Risk & Compliance

S Corp. Flap Could Strap Tax Reform Efforts

If tax reform focuses only on conventional corporations, S corporations and partnerships could suffer.
David KatzJanuary 29, 2015

Late last year, Rep. Paul Ryan, the Wisconsin Republican who in January 2015 took over as chairman of the House Ways and Means Committee, paid tribute to Rep. Dave Camp, Ryan’s immediate predecessor. “Among the big marks that he made, tax reform is arguably the biggest,” Ryan told The Washington Post. “He basically got the country and Congress thinking about it to the point where we’re now discussing not if, but when.”

Rep. Paul Ryan

Rep. Paul Ryan

On his last day at work, Camp, who was retiring, dropped the crowning achievement of his 24 years in the House on the agenda of this year’s Congress: the Tax Reform Act of 2014. To many, that never-to-be enacted bill represents a starting point for compromise between Democrats and Republicans. In essence, Camp’s bill focuses on lowering both the top individual (39.6%) and corporate (35%) federal tax rates to 25%, with a 10% surtax for the highest paid individuals. To pay for the cuts, Camp proposed a big broadening of the tax base by erasing a variety of exclusions, deductions, and credits.

Leaders from both sides of the aisle in Congress have expressed an openness to aspects of Camp’s plan. To Democrats, who tend to favor focusing on only corporate tax reform, it offers the closing of loopholes. For Republicans, who want to see tax cuts for high earners as well as corporations, Camp’s plan offers comprehensive reform. Ryan, however, has  indicated that he would be willing to consider working on legislation focusing just on corporate tax reform.

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That, however, would leave the huge number of businesses structured as “pass-through” entities, including S corporations, partnerships, limited liability companies, and real estate investment trusts, out in the cold.

Such entities choose to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. In contrast, in a C corporation, a  company which is taxed separately from its owners, “the corporation is a taxpayer, so you have to pay Uncle Sam, and you have to estimate what your taxes are going to be and what’s the most efficient way to deal with the tax laws,” explains Bob Feeney, CFO of Cürex Group, a currency-trading electronic platform that’s structured as a partnership.

“[As] a pass-through, we’re not the taxpayer,” he says. “The taxpayer is ultimately the investor, and the investor’s tax situation is unknown to us.” Curex simply provides individual and business investors with K-1 forms that reflect the portion of the firm’s income allocated to each.

Thus, if the federal government enacts tax reform focusing on just corporate tax reform, the owners of pass-through entities, which are taxed as individuals,  wouldn’t benefit from the tax cuts that C corps. would enjoy. “That would be a really lousy deal for pass-throughs,” says Jon Traub, managing principal of the Deloitte’s national tax group in Washington National Tax group. “This is why you have to tackle individual along with business tax reform.”

Tax reform for only C Corps. would provide an incentive for pass-through entities to incorporate, reversing the thrust of long-standing U.S. tax policy, “where it’s been more advantageous to get out of corporations and into these pass-through entities,” according to John Gimigliano, head of the tax legislative group at KPMG. “Let’s say you’re a very profitable and successful S corp., [whose investors pay the] 39.6% highest individual rate. That income would be taxed at that rate rather than the 25% corporate rate.”

The reason the tax code has favored pass-through entities is that they provide the flexibility for owner-investors to easily pair up with operations people, freeing such entrepreneurs of the necessity of forming boards, issuing bylaws and stock certificates, and similar red tape, Gimigliano said.

Randy Schwartzman, the tax partner in charge of the Northeast region at BDO USA,  observes a current tendency on the part of the federal government to raise taxes on individuals in order to fund corporate tax incentives such as bonus depreciation and research and development credits.

To be sure, he acknowledges, the highest individual tax rates are charged to high earners. “But a lot of businesses in America are owned by S Corps and partnerships,” Schwartzman notes. “These businesses are manufacturing and distribution operations, retail operations, medical practices, law firms, and accounting firms. And these businesses also need to expand, even though they’re taxed at the individual level.”

Schwartzman proposes that Congress should consider a special tax rate for pass-through entities on their business income, enabling them to  keep some of their cash in the business for the purpose of expansion. “If you lower the tax on business income, you leave more of the earnings in the business to be invested,” he says.