S-Corp Submits 385 Comments

July 7, 2016 by · Leave a Comment 

The debate over Section 385 continues.  The comment period ends today, and we sent in our comment letter along with the rest of the business community.

As we noted in our submission, the 385 regulations were advertised as a response to base erosion practices, but the rule itself is not limited to international transactions.  Nor is it limited to businesses of a certain size.  Instead, it targets the related party debt of domestic businesses of all sizes.   As our comments state:

Since their release, the broader business community has raised numerous concerns regarding scope of the Proposed Regulations, including the statutory authority under which they were drafted, the opaque process by which they were developed and released, and the additional costs and limitations they will impose on a broad range of traditional business loans and cash sharing arrangements. Described as a response to corporate inversions and base erosion practices, the proposed rule instead pulls in a broad array of businesses that have nothing to do with either. 

We share these concerns and recommend that the Proposed Regulations be withdrawn and recrafted. As currently drafted, the Proposed Regulations would apply to domestic businesses of all sizes – there simply is no de minimis threshold for the “bifurcation” rule that would allow the IRS to recraft debt as part equity.  See Treas. Reg. Section 1.385-1(d).  Without significant revision, we believe these Proposed Regulations are overly broad and will have a material and negative impact on business investment and hiring in the United States.  These negative effects are wholly unnecessary and could be avoided. 

As to our recommendations, S-Corp joined the rest of the business community in calling for Treasury to slow the process.  We also made a strong case for S corporations to be excluded from the rule.  Not only do S corporations have little opportunity to engage in the tax arbitrage practices targeted by the rule, but they also face a higher level of risk from the rule than other business forms.  As our comments note:

Unlike C corporations, the distinction between nondeductible dividends and deductible interest has virtually no significance for S corporations. Any income distributed to the shareholders of an S corporation in the form of dividends has already been taxed to them, and will not be taxed again upon distribution. Admittedly, income paid out in the form of interest will be deductible, but it will also be fully taxable to the recipient. Thus, all income in the S corporation context is taxed once, and only once, and there is no substantial tax motivation to recharacterize profits distributions (i.e., dividends) as interest in order to achieve deductibility at the corporate level. It was primarily this concern, which does not apply in the S corporation context, that gave rise to the enactment of Section 385 of the Internal Revenue Code to begin with.

And:

The importance of providing S corporations with an exception from the Proposed Regulations is compounded by the fact that S corporations are subject to the single class of stock requirement, as well as the limitations on eligible shareholders.  Internal Revenue Code Section 1361(b)(1)(B),(D). 

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 status, in turn, would result in costs far in excess of any recharacterization of debt into 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. 

So S corporations have little or no opportunity to game the system and they would be unduly harmed by the effects of the proposed rule.  If and when Treasury moves forward with this rule, S corporations should be excluded.

 

More Hill Actions on 385

A couple items of note on 385 from the Hill.  First, a group of Finance Committee Republicans, led by Senator Dean Heller (R-NV), wrote to Treasury late last week expressing their significant concerns over the rule. As the letter states:

Over the past few months, we have heard from numerous stakeholders, including small businesses, business associations, and companies with operations in our home states that would be impacted if the proposed regulations are implemented without significant alterations.  We respectfully request that, at a minimum, you substantially modify the proposed rules so that ordinary business transactions unrelated to tax avoidance are not adversely affected by the broad scope of these proposed rules. 

The letter goes on to highlight several of the authors specific concerns, including the harm the proposed rule will have on S corporations:

Below are just a few of the concerns we have repeatedly heard from stakeholders regarding these regulations.  We note this is not an exhaustive list.  In addition to the other critical issues that have been raised, we expect to see – at the very least – the following reforms should Treasury decide to finalize the proposed regulations:

  • Ensure that S corporations, a critical component of America’s small business community, do not lose their S corporation tax status by virtue of having their debt recharacterized as equity and are not penalized for their domestic-to-domestic transactions…

Next, the Joint Committee on Taxation hosted a “closed door” meeting yesterday morning for Treasury officials to brief a bipartisan group of tax writers from both the House and the Senate.  According to Politico:

Treasury officials were less than enthused – read, not at all – Wednesday when congressional tax writers suggested they should slow down their implementation of Section 385 regulations, which have become the most contentious tax issue in town. Our Katy O’Donnell reports that members of the Joint Committee on Taxation met behind closed doors with Mark Mazur, assistant secretary of the Treasury for tax policy, and Bob Stack, deputy assistant secretary for international tax affairs, for about two hours. House Ways and Means Chairman Kevin Brady said the men “seemed somewhat dismissive” of the idea of delaying the regs, which would re-classify some debt as equity in related-party financing transactions and are a key part of the Obama administration’s effort to fight inversions. Businesses are convinced the rules, as written now, will hamstring legitimate transactions. Rep. Sander Levin, the top Democrat on Ways and Means, was a little more charitable than Brady. “The administration made clear that they are going at this deliberately,” he said. “They know there are some specific concerns, and they expect to be able to address them.”

Tax Notes added this:

After a July 6 meeting with some Treasury officials to discuss controversial debt-equity proposed rules, some taxwriters remained unsatisfied that the Treasury Department will move to accommodate congressional and stakeholder concerns about section 385.

“It did not sound to me that they had a complete plan that would work,” Senate Finance Committee Chair Orrin G. Hatch, R-Utah, told reporters as he emerged from the closed-door meeting that also included Joint Committee on Taxation members and several House and Senate taxwriters and their staff.

“This is very complex, and it’s going to be very difficult for businesses,” Hatch said, adding that there is “a real chance” that the proposed rules (REG-108060-15) would push more U.S. companies to move abroad.

Asked if there were specific areas, such as the treatment of S corporations and cash pooling, that Treasury would accommodate, Hatch said, “They think they are making accommodations — to the degree that they are — but I question if they are making enough accommodations. We’ll see.”

Our own feedback also suggests the discussion went far beyond questions of timing and covered the effects of the proposed rules on cash pooling practices, the insurance and banking industries, and the cost the rule will impose on the business sector and the economy as a whole.  The particular plight of S corporations was raised by a number of members and discussed at length.

The “official” comment period for the proposed 385 rules may close today, but we expect the policy and political discussion surrounding the rule to continue in an energized fashion.  This rule is expansive and harmful, and it needs to be changed significantly if it’s going to accomplish the goals of its authors without destroying jobs and investment in the process.  That’s the message from the Hill and the business community.  Time will tell if Treasury is listening.

House Tax Blueprint

June 28, 2016 by · Leave a Comment 

You have to feel for the House tax writers.  They spent months putting together a plan to reform the tax code and now all anybody wants to talk about is Brexit and Section 385.  That’s too bad, because the plan outline released last week is pretty good.

You can read the whole outline here, plus there’s been lots of discussion among the tax experts on how it would help to simplify tax collections while encouraging more business investment and job creation:

From the S-Corp perspective, the headline is the plan would make progress on all three of the key “pass-through principles” we’ve been championing since 2011 – that is, it takes a comprehensive approach to reform, it reduces both the corporate and pass-through rates to more reasonable and similar levels, and it makes progress on reducing the harmful double tax imposed on corporations.  It also gets rid of the dreaded estate tax, which hits private companies much more acutely than publicly-owned ones.

And while some folks are concerned about the fact that the initial tax on C corporation income is 20 percent while the pass-through tax rate is 25, the simple fact is that the tax imposed on successful S corporations and partnerships will be almost 20 points lower under this plan than it is under current law.  That’s a huge rate cut and one that would be welcomed by S corporations across the country.  As Tax Notes reported yesterday:

At the briefing, House Republican taxwriters insisted that their plan offers parity for the various types of businesses, with a 25 percent rate for small business and passthrough income and a 20 percent rate for C corporation income.

Double taxation on corporations’ paid dividends accounts for their lower rate under the plan, Nunes said.

“It’s not based on small or large. It’s based on how you’re legally set up. I could be a one-man C-corp and get a 20 percent rate,” Nunes said. “Because of the double taxation on C-corp is why it’s necessary to have a little lower rate than the individual. But any company can create an LLC or C-corp no matter what size you are.” The blueprint labels the two rates as applying to “small businesses” and “large businesses,” respectively.

Brady emphasized that the GOP plan’s rate for small businesses is a dramatic drop from the current tax structure.

“Don’t let that myth continue. You know right now that our passthroughs are paying the top rate of 44.6 percent as individuals, not just 39.6 percent. That’s the dramatic cut to 25 percent,” Brady said.

Regarding next steps, the Committee views this white paper as a discussion draft and is soliciting comments from stakeholders.  We like the broad parameters outlined last week, but there are lots of details that go unexplored. For example, the 25 percent rate on pass-through businesses is structured as a rate cap rather than a separate tax rate schedule.  That approach may work similar to a top rate in principle, but in practice it seems to be susceptible to being limited either by size or by industry (see our comments on the Buchanan bill).  The authors of this plan need to resist the temptation to limit the pass-through rate in any way, and treat it just the same as the top rate on corporations.

We intend to comment further on this and other key aspects of the blueprint.  There’s lots here to like, and much more that needs to be clarified.  Our goal will be to ensure that the plan continues to be something Main Street can support as it moves through the process.

 

House R’s and D’s Weigh In on 385

Speaking of Section 385, in separate letters to Treasury Democrats and Republicans on the Ways and Means Committee have communicated their respective concerns about the pending regulations.

First, eleven Ways and Means Democrats sent a letter to Secretary Lew last week that applauded his agency’s efforts to crack down on inversions and base erosion practices, but also raised concerns that the proposed regulations implementing Section 385 go too far:

However, there may be a number of unforeseen circumstances in which the regulations could adversely affect ordinary course business transactions between related parties in the absence of tax avoidance motives.  It has been raised that certain business sectors, including financial services, insurance, and utilities, may encounter industry-specific challenges to implementing these regulations due to various regulatory requirements unique to those industries.  We also have been informed that there are broader concerns related to various internal cash management practices, such as cash pooling, and appreciate that Treasury is continuing to examine the effect of the proposed regulations on those practices.  For these and other limited circumstances, we ask that you give careful consideration to whether exceptions or special rules, including transition rules, are appropriate.  

Next, all the Republicans on the Committee signed a letter to Secretary Lew today that takes a much more aggressive and critical tone regarding the rule.  As the letter notes:

We believe any finalization of the proposed regulations in present form will have a profound and detrimental impact on business operations nationwide. If not significantly altered, they will undoubtedly reduce overall investment and economic activity to the detriment of the United States and its business community. Since the release of these proposed 385 regulations, strong concerns have been raised with our offices by constituent companies and business groups representing every economic sector and industry in the United States. …

Furthermore, the proposed regulations represent a dramatic departure from current policy and practice, overturning more than a half century of well-established jurisprudence based upon analysis of an instrument’s actual substance …  the proposed regulations are broadly applicable to a wide array of ordinary business transactions, creating unacceptably high levels of uncertainty and adverse collateral consequences for non-tax motivated business activity.

So, in addition to the broad concerns raised by the business community to date (here and here), we now have bipartisan concerns raised by Republicans and Democrats alike regarding the 385 rule.  Let’s hope Treasury is in listening mode.

More on 385

June 23, 2016 by · Leave a Comment 

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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