The Senate Finance Committee held a hearing Wednesday on tax reform and the tax treatment of different business entities such as pass-through S corporations and C corporations.

“Today, 95 percent of all U.S. businesses are structured as so-called pass-through entities—which are partnerships, limited liability firms, sole proprietorships and S corporations,” said Senate Finance Committee Chairman Max Baucus, D-Mont., in his opening statement. “Originally used primarily by small businesses, recent changes in the law have made it easier for medium and large businesses to be taxed as pass-throughs and still retain the benefits of limited liability.”

Baucus pointed out that pass-through structures give businesses unique tax incentives that might discourage companies from accessing stock markets. “Pass-throughs don’t pay corporate taxes; their business income is taxed at individual income tax rates,” he said. “However, C corporations get taxed on income, and then—when that money is distributed in dividends to shareholders—it is taxed again. While a valuable tool for small businesses, we should examine if the use of pass-throughs have disrupted the level playing field for larger non-public companies and their public competitors.”

Sen. Orrin Hatch, R-Utah, the ranking Republican member of the committee, noted that the top U.S. corporate tax rate of 35 percent is about 10 percentage points higher than the average top corporate tax rate of other industrialized countries and he pointed out that the earnings of a C corporation are frequently taxed at both the corporate level and again at the shareholder level if the earnings are distributed in the form of a dividend.

“It makes no sense today to have two levels of taxation of corporate earnings,” said Hatch. “In fact, I am not sure it ever made sense to have two levels of taxation even in the early years of our income tax system.” He contended that President Obama’s framework for business tax reform would also subject certain pass-through entities to double taxation. “Like all bad ideas, this one should be rejected,” said Hatch. “All business income, whether earned by a C corporation, a large pass-through entity, or a small business, should be subject to a single level of tax—either at the entity level or at the owner level. A big challenge in moving to a tax system in which all business income is subject to a single level of tax, which we should do, is that such a system may raise less revenue than the current system.”

Dana Trier, a tax law professor and a former Treasury Department official, testified about some of the complex entity structures used by many businesses today. “A central feature of the contemporary tax planning landscape for business entities is the use of structures in which entities with more than one type of tax treatment are used simultaneously in configurations ranging from the relatively simple to the quite complicated,” he said. “In my view, many of those structures do not raise significant policy concerns, particularly when viewed from the perspective of my policy predilections. But that decision should be made by Congress advertently, not with ignorance of the actual facts on the ground.”

He described in his prepared testimony the use of so-called “UPREITS” in the real estate market to allow real estate partnerships to access the capital markets, leading to so-called “Up C” structures in other industries. He does not see many problems with these, even though they may be able to avoid some taxes. But the use of so-called “blockers” and “stoppers,” in which an entity is inserted in a structure to change the character of the underlying income or assets to change the reporting method or achieve some other tax purpose, may be more problematic from a policy perspective, particularly when they are used for foreign or offshore income and investments.

Harrison LeFrak, vice chairman of the LeFrak Organization, which is involved in real estate, energy exploration and investment industries, said his family business does not use corporations as investment vehicles to conduct its business because “the cumulative rate of taxation on our enterprises would be confiscatory.” He estimated that the combined effective tax rate would go from about 51.88 percent to 64.53 percent if it went from a partnership to a corporate tax structure this year, and 78.45 percent next year if Congress does not extend the Bush tax cuts.

“We as a family enterprise reinvest more than 95 percent of our business income back into our business activities and this tax proposal would be particularly onerous,” said LeFrak. “We also rely entirely on our on capital to fund our business activities and do not receive one dollar of carried interest income. If this proposal becomes law, my family will stop building, stop drilling, and stop taking any risks.”

Harvard Law School professor Alvin C. Warren argued that U.S. taxation of corporate and investor income needs to be reformed to reduce economic distortions. “The boundary between taxable and pass-through entities needs to be rethought to reflect changes in the legal environment and in the capital market,” he said. “Reform of the taxation of business entities is extraordinarily complex because it requires consideration of a large array of different combinations of domestic and foreign income, entities and investors.”

Fred de Hosson, a partner at the Amsterdam office of the law firm of Baker & McKenzie, discussed the question of why, compared to the United States, relatively little use is made of pass-through entities for regular business ventures in most Western European countries.

“In some jurisdictions, the less defined legal position of pass-through entities with respect to legal ownership and protection against liabilities is a major obstacle for their use as business entity,” he said. “The international environment wherein most European businesses operate requires more certainty with respect to the tax and legal treatment of the entities by the countries involved. The relatively low corporate tax rates in Europe as compared to individual income tax rates make the use of corporations more attractive; and the availability of tax facilities for corporations as a result of EU direct tax measures makes corporations the most suitable entities for expansion in the EU internal market.”

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