Treasury’s Proposed Minority Discount Rules Finally Released

August 3, 2016 by · Leave a Comment 

The regulatory assault continues – this time in the form of newly proposed rules out of Treasury to increase valuations – and taxes – on family businesses when they are transferred as part of an estate.

These are the long-awaited rules Treasury officials foreshadowed as far back as the Spring of 2015, and they appear to be consistent with the Obama budget proposal offered back in 2012 that was estimated to raise $18 billion over ten years!

While the rules were just released yesterday, their impact on family partnerships and estate plans is already the hot topic of debate with tax planners nationwide.  Are they narrowly limited to certain revocable ownership restrictions?  Or are they more broad and targeted at the core “lack of control and marketability” discounts that have been the bedrock of family business valuation since the dawn of time?

According to Mark Mazur– the head of Tax Policy at Treasury – who wrote a blog post that accompanied the release, Treasury is just going after loopholes in the rules:

It is common for wealthy taxpayers and their advisors to use certain aggressive tax planning tactics to artificially lower the taxable value of their transferred assets. By taking advantage of these tactics, certain taxpayers or their estates owning closely held businesses or other entities can end up paying less than they should in estate or gift taxes. Treasury’s action will significantly reduce the ability of these taxpayers and their estates to use such techniques solely for the purpose of lowering their estate and gift taxes.

What sort of restrictions?  According to the rules:

Under §25.2704-3 of the proposed regulations, in the case of a family-controlled entity, any restriction described below on a shareholder’s, partner’s, member’s, or other owner’s right to liquidate his or her interest in the entity will be disregarded if the restriction will lapse at any time after the transfer, or if the transferor, or the transferor and family members, without regard to certain interests held by nonfamily members, may remove or override the restriction.

Types of restrictions described in 2704-3 include:

  1. Limitations on the ability to compel the liquidation or redemption of an ownership interest;
  2. Limitations on the amount received when liquidating or redeeming their ownership interest;
  3. Limitations requiring the deferral of those payments; and
  4. Limitations requiring the payment in a form other than cash or property.

But the fact that these “disregarded” restrictions are limited to ownership interests in a “family-controlled” business should raise red flags in the valuation world.  The IRS has a long history of fighting, and losing, the battle to value family-owned businesses significantly higher than businesses owned by unrelated parties.  We’ve battled the “family attribution” concept in the past and we may have to battle it again here too, depending on just how broadly these rules are written.

Broad or narrow, the new rule will, by Treasury’s own estimates, raise taxes significantly on the family business community and will, when coupled with the pending 385 regulations and other administrative actions, continue to hurt its ability to invest and create jobs.  With the economy barely growing at the moment, that’s exactly what we don’t need.

S-Corp Mod Bills Introduced! 

July 14, 2016 by · Leave a Comment 

Good news on a hot day in July!  The 2016 version of the “S Corporation Modernization Act” has been introduced the House and the Senate.  Led by Senators Thune (R-SD) and Cardin (D-MD) and Representatives Reichert (R-WA) and Kind (D-WI), the bill includes a half-dozen provisions designed to improve the rules that govern S corporations.

  • You can see the entire bill here
  • You can see the section-by-section analysis here
  • You can see the S-Corp press release here

Yesterday’s introduction of companion bills is the first time in a while that the S corporation community has had this important legislation being championed in both bodies, and we really appreciate the hard work the members and their staffs put in to get the provisions just right.

Of particular note is the fact that Senator Thune is taking on the leadership of the bill from Finance Committee Chair and longtime S corporation advocate Senator Orrin Hatch (R-UT).  South Dakota has a ton of S corporations and ranks second nationally in pass-through employment, so this effort is important to Senator Thune and his state and we look forward to his enthusiastic leadership.  As he noted at the introduction:

Family owned small businesses are the backbone of the U.S. economy and can be located in every corner of the country.  Small towns and rural communities are oftentimes the ideal location for these small- and medium-sized businesses, which is why making these common-sense reforms to S corporations is so important to South Dakota.

Senator Ben Cardin added:

S corporation businesses are critical to the well-being of the Maryland economy and account for more than half of our state’s private-sector workforce.  Unfortunately, our federal tax code has not kept up with the increasingly important role that these types of companies play,” said Cardin.  “The S Corporation Modernization Act contains much-needed changes to the tax treatment of S corporations, allowing them to better attract capital, create jobs, and make charitable investments in their communities.

Key changes in this version relative to past efforts include:

  • Dropping the two provisions – BIG and charitable – that were made a permanent part of the Tax Code last December
  • Moving the Nonresident Alien provision up to the top slot – it is time for direct foreign investment to be available to S corporations; and
  • Including the new internal basis adjustment provision to ensure that S corporation assets receive similar treatment as partnerships.

So your S-Corp team has a new bill, new champions, and new priorities to accomplish in the coming months and years.  The legislative outlook is uncertain, with Congress preparing to break for the party conventions and then, after a short fall session, the November elections.  That doesn’t leave us much time, but as always we will be looking for opportunities to get something done.  With a terrific bipartisan set of advocates on the Hill, we are in a good position to do just that.


S-Corp Concerns Dominate 385 Comments

The comment period is closed and the verdict is in – just take S corps out.  That’s what numerous trade associations and other groups recommended to Treasury regarding the pending section 385 regulations.  Here’s what the National Association of Manufacturers had to say:

The proposed regulations also significantly impede the ability of businesses organized as subchapter S corporations to utilize their cash effectively. In particular, the bifurcation rule in the proposed regulations, which allows the IRS to treat a debt instrument as part debt and part stock, could cause a subchapter S corporation to lose its S status and become taxed as a C corporation.

In order to qualify as an S corporation, an entity must have only one class of stock (identical rights to distribution and liquidation proceeds) and must be owned only by eligible shareholders (examples of ineligible shareholders include C corporations, foreign corporations, partnerships, insurance companies and non-resident aliens). The reclassification to stock, or part stock, could inadvertently create an ineligible S corporation shareholder (e.g., if the debt reclassified to stock was held by a C corporation, the C corporation would become an ineligible S corporation shareholder); and/or the reclassification to stock could create a second class of stock via preferred return consideration on the debt instrument….

The proposed regulations do not apply to corporations filing a consolidated tax return. S corporations under common ownership, however, are not permitted to file a consolidated tax return and thus, the proposed regulations apply to commonly-owned S corporations, even those with solely domestic activity. The NAM strongly recommends that subchapter S corporations be exempted from the final regulations.

Other groups made similar arguments and their conclusions were just as strong.  Here’s just a sample:

American Bar Association

Exclude S corporations from the expanded group.

National Retail Federation

We recommend that S corporations be exempted from the application of the regulations.

American Institute of Certified Public Accountants

Provide exceptions to ensure that S corporations do not inadvertently terminate their status when debt is reclassified as equity.

Florida Bar

The rules should exempt S corporations which clearly cannot be a focus for the issues of concern regarding the Proposed Rules.


Exclude S corporations, as well as certain other entities, from the ambit of the proposed regulations (i.e., revise Prop. Treas. Reg. § 1.385-1(b)(3)(i)(A) so that it only “turns off” paragraph (3) of section 1504(b)).

The IRS is holding a public hearing on the proposed rules today.  Of the 18 speakers listed, many of them are from groups that support excluding S corporations from the rule.  We’ll be watching closely to what, if any, reaction there is from the Treasury and IRS officials in attendance.  More to come.

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.


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.

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