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.
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.
Lost in all the hoopla over the Treasury’s new inversion policies was the accompanying update to their corporate tax reform outline. You can read the whole 30-page document here, but the bottom line is that not much has changed.
The plan still treats the pass-through community as second-class citizens by broadening the tax base for all businesses while only reducing rates for those organized as C corporations. As a result, successful pass-through businesses would be subject to 45 percent top rates on a broader base of income – a double whammy coming just three years after the Fiscal Cliff hiked their tax rates.
That’s simply a non-starter with Congress. From Politico:
McConnell also said he’s not interested in corporate-only tax reform, noting “most American businesses are not corporations” and lawmakers are not going to “carve out one section of American business and give them breaks and leave the others with very high rates.”
The plan also makes clear just how far apart the Administration and Congress are on tax policy.
The Ways and Means Committee continues to work on an international reform package that, by all accounts, includes an innovation box as the sweetener to help offset some of the new enforcement provisions. Meanwhile, the Administration spends two pages explaining why innovation boxes are a bad idea.
Finance Committee Chair Orrin Hatch (R-UT) continues to refine his plan to integrate the corporate and individual tax codes – something more than 100 national business groups have argued is an essential component of tax reform. Meanwhile, the Administration stands by their budget plan to increase shareholder taxes instead. (Exactly how combining lower corporate rates and sharply higher shareholder taxes helps to improve business taxation or encourage more investment here in the United States is not discussed in the Administration’s outline or anywhere else. It’s simply incoherent.)
And finally, while the majority in Congress stands uniformly opposed to raising taxes, the Administration’s plan explicitly calls for at least two significant tax hikes – a one-time 14 percent assessment on un-repatriated profits that would pay for new infrastructure spending, and a retroactive tax hike to offset to last year’s extender package. As Politico notes:
The Obama administration now wants to pay for that giant tax deal approved in December. After agreeing to stick the bill’s $680 billion cost onto the deficit, the administration now wants business tax reform to cover that cost. “Reforming the business tax system must be done in a fiscally responsible manner, including paying for December’s business tax cuts,” the administration said in an update of its business tax reform framework.
Most observers doubt there’s any chance for meaningful tax policy this year. The net result of this framework is to make that more clear.
Corporate Tax Base v. Business Tax Base
As noted above, there’s lots to dissect in the Treasury update, but you need not go further than the first paragraph to find something offensive. When it comes to the business community, it is obvious this Administration is focused only on large corporations.
America’s system of business taxation is in need of reform. The United States has a relatively narrow corporate tax base compared to other countries—a tax base reduced by loopholes, tax expenditures, and tax planning.
But the US doesn’t have a corporate tax base – it has a business tax base that includes both corporations and pass-through businesses. The good news here is that the US business tax base is large and growing.
According to the Tax Foundation, the business tax base made up 9 percent of US income prior to the 1986 Tax Reform Act, but makes up 11 percent today. That’s bigger. True, the corporate tax base has declined from 8 percent of US income in 1986 to 5 percent today, but the growth of the pass-through business community during that same time from just one percent to 6 percent has more than offset that decline.
So corporate-only tax reform advocates like the Administration are fond of pointing out that the corporate tax base has eroded over the past three decades. What they never point out, however, is that the business tax base – including both corporations and pass-through businesses – has grown significantly since the 1986 Tax Reform Act.
That’s a good news story that every tax writer in DC needs to learn.