The verdict is in, and Treasury’s proposed rules on estate tax valuations of family-owned businesses are broad – very broad indeed. They are, simply put, a direct assault on America’s family-owned businesses.
Here’s the take of WealthManagement.Com:
Although the details are significant, the bottom line is that the proposed regulations would appear to eliminate almost all minority (lack of control) discounts for closely held entity interests, including active businesses owned by a family. To accomplish that, restrictions under the governing documents and even those under state law would be disregarded for valuation purposes.
And Steve Leimberg’s Estate Planning Email Newsletter:
In short, it may appear that, outside of the new three year rule, that not much is being proposed with respect to the valuation of minority discounts. One might, therefore, conclude… that minority discounts remain largely intact with a narrow exception for transfers made within three years of death. That reading would not, however, be accurate. As will be discussed, the proposed regulations under Section 2704(b), in particular based upon a new concept referred to as “Disregarded Restrictions,” are a frontal attack on the concept of discounts in the context of family entities. Given the failure the IRS has sustained in the courts in terms of its argument favoring a family-attribution principle and given its resulting frustration, it must be conceded that the new Disregarded Restrictions approach seems masterfully drafted.
So so-called “minority interest” discounts are at risk under the proposed rules. What does that mean? It means that family owned businesses will be valued, and taxed, at significantly higher rates than businesses owned by non-related parties. How much more depends on the facts and circumstances of each case, but minority discounts of 20, 30, 40 percent and higher are common and have been approved by the courts.
But aren’t these discounts just a loophole? No, not at all. Minority interest or “lack of control” discounts reflect the underlying economic reality that ownership without control – control to sell, control to make management decisions, control to distribute profits — is worth significantly less than ownership with control. If you own 30 percent of a company, but have no say in how the business is run or when it is sold, then your share of the company is worth significantly less than 30 percent of the total value of the company.
For examples of minority discounts, look no further than the stock exchanges. Every stock on the New York Stock Exchange is traded with a minority discount imbedded in the price. That is why investors seeking to buy a controlling interest in a publicly traded company are willing to offer a premium over the traded price. Unlike retail investors, they expect to have a controlling interest at the end of the day, so they are willing to pay more.
So when Treasury calls this a “loophole”, what they are really upset about is the underlying economic reality of control. One might as well complain that the sky is blue.
This is not a new fight. The IRS has been waging, and losing, the battle over these discounts for decades. But the newly proposed rule represents a whole new tact on the part of Treasury that needs to be taken seriously by the business community. This is the first time in the long battle over discounts that Treasury has hung its efforts on an existing, albeit 26-year old, statute.
So does section 2704 give Treasury the authority to eliminate minority interest discounts for family-owned enterprises? Probably not. But we won’t have the ultimate answer to that question until these rules are fully litigated in the press, the comments to Treasury, the elections, the Congress, and finally the courts.
For next steps, there’s the 90-day comment period ending in early November, a public hearing in early December, and then the bums rush by Treasury to get these regulations out the door before the end of the Obama Administration.
In the meantime, the business community, including your S Corporation Association, will be up in arms once again. This proposed rule combines the two signature trademarks of this Administration – a jaded view of private enterprise coupled with a willingness to push the envelope on legal authority. We expect to ultimately win this battle, but it will take a long time and waste innumerable resources that could otherwise be used to invest and create jobs. What’s the point in that?
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.
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:
- S corporations may have only one class of stock;
- They are limited to 100 or fewer shareholders; and
- 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:
- 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.
- 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.
- 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.
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:
“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:
“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.