[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 [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] ______ U.S. GOVERNMENT PUBLISHING OFFICE 94-397 WASHINGTON : 2016 ----------------------------------------------------------------------- For sale by the Superintendent of Documents, U.S. Government Publishing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 [[Page ii]] 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 [[Page iii]] 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 [[Page (1)]] 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:] [[Page 8]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 9]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 10]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 11]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 12]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] 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:] [[Page 14]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 15]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 16]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 17]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 18]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 19]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 20]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 21]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 22]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 23]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 24]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 25]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 26]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 27]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 28]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 29]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 30]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 31]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 32]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 33]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 34]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 35]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 36]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 37]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 38]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 39]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 40]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 41]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] 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. [[Page 43]] 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:] [[Page 44]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 45]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 46]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 47]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 48]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 49]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 50]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 51]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 52]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Chairman TIBERI. Mr. Nichols, you are recognized for 5 minutes. [[Page 53]] 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:] [[Page 55]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 56]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 57]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 58]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 59]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 60]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 61]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 62]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] [[Page 63]] [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] 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 [[Page 68]] 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 [[Page 69]] 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---- [[Page 71]] 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. 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