Subchapter S: Vivé le Difference

Roberta Mann University of Oregon

Chapman Law Symposium March 14, 2014

Presenta(on  Outline  •  Why  subchapter  S?  

–  Poli(cians  want  to  help  “small  businesses”  •  Why?  

–  Does  subchapter  S  help  small  businesses?  

•  Sta(s(cs  –  S  corps  s(ll  popular  –  Returns  filed  by  en(ty  type  –  S  corps  are  generally  “small”  

•  Comparing  taxa(on  of  S  corps  and  LLCs  

•  Reviewing  the  arguments  for  repeal  –  Having  two  passthrough  regimes  is  “inefficient”  

–  Plain  vanilla  LLCs  are  just  as  simple  as  S  corps  

–  The  danger  of  choice  vs.  the  value  of  choice  

•  Conclusion  –  Taxpayers  should  have  choice  

What’s  good  for  small  business?  

S  Corps   LLCs  

A Brief Overview of Business Types and Their Tax Treatment

Congressional Research Service 2

And third, there have been off and on discussions about moving to a more uniform business tax environment. According to traditional economic theories of taxation there is no reason why otherwise identical businesses should be taxed differently. According to the same theories, when such differences do exist, the result is an inefficient allocation of resources, which occurs at the expense of stronger economic performance. The current tax disparity could be reduced via two general approaches. First, the corporate and individual tax systems could be combined or “integrated” so that corporations were treated similar to pass-throughs.3 Second, pass-throughs could be subjected to the corporate tax.4

Figure 1. Distribution of Business Tax Returns Filed in 2009

Source: CRS Analysis of Internal Revenue Service, Business Tax Statistics, http://www.irs.gov/uac/Tax-Stats-2.

It is perhaps useful to briefly quantify the business landscape across the various business forms before proceeding. Figure 1 displays the distribution of business tax returns filed in tax year 2009. The Internal Revenue Service (IRS) reports that there were approximately 29.5 million corporate and pass-through tax returns filed.5 The majority (67%) were sole proprietorships. The

3 In 1992, the Department of the Treasury drafted a 268-page report containing a comprehensive analysis of corporate and individual tax integration. See, The Department of the Treasury, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once, Washington, DC, January 1992, http://www.treasury.gov/resource-center/tax-policy/Documents/integration.pdf. For a summary of the Treasury report, see R. Glenn Hubbard, “Corporate Tax Integration: A View from the Treasury Department,” Journal of Economic Perspectives, vol. 7, no. 1 (Winter 1993), pp. 115-132. 4 In early 2011, Senate Finance Committee Chairman Max Baucus suggested the possibility of taxing pass-throughs with earnings above a certain income as corporations. See, Nicola M. White and Drew Pierson, “Baucus Says Congress Should Look at Taxing Passthroughs as Corporations,” Tax Notes Today, May 5, 2011. The Obama Administration also suggested such a policy change could be needed to lower the corporate tax rate in a report outlining the President’s framework for business tax reform. See, A Joint Report by the White House and the Department of the Treasury Department, The President’s Framework for Business Tax Reform, Washington, DC, February 2012, p. 10, http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Framework-for-Business-Tax-Reform-02-22-2012.pdf. House Ways and Means Committee Chairman Dave Camp, however, has expressed his opposition to such a policy change. See, Bernie Becker, “Members eager for White House tax plan,” The Hill, May 4, 2011, Online edition, http://thehill.com/business-a-lobbying/159351-lawmakers-eager-for-white-house-tax-plan-. 5 Internal Revenue Service, Tax Statistics, various tables, http://www.irs.gov/uac/Tax-Stats-2.

Doc 2013-14370 (12 pgs)

A Brief Overview of Business Types and Their Tax Treatment

Congressional Research Service 3

next most popular was S corporations (12%), followed by partnerships (9%), and LLCs (6%). C corporations comprised the smallest share of business returns filed (5%).

Figure 2. Net Business Income By Business Type, 1980-2008

Source: CRS analysis of Internal Revenue Service, Statistics of Income, Integrated Business Data, http://www.irs.gov/pub/irs-soi/80ot1all.xls.

Figure 2 displays the share of net business income generated by the various business types between 1980 and 2008. The most noticeable trend has been the decline in the share of income generated by C corporations.6 At the same time, the shares generated by S corporations and partnerships have trended upward. LLCs have also slowly increased their share of business income since 1993, when LLCs first appeared as an option on the partnership tax form (this is discussed in the “Limited Liability Companies” section). Sole proprietorships appear to have possibly decreased in importance as a generator of business income, although it is difficult to conclude whether this decrease is the result of a cyclical downturn towards the end of the sample period, or a more permanent trend. In the end, Figure 2 highlights the fact that pass-throughs are just as significant as corporations when it comes to economic activity.

C Corporations A popular business structure is the corporate form, of which there are two types; C corporations, which are discussed in this section, and S corporations, which are discussed later. C corporations, also known as ordinary corporations, are named for Subchapter C of the Internal Revenue Code (IRC), which details their tax treatment. Businesses incorporate under state law and the exact requirements for incorporation may vary from state to state. Typically, a business must first file articles of incorporation at the state level in order to incorporate.7 C corporations are considered

6 For an in-depth analysis of why corporate tax revenues have fallen, see CRS Report R42113, Reasons for the Decline in Corporate Tax Revenues, by Mark P. Keightley. 7 While a business may choose any state in which to incorporate, Delaware is by far the most popular. According to Delaware’s Division of Corporations, 63% of Fortune 500 companies chose Delaware as their state of incorporation. (continued...)

Doc 2013-14370 (12 pgs)

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Two  Passthrough  Regimes  

Subchapter  S  •  Limits  on  ownership  

–  100  maximum  shareholders  •  Family  members  count  as  one  shareholder  

–  Individuals,  estates,  certain  trusts  and  certain  non-­‐profit  en((es  •  No  non-­‐resident  aliens  •  No  corpora(ons  

–  Only  one  class  of  stock  allowed  •  Inflexible  tax  alloca(ons  

–  Per  share,  per  day  rule  –  Loss  alloca(ons  limited  to  basis  in  stock  and  

debt  •  Subchapter  C  rules  apply  

–  Contribu(ons  •  §  351  applies  

–  Distribu(ons  of  property  •  §  311  applies  

•  Transfer  of  ownership  interests  •  Employment  taxes  

Subchapter  K  •  No  limits  on  ownership  

–  Number  of  owners  –  Category  of  owners  –  Classes  of  equity  interests  

•  Flexible  tax  alloca(ons  –  Subject  to  “substan(al  economic  effect”  

test  –  Loss  alloca(ons  limited  to  basis,  which  

includes  share  of  partnership  liabili(es  •  Contribu(ons  and  distribu(ons  

–  No  control  test  for  tax-­‐free  contribu(ons  –  Pre-­‐contribu(on  gain  or  loss  allocated  to  

contribu(ng  partner  –  Distribu(ons  “generally”  not  taxed  

•  Transfer  of  ownership  interests  •  Employment  taxes  

Is  choice  inefficient?  Is  efficiency  more  important  than  freedom?  

More  choice?   A  be5er  choice?  

Can  an  en(ty  taxed  as  a  partnership  be  “plain  vanilla?”  

•  Tracking  of  pre-­‐contribu(on  gain  and  loss  

•  Mixing  bowl  transac(ons  

•  Hot  asset  rules  •  Alloca(ons  of  recourse  and  non-­‐recourse  debt  

Would  limi(ng  choice  limit  abuse?  •  “The  elec(ve  treatment  of  

private  firms  under  current  law  undermines  both  equity  and  efficiency  objec(ves  for  the  income  tax.”    –  George  Yin  (1999)  

•  “There  is  a  significant  risk  that  the  uniform  system  will  produce  an  unhappy  combina(on:    rules  s(ll  too  complicated  for  the  less  sophis(cated  and  too  imprecise  and  manipulable  for  the  more  sophis(cated.”  –  George  Yin  (2013)  

Camp  Op(on  2  •  Eligible  en((es:    all  except  

–  Publicly  traded  –  Banks  –  Insurance  companies  –  DISCs    

•  No  limits  on  number  or  class  of  equity  interests  

•  No  ownership  eligibility  requirements  

•  Tax  alloca(ons  “consistent  with  economic  interest”  

•  Losses  limited  to  owner’s  basis  (not  clear  on  how  en(ty  level  debt  factors  in)  

•  Contribu(ons  –  No  control  requirement  

•  Distribu(ons  –  Gain  must  be  recognized  on  

distribu(on  of  appreciated  property  

–  Pre-­‐contribu(on  gain  or  loss  allocated  to  contribu(ng  partner  

•  Transfers  of  equity  interests  –  Hot  asset  rules  apply  

Conclusion  Á  chacun son goût

Recommenda:ons  •  Keep  subchapter  S    

–  Simplicity  advantages  •  Per  share,  per  day  alloca(on  •  No  need  to  track  assets  

•  Changes  –  Include  en(ty  level  debt  in  

owner’s  basis  –  Eliminate  employment  tax  

loophole  •  Either  by  repeal  OR  •  By  allowing  LLC  to  use  

“reasonable  compensa(on”  as  the  base  for  employment  tax  

Will  this  help  small  businesses?  •  Flow  through  tax  treatment  

not  a  good  proxy  for  small  business  

•  Small  businesses  not  necessarily  “job  creators”  

•  BUT  •  Vast  majority  of  S  corpora(ons  

have  3  or  fewer  shareholders  •  Most  S  corpora(ons  are  small  

in  terms  of  asset  value