Originally published on Forbes.com May 28th, 2013
Reforming the tax rules related to flow through entities would be a really good idea. It may have some chance of success, because the current system does not have much of a constituency, as far as I can tell. The Ways and Means Working Group presented two alternatives in its small business report, the second went much further than the first, although perhaps not far enough.
Option 1
I didn’t find option 1 that interesting. The bottom line of it seems to be to make things easier on S Corporations, by, for example, allowing more types of shareholders. It then attacks some of the fancy tricks with basis and gain recognition that partnerships can pull. The one thing that really makes a lot of sense is a reordering of due dates. Partnerships would be due on March 15, S Corporations on March 31 and individuals and C corporations on April 15. You really do need partnerships to get done first, because anybody, including a C corp or an S corp, can be a partner in a partnership.
Option 2
Option 2 is much more interesting. It calls for the elimination of both Subchapter S and Subchapter K and their replacement with a single scheme for flow-throuh regardless of entity type. I think I’ll call the new universal flow-through a Sparta, because Spartans are cool. There would be a requirement for entity level withholding. One part of the proposal is a little puzzling:
Prevent owners from gaming the tax system by using losses to reduce tax liability by limiting deductions for losses to an owner’s basis in his pass-through interest, but allowing excess losses to be carried forward indefinitely.
Ensure that taxes are paid on real, economic gains (but not on returns of capital) by limiting tax-free distributions to the owner’s basis in the business.
Limiting losses to basis is the current rule for both S corporations and partnerships, as is allowing tax-free distributions up to basis.
The biggest difference between S corporations and partnerships is probably the fact that owners have basis in their share of the partnership’s liabilities. If the working group were aiming for the greatest level of simplicity they would have Spartas follow the S corporation rule that does not give owners basis for their share of the entity’s liabilities.
Allocating liabilities among partners is on the complicated side. Frankly, I think it is seldom done correctly, although, often, it does not matter. The real estate community would be up in arms if it were suggested that partners not have basis in liabilities. I think, though, that a lot of simplicity would be achieved by not allowing anybody to get basis through non-recourse liabilities.
That would eliminate most of the need for the at-risk rules. It would present the prospect of recognizing gain from borrowing money, but arguably people getting risk-free cash from low basis assets probably should not be able to defer gain. Conceivably, making debt financing less attractive might be good for financial stability.
What About Rates ?
In an article in Fortune, Stephen Chipman and Doreen Griffith expressed concern that a corporate rate lower than the individual will seriously disadvantage flow-through entites. The article is reflective of the comments that Grant Thornton submitted to the Small Business working group. (Chipman and Griffith are respectively GT’s CEO and National Managing Partner of Tax.)
Tax fairness dictates that the same tax rates should apply to all active business income. This can be accomplished by ensuring that the individual rate does not exceed the corporate rate (as was the case for the past 12 years) or by establishing an elective business equivalency rate for active business income. A business equivalency rate could be implemented by separating active business income that is reported on an individual owner’s return and subjecting it to an alternative rate, as is currently done with capital gains and qualified dividends. Alternatively, the individual taxpayer could be allowed to make two separate tax calculations and combine them to determine tax liability for the year. One calculation would tax the income attributable to an active business at a flat rate equal to the maximum C corporation rate and the second calculation would tax all other income under normal tax rules. Either approach would allow income attributable to an active business to be taxed at no higher a rate than the rate applicable to a large C corporation competitor.
The business equivalency rate certainly does not make for simplification, but, of course, the tension between fairness and simplicity is one of the problems of designing a tax system.
Is A Higher Rate For Flow-throughs Unfair?
In the wake of the 1986 act, the circumstances in which it made sense to organize as a C corporation became more unusual. Many C corporations elected S status and many of the owners of those that did not would come to regret it. The check-the-box regulations made partnership treatment a lot easier and partnerships, being a purer flow-through, became more popular particularly as limited liability companies were allowed partnership treatment. Then, for a while, the top individual rate was higher than the top corporate rate. I don’t think I had anybody who gave up their S election in response to that condition. We did a study for one of our largest clients that showed a fairly significant current cash flow advantage, but the advantage of retaining S status dwarfed the cash flow advantage when the possibility of selling the business was considered.
Basically a lower rate for C corporations is a very big advantage if you assume that a business entity is going to keep plowing its after tax income into expanding its existing business or acquiring new ones. If the business entity is going to mainly pump its after tax income out to its owners, the extra layer of taxation will likely cancel out any benefit of a lower corporate rate. Double taxation on an asset sale can seem like a disaster.
Real Simplification Would Be Crude
S corporations may have a surge in popularity, because they can still, within reason, limit payroll taxes. They remained somewhat popular, because a lot of people thought partnerships were too complicated. Partnerships did not have to be complicated, but because they could be, the agreements of even simple partnerships would look complicated.
S corporations allocate taxable income in accordance with ownership percentages only, cannot distribute property without recognizing gain and do not give owners basis in a share of the S corporations liabilities. If those were the rule for Spartas, it would be simpler. You would have to come up with some way of dealing with preferred returns to make it work, but if you went on the crude assumption that any return not in proportion to capital invested is compensation for services, you would have a simple system, that would be difficult to game. I doubt we are going there, as I doubt that a lower income tax rate for business flow-through income as compared to salaries, for example, would generate a lot of sympathy.
You can follow me on twitter @peterreillycpa.
Full disclosure. I worked for Grant Thornton until recently. Somebody tried to explain the business equivalency rate to me at a leadership meeting, but I didn’t really grasp it. I found the Fortune article stumbling around on the internet, not from any internal GT source.