2704 and Family Businesses

Remember the Obama Administration’s family-business valuation rules?  They were proposed back in August and resulted in such a backlash from the family business community that Treasury received nearly 29,000 comments during the 90-day comment period.  That’s a record as best as we can tell.

So where do the rules stand now?  Here’s the latest.

Two weeks ago, President Trump signed an Executive Order calling on Treasury to review all “significant tax regulations” issued last year and 1) identify those that are burdensome, complex or exceed Treasury’s authority, 2) issue a report within 60 days listing those identified rules, and 3) issue an action plan within 150 days on what Treasury plans to do about them.  Here’s what it says:

Addressing Tax Regulatory Burdens.  (a)  In furtherance of the policy described in section 1 of this order, the Secretary of the Treasury (Secretary) shall immediately review all significant tax regulations issued by the Department of the Treasury on or after January 1, 2016, and, in consultation with the Administrator of the Office of Information and Regulatory Affairs, Office of Management and Budget, identify in an interim report to the President all such regulations that:

(i)    impose an undue financial burden on United States taxpayers;

(ii)   add undue complexity to the Federal tax laws; or

(iii)  exceed the statutory authority of the Internal Revenue Service.

This interim report shall be completed no later than 60 days from the date of this order.  In conducting the review required by this subsection, earlier determinations of whether a regulation is significant pursuant to Executive Order 12866 of September 30, 1993, as amended (Regulatory Planning and Review), shall not be controlling.

(b)  No later than 150 days from the date of this order, the Secretary shall prepare and submit a report to the President that recommends specific actions to mitigate the burden imposed by regulations identified in the interim report required under subsection (a) of this section.

The 2704 valuation rules easily fit within the EO’s description of targeted rules.  They are obviously burdensome, confusingly complex, and the case can be made that they exceed Treasury’s authority under Section 2704.  A trifecta worthy of Churchill Downs.

Meanwhile, Team Trump continues to press for full repeal of the estate tax.  As Trump’s lead at the National Economic Council Gary Cohn stated the other day:

We are going to repeal the death tax. The threat of being hit by the death tax leads small business owners and farmers in this country to waste countless hours and resources on complicated estate planning to make sure their children aren’t hit with a huge tax when they die. No one wants their children to have to sell the family business to pay an unfair tax.

So we expect 2704 to be on the target list released by Treasury in the next couple months and the action plan released later in the year.  Since the rules are merely pending and not finalized, the obvious action is for Treasury to simply withdraw them.  No action by Congress or the President is required, which makes this an easy win for the Trump Treasury team and a significant relief to the family business community across the country.  More on this to come.

 

Tax Foundation and the Kansas Straw Man

Our friends at the Tax Foundation are generally rock solid on tax policy, but they missed the mark in a recent Politico piece.  Several of their economists took a look at the situation in Kansas, where the Governor several years ago cut the pass through tax rate to zero, and applied those lessons to the pending Trump Administration proposal to cut tax rates on corporations and pass through businesses alike down to 15 percent.  According to them:

Small-business advocates have suggested that these proposals will help create tax rate parity between pass-throughs and C-corporations by taxing them at the same rate. But these arguments ignore that corporate income is taxed twice, at both the business level and the shareholder level—for a combined tax of more than 50 percent. Lowering the corporate rate and continuing to tax pass-throughs at the individual income tax would move the U.S. tax code closer to treating all income equally. Enacting a lower tax rate specifically for pass-throughs would do the opposite.

Problem is, none of this is true.  Neither the S Corporation Association nor the Parity for Main Street Employers coalition has endorsed the Trump plan, partly because we still don’t understand it and partly because it’s hard to see how the math works.

We don’t ignore the double tax on C corporations, either.  Our tax reform principles letter, signed by 120 national Main Street trade groups, has just three key principles, one of which is to eliminate the double tax on C corporations. Far from ignoring the double tax, we made its elimination one of our goals in tax reform.

And finally, that corporate tax of “more than 50 percent” belongs in the fiction section.  Yes, if you add the 35 percent corporate rate with the 23.8 percent shareholder rate, you get a combined rate that high, but very little business income is ever subject to the classic double corporate tax.  As we pointed out back in January, the Tax Foundation’s own numbers show that less than 10 percent of all business income is even potentially subject to the double tax.

So the Tax Foundation is fighting straw men.  To be sure, the Tax Foundation is not alone in raising these points.  The Tax Policy Center has published several posts on the tax rate parity issue – here and here, for example.  These papers suffer similar challenges – they ignore the economic harm of the double corporate tax, they take it on faith that C corporations pay more than pass through businesses, and they ignore the gaming opportunities C corporations will have under the new, low rate structure.

The simple fact is that the business community has largely abandoned the classic model of business taxation.  Most C corporation shareholders don’t pay taxes, most C corporations don’t pay dividends, and most business income is earned under the pass through structure.  Any reform pushing companies back into the harmful double corporate tax is a step backward, not forward.

The correct way to tackle tax reform is to tax all income once, tax it when it is earned, tax it at similar reasonable top rates, and then leave it alone.  The business community is already there and it’s time for the tax code, and our think tank friends, to catch up.

 

Treasury Nominee Disappears

What ever happened to David Kautter?  Wasn’t he going to be named to be the next head of tax policy over at Treasury?  Politico and other outlets reported that over a month ago.  Since then, nothing.  No announcements, no nominating papers, nothing.

Which is too bad, because not only does Treasury need the help, but Kautter appears to understand the importance of Main Street businesses to jobs and economic growth.  In 2014, he testified as an expert to the Small Business Committee at a hearing on “The Biggest Tax Problems Facing Small Businesses.” You can read his entire written testimony here, but his section on the need for a single layer of taxation for business is worth highlighting:

“As part of the process of broadening the tax base and lowering the corporate tax rate, I believe the time has come for Congress to consider a single tax rate schedule for all business income no matter what legal form a business uses to conduct business. Given the importance of small businesses to our economy, it makes little sense that income earned by unincorporated businesses (which tend to be small businesses) is subject to tax at the higher individual rates while income earned by corporations is taxed at lower corporate rates.”

He concludes with this:

“In short, what is needed is “business tax reform” not simply corporate tax reform. A single business rate schedule would move us toward a more comprehensive system of business taxation – one that applies to all businesses equally across the board. If done right, it could ease the tax burden of small businesses while increasing simplicity and fairness. And ultimately, that could provide small businesses with some of the relief they need in order to compete and thrive.”

Couldn’t have said it better ourselves.  Now if we could just find him.

Treasury Hits Family Businesses!

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?

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.

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