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!