While Congress continues to struggle this year to address such issues as how to deal with the federal deficit and the sequester, the House Ways and Means Committee has put forth a series of discussion drafts focused on fundamental tax reform.
It is possible that the only way Democrats, who want loophole closers to be part of the sequester solution, and Republicans, who only want loophole closers considered as part of tax reform, can come together on a sequester solution is by combining the sequester effort with tax reform.
House Ways and Means Chairman Dave Camp, R-Mich., has released three discussion drafts so far, focused on international tax, financial products, and small business. Although labeled a small-business discussion draft, that draft proposal devotes a significant portion to pass-through taxation under the Tax Code, and ways the pass-through regime might be simplified.
The small-business discussion draft has already generated considerable discussion, and its enactment could significantly alter the tax treatment of S corporations, partnerships, and limited liability companies.
SMALL-BUSINESS DISCUSSION DRAFT
The discussion draft includes some core component suggestions with respect to tax law changes impacting small business, two alternative options for reforming the tax rules affecting partnerships and S corporations, a list of issues not addressed in the discussion draft, and a list of issues on which the Ways and Means Committee is particularly interested in receiving constructive feedback.
The suggested tax law changes impacting small business for the most part are an expansion of existing provisions and are not too controversial as presented. These include making permanent Code Sec. 179 small-business expensing, although only at pre-stimulus expensing levels of $250,000 per year. The availability of the cash method of accounting would be expanded to apply to all businesses with gross receipts of $10 million or less. The draft acknowledges that it has not addressed the possible impact of expanding the cash method on other provisions of the code not directly related to accounting methods. The current tax provisions for start-up and organization expenses would be combined to apply to start-up expenses up to $10,000, with a phase-out beginning at $60,000. The due dates for business tax returns would be modified to create more lead time between the due date for the pass-through entity information returns and the due date for the individual returns.
• Option 1: Reforms to the tax treatment of partnerships and S corporations. The first option set forth in the discussion draft for reforming the tax treatment of partnerships and S corporations is the less radical of the two. It would preserve the separate tax treatment of partnerships and S corps, but make a number of changes to both tax regimes.
For S corporations, the discussion draft under Option 1 proposes the following:
1. Make the five-year period for built-in gains permanent;
2. Increase from 25 to 60 percent the portion of an S corporation's income that may be passive and drop the rule requiring termination of S status for excess passive income for three consecutive years;
3. Permit non-resident aliens to be S corporation shareholders through a U.S. electing small-business trust;
4. Allow an ESBT to deduct charitable contributions made by the S corporation;
5. Modify the shareholder basis adjustment rules for S corporations making charitable contributions, conforming to partnership rules, and limiting the decrease in stock basis to the adjusted basis of contributed property; and,
6. Simplify and extend the time for making an S corporation election.
These proposals are in general not too controversial, with some being just expansions or extensions of current law, and have in general received favorable comment.
For partnerships, the discussion draft under Option 1 proposes the following:
1. Repeal the rules relating to guaranteed payments to partners, including special rules for deceased or retiring partners, and treat the payments as either payments in their capacity as partners or in their capacity as non-partners;
2. Require mandatory adjustment of a partnership's basis in partnership property when a partnership distributes property to a partner or a partner transfers his interest in a partnership, with corresponding adjustments for tiered partnerships;
3. Conform the partnership rules for limiting a partner's share of losses, to take into account charitable contributions and foreign taxes, to the S corporation rules;
4. Clarify that all distributions of inventory items are treated as a sale or exchange between the partner and the partnership; and,
5. Require that partners contributing property with built-in gains or losses be subject to tax on the pre-contribution gain or loss when the partnership distributes such property, without the current limitation of seven years.
These partnership proposals are probably a little more controversial than the S corporation proposals, but they by and large reflect concepts that are generally viewed as worthy of consideration with perhaps some tweaking of the details.
• Option 2: Unifying the tax treatment of partnerships and S corporations. The more radical and controversial of the options put forward in the discussion draft would repeal the current Subchapter K and Subchapter S of the code and replace them with a uniform and simplified set of rules for non-publicly traded businesses.
Among some of the other features of the proposed new set of rules would be the following:
1. Permit only net ordinary income or loss, net capital gain or loss, and tax credits to be specifically allocated to owners;
2. Require entity-level withholding on the pass-through entity's income and gain;
3. Limit deductions for losses to an owner's basis in his pass-through interest, which will allow excess losses to be carried forward indefinitely;
4. Limit tax-free distributions to the owner's basis in the business;
5. Prevent the use of pass-through entities to shift gains and losses amongst owners with different tax profiles by requiring pass-through businesses to recognize gain on all distributions of appreciated property, and preserving losses in distributed property by requiring owners to take carryover basis in the distributed property;
6. Allow owners basis in their ownership interests for entity-level debt in conformity to current partnership rules; and,
7. Allow owners to be treated as employees of the business.
Many commentators have suggested that, when starting from scratch, developing one unified pass-through regime would make a lot of sense. However, having developed two pass-through regimes for such a long period of time, the transition problems of getting from one system to the other are greater than the ultimate benefit. The discussion draft is candid in admitting that it has not yet addressed the transition issues. Other issues not addressed in the discussion draft relate to employment and self-employment taxes, the treatment of foreign partners, and mergers, divisions and re-organizations.
The S corporation system offers a simplified pass-through system for those with relatively simple aims that avoids the costs of setting up and maintaining a partnership system. These commentators ask why impose a complex partnership-type system on entities that prefer a simpler life. The commentators seem to feel that these changes imposed on a partnership, like the changes imposed under Option 1, are changes that have merits and are worth considering, again with some potential tweaks. The main concern appears to be imposing these additional complexities on over 4 million entities that have chosen simplified pass-through treatment under Subchapter S.
The House Ways and Means Committee discussion draft is just that - a discussion draft. Most practitioners seem happy that it was put out in that form so that these ideas can get a full airing before being put into legislative proposals. Even those opposed to many of the concepts seem to welcome the opportunity to discuss the issues involved. No one ever said simplification would be easy, and this discussion draft serves well to highlight that point.
The committee has particularly sought further comment on the following issues:
1. How can the present rules for different treatment of debt, allocations of income, loss, and deductions, and property distributions be coordinated and modernized to minimize the disparate treatment between partners and S corporation shareholders?
2. What effect do the allocation rules have on current partnership transactions where businesses (or assets) have been combined and each owner receives income from a separate business (or separate assets)?
3. Should the IRS be permitted to audit and assess tax liability at the entity level?
4. How should tax-indifferent owners, such as pension funds and other tax-exempt organizations, be incorporated into the withholding proposal?
5. How can transition rules be designed to minimize the burdens on existing businesses currently treated as partnerships and S corporations?
The fundamental and broad nature of these questions highlights that many of the potential problems with the proposals in this discussion draft have yet to be analyzed thoroughly. If there is one theme that seems to run through the commentary, it is that this is a wonderful discussion to have, and that there are many ways in which the taxation of partnerships can be improved in the areas identified in the discussion draft, but that it may not be worth the cost to force a relatively simple and successful S corporation system into the same morass of complexity already faced by partnerships and likely still to be faced by partnerships under the discussion draft proposals.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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