[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/
                                 house


                     U.S. GOVERNMENT PRINTING OFFICE
42-526 PDF                 WASHINGTON DC:  2008
---------------------------------------------------------------------
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092104 Mail: Stop IDCC, Washington, DC 20402ï¿½090001


                   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.]

    [GRAPHIC] [TIFF OMITTED] T2526.001
    
    [GRAPHIC] [TIFF OMITTED] T2526.002
    
    [GRAPHIC] [TIFF OMITTED] T2526.003
    
    [GRAPHIC] [TIFF OMITTED] T2526.004
    
    [GRAPHIC] [TIFF OMITTED] T2526.005
    
    [GRAPHIC] [TIFF OMITTED] T2526.006
    
    [GRAPHIC] [TIFF OMITTED] T2526.007
    
    [GRAPHIC] [TIFF OMITTED] T2526.008
    
    [GRAPHIC] [TIFF OMITTED] T2526.009
    
    [GRAPHIC] [TIFF OMITTED] T2526.010
    
    [GRAPHIC] [TIFF OMITTED] T2526.011
    
    [GRAPHIC] [TIFF OMITTED] T2526.012
    
    [GRAPHIC] [TIFF OMITTED] T2526.013
    
    [GRAPHIC] [TIFF OMITTED] T2526.014
    
    [GRAPHIC] [TIFF OMITTED] T2526.015
    
    [GRAPHIC] [TIFF OMITTED] T2526.016
    
    [GRAPHIC] [TIFF OMITTED] T2526.017
    
    [GRAPHIC] [TIFF OMITTED] T2526.018
    
    [GRAPHIC] [TIFF OMITTED] T2526.019
    
    [GRAPHIC] [TIFF OMITTED] T2526.020
    
    [GRAPHIC] [TIFF OMITTED] T2526.021
    
    [GRAPHIC] [TIFF OMITTED] T2526.022
    
    [GRAPHIC] [TIFF OMITTED] T2526.023
    
    [GRAPHIC] [TIFF OMITTED] T2526.024
    
    [GRAPHIC] [TIFF OMITTED] T2526.025
    
    [GRAPHIC] [TIFF OMITTED] T2526.026
    
    [GRAPHIC] [TIFF OMITTED] T2526.027
    
    [GRAPHIC] [TIFF OMITTED] T2526.028
    
    [GRAPHIC] [TIFF OMITTED] T2526.029
    
    [GRAPHIC] [TIFF OMITTED] T2526.030
    
    [GRAPHIC] [TIFF OMITTED] T2526.031
    
    [GRAPHIC] [TIFF OMITTED] T2526.032
    
    [GRAPHIC] [TIFF OMITTED] T2526.033
    
    [GRAPHIC] [TIFF OMITTED] T2526.034
    
    [GRAPHIC] [TIFF OMITTED] T2526.035
    
    [GRAPHIC] [TIFF OMITTED] T2526.036
    
    [GRAPHIC] [TIFF OMITTED] T2526.037
    
    [GRAPHIC] [TIFF OMITTED] T2526.038
    
    [GRAPHIC] [TIFF OMITTED] T2526.039
    
    [GRAPHIC] [TIFF OMITTED] T2526.040
    
    [GRAPHIC] [TIFF OMITTED] T2526.041
    
    [GRAPHIC] [TIFF OMITTED] T2526.042
    
                                 
