[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
SUBCOMMITTEE HEARING ON S-CORPS:
ENSURING PARITY, GROWTH AND
DEVELOPMENT FOR SMALL BUSINESSES
=======================================================================
SUBCOMMITTEE ON FINANCE AND TAX
COMMITTEE ON SMALL BUSINESS
UNITED STATES HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
JUNE 18, 2008
__________
Serial Number 110-100
__________
Printed for the use of the Committee on Small Business
Available via the World Wide Web: http://www.access.gpo.gov/congress/
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HOUSE COMMITTEE ON SMALL BUSINESS
NYDIA M. VELAZQUEZ, New York, Chairwoman
HEATH SHULER, North Carolina STEVE CHABOT, Ohio, Ranking Member
CHARLIE GONZALEZ, Texas ROSCOE BARTLETT, Maryland
RICK LARSEN, Washington SAM GRAVES, Missouri
RAUL GRIJALVA, Arizona TODD AKIN, Missouri
MICHAEL MICHAUD, Maine BILL SHUSTER, Pennsylvania
MELISSA BEAN, Illinois MARILYN MUSGRAVE, Colorado
HENRY CUELLAR, Texas STEVE KING, Iowa
DAN LIPINSKI, Illinois JEFF FORTENBERRY, Nebraska
GWEN MOORE, Wisconsin LYNN WESTMORELAND, Georgia
JASON ALTMIRE, Pennsylvania LOUIE GOHMERT, Texas
BRUCE BRALEY, Iowa DAVID DAVIS, Tennessee
YVETTE CLARKE, New York MARY FALLIN, Oklahoma
BRAD ELLSWORTH, Indiana VERN BUCHANAN, Florida
HANK JOHNSON, Georgia
JOE SESTAK, Pennsylvania
BRIAN HIGGINS, New York
MAZIE HIRONO, Hawaii
Michael Day, Majority Staff Director
Adam Minehardt, Deputy Staff Director
Tim Slattery, Chief Counsel
Kevin Fitzpatrick, Minority Staff Director
______
Subcommittee on Finance and Tax
MELISSA BEAN, Illinois, Chairwoman
RAUL GRIJALVA, Arizona VERN BUCHANAN, Florida, Ranking
MICHAEL MICHAUD, Maine BILL SHUSTER, Pennsylvania
BRAD ELLSWORTH, Indiana STEVE KING, Iowa
HANK JOHNSON, Georgia
JOE SESTAK, Pennsylvania
.........................................................
(ii)
C O N T E N T S
----------
OPENING STATEMENTS
Page
Bean, Hon. Melissa............................................... 1
Buchanan, Hon. Vern.............................................. 2
WITNESSES
PANEL I:
Blankenship, Ms. Cynthia L., Vice Chairman and Chief Operating
Officer, Bank of the West, Irving, TX, On behalf of the
Independent Community Bankers of America....................... 3
Klahsen, Mr. Rick, Managing Director/Partner, RSM McGladrey,
Bloomington, MN, On behalf of the S Corporation Association.... 5
Kerr, Mr. Bob, Senior Director, Government Relations, National
Association of Enrolled Agents................................. 7
Anderson, Mr. Kevin D., Partner, National Tax Office, BDO
Seidman, LLP, Bethesda, MD..................................... 9
Shinn, Mr. Byron, President, Shinn & Company, P.A., Certified
Public Accountants and Consultants, Bradenton, FL.............. 11
APPENDIX
Prepared Statements:
Bean, Hon. Melissa............................................... 25
Buchanan, Hon Vern............................................... 27
Chabot, Hon. Steve............................................... 28
Blankenship, Ms. Cynthia L., Vice Chairman and Chief Operating
Officer, Bank of the West, Irving, TX, On behalf of the
Independent Community Bankers of America....................... 29
Klahsen, Mr. Rick, Managing Director/Partner, RSM McGladrey,
Bloomington, MN, On behalf of the S Corporation Association.... 40
Kerr, Mr. Bob, Senior Director, Government Relations, National
Association of Enrolled Agents................................. 47
Anderson, Mr. Kevin D., Partner, National Tax Office, BDO
Seidman, LLP, Bethesda, MD..................................... 50
Shinn, Mr. Byron, President, Shinn & Company, P.A., Certified
Public Accountants and Consultants, Bradenton, FL.............. 60
(iii)
SUBCOMMITTEE HEARING ON S-CORPS:
ENSURING PARITY, GROWTH AND
DEVELOPMENT FOR SMALL BUSINESSES
----------
Wednesday, June 18, 2008
U.S. House of Representatives,
Committee on Small Business,
Washington, DC.
The Subcommittee met, pursuant to call, at 10:02 a.m., in
Room 1539, Longworth House Office Building, Hon. Melissa Bean
[chairwoman of the Subcommittee] presiding.
Present: Representatives Bean, Ellsworth, and Buchanan.
OPENING STATEMENT OF CHAIRWOMAN BEAN
Chairwoman Bean. Good morning. We are calling this hearing
to order. Thank you all for being here today.
Entrepreneurs face many challenges when starting their
businesses. Small-business owners must secure capital, develop
their products and services, identify markets, secure a
workforce and keep their customers happy. One of the most
important decisions they will make is how to structure or
incorporate their company.
In the Small Business Committee, we have explored business
concerns about scarce capital, rising insurance and gas costs,
but what sometimes gets overlooked is how disparities in the
tax rules for different types of company entities can have
long-term impacts on its business and its owners.
Today's hearing will examine one of the most common
business classifications in the tax code, the S Corporation,
and review suggestions for potential reforms that might better
reflect the intentions of our tax code and more effectively
support a growth economy.
In 1958, Congress created a corporate structure known as
the Subchapter S Corporation to promote the growth of small
businesses. As the S Corporation has evolved, it has become a
cornerstone of the small-business community. Currently there
are approximately 4 million S Corporations nationwide, up from
500,000 in 1985. These companies range from local community
banks to home businesses to manufacturing firms.
Despite the growth in the number of S Corps, there are
concerns that certain requirements are either unnecessarily
burdensome or create obstacles to expansion. Many of these
provisions were written almost 60 years ago, and it is
important that Congress revisit these measures to see that they
are still best serving our Nation's economic objectives.
One of the challenges for S Corps, as with many small
businesses, is raising capital. For instance, S Corps have
limitations on eligible shareholders and investors, and these
regulations provide little flexibility in obtaining equity
financing.
Small businesses also face challenges in offering health
and retirement benefits. Currently, the tax code provides C
Corps tax advantages unavailable to S Corps when it comes to
these types of programs. Would providing equal tax treatment
improve the ability of small businesses to offer health
insurance coverage and reduce the number of Americans without
health insurance, or should S Corps change their corporate
structure if they want to provide those types of benefits.
Today we will hear testimony to examine these questions and
explore where changes might be advantageous. With our economy
facing serious difficulties, it is more important than ever to
ensure that our tax policy does not unnecessarily impede small
firms' growth potential.
I would like to thank our witnesses for coming here to
share your experience and your expertise on the issue of tax
code disparities, and look forward to your testimony.
I will now yield to Ranking Member Buchanan for his opening
statement.
OPENING STATEMENT OF MR. BUCHANAN
Mr. Buchanan. I want to thank the Chair for calling this
important hearing to examine the challenges and the
possibilities facing S Corps as they strive to compete in the
modern, global marketplace.
I would also like to extend my thanks to our witnesses, who
have taken their valuable time out of their schedule to provide
the Subcommittee with the benefits of their experience and
testimony today.
Today we meet on the 50th anniversary--I didn't know that,
but that is interesting--the 50th anniversary of the passage of
legislation permitting the formation of S Corporations. For the
past half-century, S Corps have offered small-business owners
around the Nation the ability to benefit from limited-liability
corporation.
And myself, my wife and I started our first company in
1976, and we had C Corps, and then a lot of things rolled into
S Corps, which were huge because the double taxation, as you
know, and the liability factor, both of those. So it was a big
thing for us because it provided us capital on our company's
gross, so it was important.
Today, however, in the last 7, 8 years, and being a new
Member of Congress, last year and a half, we are doing a lot
more with limited-liability companies. So I am interested to
see if the S Corp, in some ways, has become a little obsolete
and what we can do to fix it or, you know, where we are at on
that.
But, as everybody knows, times have changed, and what was
right 50 years ago might not apply today. So that is why we
have this hearing. Back then, it probably seemed good enough to
make possible a business framework where a few owners would be
able to prosper directly from investment while avoiding having
their enterprise double-taxed by the Federal Government. But
yet, we explore potential reforms that promote parity in growth
and development for S Corporations, leading to some of the
following questions I would like to have us talk about today a
little bit.
First is the Sub-S, should it be given additional expansion
in terms of legal protection?
Secondly, should the number of owners permitted an S Corp,
which used to be 100, should that be expanded? I am not quite
sure how they came up with 100, but I think even before maybe
it was less than 100. But I know some people are thinking about
it should be 200 or something.
Thirdly, in a global economy where so much American
business is financed by foreign investors, should S Corps have
the same ability to raise the needed resources abroad as C
Corporations do today?
I don't think we are talking about a matter that requires
complete overhauling. It seems to me that we can achieve
greater fairness, safety and opportunity by simply bringing the
existing system into the modern age, the 21st century.
Again, I would like to thank the chairman for holding this
today, and I would like to thank our witnesses again for taking
the time out of their schedule. And I look forward to your
comments and testimony today.
I yield back.
Chairwoman Bean. Thank you.
We are now going to move to testimony from the witnesses.
Witnesses will have 5 minutes to deliver their prepared
statements. The timer begins when the green light is
illuminated. When 1 minute of time remains, the light will turn
yellow. The red light will come on when your time is up.
And our first testimony is going to come from Cynthia
Blankenship, who is vice chairman and chief operating officer
of the Bank of the West in Irving, Texas. Bank of the West is a
full-service independent bank specializing in customer service
and small-business financing. She is testifying today as
chairman of the Independent Community Bankers of America. ICBA
is the only national trade association that exclusively
represents community banks.
Thank you so much for being here.
STATEMENT OF MS. CYNTHIA L. BLANKENSHIP, VICE CHAIRMAN AND
CHIEF OPERATING OFFICER, BANK OF THE WEST, IRVING, TEXAS, ON
BEHALF OF THE INDEPENDENT COMMUNITY BANKERS OF AMERICA
Ms. Blankenship. Thank you. Madam Chairwoman, Ranking
Member Buchanan and members of the Committee, Cynthia
Blankenship, vice chairman, chief operating officer of Bank of
the West in Irving, Texas. I am also chairman of the
Independent Community Bankers of America. I am pleased to have
this opportunity to present the views of the Nation's community
banks on S Corporation reform.
ICBA represents 5,000 community banks throughout the
country. Bank of the West is part of a two-bank holding company
with assets of $250 million. We have eight locations in the
Dallas-Fort Worth metroplex.
Subchapter S businesses are found on Main Street, not Wall
Street. Bank of the West itself is a Subchapter S entity. Many
of our small-business customers are S Corps, as well.
For decades, community banks were completely shut out of
electing S Corp status. In 1996, Congress passed the Small
Business Job Protection Act that allowed small banks to elect S
Corp status for the first time, starting in tax year 1997.
Unfortunately, many community banks continue to be
obstructed from converting to S Corps and benefiting from
Congress's intended relief because of technical rules and
community bank-specific regulations.
Subchapter S is an important business option. There are
more than 2,500 S Corp banks in the United States, representing
one-third of the entire banking industry. My home State of
Texas alone has 291 S Corp banks, which represents 44 percent
of all the banks in Texas. Madam Chair, your home State of
Illinois has 237 S Corp banks, which represents 35 percent of
the banks in your State.
We must ensure our tax code is simple and does not
unnecessarily impair small-business vitality and opportunities.
ICBA urges additional Subchapter S reforms be enacted to keep
pace with the growing small-business sector in America.
Currently, before making the S Corp election, community
banks must first overcome difficult obstacles not faced by
other corporate tax structures, such as the limited-liability
corporations. The obstacles most often facing community banks
include restrictions on the types of shareholders, the number
of shareholders, the limitations on the options for raising
capital, the complex treatment of the IRA shareholder, and the
burden of the built-in gains tax.
ICBA recommends several reforms that would simplify the tax
code and provide more flexibility. We recommend the maximum
number of S Corp shareholders to go to 150. For all small
businesses, raising capital is critical to start, survival and
growth of the business. Arbitrary and restrictive limits on the
number of Sub-S shareholders can jeopardize the ability for S
Corps to raise capital.
By their nature, community banks were created by involving
a large number of shareholders in the community. ICBA supports
the bipartisan Community First Act introduced by Small Business
Committee Chairwoman Velaquez that would increase the S Corp
shareholder limit to 150 from 100.
We recommend allowing new IRAs as eligible S Corp
shareholders. S Corp community banks seeking to raise capital
are excluded from allowing new IRA shareholders. ICBA supports
the bipartisan S Corporation Modernization Act, introduced by
Representative Kind in the House, to address the IRA
shareholder issue.
ICBA recommends allowing S Corp community banks to issue
preferred stock. Current law only allows S Corps to have one
class of stock outstanding. Community banks must maintain
certain capital ratios to be considered well-capitalized for
regulatory purposes. As a community bank grows in size, its
earnings alone may not be sufficient to fund its growth. We
recommend allowing a national limited-liability company bank
charter. Community banks are small businesses, yet are often
unable to use preferred business forms to other businesses such
as the LLC.
Congress should also work to preserve the 35 percent top
marginal tax rate on Subchapter S income. Maintaining cash flow
is vital to the survival of any small business, and taxes are
typically the second-highest expense after labor cost. During
this difficult economic period, at a minimum, the current top
tax rate of 35 should be preserved on both small-business
Subchapter S and C Corporation income, not increased.
ICBA is concerned with the overly aggressive of IRS
regulations and the threat of encroaching payroll taxes.
In conclusion, reforms to outdated and onerous Sub-S laws
would provide a much-needed boost to many small businesses at a
critical time. Additional simplification to the S Corporation
area would go a long way in allowing community-based banks to
convert to S Corp status, as Congress intended in 1996.
Thank you for allowing me to be here today.
[The prepared statement of Ms. Blankenship may be found in
the Appendix on page 29.]
Chairwoman Bean. Thank you for your testimony.
And we are now going to move to Rick Klahsen, who is
managing director and partner of RSM McGladrey in Bloomington,
Minnesota. RSM McGladrey is a leading national business
consulting, accounting and tax firm that focuses on mid-sized
companies. He is here to testify on behalf of the S Corporation
Association. The S Corporation Association is the only
organization in D.C. exclusively devoted to promoting and
protecting the interests of America's 3.8 million S Corp
owners.
Thank you for being here today. And I apologize to you, and
all of you, if I sneeze during your testimony.
STATEMENT OF MR. RICK L. KLAHSEN, MANAGING DIRECTOR AND
PARTNER, RSM MCGLADREY, BLOOMINGTON, MINNESOTA, ON BEHALF OF
THE S CORPORATION ASSOCIATION
Mr. Klahsen. Thanks.
Chairwoman Bean, Ranking Member Buchanan and other members
of the Subcommittee, thank you for the opportunity to testify
today.
My name is Rick Klahsen. I am a managing director in the
national tax department of RSM McGladrey and the national
service line leader for tax advisory and compliance. RSM
McGladrey, when combined with McGladrey & Pullen, is the fifth-
largest business consulting, accounting and tax firm that
focuses on mid-sized companies. I also serve on the board of
advisors for the S Corporation Association and submit my
testimony today on their behalf.
I want to thank you for holding this hearing, and I ask
that my full testimony be inserted into the record.
Before Congress created S Corporations, entrepreneurs had
two basic choices: They could form a basic C Corporation and
face two layers of Federal tax, or they could form a
partnership and put all of their personal assets at risk. The
creation of the S Corporation in 1958 gave small-business
owners a better option: a single layer of tax with full
liability protection.
How significant was the creation of Subchapter S? Nearly a
half-century later, S Corporations are the most popular
corporate structure in America, with twice as many firms as C
Corporations.
This growth has created its own challenges. The number of S
Corporation returns has increased from less than 500,000 in
1978 to more than 4 million today. At the same time, the number
of regular C Corporations peaked in 1986 at 2.6 million and has
declined steadily since then.
The growth of pass-through businesses, coupled with the
decline of C Corps, has shifted an increasing amount of
business income from the corporate tax code to the individual
tax code. This means that tax policy for businesses is
increasingly affected by changes to the individual tax code. We
believe policymakers in Washington need to be acutely aware of
the dynamic between the individual tax rates and business
income as they consider broad-based tax reform.
The growth of limited-liability companies and the need to
update rules dating back five decades combine to make S
Corporation reform an important part of any tax code reform.
Over the years, the S Corporation Association has worked with
policymakers and Congress, as well as allied trade
associations, to develop a list of critical reforms Congress
should consider.
These legislative priorities are included in House Bill
4840, the S Corporation Modernization Act, and its companion
bill, Senate's 3063. Introduced by Ways and Means Committee
Congressmen Ron Kind and Jim Ramstad, the bill is designed to
simplify rules under which S Corporations operate, and it is
endorsed by an impressive group of business associations.
Another bill is House Bill 3874, the Small Business Growth
and Opportunity Act, introduced by Congressman Steve Kagen. The
proposal would decrease the holding period of assets subject to
the built-in gains tax from 10 years to 7 years. This latter
provision is particularly important as Congress examines what
provisions might be included in a possible stimulus package.
The built-in gains tax applies to any appreciated asset
held by a corporation converting to S Corporation. Under built-
in gains, these firms are required to hold these assets for at
least 10 years or be subject to a punitive level of tax.
Hundreds of thousands of S Corporations nationwide are
likely sitting on locked-up capital, as they cannot access or
redeploy these assets due to prohibitive tax implications of
built-in gains. In an economy where a 1 or 2 percent change in
growth can mean the difference between a recession and moderate
growth, eliminating that lock-in effect and allowing those
assets to become fully productive could be significant.
Another challenge to the S Corporation community is a
proposed reduction in the tax rate to C Corporations. The
approach outlined in Treasury and in Congress would reduce the
marginal tax rates on corporations while broadening the tax
base.
The challenge is that many of the businesses that use
Section 199, LIFO accounting, IC-DISC and other tax benefits
eliminated as part of the base broadening are not C
Corporations. In other words, the effort to cut the marginal
tax on C Corporations would also significantly raise taxes on S
Corporations and partnerships.
The S Corporation Association has met with the tax staffs
at Treasury and Ways and Means Committee to discuss this
adverse outcome for pass-through businesses.
A final important issue to the S Corporation community is
how to appropriately tax income earned by S Corporation
shareholders who actively work at their business. The S
Corporation Association appreciates the concern that certain
taxpayers are paying less than their fair share of payroll
taxes. However, the IRS already has the tools necessary to
identify these taxpayers and to force them to pay the correct
level of tax.
While applying these rules may be time-intensive and
costly, alternative proposals risk raising payroll taxes on
family-owned businesses already fully compliant with the law.
Getting the solution right to this challenge is important, and
the S Corporation Association looks forward to working with the
Ways and Means Committee and the Small Business Committee to
ensure whatever reform is enacted does not adversely impact
law-abiding business owners.
Chairwoman Bean, the S Corporation Association and I
greatly appreciate the opportunity to testify today and to
highlight various issues of concern to the S Corporation
community. I thank you for the opportunity, and I am happy to
answer any questions you might have.
[The prepared statement of Mr. Klahsen may be found in the
Appendix on page 40.]
Chairwoman Bean. Thank you for your testimony. You have
raised some of the things I know we want to ask more questions
about.
And now we would like to introduce Mr. Kerr, who is senior
director of Government relations at the National Association of
Enrolled Agents. He represents the interests of enrolled agents
who are tax practitioners licensed by the IRS and serves as
their liaison to the IRS. The National Association of Enrolled
Agents is the professional society that represents 40,000
enrolled agents nationwide.
Thank you for being here.
STATEMENT OF MR. ROBERT KERR, SENIOR DIRECTOR OF GOVERNMENT
RELATIONS, NATIONAL ASSOCIATION OF ENROLLED AGENTS
Mr. Kerr. Thank you, Madam Chair, Mr. Buchanan, members of
the Subcommittee, for the opportunity to testify before you
today. My name is Bob Kerr, and I am the head of government
relations at NAEA.
Enrolled agents are the only tax practitioners for whom IRS
directly attests to their competence and ethical behavior. NAEA
represents the interests of some 46,000 enrolled agents across
the country. Our members usually work with those on the smaller
end of the small-business scale and more typically see gross
incomes in the tens of thousands, rather than the tens of
millions.
I will discuss two issues today, reasonable compensation
and record-keeping, and provide several approaches that would
help S Corps and, to some extent, all small businesses operate
more easily.
One of the advantages of an S Corp is that shareholder
employees can receive both wages and profit distributions, both
of which are subject to the shareholder's personal income tax
rate, but only the wages are subject to payroll taxes. Not
surprisingly, the tax advantage for distributions over wages
leads to challenges for the corporation, namely in determining
what constitutes the reasonable compensation required by IRS.
In the absence of clear guidance, people disagree on what
constitutes "reasonable," and many EAs find themselves enmeshed
in or refereeing, shall we call, spirited conversations with
their S Corp clients as a result. Meanwhile, other small S
Corps are completely unaware of the reasonable compensation
requirements, which can lead to very unpleasant surprises
during an audit.
With respect to reasonable comp, EAs and others are in a
quandary when asked what is reasonable or when suggesting to a
client that his comp is in fact not reasonable. I know there
are those who believe that treating S Corp and partnership
income similarly would solve that problem. I am not at all
certain that we would buy into that solution, however.
At the same time, in the absence of a significant fix right
now, we suggest that practitioners and S Corps could be helped
by practical IRS guidance in determining what is reasonable
compensation. This could take many forms, so we suggest an
audit technique guide may be appropriate.
As to my second point, I can't imagine I am the first
person to come before this Committee stating that record-
keeping is the bane of a small-business man's or small-business
woman's existence. Record-keeping is burdensome, and the code
requires small businesses to keep a myriad of records. For
instance, Section 274(d) requires stringent documentation for
deductions both for cell phone use and for business use of an
automobile. Section 280(a) requires in-home offices to be used
for business activities solely and for deductions to be made as
a proportion of the entire home. Further, there is no de
minimis amount for expensing rather than depreciating business
assets.
At the end of the day, small-business owners are not tax
experts, though the complexity of our tax code really does
dictate that small businesses retain tax experts to advise them
of their obligations and to help them take advantage of tax
code provisions such as Section 179 expensing or the business
provisions of the recently passed stimulus bill.
NAEA has advocated for years for simplification wherever
possible in the tax code. To that end, we applaud and encourage
the conversations recently under way with respect to a safe
harbor for in-home offices, and particularly note Chairwoman
Velaquez's bill, H.R. 46. Further, Chairman Rangel in H.R. 5719
recently proposed removing cell phones from the Section 274(d)
listed property, which is a move that would dramatically lower
record-keeping requirements. We enthusiastically support such
provisions.
Now, if I may be so bold, S Corps and small businesses
would be greatly assisted if Congress measured complexity and
gave it weight when considering various tax law changes.
Further, both the IRS and tax professionals are well-placed to
provide the information to S Corps and to small businesses as
they organize. EAs far too often find these businesses in tax
trouble not because of malice aforethought, but because of
sheer ignorance or because of bad advice from unqualified
preparers.
Congress could act to improve competence in the tax
preparation industry by enacting H.R. 5716, the Taxpayer Bill
of Rights, introduced by Representative Becerra. We believe
that greater competency leads to better advice and better
compliance.
For its part, in recent years, IRS has made decided efforts
to educate small businesses, and should be supported and
encouraged as it moves forward and as it continues to balance
its compliance obligations with its assistance obligations.
This concludes my testimony. I will be happy to answer
questions.
[The prepared statement of Mr. Kerr may be found in the
Appendix on page 47.]
Chairwoman Bean. Thank you for your testimony. You are
certainly not the first one to bring up record-keeping as
burdensome.
Mr. Kerr. Didn't think I would be.
Chairwoman Bean. We would now like to hear from Kevin
Anderson, who is partner of the National Tax Office of BDO
Seidman, LLP, in Bethesda, Maryland. His practice is focused in
the areas of mergers and acquisitions, corporate structure and
related tax accounting issues. BDO Seidman, LLP, is a national
professional services firm providing assurance, tax, financial
advisory and consulting services to his client companies.
Thank you for being here.
STATEMENT OF MR. KEVIN D. ANDERSON, PARTNER, NATIONAL TAX
OFFICE, BDO NEIDMAN, LLP, BETHESDA, MARYLAND
Mr. Anderson. Thank you. Good morning, Madam Chair, Ranking
Member Buchanan, members of the Committee. I am Kevin Anderson,
and I am pleased to have this opportunity to present my own
views on S Corporation reform and expansion.
I do wish to emphasize that I am here to offer my own
personal views based upon my own experience, and I am not here
to advance the interests of any particular client or those of
my firm.
While it may come as a surprise to my other panelists, I am
really not here to advance or oppose any particular provision
but, really, to provide a little bit of guidance as to how I
think Congress may wish to consider some of the proposals that
are before them. I have an abiding interest in tax policy and
have been a member of the Treasury Department Office of Tax
Policy back in the 1990s.
The S Corporation has always had some features common to
both corporations and partnerships, as you can tell from the
other testimony that we have heard this morning. The flow-
through regime, of course, is borrowed from the partnership
area, whereas many of the other provisions are borrowed from
the C Corporation area, and many of the rules that apply to C
Corporations also apply to S Corporations.
And so, because an S Corporation has features that are
common to both of the worlds, the partnership world and the C
Corporation world, it is hard to know which of the provisions
we would like to borrow from. Is it going to be a best-of-both-
worlds scenario for S Corporations?
With respect to the issue of parity, for example, one of
the objectives of this hearing, I would simply ask, what it is
do we want parity with? Is it parity with business income? Is
it parity with partnerships? Is it a parity with C
Corporations? Is it, as I mentioned before, sort of a best of
both worlds?
We have talked a little about tax rates. Other panelists
have talked about the prospects for changes in the corporate or
individual tax rates. And I think there is going to be some
stress upon the S Corporation model if C Corporation rates go
down or if individual rates go up after 2010, as they are
scheduled to do, for example. So I think that those are one of
the policy considerations that we will have to consider.
Clearly, any provision which makes the S Corporation form
more readily available is going to have revenue implications.
And in this day and age, sometimes we try to pay for things
with offsets; sometimes we don't. But every provision in the
last 10 years that has expanded the scope of the S Corporation
model has been scored by JCT as a revenue loser. So that is
also something that needs to be taken into account.
We have talked a little bit about simplicity. Simplicity is
evidenced by the single class of stock requirement for S
Corporations. And many of the provisions, quite frankly, that
we are talking about here may actually make S Corporations more
complex to comply with. And so one must not lose sight of
simplicity.
Also would not like to lose sight of the small nature of S
Corporations. They are, after all, in the code referred to as
small-business corporations. But I think the documents that
have been circulated for this hearing have made it clear,
correctly, that the only way that S Corporations are kept small
is through shareholder limitations and not by restrictions on
their revenues or assets or their employees or the size of the
business per se. So, at some point, we may have to consider
thinking these are no longer small-business corporations,
although many of them will continue to be.
We need to make sure that S Corporation income is taxed
currently, as most of the provisions in the code already do,
even for tax-exempt organizations. But the only exception that
is contained in the existing rules are for stock owned by an
employee stock ownership plan, or an ESOP.
Finally, we have talked a little bit about the built-in
gains tax, which is a measure that addresses the so-called
General Utilities repeal back from 1986. I think the big
elephant in the room is that we do not tax conversions per se
of C Corporations to S Corporations, whereas we would impose
full measure of taxation on a conversion from C Corporation
status to partnership status. And it is for that reason that we
have a built-in gains tax. Quite frankly, 10 years was
arbitrary. Seven years is just as arbitrary. The only thing
that it has to advance it is that it is shorter than 10 years.
I will skip discussions about the specific proposals,
although I would be happy to address them in questions and
answers. I do appreciate the opportunity to provide my views. I
think it is an important matter for the Committee, the
Subcommittee to address. And I will be happy to address
questions at a later time.
Thank you.
[The prepared statement of Mr. Anderson may be found in the
Appendix on page 50.]
Chairwoman Bean. Thank you very much for your testimony.
And now Congressman Buchanan is going to introduce our last
witness, Byron Shinn.
Mr. Buchanan. Thank you, Madam Chair.
I am excited today we have someone from our congressional
area. He has been a very highly regarded professional and
business leader in Florida. He has worked as a public
accountant for 30 years. He has his own firm, and his firm is a
Sub S, so he knows a lot about Sub S's.
He is president of the CPA firm Shinn & Company located in
Bradenton, Florida. He has been the past chairman and board
member of the Florida State Board of Accountancy and also the
past chairman of the Manatee Chamber of Commerce in our area,
which is a good-sized county.
I welcome your testimony today. It is great to see you.
STATEMENT OF MR. BYRON SHINN, PRESIDENT, SHINN & COMPANY, P.A.,
CERTIFIED PUBLIC ACCOUNTANTS AND CONSULTANTS, BRADENTON,
FLORIDA
Mr. Shinn. Thank you. Good morning, Madam Chairman, Ranking
Member Buchanan and members of the Committee. My name is Byron
Shinn. I am a CPA in Florida. I graduated from the University
of South Florida in 1979, and I have worked in public
accounting since my graduation.
I am currently a shareholder of a small-business S Corp, as
Congressman Buchanan mentioned. I currently serve on the
Probable Cause Panel of the State Board of Accountancy, where
we have reviewed complaints against licensees. I am also on the
advisory board of the University of South Florida's School of
Accounting, and I have previously served on the National Ethics
Committee for the National State Boards of Accountancy.
I wanted to talk to you as someone who is on the ground, in
the trenches, dealing with small business. As a CPA that is
face to face with those owners, over these last 30 years as we
deal with what entity to be, once they have elected Sub-S, we
have a distancing, if you will, between a C Corp and an S, and
then you have partnerships.
And several years ago, Wyoming started the LLCs. LLCs then
were supported by the IRS in the late 1980s to be acted on and
treated like a partnership. So for those older entities that
are still S Corps that would like to go to an LLC, we have a
tax trap. We have cured tax traps in most places to help the
businessperson run their business. We have a situation where we
are moved from a C to an S by an election. We have a built-in
gains tax that prevents abuses. We have opportunities for
owners to move from a sole proprietorship to a partnership. And
there is the disguised sale rules that have a 7-year period. So
the opportunity to move built-in gains to 7 years is a
convergence of similarities, similar to what we have done with
fringe benefits.
I would like to point out that maybe, as we sit here and
tinker with a lot of tax law and it becomes harder and harder,
maybe we ought to just keep it simple. Why don't we provide an
opportunity for them to make an election to move from an S,
which they did back in the 1970s or 1980s or 1960s--it goes
back to 1958--and allow a bridge for them to move to an LLC and
operate as a partnership? Why wouldn't they want to do that? It
is better raising of equity. You have disproportionate
distributions. Or you can have a broader source of ownership.
You can have partnerships. You can have IRAs. You can have
other Sub-S's as owners of an LLC. But a partnership can't own
a sub-S. So therein lies the trap.
Now, how do you avoid the abuses? Put in something similar
to a built-in gain, the disguised sale rules. Just basically
say, move the assets from a Sub-S to an LLC. And if you do it
and you do it in whole, as long as it stays in that sphere of
business assets in that entity, if you want to take it out, you
want to distribute it out, you want to reshape the business,
yeah, you ought to tax the heck out of them, just like you
would in a normal situation. But if you are keeping the
business in a hole, trying to make a go of it and raise
capital--the other thing that is a real problem with S Corps is
the opportunity--every small business goes through its ups and
its downs.
You heard from the bigger S's, the banks. Well, they are
having losses right now. The limitation on shareholders taking
losses is limited to the basis in their stock. I know that is a
tax terminology. But in a partnership or an LLC world, you can
share in the debt generally as part of their basis to take
losses. In a Sub-S, the shareholder is guaranteeing those
debts. Those guarantees don't count as basis. That corporate
debt doesn't count as basis. Why is that? It doesn't make
sense. When I explain this to the owners of those companies
that are S Corps, they scratch their head, and they say, it
doesn't make sense.
Again, raising equity is very, very important. Whether we
like it or not, there are pockets of prosperity right now, but
we are in a recession. I am from Florida. It is real severe. In
places it is worse than others. I am on the west coast of
Florida. We are very real-estate-oriented. And unfortunately it
has taken its toll.
As people look to try to get equities into their
businesses, if you are an S Corp, it is really, really
difficult because those investors want a preferred rate of
return. They might want convertible debt. Those two items are
not allowed in an S. They could trigger a termination.
One thing that was mentioned earlier was the abusiveness of
payroll taxes in an S Corp. And as I have seen taxpayers come
to me asking for my help, I have seen situations that are
abusive. And I don't want to beat up on the small business. It
is so hard to make a buck and do your part and make your
payroll, pay the rent. A lot of my S Corps aren't the really
large businesses that you referred to. I am in the ditches with
the smaller businesses. I don't have any public companies as
clients. I don't want them. I want to have the big four and the
BDO Seidmans do those. But they are doing smaller businesses
too.
Another thing I want you to think about is the passive loss
rules. Right now in an S Corp, you maintain their identity. If
you own your business and you have a building you are in, and
you are renting out part of that building to a third party,
your operating profits or losses are maintained separately.
Those losses are currently limited. As real estate takes its
hit and our banks go through their struggles, it is real
important, I think, to allow for at least some tax savings to
these small businesses. Because of the losses that are
incurred, ought to be getting current tax benefits. It might
take some of the pressure off the foreclosures we are seeing.
And lastly I listed in some of my written testimony some
items of accounting method changes, some of which are currently
in bills and had been discussed. The bonus to appreciation I
fully support. The increase in the 179 expense, absolutely. And
please just don't do it for 1 year. Make it stick; let it last
for a while. The small-business person keeping up, they have to
pay for the accountants. And it is part of their--how many
times have I been told I am just administrative overhead.
Also, the write-off of bad debts. Banks are allowed to do
reserves. Small businesses, we have to only write off the
receivables when they go bad. But there is a history of
percentages. We ought to think about it.
And lastly, the restauranteurs. The ones that get hit
really tough, the FICA tip credit. We have a wonderful area for
opportunity, but it is so narrow. If the restaurant is losing
money, they don't get any benefit from it. If they are making
too much, they can't get to it. The window to use the FICA tax
credit is so small that it is almost useless. It is really sad.
So, lastly, I wanted to mention finances, since you are
Finance and Tax. And I can get going on taxes, but as far as
finances, the banking industry, because of the easy credit that
was through the last few years and how we have gotten ourselves
into this situation, the regulators have now come back and been
very, very tough.
And all these small businesses--remember, most of these
small businesses had to personally guarantee these loans. They
also probably had to put up their houses as collateral. Well,
as these houses--excuse me.
Chairwoman Bean. You are starting to run out of time.
Mr. Shinn. Sorry.
So this equity is now gone. And they are really in a bad
situation from a banking perspective.
So thank you for this time.
[The prepared statement of Mr. Shinn may be found in the
Appendix on page 60.]
Chairwoman Bean. Thank you for your testimony.
I guess, Mr. Anderson, you reminded us of some of the
potential perils of rushing toward change too quickly. The rest
of our witnesses were mostly advocating for specific changes.
And I guess what I would like to do is challenge those of you
who are recommending changes, is there a change that you would
recommend against, that you can understand the rationale for
some of the existing structure. If you have one, I would like
you to share that.
And conversely, Mr. Anderson, any that you do think is
antiquated by today's standards and current situations that you
would say is something that you think is worthy of
consideration for change. I will go to you first.
Mr. Anderson. I would be happy to go first and point to the
written testimony that I had prepared and indicate that the
passive income threshold is probably something that does merit
an increase.
And, in my testimony, I indicated that I thought if there
was a reason for the tax in the first place, is that it has
analogies to the personal holding company tax for C
Corporations. And although, as I mentioned, the thresholds are
different, the terminology is different, the PHC tax kicks in
at a 60 percent threshold. And I believe that is really why
folks are advocating an increase from 25 to 60 percent.
That is probably at the top of my list.
Chairwoman Bean. Okay. Thank you.
Does anyone else have any that they would want to preserve
that are important differentials between the different types of
entities?
Mr. Kerr?
Mr. Kerr. Absolutely. I mentioned in my testimony that some
folks are interested in getting a real parity between
partnerships and S Corps. Now, there are benefits to an S Corp;
there are benefits to partnerships. And I think there is an
attraction to the simplicity of the solution that we will just
make them equal. But I would caution rushing in that direction
without thinking real hard about why we have these two
structures in the first place. And if we are going to move in
that direction, then perhaps a semi-crazy notion is, well,
let's just have one instead of two.
Chairwoman Bean. Thank you.
Ms. Blankenship?
Ms. Blankenship. Well, I would like to recommend that 35
percent marginal tax rate be kept in place, because if you go
back to lowering the tax rate on the C Corporations, then it
really penalizes the S Corporations. And the S Corporations, by
virtue of their entity structure, allow those small businesses
to build greater equity and retain greater equity because of
the tax structure.
And if you go back to decreasing the C Corp top level tax
rate, then it would encourage, you know, maybe a flip-flop. And
that is the last thing that you would want the small-business
community to have to deal with, is going back and making those
conversions back and forth.
So we need to continue to encourage that top marginal tax
rate on the Subchapter S income and it not be increased, so we
can continue to build our equity.
Chairwoman Bean. Thank you.
Mr. Shinn?
Mr. Shinn. That is why I made the comment, if you can't--in
trying to converge and bring together, like we have done with
fringe benefits, it is going to be very, very difficult. But at
the advent of the LLC, you have the corporate protection but
you have the partnership flexibility from running the business
and growing equity. And that is why I threw out the idea of
trying to build some kind of a bridge where the S owner could
think about--in certain situations, be allowed to go to an LLC
form. Still a corporation for State charter purposes, but then
give them the flexibility to operate its business.
And as long as they do it where they are moving the whole
business, defer the tax, similar to the built-in gains, similar
to the disguised sale. So you can still avoid the abusiveness
but still get to the business focus.
And I challenge you to try to come up with something that
would work, because that will open up a lot of opportunities
for the small-business person that is running their business.
Chairwoman Bean. All right. Thank you.
Mr. Klahsen?
Mr. Klahsen. In some respects my comments will echo those
of Ms. Blankenship, in terms of the change that I would propose
not be implemented is the change of the corporate rate to a
lower rate than it currently is. I think the parity of the
rates, the highest individual tax rates and the corporate rate,
cause people to do things, you know, for more appropriate
reasons. They aren't influenced solely by tax reasons.
And if you look at the proposed drop in the corporate tax
rates and the offsets to pay for that, it has the potential
impact of--if the individual rates increased to, say, 39.6
percent, you lose some of the benefits: the domestic
manufacturers deduction, LIFO accounting, IC-DISC. The
combination of those would result in a significantly higher
rate of tax for S Corporations and other pass-throughs as
compared to C Corporations. And we would, as a result,
influence people's behavior, I believe, in inappropriate means.
Chairwoman Bean. All right. Thank you.
Mr. Buchanan?
Mr. Buchanan. I am just going to open it up with the same
thing. One of the things I think that with pass-through incomes
on S Corps and LLCs, that we have to have a better
understanding up here. I happened to be chairman of the Florida
Chamber. We represented 137,000 businesses. Most of those
businesses, 95 percent, were 50 employees or less. So you have
a lot of LLCs, you have a lot of Sub S corporations.
But one of the things I try to get people to understand--
some do understand--if we raise taxes in general, up from 35
percent, that a lot of people that are in these small
businesses that are personal tax rates up to 40 or 45 or 43
percent, a lot of this money, you know, ends up affecting all
the small businesses. In turn, they can't buy the equipment and
capital.
Most people I know--and I have seen zillions of them, as
you have--have made $400,000, let's say, at the bottom line.
But when you really look at it, by the time they spend some
money on capital and some other things, maybe some debt, the
capital are retiring, debt in their business and other things,
they really end up maybe with $100,000. They have added, you
know, a couple other employees, that type of thing.
So I would like to first just have you comment on the
impact it would have on small business, of any kind of a tax
increase on personal income, you know, your thoughts on that.
If we went from 35 to 39 or 45 to 44, what does that do to your
businesses, your clients, small business in general?
And you start off wherever you would like to start there.
Mr. Kerr?
Mr. Kerr. I was really rather hoping not to go first on
this one.
Mr. Buchanan. Yeah.
Mr. Kerr. In the main, of course, it is difficult to sit
here and ever advocate for higher taxes in any sense. So I
don't think that I am going to start doing so.
I certainly see the concerns and the interest in keeping
the marginal rates the same, the 35 percent. It could be an
environment to consider, well, is there a way to broaden the
base and lower the rates on both sides? Now, obviously, that is
an issue that is decided elsewhere, but I just want to throw
that out for consideration. Otherwise, I don't really have
anything to add to that.
Mr. Buchanan. Okay.
Anybody else want to add a comment on that?
Mr. Klahsen. Mr. Kerr referred to the broadening of the
base and potentially lowering the rates. I think we need to be
careful of the end result of that. And I believe that is
perhaps where you were going, Mr. Buchanan.
There is a great appeal to the sound of reducing a tax rate
from 35 to 30 percent. But if the result of that is that a
great number of things are taken out of the tax code in terms
of deductions or potential benefits and ultimately the tax
burden increases, that is the burden that the small-business
owners feel. They don't attach so much to what is the rate; it
is, what am I paying.
Mr. Buchanan. I guess what I was trying to get at, I have
just seen over the years, someone makes $500,000 and they
always say, well where is my liquidity? Where is my cash? Well,
they have paid out a third in taxes. They have made some
additional investments in equipment that they write off over 5
years, that is gone. They have added some additional inventory.
Before you know it, they have made $500,000 in a sense on their
tax return, but they have $50,000 in the bank. That is what
happens, I have seen over the years.
Mr. Shinn, do you want to comment any more on that?
Mr. Shinn. Yes. I think where you are headed with the bonus
depreciation and the increase in the 179 deduction is a great
start. But some of the opportunities for more installment sales
on sale inventory, things like that, would allow them that
opportunity where the cash flow and the payment of the taxes
are more in sync.
Mr. Buchanan. Okay.
I want to shift over to the other thing on the S Corp and
the LLC. It just seems like there is--I know there are benefits
on both sides, and I haven't paid as much attention on the S
Corp, because it seems like everything I have done in the last
8, 10 years, we have been pushed--everything has been LLC,
because of I think the flexibility.
But what is the biggest difference? Is the S Corp, is there
any sense that that could be obsoleted? Or is it because of the
shareholder's ability to raise capital? You know, it just seems
like the LLC, everybody I am talking to--now, maybe it is
because there are only two, three owners--everybody is moving
to LLC. That is just what my tax attorneys and tax people have
been pushing me to, and I hear a lot of my friends are moving
to that. They own businesses. I would be interested to see what
the S Corp was 10 years ago, the numbers, and then what it is
today. And maybe it is because of business, in general, it is
up.
But, Byron, what is your feeling? What is the big
difference? What do you find with small business from the S
Corp and the LLC? Because everybody used to do the S Corp; now
everybody, it looks like, is in the LLC.
Mr. Shinn. Once the States have had some litigation and
people see how the safety of that corporate insulation, they
have gotten comfortable with it. And you see more and more
people going with they are operating companies that way. If
they are in LLLPs or LPs, they still might do a LLC that is
going to be the general partner and they will elect S as the
general partner. So there are still opportunities for S as a
managing partner of a large, limited-liability partnership or
an LLC that is, for tax purposes, being treated as a
partnership so the managing member might end up being an S
Corp.
The other thing that really stands out with that, small
businesses usually lose money when they first start out, and
losing money cash-flow-wise. That is the investment you talk
about of the assets and the loans and the inability to deduct
those losses. And the IRS has time and again held true to S
Corps. They don't want to allow guaranteed debt as basis. They
don't want to have co-makers. So if Byron signs a loan, Byron
Shinn and Shinn & Company, it is not allowed. They want me to
borrow the money individually and then put it into the
business. It has to be that refined.
And there has been so much case law on this. It is abusive
from a standpoint of really hamstringing those S Corporate
owners. So why do they go to the LLCs? Just because of that.
Mr. Buchanan. Mr. Anderson, any comment? Just in term of
your thought on S Corps and LLCs, I am sure they have a
different role, but is the shift in general for small
businesses and entities with three, four, five, 10
shareholders, are they doing more of an LLC? Or does it just
depend?
Mr. Anderson. Well, I think the advice that we give to our
clients really depends upon whether we are talking about an
existing entity or a newly formed entity.
From my perspective, although I love S Corporations, I am
the first to acknowledge that an LLC taxed as a partnership is
probably the most flexible vehicle for a newly formed entity.
But when you are converting an existing C Corporation, I
think the S Corporation is the only game in town, quite
frankly, for the reasons that I mentioned this in my testimony.
And that is that when you convert a C Corporation to an S
Corporation, there are no immediate--and I emphasize
immediate--tax consequences. But if you were to convert an
existing C Corporation to an LLC taxed as a partnership, the
consequences could be disastrous.
And so we preserve the C Corporation attributes by
converting to S Corporation status.
Mr. Buchanan. Is that something that should be looked at? I
mean, should a C Corp have the same opportunities as an LLC? I
mean, in terms of that conversion? I mean, you can move to an S
Corp but you can't move to an LLC. Is that something that makes
any sense?
Mr. Anderson. Well, I think that there had been proposals
floated over the past several years that would go either way.
For example, some proposals would say if you are going to make
an S Corporation conversion, a C to S conversion, and you are
of a particular size, we will tax that as a fully taxable
liquidation. Great for simplicity but terrible for the business
itself, if you happen to be the one converting.
On the other hand, there have been proposals that would
cause a C to S conversion to be treated as a nonrecognition
event. There are partnership provisions that would be built
into those provisions that would preserve the gains at the
entity level so that they are ultimately taxed somewhere.
But I have to submit that those are very, very complex.
There is nothing really more complex than the partnership gain
and loss allocation provisions. And, again, do we want
complexity? Do we want it to be simple? We are really caught
here, because we have lots of history and just, quite frankly,
no way to go. It would be tremendously complex, I think, to
allow conversions from C to S status and give them the
equivalent of partnership status.
Mr. Buchanan. Mr. Klahsen, let me just ask you your
thought. You are the S Corporation Association. What is
happening with the trend lines? Because I still have probably
some of the old S Corps, but are people, new entities, are they
moving more to the LLC?
Mr. Klahsen. Actually, the numbers are quite interesting.
The number of S Corporations continue to increase, as Mr.
Anderson points out. A number of those are conversions of C
Corporations. But, as I recall the most recent numbers, the
annual increase in S Corporations are about evenly split
between newly created S Corporations and those that have
converted from C Corporation status.
And the reasons are varied. I think Mr. Anderson touched on
a number of them why certainly that conversion, that is the way
to go if you are currently a C Corporation. There are other
instances where S Corporations provide a simplicity and a
clarity. And I know that is a little bit contrary to what we
have been talking about today. But if your alternative is
partnership, things can become very, very complex very, very
quickly. And so for some entities, the creation of an S
Corporation, as opposed to an LLC or specifically a
partnership, is still an appealing way to go.
Mr. Klahsen. Mr. Kerr, I want to just touch real quick on
the bookkeeping, the IRS. How does the IRS treat, you know, a
Sub-S over another entity, in terms of auditing? Is there a
difference from your standpoint? Just out of curiosity.
Mr. Anderson. I don't think our members see a difference
when IRS selects an entity for audit, whether it be a
partnership or whether it be an S Corp. As an aside, I think it
is interesting--
Mr. Buchanan. I am thinking, like, a sole proprietor or
just a small partnership or an S Corp. Do they treat an S Corp
differently?
Mr. Anderson. Oh, okay. I was looking at the selection
criteria.
Mr. Buchanan. I am not looking so much at the C Corp,
comparing that. I am just curious, an S Corp, how that compares
to a--
Mr. Anderson. I don't think so. Because, at the end of the
day, many of the tax code provisions apply regardless of the
entity that you have chosen. And IRS tends to be interested in
those provisions, and they apply without respect to the
structure of your company.
As an aside, the other interesting thing is that IRS is in
the process of what they call an NRP, a national research
project, in which they are focussing on S Corps. And they have
selected 2 years of returns, I think, with 2002-2003. And I
would expect that those results are coming out imminently. And
I think that it may be interesting for those of us in this room
to pay attention to what IRS has found in its rather detailed
audits of about 5,000 S Corps.
Mr. Buchanan. Let me, just in my last question in general,
is just the attraction, will a lot of companies, S Corps, be
able to attract capital. You know, this is something we set up
50 years ago now today. There is probably opportunities, a lot
of opportunities for foreign companies or foreign investors
into S Corps, which I think is not allowed, I guess, from my
understanding.
You know, what is your thought on that? Is that something
that you think we have to consider and give them more
capability, like a C Corp, to look at foreign investors and S
Corps, in terms of them having access to capital?
Do you want to comment, Mr. Klahsen?
Mr. Klahsen. I would. I certainly would encourage
consideration of measures that would increase the access to
capital for S Corporations. And it can be done through a
variety of ways. Increasing the number of share holders is
certainly a possibility. Implementing procedures or changes to
allow certain types of other equity investments, so-called
quality. A qualified preferred stock would be another option.
Certainly, you know, going back to some earlier comments,
some built-in gains and the implications of that, when those
assets are subject to tax for 10 years, it causes the S Corp
owners to hold those assets for an extended period of time and
causes even greater complications in terms of their access to
capital. In many respects, S Corporations are left with very
vanilla means of accessing capital. And any provisions that
could expand upon that I think would be certainly appreciated
by the S Corp community. RPTS MERCHANTDCMN HOFSTAD[11:05 a.m.]
Mr. Buchanan. Any other comments on that that you want to
add.
Mr. Shinn, I just wanted to ask one last question about
passive losses. And I was interested, I know that Florida and I
am sure Vegas and parts of California have been devastated
about the whole concept, in terms of real estate values
falling, the idea that a lot of people probably have passive
losses they can't use, which would be helpful if we are able to
free them up.
Give me your thoughts on passive loss in terms of S Corps.
You know, would it make a big difference?
Mr. Shinn. Just like the one example I gave you where a
business owns their building and they are renting out part of
building, that particular loss is trapped in 469 part of the
code. And I think that either allowing it to be part of--if the
business is in the building, give them a break.
The other thing is with 469, as we sit here and we watch--
that is because of the section for passive losses--we have
really destroyed the opportunity for people to take the cash-
flow losses that they have on their rental property. And let's
say the person has their tile business and they lay tile in
houses and commercial property, and so they decide to buy a
couple of rental houses. Well, they have huge losses now, and
some of those houses are maybe going to go back to the lenders.
Instead, maybe give them the opportunity to take more of the
loss. There is a $25,000 limit right now for low-income people.
Maybe increase that amount.
But I think that our passive loss rules have created a real
tax blunder, so that now we are faced with this real estate
issue. Now, how does it spin with the small businesses? I have
tried to give you some examples of two situations where small
businesses--of a doctor office, they bought a bigger building,
they only needed a quarter of it, but they put up the capital
for the full building. And as they try to find tenants and the
tenants can't pay and they are 2 months slow, they are
incurring losses. And those losses aren't allowed to be
deducted against their other income because of the passive loss
rules.
Mr. Buchanan. Thank you.
I yield back.
Chairwoman Bean. Thank you.
I would like to recognize the gentleman from Indiana, Mr.
Ellsworth.
Mr. Ellsworth. Thank you, Madam Chair.
Just a couple questions. What do we know? We hear, in this
Committee and the other Committees, about cash flow for small
businesses. And I was wondering, Mr. Anderson and anybody else
that wants to comment, if you have specific changes that might
allow for more cash flow for small businesses and changes to
the S Corp rules that would better help corporations, small
businesses. And anybody can comment, but if you have specifics
please.
Mr. Anderson. Well, I think we have alluded to some of
those provisions before, but I will be the first to acknowledge
that the things I would talk about are not unique to the S
Corporation area. These are issues that are common to
partnerships and also to C Corporations.
The examples that went back and forth between Mr. Buchanan
and Mr. Shinn dealt with an entity that has to invest, make
capital expenditures to grow its business. Those capital
expenditures are not deductible for tax purposes but must be
depreciated. And the two relief provisions are the bonus
depreciation for 2008 only and the first-year expensing, which
also has limitations.
Those are two provisions that more closely tie a
corporation's taxable income to its cash flow. And it seems to
me that if there is an interest in those provisions, perhaps
they ought to be expanded, increased, in the case of the bonus
depreciation made permanent, subject to revenue constraints and
other similar considerations.
Chairwoman Bean. Could you repeat the last part? You said
expanded, increased?
Mr. Anderson. The point about the bonus depreciation is
that it was enacted as stimulus only for 2008, and it will
expire for property that is acquired after the end of 2008. It
was part of the 2008 stimulus package. So, next year, a
business making capital expenditures will have the first-year
expensing under Section 179 but will not have the bonus
depreciation under current law.
Mr. Kerr. And then the 179 also is not permanent, so then
you still have the problem of not knowing from year to year,
which is frustrating and difficult for a small business or for
any taxpayer to plan, if you don't know what the tax law is
going to be.
Mr. Anderson. Well, the provision is permanent, but the
dollar amounts will go up and down.
Mr. Kerr. Yes, I am sorry. Yes, that is right.
Mr. Shinn. I would like to add that I concur that the bonus
depreciation needs to be more than just a one shot, 1 year or 2
years, because, as Representative Buchanan made reference to,
the businesses, you want them to reinvest to grow the business.
That brings jobs. And, as we know, that is a big part of our
GNP here.
I would like to point out, though, that, during those
periods when you make large improvements to your business, you
will incur a loss. And right now the 179 rules prevents you
from creating a loss. I think you need to take that off. If
they are going to make the investment, the bank is behind them,
they are not going to make the loan right now, especially
today, unless you have plenty of equity and you are signing on
it personally.
That is why I come back to say, in an S Corp world, you
need to allow that to be a basis and you need to take off the
income cap limit for 179.
Mr. Ellsworth. Thank you.
It is my understanding that in S Corp they are only allowed
one class of stock. Is that a problem? If it is a problem, what
are the problems, and what can we do to rectify that?
And, Mr. Shinn, you are shaking your head. I will give you
the first--
Mr. Shinn. Oh, absolutely. Right now you can have just
voting and nonvoting. And when you look for a passive investor
to infuse capital, let's say the banks just aren't there--and I
have a situation right now with a marine business. The banks
are scared to death of the marine business, and it is a big
part of our business community. And so we are looking at equity
to come in in a passive investment.
They want preferred guaranteed returns. They want
convertibility of the debt to equity. And either of those cases
would create a taxable event. That is why I am saying maybe it
would be nice for them to bridge into an LLC or release those
limitations so they walk and talk more similar to an LLC
partnership environment.
So giving them the opportunity for preferred stock and
allowing them to have disproportionate distributions. That is
the terminology you will see in the court cases. Because right
now it is just pro rata. If you are a 30 percent owner, you
have to get 30 percent of the dividend.
Mr. Ellsworth. Ms. Blankenship?
Ms. Blankenship. Yes, for community banks this is
critically important, because I heard today 2,400 banks in the
Nation are sub-S. But when they want to go out and raise
capital, they either have to dilute their current ownership,
which sometimes would threaten their independence and the Main
Street presence, you know, on Main Street America, in the
community, or they have to sell out. You know, because you have
to give banks the ability to raise capital, because the more
capital they can grow, the more they can infuse back into the
community, of course.
And so, by extending that, by allowing a preferred stock or
the conversion to the limited-liability charter in a tax-free
transaction, particularly for community banks, would be very
beneficial to the economy of Main Street.
Mr. Anderson. Mr. Ellsworth, I would just add that an S
Corporation, even under current law, is not limited to simply
issuing either common stock or plain vanilla debt, if you will.
The current regulations promulgated by the Internal Revenue
Service permit S Corporations to have a variety of, what I
might call, equity-flavored instruments. There are some lenders
who will lend if they can get options or warrants to acquire
stock of the company. Obviously, if those warrants were ever
exercised, there might be a terminating event for the S
Corporation.
But lenders can participate in the upside potential of a
company through acquiring some of these equity-flavored
securities or instruments that do not violate current
regulations. Employees can be incentivized through stock
appreciation rights or stock options, and they are generally
not considered to be shareholders and so don't violate any of
the requirements applicable to S Corporations.
Mr. Klahsen. I would offer that while I agree with Mr.
Anderson's comments, that there are certainly other things
other than simply voting or nonvoting stock and access to
equity in some respects in that manner, the introduction of an
opportunity for investors to invest in preferred stock would
greatly expand that capital access pool.
The opportunity to use some of the instruments that Mr.
Anderson mentioned are honestly quite limited, and some of them
do have the potential for terminating the S election, as he
referred to. So the introduction of a preferred equity
instrument greatly expands the investment community and
improves the access to capital for S Corporations.
Mr. Ellsworth. Thank you.
Thank you all.
Madam Chair, I yield back.
Chairwoman Bean. Thank you for your questions and your
testimony.
I had a last question for Mr. Anderson. Under current law,
certain shareholders of an S Corporation, as we heard many of
you talk about, are taxed on their fringe benefits, while
larger corporate entities, both for employees and owners, those
are nontaxable benefits.
What do you think this does to the ability of those smaller
S Corps to provide such benefits?
Mr. Anderson. Let me try to articulate what I think are the
rules that apply to S Corporation shareholder employees. These
are rules that apply to shareholder employees who have 2
percent or more of a company's stock, and they are simply
treated as partners for fringe benefit purposes.
The biggest fringe benefit that most companies seem to
provide to their employees would be health insurance. And under
current law at least, there is, quite frankly, no significant
distinction between the treatment of S Corporation shareholder
employees and the treatment of C Corporation employees. While
the fringe benefit is taxable to the shareholder employee,
there is also an offsetting deduction that the individuals are
entitled to claim. So, at the bottom line, if you will, there
is probably no net impact to the shareholder employees.
The same cannot be said of the other type of fringe
benefits that are provided. They are less significant, I think,
in the mainstream than health insurance. And they would apply
to such things as group term life insurance, disability
insurance, some de minimis fringe benefits.
Beyond that, I don't think I can really comment. I don't
see that S Corporations are coming to me, at least, or our firm
and saying, this is a tremendous burden or a disincentive to
conversion.
Mr. Buchanan. Just one question. I wanted to ask Ms.
Blankenship, you had mentioned on behalf of the Independent
Community Bankers that it is important or you would like to
have considered going from 100 shareholders to 150
shareholders. I think I understand where you are going with it,
but why don't you explain to myself and everybody else your
thought there.
Ms. Blankenship. Well, I think I stated it in my testimony,
but typically when community banks go out to raise capital,
they go out into their communities, and they raise capital from
a large number of shareholders in the community. Because they
are not going to a broker on Wall Street. They are going to be
partners with those people in the community. The community
invests in the bank, and the bank invests, in turn, in the
community.
And, you know, 100 shareholders typically is--it would take
more than 100 shareholders in a typical community bank capital-
raising transaction. So it just allows the viability of that
Main Street community bank to be able to continue to partner in
their community. And that is why it is so important for us to
have the expanded number, expanded types of shareholders,
because our own bank couldn't convert for 10 years because of
those very restrictions.
Mr. Buchanan. I was just curious why you picked 150 and not
300 or 200? Is there any particular reason?
Ms. Blankenship. We would take 300.
Mr. Buchanan. Yeah, okay. Okay.
Ms. Blankenship. No, there is not a particular reason. You
know, we were trying to be respectful about the limits and
realistic. Other small businesses may not need that number
because of the types of investors, but for community banks it
is a little different animal.
Mr. Buchanan. We have in our area, and I am sure around the
country, but in Florida it just seems like we have a new
community bank a week opening up. And they do raise the
capital, most of it, in the community.
Mr. Blankenship. Yes.
Mr. Buchanan. Thanks for your comment.
Ms. Blankenship. Thank you.
Chairwoman Bean. Well, I want to thank you all for your
testimony today. I think it provokes further questions, but we
will probably have to ponder a little before we come up with
those, and hope to follow up with some of you in the future.
I ask unanimous consent that members will have 5 days to
submit statements and supporting materials for the record.
Without objection, so ordered.
And this hearing is now adjourned. Thank you.
[Whereupon, at 11:15 a.m., the Subcommittee was adjourned.]
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