With the elections approaching, we won't see anything substantive on taxes coming out of Washington, D.C. until after November. However, small business owners shouldn't be lulled – lawmakers and their staffs are working now on ideas and proposals for tax reform which are wide-ranging and significant.
There is no question that the Goliaths – big business – have been active and engaged with discussions in Congress focusing on the need to lower the corporate rate. Perhaps most stunning is that some in Washington have even proposed increasing taxes on the Davids – small and medium business – to lower the taxes on the Goliaths (by, for example, expanding the corporate tax base to include successful small and medium businesses that currently elect to be a pass-thru and using the additional revenues to lower the corporate tax rate overall).
However, not all is lost – Congressman Dave Camp, Chairman of the Ways and Means Committee is taking a strong interest in ensuring that tax reform also benefits small and medium business. It is expected that Chairman Camp will sometime before the election put out a proposal on pass-thrus (similar to the thoughtful white paper put forward on international tax issues earlier). Recent Congressional hearings, reports by Bush Treasury , Obama Treasury, two from Congressional Research Service (including the inimitable Dr. Jane Gravelle – who was of great help to me for this article) have all highlighted different issues and concerns and may be of interest to readers who want to look at this in further detail.
What are some of the ideas that are being talked about for tax reform for pass-thrus in Washington? Here are six:
1) A uniform tax treatment of all pass-thrus. Meaning – if you are organized as an S Corporation, LLC, partnership, etc. – you would be treated the same under federal taxes. Now, uniformity can be good, bad or middling depending on how you slice it – but the idea is a simpler code that is business-friendly is a priority. How would you propose creating uniformity?
2) Taxation at the partnership level. Now this is different than double taxation a la C Corporations. The idea is that there will still be taxation at only one level – but it will be at the entity level (and owners won't be taxed on dollars received). The reason for this – something that I was aware of from my time on the staff of the Senate Finance Committee – is that the IRS has the devil trying to deal with the “waterfall” effect of layer after layer of partnerships – and trying to ascertain the ultimate taxpayer. Taxation at the partnership level is a way to short-circuit this problem for the Service.
In addition, taxation at the partnership level has a potential big policy ramification – it would allow Congress to decide to set the top tax rates for business income of pass-thrus at the same rate as a corporate tax. Example, corporate tax rate lowered to 29% — taxation of the pass-thru entity also at 29%. This is an interesting finesse of the wars on the top rate and concerns about the impact on small businesses and job creation of increasing the top ordinary income rate.
3) Treatment of debt. There has been an ongoing interest in treatment of debt and equity –and the current tax code preference for debt (businesses can deduct interest payments). There is a recognition that small and medium businesses are not able to raise equity easily in the market and therefore look to credit (not that getting credit is all that easy). The question is –is there a reasonable limitation/cap that should be provided for loan payments for small and medium businesses and/or businesses overall.
4) Manufacturing Reinvestment Account (MRA). This is an interesting idea championed by Hugh McCann and Jamie Scott – both small business owners. I have gotten a good deal of positive feedback from business owners when I have talked about it – basically allowing a company to set aside $500,000 a year tax-free for up to 7 years for investments in new machinery, equipment and training (and then imposing a 15 percent tax when funds are ultimately used). This is a distant cousin for what is allowed for shipbuilders now. The nice thing for small and medium business owners with this idea is that they wouldn't get taxed on monies when they set them aside for saving to reinvest and grow their business. Congresswoman Rosa DeLauro (D-CT) has introduced legislation – HR 110 creating MRA's — and you can read more details here – Senator Blumenthal (D-CT) has introduced companion legislation.
5) Repeal the General Utilities Doctrine. Dave Springsteen a partner at the New Jersey CPA of Withum, Smith & Brown made the negative impact of this clear to me. As Dave said in a note to me:
Owners of professional service businesses historically, prior to the 1990′s, have used the various state statutes to provide limited liability protection to their shareholders (especially licensed professionals) operating in the service arena. These businesses are small to medium sized companies providing much of the backbone and fabric to the US economy. Originally, the corporate structure was preferred over operating as an individual sole proprietor or general partnership because these structures did not provide liability protection to the owners, and subjected their personal assets to the claims of potential creditors.
LLCs became popular in the 1990s for licensed professionals. In many states LLCs created an opportunity for newly formed professional and personal service companies, but created a trap for the existing “C”, “S” or “PSCs”. Why? Because of the tax law change in 1986, the repeal of General Utilities doctrine that imposes a tax on the liquidation or conversion of a corporation into an LLC. The liquidation tax prevents PSC, C, and S corporations from converting to the new, preferred LLC structure by imposing a tax toll charge even though the historic business operations and ownership would be continued.
6) 100 – Person limit on S Corporations. Mr. Springsteen also makes the useful reminder that S corporations are also particularly burdened because there is a 100 shareholder limit. Once an S corp. hits 100 shareholders, it cannot convert to an LLC tax-free to allow for additional ownership. Despite the “flow through” tax treatment of S corporation income, (like the LLC), the liquidation, merger, or conversion to an LLC, creates a “deemed” sale of the S corporation assets creating a current gain, taxed then even though the entity continues to operate its historic business and needs to convert to facilitate growth.
An example of the liquidation tax burden on conversion to an LLC follows: a C corporation and S corporation would face a liquidation tax of $2,237,500 and $750,000, respectively by converting to an LLC based on a $5 million valuation and no basis at current income tax rates. Needless to say, this impedes growth. Naturally, none of this helps the growth of small and medium businesses.
What are your ideas for reform?
alliantgroup has been honored to be asked by leading policymakers in tax for our thoughts and input on what should be done when it comes to tax reform for small and medium business. While Congress hears from the Goliaths all the time (invited or not) it is rare that they hear from the Davids. It is important that the voice of the Davids – 93% of the businesses in this country are organized as pass-thrus – are heard in the discussion of tax reform.
The sad truth is that being for David is not easy. But tax reform is too important for the Goliaths to be the only ones in the arena – so we will continue fighting for the Davids. Please give us your ideas and thoughts for tax reform and don't forget now is the time to talk to your elected officials – don't wait until after the elections.