More on 385

S-Corp continues its efforts to educate policymakers about the pending Section 385 rules and the harm they will cause to domestic employers and American jobs starting…well, now.

That’s the dirty little secret about the 385 rules.  Released as part of a package of “anti-inversion and base erosion” tools, much of their impact will be on normal domestic business practices instead.  All that is necessary to be subject to the rule is 1) a group of investors that controls two or more corporations and 2) a loan or cash pooling between members of the group.

That’s it.  No international component required.  And the portion of the rule that could damage S corporations the most – the so-called “bifurcation rule” — has no de minimis threshold, so businesses of all sizes could be subject to the new rule depending on how they are organized.  As the Wall Street Journal noted on Tuesday:

… Treasury aims to solve this alleged problem by overturning decades-old interpretations of tax law and forcing many loans between related businesses to be treated as equity instead of debt. Businesses commonly pool the cash from various subsidiaries in one account, or they may fund one business with loans from an affiliate that has available cash. Recasting these transfers within a corporation as equity investments will trigger higher taxes for many firms unless they hire outside banks to provide the financing they used to do internally.

To give an example, the “Brother-Sister” company illustration below from our 385 Power Point is an extremely common means of organization, where the business operations are housed in one S corporation while the real estate assets are housed in another.  How common?  Impossible to say at this point, but with 4.5 million S corporations out there, our advisors tell us that such brother-sister arrangements are likely to number in the hundreds of thousands, or more.

385 Graphic

Under the proposed rule, this business would need to end any cash pooling between the two companies or give up its S election.  Neither is an attractive option, and to what purpose?

Base erosion is the practice of shifting profits overseas through loans and other pricing strategies.  But S corporations, by definition, have to be domestic businesses with domestic ownership, and all S corporation income must be taxed here in the United States.  Non-resident aliens are not permitted to own S corporation stock. Nor are foreign companies.

Moreover, unlike a C corporation, an S corporation that has foreign subsidiaries does not get a US tax credit for the foreign taxes the subsidiary pays.  For this reason, the vast majority of S corporations use branches for their overseas operations, not separate corporations, which means that all of their income, whether earned here or overseas, is taxed immediately in the United States.

So if the Treasury wants to go after base erosion practices, looking at S corporations is simply the wrong place to start.  There’s no there there.

Despite these realities, the draft rules include S corporations, putting them at risk along with the rest of the business community to having their debt converted into equity.  But S corporations face an additional risk not shared by the broader business community.  That is because S corporations are unique in the tax code in that they can lose their S election if they violate any of the following restrictions:

  1. S corporations may have only one class of stock;
  2. They are limited to 100 or fewer shareholders; and
  3. S corporation shareholders are restricted to US residents, estates and certain trusts and exempt entities.

Converting debt into equity could cause an S corporation to violate some or all of these requirements, which means years of additional fees, penalties, taxes, and reconfigured finances.  It’s a very serious threat and one S corporation owners need to focus on now.

What should Treasury do to fix this?  Based on outreach to our membership and feedback from meetings with the Hill and the relevant agencies, we have developed the following asks:

  1. Treasury should slow down the process and delay the effective date of the final rule. This rule is expansive and would in many cases force businesses to reconfigure how they finance their day-to-day operations.  That would impose significant costs on them and take time to execute. Treasury should take time too and ensure it avoids any “innocent bystander” damage here.
  2. Treasury should make sure these regulations do not apply to S corporations. For the reasons articulated above, S corporations are the wrong place to look if you’re trying to clamp down on base erosion practices.
  3. Treasury should ensure that S corporations do not lose their S corporation status. Cash pooling and related party loans are not crimes, but losing an S election would impose criminal-level costs on these companies. Treasury needs to make clear that no S corporation will lose its election because of this rule.

The comment period for the proposed rules closes on July 7th, and the IRS has announced it will hold hearings on the matter the following week on July 14th.  We plan to submit extensive comments and we encourage other business groups and S corporations to do the same.  Treasury has made clear it intends to finalize these rules this year, so it is extremely important that S corporations act now to ensure the rules are fixed before they are made final.

Reichert, Buchanan Present S Corp Tax Relief to Ways and Means

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:

Reichert

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“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:

Buchanan

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“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.

Treasury’s Section 385 Regs and S Corps

The business community is beginning to recognize that Treasury’s new Section 385 regulations published on April 4th have a much broader reach than anybody thought.  S corporations in particular need to pay attention.

How broad are they?  Here’s how Tax Notes described a meeting of the ABA Section of Taxation here in DC last week:

Practitioners who specialize in the taxation of S corporations said they’re concerned that many S corps may end up gratuitously losing their S corp status if the new related-party debt rules are applied as written without exception.

Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC said that as he reads the new rules— in particular the bifurcation rule of prop. reg. section 1.385-1(d), which enables the
government to divide a purported debt instrument into part debt and part stock — they could apply to debt issued by an S corp in a way that could automatically invalidate an S corp election.

Released April 4, the proposed section 385 regulations (REG-108060-15) generally treat
related-party debt as equity unless it facilitates new net investment in the borrower’s operations.

Although the regs were released along with a set of new anti-inversion rules, the section 385
regs can apply to transactions that have no connection at all to foreign acquisitions of U.S.
companies. Nichols said May 6 at the S Corporations session of the American Bar Association Section of Taxation meeting in Washington that the rules could turn debt into stock that could potentially violate the S corp single class of stock requirement or the eligible shareholder rule.

The disconnect appears to be that while the Treasury regulations were advertised as targeting corporate inversions, the actual policy would apply to the related party debt of all US companies, not just those moving overseas or seeking to shift income from one tax jurisdiction to another.

The bottom line is the proposed rules appear to give the IRS the ability to re-characterize the related party debt of a large percentage of S corporations.  As S corporation owners know, the downside of having your debt remade into equity is not limited to the loss of an interest deduction.  S corporations are only allowed to have a single class of stock.  If they have more than one class of stock, they revert back to C corporation status.

Existing tax rules provide S corporations a safe harbor to ensure that different forms of debt are not misconstrued as equity and threaten their status.  The proposed 385 regulations appear to override those existing rules.

A final point to make is that the effective date for the proposed regulations is April 4, 2016.  So unless they are pulled entirely, or revised significantly, the proposed regulations already threaten the normal business practices of S corporations across the country.

The business community is gathering its forces to communicate its response to this massive regulatory proposal.  It will be interesting to see if this Treasury Department listens.

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