[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]







                    SMALL BUSINESS AND PASS-THROUGH
                   ENTITY TAX REFORM DISCUSSION DRAFT

=======================================================================

                                HEARING

                               before the

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                    ONE HUNDRED THIRTEENTH CONGRESS

                             FIRST SESSION

                               __________

                              MAY 15, 2013

                               __________

                            Serial 113-SRM02

                               __________

         Printed for the use of the Committee on Ways and Means


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                                ______

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                      COMMITTEE ON WAYS AND MEANS

                     DAVE CAMP, Michigan, Chairman

SAM JOHNSON, Texas                   SANDER M. LEVIN, Michigan
KEVIN BRADY, Texas                   CHARLES B. RANGEL, New York
PAUL RYAN, Wisconsin                 JIM McDERMOTT, Washington
DEVIN NUNES, California              JOHN LEWIS, Georgia
PATRICK J. TIBERI, Ohio              RICHARD E. NEAL, Massachusetts
DAVID G. REICHERT, Washington        XAVIER BECERRA, California
CHARLES W. BOUSTANY, Jr., Louisiana  LLOYD DOGGETT, Texas
PETER J. ROSKAM, Illinois            MIKE THOMPSON, California
JIM GERLACH, Pennsylvania            JOHN B. LARSON, Connecticut
TOM PRICE, Georgia                   EARL BLUMENAUER, Oregon
VERN BUCHANAN, Florida               RON KIND, Wisconsin
ADRIAN SMITH, Nebraska               BILL PASCRELL, Jr., New Jersey
AARON SCHOCK, Illinois               JOSEPH CROWLEY, New York
LYNN JENKINS, Kansas                 ALLYSON SCHWARTZ, Pennsylvania
ERIK PAULSEN, Minnesota              DANNY DAVIS, Illinois
KENNY MARCHANT, Texas                LINDA SANCHEZ, California
DIANE BLACK, Tennessee
TOM REED, New York
TODD YOUNG, Indiana
MIKE KELLY, Pennsylvania
TIM GRIFFIN, Arkansas
JIM RENACCI, Ohio

        Jennifer M. Safavian, Staff Director and General Counsel

                  Janice Mays, Minority Chief Counsel

                                 ______

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                   PATRICK J. TIBERI, Ohio, Chairman

ERIK PAULSEN, Minnesota              RICHARD E. NEAL, Massachusetts
KENNY MARCHANT, Texas                JOHN B. LARSON, Connecticut
JIM GERLACH, Pennsylvania            ALLYSON SCHWARTZ, Pennsylvania
AARON SCHOCK, Illinois               LINDA SANCHEZ, California
TOM REED, New York
TODD YOUNG, Indiana

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                            C O N T E N T S

                               __________
                                                                   Page

Advisory of May 15, 2013 announcing the hearing..................     2

                               WITNESSES

Mr. Roger Harris, President, Padgett Business Services, Testimony     8
Mr. Willard Taylor, Former Partner, Sullivan & Cromwell, 
  Testimony......................................................    14
Mr. Blake Rubin, Partner, McDermott Will & Emery, Testimony......    44
Mr. Thomas Nichols, Meissner Tierney Fisher & Nichols, Testimony.    55

                   PUBLIC SUBMISSIONS FOR THE RECORD

AdvaMed..........................................................    78
AIA..............................................................    85
AICPA............................................................    87
American Council of Engineering Companies........................   107
American Farm Bureau Federation..................................   109
Alliantgroup.....................................................   113
BIO..............................................................   117
CBSI.............................................................   123
FAIR Coalition...................................................   126
Florists Coalition...............................................   133
Independent Community Bankers of America.........................   137
National Association for the Self Employed.......................   140
National Pork Producers Council..................................   145
National Retail Federation.......................................   149
Real Estate Roundtable...........................................   151
SBLC.............................................................   156
Small Business Investor Alliance.................................   159

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                    SMALL BUSINESS AND PASS-THROUGH
                   ENTITY TAX REFORM DISCUSSION DRAFT

                              ----------                              


                        WEDNESDAY, MAY 15, 2013

             U.S. House of Representatives,
                       Committee on Ways and Means,
                   Subcommittee on Select Revenue Measures,
                                                    Washington, DC.
    The subcommittee met, pursuant to call, at 10:00 a.m., in 
Room 1100, Longworth House Office Building, the Honorable Pat 
Tiberi [chairman of the subcommittee] presiding.
    [The advisory of the hearing follows:]

[[Page 2]]

HEARING ADVISORY

FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                  Chairman Tiberi Announces Hearing on

                     Ways and Means Small Business

                        and Pass-Through Entity

                      Tax Reform Discussion Draft

1100 Longworth House Office Building at 10:00 AM

Washington, May 7, 2013

    Congressman Pat Tiberi (R-OH), Chairman of the Subcommittee on 
Select Revenue Measures, today announced that the Subcommittee will 
hold a hearing on the small business and pass-through entity tax reform 
discussion draft released on March 12, 2013, by the Committee on Ways 
and Means (``the Committee''). The Committee released the discussion 
draft to solicit feedback on the details of the draft proposals, which 
the Committee intends to include as part of comprehensive tax reform 
legislation that broadens the tax base, lowers tax rates, and 
simplifies the Code for households, small businesses, and corporations. 
The hearing will take place on Wednesday, May 15, 2013, in Room 1100 of 
the Longworth House Office Building at 10:00 A.M.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. However, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Committee and for 
inclusion in the printed record of the hearing. A list of invited 
witnesses will follow.
      

BACKGROUND:

      
    As part of its pursuit of comprehensive tax reform, the Committee 
released on March 12, 2013, a discussion draft of one specific 
component of broader tax reform legislation involving tax provisions 
affecting small businesses and pass-through entities (including 
partnerships and S corporations). The Committee released this draft 
because it hopes to achieve simpler, more uniform tax treatment for 
small businesses and pass-through entities, and in the interests of 
transparency, seeks feedback from a broad range of stakeholders, 
taxpayers, practitioners, economists, and members of the general public 
on how to refine these proposals. Ways and Means Committee Chairman 
Dave Camp (R-MI) asked Chairman Tiberi to schedule this hearing to 
gather analysis from outside experts on the details of the discussion 
draft.
      
    The discussion draft contains several core components intended to 
simplify tax compliance for small businesses and to provide certainty 
with respect to the ability of small businesses to recover certain 
costs immediately. The draft also includes two separate options 
designed to achieve greater uniformity between S corporations and 
partnerships--one that revises current rules and a second that replaces 
current tax rules with a new unified pass-through regime. The Committee 
and Subcommittee are soliciting comments from stakeholders on both 
options.
      
    In announcing the hearing, Chairman Tiberi said, ``Small businesses 
employ half of the private sector workforce and earn about half of all 
business income in the United States, so it is a major concern that 
nine out of ten small businesses are forced to rely on paid tax 
preparers because the Tax Code is too complicated for them to 
understand. We need our entrepreneurs using their capital to invest and 
create jobs, not to fill out paperwork and tax forms, and one of the 
Committee's top priorities in tax reform is to help them do that.''
      

[[Page 3]]

FOCUS OF THE HEARING:

      
    The hearing will focus on the Ways and Means small business 
discussion draft released on March 12, 2013. For purposes of this 
hearing, the Subcommittee is interested in comments and analysis 
relating to the basic architecture of the draft proposals including, in 
particular, the implications of the changes to the cash accounting 
rules, the questions that must be answered in designing a workable 
unified pass-through regime, and the real-world ramifications of the 
incremental proposals to modify the rules governing S corporations and 
partnerships.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Please Note: Any person(s) and/or organization(s) wishing to submit 
written comments for the hearing record must follow the appropriate 
link on the hearing page of the Committee website and complete the 
informational forms. From the Committee homepage, http://
waysandmeans.house.gov/, select ``Hearings.'' Select the hearing for 
which you would like to submit, and click on the link entitled, ``Click 
here to provide a submission for the record.'' Once you have followed 
the online instructions, submit all requested information. ATTACH your 
submission as a Word document, in compliance with the formatting 
requirements listed below, by the close of business on Wednesday, May 
29, 2013. Finally, please note that due to the change in House mail 
policy, the U.S. Capitol Police will refuse sealed-package deliveries 
to all House Office Buildings. For questions, or if you encounter 
technical problems, please call (202) 225-3625 or (202) 225-2610.
      

FORMATTING REQUIREMENTS:

      
    The Committee relies on electronic submissions for printing the 
official hearing record. As always, submissions will be included in the 
record according to the discretion of the Committee. The Committee will 
not alter the content of your submission, but we reserve the right to 
format it according to our guidelines. Any submission provided to the 
Committee by a witness, any supplementary materials submitted for the 
printed record, and any written comments in response to a request for 
written comments must conform to the guidelines listed below. Any 
submission or supplementary item not in compliance with these 
guidelines will not be printed, but will be maintained in the Committee 
files for review and use by the Committee.
      
    1. All submissions and supplementary materials must be provided in 
Word format and MUST NOT exceed a total of 10 pages, including 
attachments. Witnesses and submitters are advised that the Committee 
relies on electronic submissions for printing the official hearing 
record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. All submissions must include a list of all clients, persons and/
or organizations on whose behalf the witness appears. A supplemental 
sheet must accompany each submission listing the name, company, 
address, telephone, and fax numbers of each witness.
      
    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.
      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://www.waysandmeans.house.gov/.

                                 

    Chairman TIBERI. Good morning. This hearing will come to 
order. Thank you for joining us for our hearing today on the 
Ways and Means small business tax reform discussion draft. In 
March of 2011, the Select Revenue Measure Subcommittee held a 
hearing on

[[Page 4]]

small business and tax reform. We learned that the temporary 
complex nature of the Tax Code was forcing small business 
owners to invest their time and resource complying with the Tax 
Code instead of focusing on growing their businesses. The 
message was clear: simplifying the Code means more jobs created 
by small business owners. Indeed, comprehensive tax reform must 
result in a simpler, more stable code with lower statutory 
rates for small business owners.
    Today nine out of 10 small business owners rely on a tax 
preparer. There have been over 4,500 changes to the Tax Code 
over the last 10 years. And with the addition of the 3.8 
percent ObamaCare tax, small business pass-through entities, 
which pay their taxes at individual rates, will have a top 
Federal tax rate of 44.6 percent.
    Comprehensive tax reform cannot be limited to an exercise 
of only lowering the corporate rate, as the President has 
suggested; it must also focus on lowering rates for small 
business owners who employ over 50 percent of the private 
sector workforce and whose tax compliance costs are 65 percent 
higher than large businesses.
    The small business tax reform discussion draft is a step 
forward in creating a better Tax Code for small businesses, but 
that is not to say it can't be improved upon, and that is why 
Chairman Camp has released this as a discussion draft to ensure 
that through a public, transparent process, stakeholders, 
including small business owners themselves, have the 
opportunity to tell us what they need from tax reform to help 
them create jobs, increase wages for their employees.
    Looking forward to a great bipartisan discussion today. I 
thank our witnesses for being here, taking time out of their 
busy schedules. And now I yield to Ranking Member Neal for his 
opening statement.
    Mr. NEAL. Thank you, Mr. Chairman, for calling today's 
hearing on Chairman Camp's small business tax reform 
legislation. Small businesses are the engines of job creation 
in the country, and nearly 60 million Americans work for small 
business. That is about half of our private sector workforce.
    When I travel around my district back in western 
Massachusetts, I am amazed by the entrepreneurial spirit of the 
small business owners that I meet. These businesses manufacture 
medical device equipment and sophisticated plastics and paper. 
They brew great lagers, or as we call it in western 
Massachusetts, great beer. And they provide hospitality and 
entertainment to many of our visitors.
    Small business owners in Massachusetts and throughout the 
country are certainly the backbone and strength of the American 
economy.
    As we tackle tax reform, it is critical that we implement 
tax policy that helps America's small business grow and 
prosper. It is through that prism that I think we should review 
Chairman Camp's proposals today. I also commend Chairman Camp 
for including so many proposals in his bill that are 
bipartisan. His draft would make permanent increases in 
expensing for small businesses, the proposal that has received 
much bipartisan support over the years. He has also included 
proposals based on legislation

[[Page 5]]

introduced by our colleagues Ron Kind and Jim Gerlach, Mike 
Thompson and Aaron Schock.
    I think this once again demonstrates that there are 
opportunities for common ground in our approaches to tax 
policy, and that we can and should do tax reform on a 
bipartisan basis. So I thank you for calling the hearing, Mr. 
Chairman.
    And I am going to excuse myself for a brief period of time 
only to testify in front of Chairman Chris Smith's committee on 
an issue that I have long been involved in this morning. So I 
will just be gone for a brief period of time and back. And with 
that said, I yield back my time.
    Chairman TIBERI. Thank you, Mr. Neal. And we thank you for 
your leadership on this issue.
    Now I would like to turn to the panel and welcome the four 
individuals who are here today. I will introduce the four and 
then we will begin the testimony with Mr. Harris, who I will 
introduce first, Mr. Roger Harris, president of Padgett 
Business Services in Athens, Georgia. Thank you for being here, 
sir. Second, Mr. Willard Taylor, former partner at Sullivan & 
Cromwell, and currently a professor of law at New York State--
excuse me--New York University. Thank you for being here.
    Third, Mr. Blake Rubin, a partner at McDermott, Will & 
Emery here in Washington, D.C. Thank you, sir. And fourth, Mr. 
Tom Nichols, a shareholder at Meissner Tierney Fisher & Nichols 
in Milwaukee, Wisconsin. Thank you for being here, sir.
    With that, you will each have 5 minutes to present your 
oral testimony. Your full written testimony has been submitted 
for the record. And, Mr. Harris, you are recognized for 5 
minutes.

STATEMENT OF ROGER HARRIS, PRESIDENT, PADGETT BUSINESS SERVICES

    Mr. HARRIS. Thank you, Mr. Chairman. And thanks to the 
members of the Committee for the opportunity to be here today.
    I am Roger Harris. I am president and chief operating 
officer of Padgett Business Services. And I think to help 
understand my comments, it is good to understand what we as a 
company do and who we define as our small business customer. 
Padgett Business Services has provided accounting, income tax 
preparation, tax advice, payroll services to small businesses 
for almost 50 years throughout the United States through our 
network of offices.
    We have always defined our customer as a small business 
owner with fewer than 20 employees. And a lot of people look at 
those businesses individually and say they are mom-and-pop 
businesses; however, if you look at them as a group, they are a 
tremendously powerful force in this economy, and I think we 
need to make sure that their needs and their interests are 
addressed in any tax reform discussion.
    And I think it would be very difficult to find anybody in 
this room or this town or this country who doesn't think the 
Tax Code that we currently have has seen its better days and 
needs to be replaced.
    I can tell you that our small business owners particularly 
want to find something new that they can work with. They want 
something that is simple. They want something that has some 
predict

[[Page 6]]

ability to it. They would like something that encourages or 
increases their cash flow. And more importantly, they want 
something that mirrors their checkbook to some extent. They are 
tired of having to be explained what is the difference in their 
cash flow and their taxable income. So they want something that 
mirrors their checkbook as close as possible.
    I am happy to say that the draft proposal that the 
committee put out a few weeks ago, I think works towards these 
goals and is a great starting point for these people. 
Particularly beginning with the 179, if you look at the 
proposals for it to make permanent the $250,000 deduction limit 
and the $800,000 phaseout permanent in the sense that it is 
indexed, for our clients, those limits are very sufficient and 
would work wonderfully well, and would eliminate a lot of 
record keeping of tracking assets, because it would cover most 
of their purchases.
    I recognize, however, that for some industries, 
particularly heavy equipment industries, those values or those 
numbers may not be enough, but for our businesses, those values 
are great. And they also, because they have the ability to 
write them off currently and not have to track them, it mirrors 
cash accounting, which is the second part of the proposal that 
we are particularly pleased with, is that this proposal will 
expand the number of businesses who qualify for cash 
accounting.
    Again, getting down to the basic principle of a small 
business owner that when money comes in, it is income, when 
money goes out, it is an expense, and what is left is their 
income. Because if there is anything they hate more than paying 
taxes, it is having to pay taxes with money they don't have. So 
the closer that we can mirror their checkbook, this proposal 
goes a long way to do that.
    We would like to see it perhaps go a little bit farther, 
and I am sure we can talk about it more, but I think carving 
out something out like a safe harbor for the smallest 
businesses in this category to have to ignore--be able to 
ignore the tracking of inventory. I think at times, we think 
inventory is nothing but looking on a shelf and making 
calculations of how many of what sits on a shelf, and it is 
much more complicated than that, and I think we should be able 
to come out with a carve-out, again, for these small businesses 
that allows inventory reporting to be at their option if they 
are at the smallest end.
    The next part of the proposal talks about startup and 
organizational expenses. And it doubles the number from 5 to 
$10,000, which, again, for many of our clients will be 
sufficient and will have the impact of, in essence, making it 
cash accounting. However, here again, I would like to see for, 
again, the smallest of small businesses more leniency in that 
area, in that when you start a business, in the year that you 
start your business, all your expenses of startup should be 
deductible.
    From a personal standpoint, it is very hard to tell a small 
business owner that the expenses that you paid in July are 
fully deductible, but that exact same expense that you paid in 
February when you were trying to get your doors open may or may 
not be deductible. To them, it was the same check to the same 
purveyor, and they believe it should be deductible.

[[Page 7]]

    Finally, I will put on my practitioner hat and address the 
filing dates for these business returns. I want to commend the 
recommendation of moving the partnership date back to March the 
15th to create that 30-day window to still have the individual 
return prepared. I think that is long overdue. That used to be 
the date for the S Corp return. This proposal moves it up to 
March 31st. I would like to see it stay at March 15th and have 
a unified date for pass-throughs so we all know that all pass-
throughs are due the same day, and we all have the same 30-day 
window to get the individual return. I am not a sure partner or 
shareholder see themselves any different.
    With that, my time is about up. I want to thank the 
committee again for the opportunity to be here today and I look 
forward to your questions.
    Chairman TIBERI. Thank you, Mr. Harris.
    [The prepared statement of Mr. Harris follows:]

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    Chairman TIBERI. Mr. Taylor, you are recognized for 5 
minutes.

    STATEMENT OF WILLARD TAYLOR, FORMER PARTNER, SULLIVAN & 
                            CROMWELL

    Mr. TAYLOR. Thank you. Good morning. My name is----
    Chairman TIBERI. Mr. Taylor, can you turn on the 
microphone?
    Mr. TAYLOR. I am sorry.
    Chairman TIBERI. That is all right. Perfect.
    Mr. TAYLOR. Okay. Good. Thank you.
    I am an adjunct professor at New York University Law School 
and I also teach at the Yale and the University of San Diego 
law schools, in each case, a course on the Federal income 
taxation of business pass-throughs. So it is a pleasure to be 
here to talk.
    The committee discussion draft has two basic structural 
reforms: one is specific changes to Subchapter S and Subchapter 
K, that is option one; and the other is a more fundamental 
revision resulting in a single system of tax rules for all 
pass-through entities, whether incorporated or not.
    I think what is proposed in option one is basically good. 
Many of the proposals have been around for a long time. I think 
you could add some to them, I think you could also expand them, 
but they are all basically good. However, they are really just 
improvements, if you will, to the system and not fundamental 
tax reform. So I think the focus ought to be on option two, the 
single pass-through regime.
    And I think that the most compelling argument for that is 
that there really is no difference, apart from tax, between a 
limited liability company and a corporation. One's 
incorporated, the other is not, but the choice between the two 
has huge tax implications, including the treatment of foreign 
and tax exempt investors, the different treatment for payroll 
tax purposes, and we could go on and on about it.
    Subchapter S came in in 1958 at a time when it was 
necessary to give limited liability to small businesses. That 
is not necessary today. You can form a limited liability 
company and not incorporate and get the same advantages.
    Now, option two, then, offers the opportunity to address 
those differences. It also offers the opportunity for small 
businesses trapped in Subchapter C to move into Subchapter S, 
and it also provides a simplified regime.
    There is a huge amount of work that has to be done if 
option two is going to be implemented, and the draft notes a 
lot of that, and I won't go over it, but I want to mention four 
items that I think in particular should be focused on. One is 
achieving parity among investors. There really should be no 
difference in the treatment of a foreign investor in a 
partnership and a foreign investor in a privately held 
corporation. And if you don't straighten that out, you distort 
investment decisions and capital raising. And the same is

[[Page 13]]

true with respect to tax exempt investors. You should have a 
single set of rules.
    Now, on tax exempt investors, inevitably you are going to 
hear from ESOPs, who love S Corporations, as to why they 
shouldn't get that treatment continued, both for S 
Corporations, or if you have a single regime, for Subchapter K. 
That is a different issue, but I don't think you ought to 
neglect it.
    A second issue that deserves attention is payroll tax. If 
you have got a single regime for Federal income tax purposes, 
no difference between a partnership and a small privately held 
corporation, then why in the world would you have a difference 
in payroll taxes, but you do today, because the base for SECA, 
the self-employment tax, differs from the base for FICA. So you 
would have to address, how do we resolve that? How do we come 
to grips with it?
    The third issue is determinations of tax liability and do 
you do that at the entity level with a withholding tax, as has 
been proposed in the draft, or do you let each owner make his 
or her own determination? I personally think doing it at the 
entity level makes sense, but, again, it is an issue that has 
to be come to grips with.
    The fourth and final issue I would mention is foreign 
income. If you have a 95 percent dividends received deduction 
and a lower rate on dividends from the C Corporation, you are 
going to have to compare the effective tax rate for the pass-
through entities, which may be higher if you don't do something 
about it.
    So I will end there. I have sent in longer written 
comments. I agree with Chairman Tiberi that this is a hugely 
important subject, and that is the last word I will say on the 
subject. Thank you.
    Chairman TIBERI. Thank you, Mr. Taylor.
    [The prepared statement of Mr. Taylor follows:]

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    Chairman TIBERI. Mr. Rubin, you are recognized for 5 
minutes.

   STATEMENT OF BLAKE RUBIN, PARTNER, MCDERMOTT WILL & EMERY

    Mr. RUBIN. Thank you. Chairman Tiberi, Ranking Member Neal 
and distinguished Members of the Subcommittee, thank you for 
the opportunity to testify today. My name is Blake Rubin, and I 
am global vice chair of the U.S. and International Tax Practice 
at

[[Page 42]]

McDermott, Will & Emery, a law firm of approximately 1,100 
lawyers.
    I support the effort to reform the Internal Revenue Code 
and also applaud the committee for the robust and transparent 
process that it is following. I also congratulate the committee 
leadership and staff for producing a detailed and thoughtful 
set of options.
    I will focus my comments primarily on the proposed changes 
to the taxation of partnerships. I support most of the changes 
in option one. As detailed in my written statement, however, I 
believe that three of the changes in option one are 
unwarranted: eliminating the 7-year period for application of 
the so-called partnership anti-mixing bowl rules, making upward 
basis adjustments in the context of partnership interest 
transfers and distributions mandatory, and eliminating the 
substantial appreciation requirement in the partnership hot 
asset rules.
    Option two proposes much more sweeping changes, merging the 
current tax regimes for partnerships and S Corporations. This 
is an approach that has been proposed by some academic 
commentators primarily for reasons of simplicity. There is no 
denying the conceptual appeal of a single unified regime for 
pass-through entities. If one were designing a tax system from 
scratch rather than reforming a tax system that is now 100 
years old, a single unified regime might well be the way to go. 
Given where we are today, however, I believe that option two 
would significantly increase complexity, upset settled 
expectations of taxpayers and cause substantial economic 
dislocations.
    Current law provides taxpayers with a choice. Businesses 
that want a relatively simple pass-through regime and can 
tolerate a certain amount inflexibility can operate as S 
Corporations. Other businesses need greater flexibility, 
perhaps because debt is a bigger part of their capital 
structure, or because they anticipate the need to distribute 
property in kind, or they want a more complicated economic 
sharing arrangement. For those businesses, the partnership tax 
rules provide the needed flexibility to operate without 
incurring an entity level tax, but at the cost of greater 
complexity and compliance burdens.
    Option two would eliminate this choice. Worse, it would do 
so by creating a single unified regime that effectively 
combines the complexity of the current partnership regime with 
the inflexibility of the current S Corporation regime.
    Many of the provisions of the current partnership tax 
regime that create the greatest complexity are retained and 
even expanded in option two. At the same time, option two 
imports inflexibility from the S Corporation regime by 
restricting the ability to effectuate complex economic sharing 
arrangements and triggering gain on distributions of property 
in kind, even though the taxpayer receives no cash.
    I would like to briefly address two of the most significant 
changes proposed by option two. The first is the three-basket 
rule under which an owner is restricted to a single percentage 
share of all items in each of three baskets: ordinary income 
items, capital gain items and tax credit. The summary states 
that the reason for this rule is to reduce the use of complex 
structures to engage in tax avoidance.

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    I believe that the existing regulations governing 
allocations of partnership income and loss adequately police 
this area. I also believe that this change would create 
unwarranted restrictions on the ability of taxpayers to 
effectuate non-abusive commercial arrangements. For example, as 
detailed in my written statement, it is not clear that one 
pass-through owner could have a common interest akin to common 
stock and another, a preferred interest akin to preferred 
stock, because of the requirement that items of profit and loss 
in each basket be allocated in the same percentage.
    The second change I would like to focus specifically on is 
the recognition of gain on the distribution of appreciated 
property. This is, of course, the current rule in the context 
of corporations, including S Corporations, but extending that 
rule to partnerships would undeniably result in the taxation of 
non-economic gains in many cases. To take an example, assume a 
partner has a 50 percent interest in a partnership that has 
property with a $200 value and a zero tax basis. The partner's 
interest is worth $100 and has a zero tax basis. The 
partnership distributes property worth $50, also with a zero 
tax basis, to the partner in redemption of his interest. Under 
option two, the partnership recognizes $50 of gain on the 
distribution and the distributee partner recognizes an 
additional $25 of gain on the distribution.
    So a distribution of property with a zero tax basis and $50 
of value triggers not $50 of gain, but instead $75 of taxable 
gain. In this and many other common transactions, option two 
would create taxable gain that exceeds actual economic gain.
    I thank you again for the opportunity to present my views 
today and commend the committee leadership and staff for 
advancing the debate in this area. I look forward to answering 
your questions now and in the future.
    Chairman TIBERI. Thank you, Mr. Rubin.
    [The prepared statement of Mr. Rubin follows:]

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    Chairman TIBERI. Mr. Nichols, you are recognized for 5 
minutes.

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 STATEMENT OF THOMAS NICHOLS, MEISSNER TIERNEY FISHER & NICHOLS

    Mr. NICHOLS. Chairman Tiberi, Ranking Member Neal and other 
members, thank you very much for the opportunity to testify 
today.
    I have been representing closely held businesses ever since 
I began practicing tax and business law in 1979. I have been a 
member since 1986, and am a past chair of the ABA Tax Sections 
Committee on S Corporations and am currently chairman of the 
Board of Advisors of the S Corporation Association.
    The views expressed today are informed by and benefit from 
all of these relationships. I will focus my comments primarily, 
though, on S Corporations.
    Let me begin by saying that I sincerely appreciate your 
ongoing bipartisan efforts to enact genuine tax reform. Seeking 
public comment on discussion drafts takes substantially more 
time and effort, but this more open and transparent process is 
much more likely to result in a long-lasting consensus on tax 
policy that will truly benefit our economy.
    Chairman Camp has identified several fundamental principles 
to help shape the course of tax reform, namely leveling the 
playing field for all U.S. employers, while at the same time 
ensuring that low income and middle income Americans pay no 
more in taxes than they do today. In this regard, the 
bipartisan Tax Reform Act of 1986 stands out as an excellent 
template. It expanded the tax base by eliminating numerous 
preferences and privileges, thereby creating room to 
dramatically decrease tax rates for C Corporations, pass-
through businesses and individuals alike.
    As others have noted, the discussion draft before us today 
has three principle components: a more limited option one to 
address limitations of the existing S Corporation and 
partnership rules, a more aggressive option two that would 
replace the existing S Corporation and partnership rules with a 
new uniform set of rules; and finally, a set of core provisions 
that would apply to either option.
    I will begin with the core provisions and work from there. 
Generally speaking, the core provisions, such as establishing a 
higher permanent threshold for expensing equipment, are reforms 
that have been considered and vetted for years and should be 
included in any tax reform effort.
    One core provision that might not fit that description is 
the proposed mandatory use of accrual method for businesses 
with gross receipts of more than $10 million.
    S Corporations and partnerships that don't have C 
Corporation partners are currently entitled to use cash basis 
accounting. This makes sense, because closely held businesses 
do not have access to the public markets to monetize illiquid 
assets on their balance sheets, so requiring them to pay tax on 
income they have not yet collected could create cash flow 
challenges where none exists today.
    For S Corporations, option one includes many provisions 
contained in the bipartisan S Corporation Modernization Act, 
introduced by Congressman Reichert and Kind, which are 
consistent with the goals of tax reform stated above.

[[Page 54]]

    The discussion draft would make permanent the shorter 5-
year built-in gains tax recognition period. The built-in gains 
tax was initially intended to prevent C Corporations from 
electing S status simply to avoid double tax in connection with 
the sale of a business, but a 10-year period is much longer 
than necessary. Five years is much more appropriate.
    Other positive provisions in option one relate to the 
passive investment income tax, electing small business trusts, 
and charitable contributions.
    From the S Corporation perspective, option two would 
establish a better line of demarcation between pass-through 
businesses and those subject to the corporate tax, namely 
whether a business has chosen to access the capital markets and 
public ownership, and would bring this demarcation in line with 
the corresponding cut-off for partnerships.
    Updating the current limitations on types of shareholders 
eligible for S Corporation ownership as contemplated by option 
two also makes real sense.
    My basic concern with option two is that it would take two 
significantly different business structures, the simple and 
easily administered S Corporation structure, and the more 
flexible but also more complicated partnership rules, in 
attempts to meld them under a single unified regime.
    The details of option two are well thought out, but I am 
concerned that the benefit of a single unified regime may not 
be worth the cost. Option two would add additional complexity 
to existing partnership rules and then apply them to S 
Corporations. This means imposing new rules and compliance 
burdens on the more than 4.5 million S Corporations in 
existence today.
    As for new entities, S Corporation status is the most 
popular tax entity choice today, thus eliminating this 
structure could impede business formation. A better approach 
might be to take the positive reforms included in option two 
and combine them with the more modest ambitions of option one.
    Once again, I would like to thank Chairman Tiberi and the 
ranking member for inviting me to testify. I look forward to 
questions.
    [The prepared statement of Mr. Nichols follows:]

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    Chairman TIBERI. Well, thank all of you on behalf of the 
committee and the committee staff for being here today, for 
your written testimony, which I said would be part of the 
record. I don't know about you, but I was excited that you were 
going to be here, and that we were having this hearing today. 
Unfortunately, most of Washington, including the press corps, I 
think is more excited about the hearing in 48 hours in this 
room, but this is pretty important, and this is going to be 
part of the process, the transparent process that Chairman Camp 
has had, and so your testimony is very, very helpful.
    Mr. Nichols, I want to start my questioning with you. As 
you know, for the last 12 years, S Corps and pass-through 
entities have had a statutory top rate of 35 percent. In 
January that changed, and we saw the top rate rise to 39.6 
percent, but with the addition of the 3.8 percent tax from 
ObamaCare on investment income, the Pease Limitation, which 
adds another 1.2 percent, you have a reality of a tax rate much 
higher than that.

[[Page 64]]

    But something that I didn't realize until recently that I 
would like you to comment on is that that 3.8 percent tax on 
investment income that--I didn't realize actually falls on 
something much broader than investment income. So if I were 
selling--my understanding, if I were making widgets and then 
selling widgets, that 3.8 percent investment tax would fall on 
the making and selling of those widgets as well.
    So in essence, this means that the top rate on an S Corp 
manufacturer in my home State of Ohio is now 44.6 percent and 
not 35 percent; so a pretty large tax increase that is not just 
investment income. Can you expand upon that and expand upon how 
much broader this 3.8 percent tax is than many of us thought or 
think?
    Mr. NICHOLS. Yes. I would be happy to. Essentially what 
happens is there are two things at play here. One is if you 
have got any passive investors in the S Corporation itself, 
then that passive investor is going to require distribution of 
money to pay taxes based on the top rate, so you have got the 
39.6 percent rate, you add on to that the Pease reduction 
another 1.2 percent, then you add on the 3.8 percent tax, you 
get up to approximately 45 percent, as you point out.
    And essentially what happens for S Corporations is that if 
you have got, let's say, a 10 percent shareholder, let's say a 
father who is no longer involved in the business that ends up 
paying that tax, most S Corporations have an obligation under 
shareholder agreements to distribute out an amount to pay the 
tax attributable to pass-through income. The combination of 
having one shareholder subject to that tax, that 45 percent tax 
rate, and the fact that the S Corporation rules require a 
single class of stock means that if you are going to distribute 
out 45 percent to one of the shareholders, you are going to 
have to distribute out 45 percent of the income to all of the 
shareholders, even though some of them may not have to pay that 
additional tax. All of that will have to come out of the 
corporation and won't be available obviously for future use 
inside the corp.
    Chairman TIBERI. Thank you. So as you know, the 1986 Act 
reduced the top rate from 50 to 28 percent, and now we see the 
rate essentially going up to almost 45 percent; not quite 50, 
but 45. So over the last 27 years, we now have, since 1986, the 
highest rate, statutory rate for S Corps and pass-through 
entities, correct?
    Mr. NICHOLS. That is correct.
    Chairman TIBERI. And what do you see as the--as a 
practitioner, what do you see the reaction to that on the 
ground?
    Mr. NICHOLS. Well, realistically, very many, in fact, I 
would venture to say most closely-held businesses, they 
essentially earn their income; if they are pass-through 
business, they reserve to pay for the tax and then the vast 
majority of what is earned is essentially rolled back into the 
business.
    Essentially what happens if the tax rate goes up, and 
essentially it has gone up now potentially by a 10 percent 
increment from 35 percent to 45 percent, and that is without 
taking State taxes into account, essentially that 10 percent 
used to stay inside the company and used to be reserved and 
used, either reserved for capital or used to actually grow the 
business, hire people, do whatever the business needs, that 10 
percent is effectively just an additional

[[Page 65]]

slice out of the capital that would otherwise be used in the 
business, for most of them.
    Chairman TIBERI. One last question, because I have taken 
almost all my time, is a fascinating point you made in your 
written testimony that a clearer--I am trying to get this 
right--a clearer demarcation between who may be an S Corp and 
who may be a C Corp is whether they are publicly traded, which 
is kind of a line of demarcation that is proposed in option two 
for pass-through entities.
    Can you elaborate on why you think a publicly traded, 
privately owned line is conceptually a correct way to 
distinguish between the two?
    Mr. NICHOLS. Well, it is a difference--it is a distinction 
that makes a difference. Unlike the fairly arbitrary 100-person 
limit that currently exists, it is a distinction that makes a 
difference.
    There are a number of things that are different about a 
publicly held entity. They are treated differently. And 
essentially, what the point I made in the written testimony is 
that essentially, if I am selling a closely held company, a 
privately held company, I am likely to get multiples, let's 
say, you know, maybe in the neighborhood of 5, maybe 12 times 
earnings if you are lucky, whereas publicly traded companies 
regularly trade at 10 to 20 times earning. So that is a big 
difference, and it is something, frankly, I have to explain to 
some of my closely held clients that there is a difference 
being closely held. And so as a consequence, that and the other 
thing that is significant for a closely held clients, and that 
is, they don't have the opportunity to turn around and go to 
the public markets. They don't have that automatic price that 
they can sell stock for and they don't--it is not easy for them 
to go to the public markets to borrow money, either, for 
publicly held securities, and so as a consequence, that 
demarcation line is one that does have some policy 
significance, and to the extent possible, the demarcation lines 
in the Code should reflect, you know, significant differences 
between the business entities, and that one does.
    Chairman TIBERI. Thank you.
    Mr. Neal is recognized for 5 minutes.
    Mr. NEAL. Thank you for your indulgence earlier today, Mr. 
Chairman, as well. And Mr. Nichols, if you can help to explain 
some of these things to us, too, it would be helpful.
    Mr. Rubin, could you describe for me the tax consequences 
for both partners involved and the partnerships of a merger of 
two partnerships, each of which contains appreciated property 
under current law? And can you describe the tax consequences 
for both partners involved and the partnerships under option 
two of Chairman Camp's draft? Any potential administrative 
burden of the merger under option two as relative to current 
law.
    Mr. RUBIN. Sure. Under current----
    Mr. NEAL. And this is very helpful, incidentally, to us, 
very, very helpful.
    Mr. RUBIN. Great. Under current law, if two partnerships 
want to merge, first under State law and Uniform Limited 
Partnership Act, the General Partnership Act, the LLC Act, that 
can be accomplished by filing articles of merger; so relatively 
convenient way to combine two companies operating in 
partnership form.

[[Page 66]]

    From a tax perspective, let's say you have got the AB 
partnership merging with the CD partnership. For tax purposes, 
that is generally treated under current law when they file 
articles of merger as if the AB partnership contributed its 
assets into the CD partnership in exchange for an interest in 
the CD partnership and then the AB partnership liquidated and 
distributed the interest in the CD partnership out to the 
partners.
    What is important about that is that under current law, all 
of those deemed transactions are generally tax free, the 
transfer of the assets into the combined entity, if you will, 
that is deemed to occur and then the transfer of the interest 
in the combined entity that goes out.
    Under option two, that would no longer be the case, because 
when the AB partnership that is going out of existence, is 
deemed to distribute the interests in the CD partnership out to 
its partners, that is a distribution of appreciated property, 
it would trigger gain both at the AB partnership level, and 
then potentially a second gain at the AB partner level.
    So what can be consummated tax free under a carryover basis 
regime so that the built-in gain is taxed in the future on a 
disposition to a taxable disposition to a third party is taxed 
immediately under option two.
    Mr. NEAL. In Massachusetts, 92 percent of the firms are 
structured as pass-through entities, and there are nearly 
90,000 businesses structured as S Corporations. The level of 
choice is pretty unique to the United States.
    Mr. Nichols, in your testimony, you indicated that there 
are benefits to offering entrepreneurs multiple options when 
choosing a business structure. On the other hand, option two of 
Chairman Camp's draft proposes moving most S Corporations and 
partnerships into a single uniform structure. Could you go into 
a little bit more detail on what you see as the benefits of 
sticking with the current set of options of business entities 
as well as the potential costs of moving all of these 
businesses to a single new entity?
    Mr. NICHOLS. I would be happy to. Well, currently you have 
approximately 4.5 million S Corporations. It is the most 
popular format, it is the most popular tax structure for 
closely held businesses. You have got, well, a little more than 
3 million partnerships also. But the S Corporation structure 
has the advantage of being simple and being easy to administer, 
and that is something for many, many corporations. They are not 
interested in sophisticated and flexible capital-raising 
mechanisms. All they want to do is make widgets. And when given 
a choice to simply have a simple structure, not do any 
sophisticated transactions, but just focus on their business, 
they like that.
    The partnership structure is much more flexible and as a 
consequence, it is much more complicated, and some of that 
complication is imposed by Congress in order to essentially 
rein in the flexibility so that abusive transactions don't 
occur.
    What happens in option two potentially is the partnership 
rules are made somewhat more complicated and more restrictive, 
and all of the S Corporations that currently exist today 
essentially are being forced into that structure. And what 
happens then, you have got an unavoidable cost for a lot of 
just day-to-day businesses that

[[Page 67]]

have been S Corporations for many times many years. They are 
forced into that new structure. They need to deal with both the 
transition, but they also need to deal with the ongoing 
complexity of the partnership rules. For example, under the 
proposal, and even under the current law, there are changes and 
adjustments that potentially need to be made whenever there is 
a sale of any interest in the business, even a minority 
interest. There is also the need to bifurcate transactions for 
distributions on sales to determine whether hot assets are 
applicable and treating that as a separate transaction.
    All of that complexity, it may be appropriate in the 
partnership regime, which is much more flexible; on the other 
hand, it has not been found necessary in the S Corporation 
regime, but you would be essentially requiring all of the 
current 4.5 million S Corporations to switch to that more 
complicated regime and the compliance costs, but also there 
would be ongoing compliance costs. And what I don't see as a 
countervailing economic benefit, I don't see any S Corporations 
engaging in more economic activity as a consequence, and so as 
a consequence, I see a cost, but I don't see the benefit of 
that forced conversion.
    Mr. NEAL. Thank you, Mr. Chairman.
    Chairman TIBERI. Thank you.
    Mr. Young is recognized for 5 minutes.
    Mr. YOUNG. Thank you, Mr. Chairman. I appreciate you and 
Ranking Member Neal for holding this hearing. Very important to 
all of my colleagues, really to the country.
    Each of us has a plenitude of pass-through entities in our 
districts. I would like to begin just with a remark, 
respectfully reminding my colleagues and those who are paying 
attention, that we need to be attentive to one type of pass-
through entity that has not been addressed yet, at least not in 
a specific way in some of the discussion drafts, and that is 
ESOPs, the employee stock ownership entities. And I do believe 
there will be consideration of this as we move forward, but I 
think we should strive to avoid any inadvertent damage we might 
do, as Mr. Taylor indicated, to these entities, seeing as they 
empower employee ownership. And per my briefing, they are four 
times less likely during a recession to lay off employees, so 
that is something for us to consider.
    My first question relates to withholding, something Mr. 
Nichols--we have got a sound issue here. There we go. Relates 
to with--it is not working.
    Chairman TIBERI. One, two.
    Mr. YOUNG. One, two.
    Chairman TIBERI. Why don't you try another microphone.
    Mr. YOUNG. Here we go. I am Mr. Young. Thanks. As we say in 
the Marine Corps, adapt, improvise and overcome, so here we go.
    My question relates to withholding. Mr. Nichols, you 
touched on this briefly in your testimony, and I believe each 
of you are aware that in option two of the discussion draft, we 
suggest an entity level withholding rather than our current 
practice.
    Now, as practitioners that deal with small businesses every 
day, can you talk a little, either Mr. Nichols, perhaps others 
have thoughts, about the negative impacts as well as the 
positive out

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comes that this change might create? Specifically, I am 
interested in how the provision might impact cash flow, whether 
it might create cash flow problems for any type of existing 
pass-through entity.
    Mr. NICHOLS. Yes. There are a number of considerations 
here. Obviously one is compliance. And the withholding system 
that is proposed is not a completely new item. There are a lot 
of S Corporations that have out-of-state operations. They 
actually have a withholding system that they need to deal with 
in order to withhold taxes for their out-of-state operations in 
the various states that they are operative in.
    Now, the withholding system at the Federal level 
potentially creates more of a cash flow situation. The amounts 
for the State systems are typically smaller. And the other 
thing that would need to be factored in, and I am not sure the 
proposal contemplates it, or I am not sure it does, I am not 
sure it doesn't, but the other thing that would need to be 
factored in is the fact that tax rates at the corporate level, 
if they are to be uniform, are unavoidably going to impact cash 
flow. And I can give you two examples. One example would be if 
the taxpayers are in a lower tax bracket and you have got a 
mandated withholding rate that is above that tax bracket, 
obviously there is going to be an amount that is going to need 
to be withheld, and then the taxpayers are going to have to 
wait till next year to get that refunded to them. It is like 
any other withholding. You don't get it until you file the 
return at the end of the year.
    The second one that I think is potentially more 
problematic, but maybe it could be dealt with, and that is the 
idea that you have got a taxpayer that runs or has interest in 
two different businesses, and they have got $100,000 of income 
in one business, and $100,000 of loss in the other business, 
but they are in two separate entities.
    Under the withholding regime, unless you can take into 
account the individual taxpayer's facts, you would end up 
having to have withholding occur on the $100,000 from the 
profitable business, notwithstanding the fact that that 
shareholder, that owner is doing exactly what we hope they do 
in today's economy: use those profits in another business, hire 
people and use that. Well, you can't do that if you--some of 
those monies are siphoned off in the form of the withholding 
and you are not going to get them back until after the end of 
the year.
    Mr. YOUNG. Any other quick thoughts here? We have about 30 
seconds left.
    Mr. TAYLOR. Yeah. I think you are missing something in this 
whole picture. You could take withholding tax and put it in 
option one, and apply it to S Corporations and partnerships.
    The merit of option two is not the particular features, all 
of which can go in option one. The merit is it gets you to 
focus on the difference between the entities. I mean, take your 
ESOP point.
    Mr. YOUNG. Yeah.
    Mr. TAYLOR. You can have an ESOP as a shareholder of an S 
Corporation today. Okay? You cannot have an ESOP partner in a 
partnership and get the same tax consequences.
    Your point about the net investment income tax. If you are 
an S Corporation, you can eliminate a large part of that 3.8 
percent tax on your S Corporation earnings, assuming it is not 
a passive

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activity. You cannot do that generally if you have got a 
partnership.
    So the point here of option two and option one, I think, is 
option two forces you to ask the question, why is this 
different from the way it is here?
    Mr. YOUNG. Right.
    Mr. TAYLOR. And that is what you should be focusing on, I 
think, not the particular features, all of which, as I say, you 
could put in----
    Mr. YOUNG. Great.
    Mr. TAYLOR [continuing]. Option one if you wanted.
    Mr. YOUNG. Thanks so much. I yield back.
    And if you have further testimony, maybe you can submit it 
for the record.
    Chairman TIBERI. Does someone else have a thought? Go 
ahead, Mr. Harris. I feel generous today.
    Mr. HARRIS. Thank you.
    Mr. YOUNG. Thanks, Mr. Chairman.
    Mr. HARRIS. I think one thing in addition to what has been 
said when you get to entity level withholding, we have to 
consider the complexity on the small business owner of 
understanding what are we going to withhold on and what records 
are they going to have to keep and what efforts are they going 
to have to go through to calculate the number that we are going 
to withhold on.
    So I think we have to be very cognizant of the fact that we 
could be adding complexity that may or may not benefit anyone 
for the other problems here, that it could be a wrong amount, 
it could be offset somewhere else, and yet we have imposed a 
burden. So I think we should always look, if we are going to 
look at entity level withholding, withholding on something that 
is easy to get to, perhaps like payments that are made to 
shareholders and partners, as opposed to a calculated income 
amount.
    Chairman TIBERI. Thank you. Let me just tell you, I can 
tell the difference between someone who is trying to filibuster 
an answer and someone who is trying to be substantively 
helpful, and I think the four of you, your testimony, both 
written and your testimony today, is great, very helpful, very 
interesting. And so help us by being substantive in your 
answers, and don't feel pressure on the clock. Not everyone 
will always tell you that.
    Mr. Gerlach, you are recognized for 5 minutes.
    Mr. GERLACH. Thank you, Mr. Chairman. And, gentlemen, thank 
you for testifying today.
    Mr. Harris--and I would like to get the other three 
gentlemen's thoughts on this as well--but I want to base my 
question on your testimony and in particular, your written 
testimony on the issue of the startup and organizational 
expense provisions that would increase the amount as a startup 
company you could deduct under the Code. And you approve of 
that proposed draft language, although you go on to say that 
you would suggest an even more aggressive approach to startup 
expenses for small business owners that qualify for the use of 
cash accounting.
    Can you expand a little bit more, if you would, on your 
thoughts on how the current discussion draft language could be 
improved upon relative to that particular expensing that we 
would like to see

[[Page 70]]

startups be able to have so that encourages them to move 
forward with that initial business activity?
    Mr. HARRIS. Sure. I will be happy to, because I think one 
thing we can all agree upon, we want more businesses starting 
up.
    Mr. GERLACH. Right.
    Mr. HARRIS. And anything we can do to encourage that is 
going to benefit us all.
    Mine is more of really expanding the cash accounting rules 
to say when you start a business, in the year that you actually 
open your doors, I believe we should allow them to deduct any 
expenses they incurred through that process. Again, if it 
started in a prior year and it rolled into a current year, then 
that would be carried forward, but as I said in my opening 
statement, it is very hard to explain to a small business owner 
that the expense you pay in July, you can fully deduct, but the 
exact same expense that you paid in February, because it 
happened to come prior to the opening of your doors, may not be 
deductible or has to be capitalized, depending on the amount.
    And it really comes down to, again, the basic 
understanding, as I have heard a lot of discussions today, I 
think of it in terms of our clients and our small business 
owners, and they are sitting there going, this is what is wrong 
with the tax system. You know, if I paid the money and I 
started the business, why isn't it a deduction.
    Mr. GERLACH. So if you start the business November 1st, but 
of course leading up to opening those doors on November the 
1st, in February, March and April, you are incurring different 
organizational and other expenses that are justifiable for the 
startup of that entity on November 1st, all of that should be 
deductible for that tax year, is what you are suggesting?
    Mr. HARRIS. Right. Because all that money is gone and they 
have expended the funds.
    Mr. GERLACH. And it is out of the checkbook----
    Mr. HARRIS. It is out of the checkbook.
    Mr. GERLACH [continuing]. Which is the basis for which they 
make decisions.
    Mr. HARRIS. Yes.
    Mr. GERLACH. Yeah. Gentlemen, the other folks on the panel, 
do you have a thought on that same issue? Mr. Nichols.
    Mr. NICHOLS. Well, I certainly agree. I would just add to 
that, and that essentially what you have got is the dichotomy 
between the accounting principles and the tax principles. And 
there are a number of provisions in the Code. I know over the 
course of its history, for example, for accounting purposes, 
you capitalize those startup costs because you want to 
communicate to your outside investors that it is not all wasted 
money, over time it is going to build up and you are going to 
have something of value, and it makes the first year not look 
as bad as it otherwise would.
    And so you have got the accounting principles that go in 
one direction, but you have also got the tax principles that 
essentially say from the standpoint of tax policy, is this 
really a time in which we want to allow somebody--put somebody 
in a position of paying expenses and not give them the 
deduction? And when you look at it from the standpoint of tax 
policy----

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    Mr. GERLACH. Because the whole goal is you want them to be 
successful.
    Mr. NICHOLS. Exactly.
    Mr. GERLACH. And it is from a cash flow standpoint that 
they will or won't be successful.
    Mr. NICHOLS. Exactly.
    Mr. GERLACH. Is that--okay. Great. Mr. Taylor, Mr. Rubin, 
do you have a thought on that?
    Mr. RUBIN. No.
    Mr. TAYLOR. No comment.
    Mr. GERLACH. Good. Well, thank you very much. I appreciate 
that. I yield back. Thank you, Mr. Chairman.
    Chairman TIBERI. Thank you, Mr. Gerlach.
    Mr. Larson, you are recognized for 5 minutes.
    Mr. LARSON. Thank you, Mr. Chairman. And I want to thank 
our panelists as well for being here today. And, again, want to 
thank Chairman Camp for putting out his proposal.
    And obviously in the case of small businesses, especially 
the notion of simplicity is something that we all want to 
strive for. In looking at the two options that are before you, 
and I would be interested in your responses, in real terms, 
real life, anecdotal or otherwise, how does this--what does 
simplicity mean to you and what could we best do to assist 
small business in the Tax Code? Is it, as my colleague often 
suggests, not having to have an accountant 12 months of the 
year, but only that 1 month when you actually need them? Is it 
the less reporting? What is it in the overall simplification 
that we could do to make you more entrepreneurial, as Mr. 
Harris said, and to grow businesses and encourage people to get 
involved? And we will start with Mr. Harris.
    Mr. HARRIS. I think from the perspective of our clients, 
what simplicity means to them is that to the extent that it is 
possible, that the tax system can follow the records that they 
have to keep to run their business, that they aren't being 
forced to keep records solely to comply with the tax law, that 
the basic records that we all need to keep to run our business 
should be sufficient for filing taxes. It shouldn't require a 
lot of complexity.
    And it should also, I think, allow them to operate in a 
real world. As I was listening to the example of partner A and 
B merging with partner C and D and all that, in the real world, 
those are just four guys that came together to start a 
business, and yet if they heard this discussion, their head 
would explode, because they are saying, what do you mean? I 
mean, we just decided to work together.
    So I think what we have to do is we try to mirror the 
records they keep and recognize what they are doing every day 
to run a business, and try to make that our tax law as best we 
can.
    Mr. LARSON. Thank you, Mr. Harris. Mr. Taylor.
    Mr. TAYLOR. Let me just add one thing without disagreeing 
in any way with what you said. It seems to me----
    Mr. LARSON. Could you speak into the mic?
    Mr. TAYLOR. Yeah. I am sorry. Thank you. It seems to me 
great simplicity would be that you did not need to come and 
talk to us before deciding whether you were going to be a 
partnership or an S Corporation.

[[Page 72]]

    And that is the merit of option two, you know, there is 
only one system. And we can disagree as to what the features of 
that system should be, and I think there is disagreement, but, 
you know, not having your fundamental choice being something 
that is dictated can only be sensibly made from a tax point of 
view if you have an accountant or a lawyer, you know, that is 
crazy.
    And the differences between limited partnerships--I am 
sorry--limited liability companies and S Corporations from a 
tax point of view are huge and pervasive. And so if you could 
get to a single regime where you didn't need that accountant or 
lawyer upfront, that would be simplicity, I think.
    Mr. RUBIN. And I guess I would argue that that is only 
conceptual simplicity rather than practical simplicity; that 
under current law, the regime really provides a choice, that 
people who want greater simplicity and less flexibility can 
achieve that through an S Corporation, people who need greater 
flexibility to distribute properties, need to have debt 
included in basis and so forth, they can deal with the more 
complicated rules.
    You know, again, in concept, combining them means you don't 
have a choice, and maybe that is simple in a way, but I think 
as a practical matter, it means that a lot of people who 
currently are happy with the S Corp regime have to deal with a 
much more complicated set of rules.
    Mr. NICHOLS. And actually I would agree with Mr. Rubin. I 
guess if you look at this from the standpoint of the small 
business owner, watch what they do, what they want to do and 
what they have done. And 4.5 million of them, the plurality of 
them have chosen to be S Corporations. Don't disrupt what they 
are doing unless there is good reason to do so. And moving 
that--changing--what one of the things that does keep lawyers 
and accountants busy and employed is changes. And if you have 
got a system that seems to be working and seems to satisfy the 
needs of both the--the revenue needs and the needs of the 
individual businesses, and they have grown accustomed to it, 
don't change that without, you know, solid underpinning of 
reasons to do so, just because the disruption alone slows 
business down.
    Mr. LARSON. Thank you.
    Chairman TIBERI. Thank you. Mr. Schock is recognized for 5 
minutes.
    Mr. SCHOCK. Thank you, Mr. Chairman, and thank you to the 
witnesses. A couple quick follow-up questions, one on cash 
accounting. I am pleased that the chairman included the 
framework of Mr. Thompson in my bill that increased the 
threshold from $5 million to $10 million permanently, however, 
I am aware of specific groups in my district who were exempted 
from current law that allow for unlimited amounts to be used on 
cash accounting, particularly in the ag industry. I have got 
some large pork producers that currently are allowed to use 
cash accounting.
    So I am wondering, from your perspective, if you are aware 
of other folks who may be exempted currently that will not be 
exempted under the chairman's proposal, and if you could talk a 
little bit about what effect this will have on perhaps 
accountants or others in the service sector, or a large pork 
producer like the ones in my district that have to go from an 
accrual basis to a cash basis

[[Page 73]]

if, in fact, there are no exemptions for folks over $10 
million. Mr. Nichols?
    Mr. NICHOLS. I am assuming people being forced to 
essentially go from a cash basis to an accrual basis?
    Mr. SCHOCK. Correct. I am sorry. Yes.
    Mr. NICHOLS. And that--well, one of the big exemptions that 
currently exists in that is closely held--S Corporations are 
exempt currently, and this essentially would eliminate that 
exemption for all S Corporations below the $10 million level, 
and so as--and that--I think any time you vary from the cash 
being in the door to pay the tax and you are requiring tax to 
be paid perhaps before it--in this case, before it is 
collected, you should take into account that you are creating a 
cash flow situation that is potentially problematic.
    Under the current rules, there are a number of 
corporations, S Corporations and partnerships that don't have C 
Corporations as partners that are eligible for the cash basis 
method of accounting. This would eliminate that. It would 
essentially create another one of these demarcation lines that 
is somewhat arbitrary, unavoidably. If it is, you know, $10 
million, you know, if they move $1 million above $10 million 
for 3 years in a row, then suddenly they are on a completely 
different system.
    And there I would focus on is there a policy reason that is 
important enough to require enterprises that haven't collected 
the cash right away, they haven't collected the cash already, 
is there a policy reason important enough to require them to 
pay the tax on that income that they haven't received yet. And 
that is--if there is--it is kind of if it is not broken, don't 
fix it. Be careful if you change things so as not to disrupt 
the business.
    Mr. SCHOCK. Mr. Harris.
    Mr. HARRIS. Just to add to that, I think we have to 
understand that the only real difference between cash and 
accounting is when the income shows up, not if it shows up. So 
to his point, what is the incentive to require the perhaps 
accelerated reporting of the income, what is the benefit of 
doing that, as opposed to waiting until it actually shows up, 
because it will eventually show up and be income when the money 
is paid.
    So unless there is a real policy reason, as he said, to 
force that acceleration into income, I don't know why we don't 
just wait until they actually have it.
    Mr. SCHOCK. Okay. It may have something to do with the CBO 
score.
    The second question really is just genuinely interested in 
your view on this effect on small businesses. A lot of times we 
focus on the big C Corp guys. We have got a few of those 
important ones in my district. But we also recognize that the 
majority of Americans work for small companies. And it is the 
startups, really, who are the engine of our economy. And some 
of the things we do, like 179, raising that threshold to 250, 
making that permanent, is there anything else you guys are 
aware of that maybe we aren't doing that we should be doing, or 
perhaps we should look at, particularly for small startup 
companies? You think about the Apples, the Microsofts. They 
started in garages. They didn't have your traditional 
framework. You are not going to use R&D incentives for a

[[Page 74]]

small startup like that. Are there other things that we could 
be looking at for some of those organic startups?
    Mr. HARRIS. I think we have discussed a lot of the things 
that we should do. Again, when you are starting up at the 
smallest of small businesses, cash flow is of critical 
importance. They don't have access to capital. They are 
probably doing it from maybe even credit cards or living on a 
spouse's salary.
    So we should do everything we can to allow them to keep as 
much of their cash as they can and not get into complicated, 
broadening base exercises, if you will, which is basically 
saying something you spent can't be reported yet, can't be 
deducted yet, is to allow them to keep the money in their 
startup years when it is the most critical. Because if they can 
get through those 1 or 2 startup years, they tend to have a 
chance to survive.
    So we should be very careful to do everything we can in a 
startup mode to allow their tax return to mirror their cash 
flow as closely as possible. Because cash is at a premium at 
that point.
    Mr. SCHOCK. Anyone else?
    Mr. Nichols.
    Mr. NICHOLS. Well, I am finding myself agreeing with Mr. 
Harris more and more. But, essentially, to a great extent what 
I am going to do is repeat what he just said, but essentially 
there are two ways; one is by recognizing income only when it 
is collected, and the other is by giving the benefit of 
deductions to startup businesses when they actually pay it as 
opposed to over time. And both of those, frankly, help small 
businesses, especially startups, who are cash starved.
    Mr. SCHOCK. And what is proposed in the rough draft you 
feel is sufficient.
    Mr. NICHOLS. It is an improvement. I don't disagree with 
Mr. Harris that the idea of allowing startups to actually 
expense, at least maybe up to a cap, actually expense 
immediately startup expenses. I am not sure that is bad policy. 
I understand cost revenue, but it is putting the incentives 
towards starting up businesses right where they should be. At 
least, I am going to get my deduction when I am paying the cash 
out.
    Mr. SCHOCK. Okay. Thank you guys.
    Chairman TIBERI. Thank you, Mr. Schock.
    Mr. Marchant, you are recognized for 5 minutes.
    Mr. MARCHANT. Thank you, Mr. Chairman.
    I would like to follow up on some of the chairman's earlier 
questions. Partnerships draw their earnings through K1s, don't 
they? And Sub-S. Basically, it is a straight pass-through. So 
going back to the ObamaCare tax and the Pease tax that is 
attached to that, is it going to provide a disincentive for an 
investor to look at a small business, a Sub-S or a partnership, 
and know that they possibly could get a K1 or pass-through 
income, that there will be no cash following those documents, 
so that they can be taxed? Normally, in small businesses there 
is no requirement, is there, that the amount of income that you 
have to show on your income taxes as a pass-through is followed 
by any cash. Is that correct?
    Mr. TAYLOR. That is correct. You would normally make sure 
that it was followed by cash as a contractual matter. If you 
were

[[Page 75]]

just an investor, you would make sure the cash distributions 
were at least equal to what you thought the tax liability was.
    Mr. MARCHANT. But in a C Corp, you can have earnings----
    Mr. TAYLOR. In a C Corp, you are perfectly right. You can 
have earnings and nothing to report. Unless you get a 
distribution, you just report your distribution. If you are in 
an S Corp or a partner in a partnership, you report your share 
of the income or loss of the S Corporation or partnership, 
whether or not you got it, on the one hand. On the other hand, 
typically you would make sure that, either because you were 
part of the management or you thought about this in advance, 
that they did make distributions sufficient to cover your 
liability.
    Mr. MARCHANT. Well, if you are a passive investor in a 
partnership, then you usually don't have a lot to say about the 
general day-to-day----
    Mr. TAYLOR. Okay, fine. But would have a lot to say about 
the terms of your investment. You want my money, here's the 
circumstances under which I will make it.
    Mr. MARCHANT. In the discussion draft, it sets a $250,000 
limit on the cost of new property and equipment that a small 
business can expense during the tax year, and immediate expense 
begins to phase out once the taxpayer places more than $800,000 
of that property into service in a year. These levels parallel 
those that were in effect prior to the stimulus. Do you think 
that these levels reasonably reflect the need of small 
businesses?
    Mr. HARRIS. Well, as I said in my opening statement, from 
our client perspective, it is going to get most of them. Those 
limits would be sufficient for most. But it is very clear you 
can go buy a printing press if you are in a printing business 
that is going to exceed $800,000, or it can be $1 million. So 
no matter what the limits are, there is always going to be 
someone who wants more. And I guess that is the beauty that we 
have on this panel. We don't have to consider revenue impacts. 
In a perfect world, I would say let everybody write off their 
equipment no matter how much they buy in a year. But we can 
just say that because we don't have to balance a budget in 
Washington. But I think that is going to depend on the kind of 
business you are in. But I can say for a lot of our clients, 
$250,000 and $800,000 would cover most of our clients' 
acquisitions in a year.
    Mr. MARCHANT. Mr. Chairman, in the spirit of the Chairman 
Camp's intent that the Tax Code be simplified and that the 
rates get lowered and that we encourage formation of small 
business, I think this is a very important hearing. I do think 
that the whole issue of the additional 5 percent tax on the K1 
and the Sub S income is a very significant thing in this whole 
formula. And I don't want to see us do anything in the Tax Code 
that will encourage people to go into C Corps instead of 
partnerships and Sub S's, because in my district probably 
three-quarters of the businesses organize at that level.
    Thank you.
    Chairman TIBERI. Ditto. Thank you, Mr. Marchant.
    Mr. Young brought up earlier ESOPs. And I know Mr. Neal is 
a big supporter of ESOPs as well. And you all know that in the 
draft, option two, going to a single entity, we don't address 
the

[[Page 76]]

issue of S Corp ESOPs in terms of how we go forward on that. 
Have any of you thought of a way to do that? The reason why I 
ask is what we don't want to do is have a detrimental impact on 
something that I think there is bipartisan agreement on that it 
has been successful in our communities and in our districts.
    Mr. Nichols, do you want to start?
    Mr. NICHOLS. I would be happy to. S Corporation ESOPs have 
actually been very successful in essentially expanding the base 
of ownership, essentially, and moving, frankly, both the profit 
and loss and risk to the business among the entire employee 
base, which from the standpoint of inclusion in the American 
economy, has a pretty fundamental function. And so as a 
consequence, doing what can be done in order to encourage that, 
it doesn't surprise me that there is bipartisan support.
    You are right, I am not sure I read anything in one way or 
another in the proposals. I am not quite sure I would tinker 
with that. In order to have an ESOP, you would have to have a 
corporation. But the proposals don't seem to change that. So if 
the policy is along the lines of if it is not broke, don't fix 
it, it seems to be working very well. I am not quite sure I 
would try to change that as part of these proposals.
    Chairman TIBERI. Mr. Rubin, anything to add?
    Mr. RUBIN. I guess I would say that I agree that in general 
S Corp ESOPs have certainly broadened ownership of S 
corporations and allowed employees to participate in that. I 
guess, with a nod to Mr. Taylor, I would say there is probably 
no conceptual reason why you couldn't craft a regime that 
allowed an ESOP to own interest in an LLC. But on the other 
hand, I don't think that there is a great need to do that, 
given where we are today.
    Chairman TIBERI. Mr. Taylor.
    Mr. TAYLOR. To just reiterate what I said, if you have a 
special rule for ESOPs, it ought to be across the board. You 
shouldn't have people saying well, I have got to form an S 
Corporation because it is the only way I can do an ESOP, as 
opposed to setting up a limited liability company. So it ought 
to be across the board.
    I do think there is a fundamental issue about ESOPs. You 
give them treatment that you do not give to other tax exempts, 
including regular pension plans. Because there you would have 
so-called unrelated business income for many of these 
investments, and you do not when it is done through an ESOP. So 
you have another issue not related to this small business 
reform, if you will, about whether or not you are not giving 
ESOPs an advantage from a tax point of view that should not be 
given to other tax exempt organizations, including other 
benefit plans.
    Chairman TIBERI. Mr. Harris.
    Mr. HARRIS. I really don't have much to add to what has 
already been said other than, again, if we have got something 
that is working, the last thing we want to do is do anything to 
make it not work. So I would defer to their judgment. But I 
think it is working, so let's just don't hurt it.
    Chairman TIBERI. Okay. Any other members have any questions 
with our expert witnesses here?
    You want to ask us a question? I defer to Mr. Neal.

[[Page 77]]

    Mr. TAYLOR. I don't have the courage to do that. But I 
would make one point here; that it is not working, to start 
right there. The system is conceptually enormously messed up. I 
am not talking specifically about ESOPs or anything like that.
    Chairman TIBERI. You are talking about the Tax Code?
    Mr. TAYLOR. The Tax Code and the particular provisions we 
are talking about, they don't work. And you ought to start from 
the assumption that there are serious flaws in them. And that 
is why, as I said, there is great deal of merit in focusing on 
option two. Even if you decide in the end you are not going to 
do it, you are just going to take the ideas and build them into 
option one, it has the merit of making you focus on what is 
wrong.
    Chairman TIBERI. Thank you. Anybody else want to add a 
comment? That is why we are having this hearing. That is why 
the chairman has decided to do these drafts. And we appreciate 
you four being here today and adding your input to this 
process. I appreciate the time that you have taken.
    That concludes today's hearing. Please be advised that 
members may submit written questions to the witnesses. Those 
questions and the witnesses answers will be made part of the 
record.
    Again, thank you all for your time for appearing today, for 
the thoughtfulness and for our wonderful, educational 
discussion that we have had. I think this helps us continue to 
move the ball forward. Thank you.
    This hearing is adjourned.
    [Whereupon, at 11:12 a.m., the subcommittee was adjourned.]
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