S-Corp Submits Valuation Comments

October 18, 2016 by · Leave a Comment 

Yesterday, the S Corporation Association submitted its formal comments to the IRS on the pending Section 2704 valuation rules.  You can read all 15 pages of comments here, but the basic message of the submission was that Treasury should discard this effort and start over.  As the comments conclude:

Promulgation of the Proposed Regulations in their current form and scope will generate significant uncertainty and constitute a significant impediment for the continuity of family-controlled businesses.  The Proposed Regulations inappropriately and illegally discriminate against family controlled businesses in form and effect.  If Treasury is inclined to promulgate regulations to address perceived abuse, those regulations should be targeted in scope, capable of reasonable application and administration, and consistent with Congress’s intent, as set forth in § 2704 and the legislative history of Chapter 14.  The Proposed Regulations do not satisfy any of those conditions.

The comment period for these proposed regulations doesn’t end until November 2nd, but already Regulations.Gov reports there have been more than 3200 comments submitted, with many more expected prior to the deadline.  The NFIB-NAM letter to Treasury Secretary Jack Lew had more than 3800 signatories, so this issue is getting people’s attention.

Meanwhile, Treasury Officials continue to speak to groups and make the following two points:

  • The proposed rules are not nearly as far-reaching as what outside experts have reported; and
  • It is highly unlikely that the IRS and Treasury will be able to finalize these rules prior to the end of the Obama Administration.

We take these points seriously, but are still left with the reality of what Treasury proposed back on August 2nd.  As our comments make clear, what Treasury printed in the Federal Register is a very broad proposal that would largely eliminate the consideration of control and marketability for a wide swath of family businesses when valuing them for gift and estate taxes.  The result goes well beyond what Congress enacted back in 1990 and would be a significant hike in taxes on those family businesses, leading to fewer family businesses and a further consolidation of economic power with large, publicly-traded companies.

S Corps Exempted from 385 Rules

October 14, 2016 by · Leave a Comment 

Here’s a bit of good news for the S corporation community – Treasury has exempted them from the newly published rules under Section 385.

This is a huge relief to the S corporation community.  The rules would have hit S corporations the hardest, despite them having no skin in the “base erosion” game.  S corporations would have suffered through the new reporting requirements and limitations on cash pooling and related party loans just like their C corporation counterparts, but they also would have faced the prospect of losing their S corporation status, together with the multitude of tax and penalty implications associated with that.

The final rules released yesterday, however, made major changes to the original draft, including exempting S corporations and other entities not likely to practice base erosion from the entire rule.  Other important changes include easing the documentation requirements and eliminating the entire so-called “bifurcation rule” that threatened smaller domestic businesses.  Those are significant improvements.

As Politico made clear this morning, however, concerns with the rule remain in the broader business community:

But by and large, the response from business was more cautious, and filled with concerns like this from the Organization for International Investment. “We will continue to analyze the final regulations, but remain concerned that they may harm the ability of the United States to attract global investment and limit opportunities for American workers,” said OFII President Nancy McLernon.

More concerns: The effective date for the regulations will still be early April, and there are still some worries that the cash pooling and foreign-to-foreign exemptions might not have enough teeth.

For S corporations, Treasury made the right decision and we applaud them for listening.  As our comments from July made clear, S corporations have little or no opportunity to game the system using debt.  As with consolidated groups (also exempted from the rule), S corporation income and loss all flow up to the same US tax returns, so deductible interest should always be paired up with taxable income.  Here’s what we said back in July:

Application in the S corporation context, however, is inappropriate as the rules relating to S corporations likewise eliminate the possibility of tax arbitrage, making the income reported on Form 1120S analogous to the income reported by a consolidated group on Form 1120 for federal income tax purposes.  Therefore, S corporations should be exempted, the same as consolidated group members.

And here’s what Treasury said yesterday when releasing the rule:

Because an S corporation cannot be owned by persons other than U.S. resident individuals, certain trusts, and certain exempt organizations, an S corporation cannot be controlled by members of an expanded group in a manner that implicates the policies underlying the final and temporary regulations. S corporations are therefore excluded from the definition of an expanded group member for all purposes of the final and temporary regulations.

Exempting S corporations allows Treasury to focus their efforts on those entities more likely to engage in base erosion practices, and it allows S corporation owners to focus more on running their businesses.  For all those Members of Congress, S corporation experts, and Main Street businesses who weighed in on this, thanks!

Now on to the Section 2704 rules!

Latest on 385

October 5, 2016 by · Leave a Comment 

It looks like the IRS and Treasury have made their revisions to the proposed 385 regulations and are just waiting for sign-off from the White House.  According to our friends at Politico:

Tax lawyers just held a big confab in Boston, and, not surprisingly, it was rife with speculation about just what the Treasury Department’s final Section 385 rules might contain. Tax Analysts sifted through some of the unanswered questions and predictions now that Treasury has sent final rules to the White House, including whether the department would only finalize part of the extensive anti-inversion rules it rolled out in April. (If so, one lawyer asked, why wouldn’t the department have sent the White House both proposed and final rules last week?) Also of concern: Will the rules still be retroactive, a particular concern of business? “They’ve got enough fights to pick here,” said David Garlock of EY. “If it’s something that’s clearly expanding the scope of the rules and making it tougher, I can’t imagine that they’re going to risk the validity of the whole package by saying that it’s retroactive to April 4.”

Now that Treasury is done redrafting the rules, the White House (the Office of Information and Regulatory Affairs, really) has up to 90 days to review them and suggest revisions.  With the Obama Presidency in its waning days, an extended back and forth here is highly unlikely, and we expect to see something posted in the Federal Register before the end of the year.

The S corporation community needs to pay attention here, because the 385 rules as previously drafted have the potential to blow up S elections.  As our comments to Treasury back in July made clear:

As a result, if S corporations were subject to the Proposed Regulations, recharacterization of related party indebtedness as stock would result in the loss of S corporation status in nearly all circumstances. The requirement that qualified subchapter S subsidiaries be 100% owned by the S corporation parent would similarly result in “Q-Sub” disqualification in the vast majority of circumstances. Internal Revenue Code Section 1361(b)(3)(B)(i).

The loss of S corporation and/or “Q-Sub” status, in turn, would result in costs far in excess of the increased taxation resulting from any recharacterization of debt as equity, including the payment of IRS and professional fees necessary to seek restoration of S corporation status, the need to change how the business is financed in order to avoid future disqualifying events, and back taxes and penalties related to the disqualification if the corporation is unable to “cure” the loss of  S corporation status with IRS consent.

Will the revisions address the concerns of the S corporation world?  The answer is unclear. Tax Notes attended the Boston ABA meeting and had this to report on the S corporation question.

Although a Treasury official said recently that the government is considering changes to the proposed debt-equity regulations to address passthroughs, including S corporations specifically, comments from two IRS officials September 30 left the impression that S corporations might want to prepare for final regs that won’t give them a specific carve-out…

Michael Gould, branch 5 attorney, IRS Office of Associate Chief Counsel (Corporate), acknowledged that when there’s a bifurcation in the case of debt issued between two related S corporations (a brother-sister S corporation scenario), that would cause the S corporation election to be invalidated. “At first blush, yes, it does look that way,” he said, adding that it puts pressure on the question “How far does the second class of stock rule go?”

And finally:

Those hoping for sympathy from the government left largely empty-handed.

“Ultimately . . . what [section] 385 is saying is: Is it debt? Is it equity? And if it’s equity, the proposed regs say it’s equity for all tax purposes,” Jacobs said. “That’s where we are. We’re saying it’s equity for tax purposes, and what happens from there is all of the other results of all the other provisions.”

So no love for S corporations here, but it is not clear if the lack of understanding was a reflection of the draft sitting over at the White House, or the fact that Treasury officials are necessarily constrained in what they can say about a rule before it’s made public.  Only time will tell, but once again the tax world gets a really good example of why Congress needs to legislate carefully.  Give the Treasury Department some discretion, and it will use it, even if it takes 47 years.

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