Mar.HWM Examines Treatment of Closely -Held Businesses in the Context of Tax Reform
At a House Ways and Means Committee Hearing on March 7, members discussed the treatment of closely held businesses in the context of tax reform. The panel of witnesses agreed that comprehensive tax reform must occur and warned of the potential negative consequences of only pursuing corporate tax reform as the divergence between the individual and corporate tax rates could have a substantial affect on closely held businesses, such as S corporations, C corporations and partnerships. Various witnesses also stressed the importance of tax certainty and the ability to retain earnings to invest back into the company. Panelists also had concerns about the looming expiration of the Bush tax cuts and the effect this would have on closely held companies’ ability to retain earnings for future investment.
Among the questions members asked were the shifting nature of small businesses to register as pass-through entities, the President’s budget and corporate tax reform proposals, House Majority Leader Eric Cantor’s (R-Va.) recent corporate tax reform proposal, the Bush tax cuts, and the impact of double taxation on small businesses.
In his opening statement, Chairman Dave Camp (R-Mich.) said the complexion of the closely held businesses “varies greatly,” and stated that the complexity of the tax code disproportionately hurts small businesses – “which tend to be closely held businesses.”
“Whether a business organizes as a C corporation, an S corporation, a partnership, or some other form of business entity, that decision should not be driven by tax considerations. Instead, it ought to be driven by what form of organization best suits that business and its needs,” Camp said.
He added that “one of the most effective ways to prevent” distortions in the tax code “is to create a neutral tax code in which the individual tax rates are similar to corporate rates.” Republicans have advocated for a top rate of 25 percent for both individual and corporate tax rates, Camp said. President Obama’s proposals would raise the top individual rate to roughly 40 percent, while reducing the corporate rate to 28 percent, which would “create more harm than good,” he said.
In his opening statement, Ranking Member Sander Levin (D-Mich.) said some individuals “have sought to continue to draw a straight line between pass-throughs and small business to justify the tax cuts for the highest earners.” He noted that pass-throughs are actually “quite large,” with 64 percent of partnership income earned by partnerships with more than $100 million in assets. He added that only a small fraction of small business income would be affected by the expiration of the top income tax rates.
Testimony
In his testimony, Mark Smetana, Chief Financial Officer of Eby-Brown Company, pointed to text in the Obama administration’s corporate tax reform framework and said it is “simply not the case” that privately held businesses organized as pass-through entities are advantaged in the current tax code over corporations. In addition, while all businesses use generally accepted accounting principles (GAAP), there are fundamental differences between the two forms of business when it comes to holders of privately held companies and investors in publicly held corporations as the former are “limited in number and have longer-term investment horizons” than investors who frequently trade securities and operate on a short-term basis.
To treat all businesses fairly and provide “consistent policy with which businesses can operation in the U.S. economy, tax reform must address both forms of organization,” he said.
In his testimony, Dewey Martin, CPA, testifying on the behalf of the National Federation of Independent Businesses (NFIB), said the NFIB recommends three changes to current law to provide for additional flexibility to small businesses by: 1) Allowing corporations to own stock in S Corporations; 2) If a business owner is employed by a C Corporation, he or she can have fringe benefits like other employees; and 3) Reducing the holding period for built-in gains tax to promote flexibility for small businesses.
As for tax reform, Martin recommended keeping tax rates low, removing the disparity between the corporate rate and the individual rate, reducing the complexity of the code, and not separating the business owner from the business. He added that the NFIB supports permanently extending the Bush tax cuts and repealing the alternative-minimum tax (AMT) and estate tax.
In his testimony, Stefan Tucker, Partner at Venable, LLP, advocated for a single tax regime for all pass-through entities, taxable C Corporations, simplified compensation rules, and for the individual and corporate income taxes to be placed on par to prevent gaming.
When it comes to small businesses, Tucker said he is particularly concerned about access to capital and capital formation, protecting personal assets from business risks, and business succession. He added that federal tax policy affects all of these concerns.
In his testimony, Jeffrey Kwall, Professor of Law at Loyola University School of Law, said the existence of pass-through entities, and Subchapter S and K regimes, are three alternative regimes, “each with different tax effects” that cause business owners “to be unduly influenced by tax considerations when deciding how to organize and operate a business.” This results in unfairness, inefficiency and complexity, he said.
Kwall made four recommendations in his testimony calling for: 1) The way in which closely held business entities are taxed should depend on the complexity of the business arrangement, not the legal form of the business; 2) A single, owner-level tax should be imposed on the income of “simple” closely held businesses under a pass-through system resembling current law’s “S regime;” 3) A singe, entity-level tax should be imposed on the income of “complex” closely held businesses to relive the tax law of the burden of allocating the income of a “complex” entity among its owners; and 4) Closely held businesses should be excluded from current law’s double-tax “C regime.” During the hearing, Kwall was adamant that closely held businesses be kept out of C Corporations.
In his testimony, Tom Nichols of Meissner, Tierney, Fisher & Nichols S.C., said the current rate structure is at risk as the expiration of tax cuts on January 1, 2013, will distort the rates between C Corporations and S Corporations as partnerships and S Corporations will see their top rates rise to 45 percent, while C Corporations will remain at 35 percent.
Nichols advocated for a single business tax structure, broadening the tax base “and lowering and flattening the tax rates,” and for whatever tax reform is implemented to be comprehensive. To do this, Nichols suggested a shorter, five-year holding period for the built-in gains tax, the reduction or elimination of restrictions on eligible shareholders of S Corporations, and that the S Corporation numerical shareholder limitation be increased to a more policy-based level than the current “unavoidably arbitrary 100-shareholder cutoff.”
He noted how some proposals have suggested forcing the double tax on C Corporations on large pass-through entities with gross-receipts more than $50 million. He added, “if the goal of reform is to make American businesses more competitive, why would you force more employers into the punitive, double-tax regime.”
In his testimony, Martin Sullivan, Contributing Editor at Tax Analysts, said the U.S. ranks second in the world only to Mexico in the size of its non-corporate sector. As he would later reiterate numerous times during the question and answer session, Sullivan said while there is widespread agreement that the U.S. should lower its corporate tax rate, the big question is how Congress would pay for rate reduction. He noted that the elimination of tax expenditures will hurt pass-through entities and said “the best way to provide tax relief for small business is not through broad-brush policies like changes in high-end rates, but through tax relief targeted toward small business.”
Sullivan referred to the Cantor’s proposed deduction equal to 20 percent of pass-through income for businesses with less than 500 employees, saying it has “technical shortcomings.” Adding further, Sullivan said the proposal “would require complex anti-abuse rules to prevent high-bracket taxpayers from shifting non-business income into these new tax-advantaged vehicles” and “the proposal is not well targeted for encouraging job creation” as the new deduction would provide “no marginal incentive to increase employment.”
A better approach, according to Sullivan, would be to “provide permanent deductions or credits equal to a percentage of each employee’s payroll with a limit on the number of employees that can qualify.”
Question and Answer
Camp focused on the President’s corporate tax reform proposal, which would raise marginal tax rates for pass-through entities to 40 percent and cut the corporate tax rate to 28 percent, and asked whether there is a risk from the spread between the rates.
Semtana, Martin, and Nichols all called for tax parity. Kwall said without balance there will be pressure to use a corporation as a tax shelter. However, “I would not allow closely held businesses access to the C Corporation regime,” he said. Sullivan said gaming is mainly the result of small businesses using C Corporation status “and that should be eliminated.”
Camp followed up by asking Martin and Nichols for their thoughts on whether it is better to have fewer business entities subject to double taxation than more, “and if we can’t eliminate the corporate income tax, wouldn’t it be better to determine who can get pass-through treatment by using a business distinction … whether an entity is complex, or whether it’s publicly traded.”
Martin said the elimination of double taxation “would be an answer to all kinds of simplification problems,” adding that S Corporations would go away “if we allowed corporations to liquidate with one level of taxation and made dividends deductible.” He said, “we shouldn’t be using the Internal Revenue Code to decide, based on a level of revenues, who should be a C Corp. and who shouldn’t be.” Martin said that as long as tax rates have parity, there is no need for a “forceful choice of an entity for anybody.”
Rep. Wally Herger (R-Calif.) was concerned about the possibility that many companies are trapped in C Corporation status “by overly restrictive tax rules for companies that want to convert to S Corporations.” He asked why so many businesses are organized as C Corporations and whether Congress should look at ways to make it easier for C Corporations to transition to a pass-through regime.
Semtana said the reasons behind entities preferring C Corporation status is due to the fact that these entities are not getting good tax advice and that there are a number of longstanding small companies that originally formed as C Corporations and “typically don’t switch.” Martin said the “built-in gains burden is significant,” and for those entities that are a cash basis business, “you really can’t elect to be an S Corp. from being a C Corp. because you have to pay tax on all receivables within the next year,” which makes them “locked in to that position.”
Rep. Richard Neal (D-Mass.) asked the panel for any reasons on why pass-throughs have grown significantly and whether this trend is a problem.
Sullivan said the invention of the limited liability company (LLC) was “open season” for larger businesses as LLCs have the advantages of limited liability and the exemption from the corporate income tax. However, this causes disparity between large businesses as some pay corporate income tax and some do not.
Kwall said the shift occurred from two changes during the 1986 tax reform including, the parity between individual and corporate tax rates, and after 1986 “you could no longer sell a C Corporation business without the imposition of a heavy corporate tax on the gain.”
Rep. Peter Roskam (R-Ill.) asked Smetana what the impact on his company would be if the Bush tax cuts expire. Smetana replied that his company would see an increase on individual marginal rates of 4 to 5 percent, which would be higher if the AMT preferences are also removed. This would have a detrimental impact on the company’s after tax cash flow and impact corporate decisions going forward, he said.
Smetana said “the fact that we’re large shouldn’t really dictate” how much profit the company keeps. He noted that there is an important distinction between the double taxation regime over C Corporations, which have investors who are active traders of securities, and closely held businesses where the income is left in the business and whose owners do not actively trade.
Rep. Erik Paulsen (R-Minn.) asked the panel to highlight the restrictions on S Corporations and whether Congress should consider proposals “outside the context of larger comprehensive tax reform, such as the limits on the types of shareholders allowed for an S Corporation” to help open up opportunities for small businesses “trapped in that C Corp. area?”
Nichols said a number of proposals Congress could look at that will not result in significant losses in revenue. He added that a lot of restrictions on S Corporations status do not need to be retained.
Tucker said there are five ways to reconcile S Corporations with partnerships within the S Corporation regime, they are: 1) take out any limit on the number of shareholders; 2) allow anyone to be a shareholder (partnership, S Corporation included); 3) reconcile inside-basis and outside-basis; 4) basis and adjusted basis; 5) allow any kind of stockholder, preferred, non-preferred or anything, “without having an issue.” He added, “let’s eliminate S Corporations and let them use the partnership regime, which would be the simpler way of doing it.”
For additional information on the hearing, please click here.
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At a House Ways and Means Committee Hearing on March 7, members discussed the treatment of closely held businesses in the context of tax reform. The panel of witnesses agreed that comprehensive tax reform must occur and warned of the potential negative consequences of only pursuing corporate tax reform as the divergence between the individual and corporate tax rates could have a substantial affect on closely held businesses, such as S corporations, C corporations and partnerships. Various witnesses also stressed the importance of tax certainty and the ability to retain earnings to invest back into the company. Panelists also had concerns about the looming expiration of the Bush tax cuts and the effect this would have on closely held companies’ ability to retain earnings for future investment.
Among the questions members asked were the shifting nature of small businesses to register as pass-through entities, the President’s budget and corporate tax reform proposals, House Majority Leader Eric Cantor’s (R-Va.) recent corporate tax reform proposal, the Bush tax cuts, and the impact of double taxation on small businesses.
In his opening statement, Chairman Dave Camp (R-Mich.) said the complexion of the closely held businesses “varies greatly,” and stated that the complexity of the tax code disproportionately hurts small businesses – “which tend to be closely held businesses.”
“Whether a business organizes as a C corporation, an S corporation, a partnership, or some other form of business entity, that decision should not be driven by tax considerations. Instead, it ought to be driven by what form of organization best suits that business and its needs,” Camp said.
He added that “one of the most effective ways to prevent” distortions in the tax code “is to create a neutral tax code in which the individual tax rates are similar to corporate rates.” Republicans have advocated for a top rate of 25 percent for both individual and corporate tax rates, Camp said. President Obama’s proposals would raise the top individual rate to roughly 40 percent, while reducing the corporate rate to 28 percent, which would “create more harm than good,” he said.
In his opening statement, Ranking Member Sander Levin (D-Mich.) said some individuals “have sought to continue to draw a straight line between pass-throughs and small business to justify the tax cuts for the highest earners.” He noted that pass-throughs are actually “quite large,” with 64 percent of partnership income earned by partnerships with more than $100 million in assets. He added that only a small fraction of small business income would be affected by the expiration of the top income tax rates.
Testimony
In his testimony, Mark Smetana, Chief Financial Officer of Eby-Brown Company, pointed to text in the Obama administration’s corporate tax reform framework and said it is “simply not the case” that privately held businesses organized as pass-through entities are advantaged in the current tax code over corporations. In addition, while all businesses use generally accepted accounting principles (GAAP), there are fundamental differences between the two forms of business when it comes to holders of privately held companies and investors in publicly held corporations as the former are “limited in number and have longer-term investment horizons” than investors who frequently trade securities and operate on a short-term basis.
To treat all businesses fairly and provide “consistent policy with which businesses can operation in the U.S. economy, tax reform must address both forms of organization,” he said.
In his testimony, Dewey Martin, CPA, testifying on the behalf of the National Federation of Independent Businesses (NFIB), said the NFIB recommends three changes to current law to provide for additional flexibility to small businesses by: 1) Allowing corporations to own stock in S Corporations; 2) If a business owner is employed by a C Corporation, he or she can have fringe benefits like other employees; and 3) Reducing the holding period for built-in gains tax to promote flexibility for small businesses.
As for tax reform, Martin recommended keeping tax rates low, removing the disparity between the corporate rate and the individual rate, reducing the complexity of the code, and not separating the business owner from the business. He added that the NFIB supports permanently extending the Bush tax cuts and repealing the alternative-minimum tax (AMT) and estate tax.
In his testimony, Stefan Tucker, Partner at Venable, LLP, advocated for a single tax regime for all pass-through entities, taxable C Corporations, simplified compensation rules, and for the individual and corporate income taxes to be placed on par to prevent gaming.
When it comes to small businesses, Tucker said he is particularly concerned about access to capital and capital formation, protecting personal assets from business risks, and business succession. He added that federal tax policy affects all of these concerns.
In his testimony, Jeffrey Kwall, Professor of Law at Loyola University School of Law, said the existence of pass-through entities, and Subchapter S and K regimes, are three alternative regimes, “each with different tax effects” that cause business owners “to be unduly influenced by tax considerations when deciding how to organize and operate a business.” This results in unfairness, inefficiency and complexity, he said.
Kwall made four recommendations in his testimony calling for: 1) The way in which closely held business entities are taxed should depend on the complexity of the business arrangement, not the legal form of the business; 2) A single, owner-level tax should be imposed on the income of “simple” closely held businesses under a pass-through system resembling current law’s “S regime;” 3) A singe, entity-level tax should be imposed on the income of “complex” closely held businesses to relive the tax law of the burden of allocating the income of a “complex” entity among its owners; and 4) Closely held businesses should be excluded from current law’s double-tax “C regime.” During the hearing, Kwall was adamant that closely held businesses be kept out of C Corporations.
In his testimony, Tom Nichols of Meissner, Tierney, Fisher & Nichols S.C., said the current rate structure is at risk as the expiration of tax cuts on January 1, 2013, will distort the rates between C Corporations and S Corporations as partnerships and S Corporations will see their top rates rise to 45 percent, while C Corporations will remain at 35 percent.
Nichols advocated for a single business tax structure, broadening the tax base “and lowering and flattening the tax rates,” and for whatever tax reform is implemented to be comprehensive. To do this, Nichols suggested a shorter, five-year holding period for the built-in gains tax, the reduction or elimination of restrictions on eligible shareholders of S Corporations, and that the S Corporation numerical shareholder limitation be increased to a more policy-based level than the current “unavoidably arbitrary 100-shareholder cutoff.”
He noted how some proposals have suggested forcing the double tax on C Corporations on large pass-through entities with gross-receipts more than $50 million. He added, “if the goal of reform is to make American businesses more competitive, why would you force more employers into the punitive, double-tax regime.”
In his testimony, Martin Sullivan, Contributing Editor at Tax Analysts, said the U.S. ranks second in the world only to Mexico in the size of its non-corporate sector. As he would later reiterate numerous times during the question and answer session, Sullivan said while there is widespread agreement that the U.S. should lower its corporate tax rate, the big question is how Congress would pay for rate reduction. He noted that the elimination of tax expenditures will hurt pass-through entities and said “the best way to provide tax relief for small business is not through broad-brush policies like changes in high-end rates, but through tax relief targeted toward small business.”
Sullivan referred to the Cantor’s proposed deduction equal to 20 percent of pass-through income for businesses with less than 500 employees, saying it has “technical shortcomings.” Adding further, Sullivan said the proposal “would require complex anti-abuse rules to prevent high-bracket taxpayers from shifting non-business income into these new tax-advantaged vehicles” and “the proposal is not well targeted for encouraging job creation” as the new deduction would provide “no marginal incentive to increase employment.”
A better approach, according to Sullivan, would be to “provide permanent deductions or credits equal to a percentage of each employee’s payroll with a limit on the number of employees that can qualify.”
Question and Answer
Camp focused on the President’s corporate tax reform proposal, which would raise marginal tax rates for pass-through entities to 40 percent and cut the corporate tax rate to 28 percent, and asked whether there is a risk from the spread between the rates.
Semtana, Martin, and Nichols all called for tax parity. Kwall said without balance there will be pressure to use a corporation as a tax shelter. However, “I would not allow closely held businesses access to the C Corporation regime,” he said. Sullivan said gaming is mainly the result of small businesses using C Corporation status “and that should be eliminated.”
Camp followed up by asking Martin and Nichols for their thoughts on whether it is better to have fewer business entities subject to double taxation than more, “and if we can’t eliminate the corporate income tax, wouldn’t it be better to determine who can get pass-through treatment by using a business distinction … whether an entity is complex, or whether it’s publicly traded.”
Martin said the elimination of double taxation “would be an answer to all kinds of simplification problems,” adding that S Corporations would go away “if we allowed corporations to liquidate with one level of taxation and made dividends deductible.” He said, “we shouldn’t be using the Internal Revenue Code to decide, based on a level of revenues, who should be a C Corp. and who shouldn’t be.” Martin said that as long as tax rates have parity, there is no need for a “forceful choice of an entity for anybody.”
Rep. Wally Herger (R-Calif.) was concerned about the possibility that many companies are trapped in C Corporation status “by overly restrictive tax rules for companies that want to convert to S Corporations.” He asked why so many businesses are organized as C Corporations and whether Congress should look at ways to make it easier for C Corporations to transition to a pass-through regime.
Semtana said the reasons behind entities preferring C Corporation status is due to the fact that these entities are not getting good tax advice and that there are a number of longstanding small companies that originally formed as C Corporations and “typically don’t switch.” Martin said the “built-in gains burden is significant,” and for those entities that are a cash basis business, “you really can’t elect to be an S Corp. from being a C Corp. because you have to pay tax on all receivables within the next year,” which makes them “locked in to that position.”
Rep. Richard Neal (D-Mass.) asked the panel for any reasons on why pass-throughs have grown significantly and whether this trend is a problem.
Sullivan said the invention of the limited liability company (LLC) was “open season” for larger businesses as LLCs have the advantages of limited liability and the exemption from the corporate income tax. However, this causes disparity between large businesses as some pay corporate income tax and some do not.
Kwall said the shift occurred from two changes during the 1986 tax reform including, the parity between individual and corporate tax rates, and after 1986 “you could no longer sell a C Corporation business without the imposition of a heavy corporate tax on the gain.”
Rep. Peter Roskam (R-Ill.) asked Smetana what the impact on his company would be if the Bush tax cuts expire. Smetana replied that his company would see an increase on individual marginal rates of 4 to 5 percent, which would be higher if the AMT preferences are also removed. This would have a detrimental impact on the company’s after tax cash flow and impact corporate decisions going forward, he said.
Smetana said “the fact that we’re large shouldn’t really dictate” how much profit the company keeps. He noted that there is an important distinction between the double taxation regime over C Corporations, which have investors who are active traders of securities, and closely held businesses where the income is left in the business and whose owners do not actively trade.
Rep. Erik Paulsen (R-Minn.) asked the panel to highlight the restrictions on S Corporations and whether Congress should consider proposals “outside the context of larger comprehensive tax reform, such as the limits on the types of shareholders allowed for an S Corporation” to help open up opportunities for small businesses “trapped in that C Corp. area?”
Nichols said a number of proposals Congress could look at that will not result in significant losses in revenue. He added that a lot of restrictions on S Corporations status do not need to be retained.
Tucker said there are five ways to reconcile S Corporations with partnerships within the S Corporation regime, they are: 1) take out any limit on the number of shareholders; 2) allow anyone to be a shareholder (partnership, S Corporation included); 3) reconcile inside-basis and outside-basis; 4) basis and adjusted basis; 5) allow any kind of stockholder, preferred, non-preferred or anything, “without having an issue.” He added, “let’s eliminate S Corporations and let them use the partnership regime, which would be the simpler way of doing it.”
For additional information on the hearing, please click here.