourage growth in companies that are approaching that level, and such companies would be incentivized to engage in a great deal of sophisticated and expensive tax planning to avoid being involuntarily subjected to the double tax system. Such maneuvers might nonetheless be justified if such a proposal were enacted, because one additional dollar of gross receipts could literally trigger millions of dollars of federal tax consequences. Such cliff-like triggers are obviously not favored for policy purposes.

Finally, just because an entity has $50 million of gross receipts does not mean that it is profitable. There are many such entities (or amalgamations of such entities) that actually have losses, which, under current law, are appropriately taken into account (and if necessary carried over) at the individual level. Forcing individual owners at that level of activity to forego the ability to deduct these losses would unavoidably impact their willingness to continue to fund these enterprises, with the concomitant impact on the jobs and financial security of their employees. Even profitable entities would not seem to merit such draconian treatment. For example, a low-margin 1 percent-of-sales business could easily have $50 million of gross receipts, but have only $500,000 of actual taxable income. Triggering C corporation status in these circumstances seems entirely unwarranted.”

Backwards Tax Reform

So earlier this month, we warned that you might hear a new argument when it comes to tax reform: cut corporate tax rates but raise them on shareholders. The idea is that corporations are mobile, whereas shareholders are not. So cut the corporate tax to encourage more firms to locate here, and raise taxes on shareholders because they’re stuck and can’t go anywhere anyway.

Well, we didn’t have to wait long to hear this flawed argument again. At last Tuesdayb’s Senate Finance Committee hearing, Dr. Robert Atkinson he believed in corporate tax reform that raises taxes on high-income individuals and lowers them on the corporate side is the way to go, saying that while “rich people are not going to move to Mexico or Taiwan, corporations will do that.” He went on to say that the idea that we cannot raise taxes on the rich is a mistake, and that it is much more important to get this right on the corporate side.

Here’s the clip of his testimony:

Setting aside the corporate governance issues of further separating the interests of management from the interests of shareholders, the principle challenge with this argument is that it ignores the most mobile commodity of all: capital. Raising the overall tax burden on business investment in the United States is not going to encourage additional investment here, even if it’s done in a manner that reduces one tax rate while hiking another. As Alex Brill and Alan Viard wrote last week, the tax hike under consideration is remarkably large:

The president’s proposal would allow the 2003 dividend tax cut to expire for high-income households at the end of the year, pushing the top dividend tax rate up from 15 to 39.6 percent. That’s a dramatic increase in its own right. But, other provisions make the true increase even larger. The president also wants to bring back a provision phasing out deductions for high-income taxpayers, which will cause each additional dollar of dividends to trigger 1.2 cents of extra taxes. And, beginning next year, the president’s health care law will impose an additional 3.8 percent tax on dividends and other investment income of high-income households. Under the president’s proposal, the top all-in dividend tax rate will be 44.6 percent – almost triple today’s 15 percent rate.

You can pretend that shareholders are not the real owners of businesses organized as public corporations, and maybe those businesses behave like they have no shareholders for short periods of time, but eventually those shareholders makes themselves known by voting with their feet and capital will flow out the U.S. and into those countries with a lower overall tax burden on equity investment.

These days, that’s just about everybody else.

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