Tax Law Fuels S Corporation Conversions Ahead of Overhaul

Dec. 23 — Companies have been steering away from the corporate side of the U.S. tax code to be treated more like lower-taxed individuals since the Tax Reform Act of 1986. The tax package Congress passed last week could keep the trend going.

Corporations that pass along income tax liability to their individual shareholders, known as S corporations, secured two victories in the legislation. The 10-year period on which S corporations that converted from corporate tax, or “C,” status used to have to pay corporate taxes on built-in gains will be permanently cut in half; and S corporations that make charitable contributions will be treated more favorably in the tax code.

The S-Corporation Association of America, which pushed for the provisions, cheered their inclusion in the tax bill, which combined short- and medium-term extensions of expired tax credits and deductions with permanent changes in tax policy. But other priorities for S corporations that didn't advance in 2015 await when Congress revisits the tax code in 2016 and 2017.

“C corporations looking to convert to S corporations now have one fewer roadblock in their path,” said Scott Greenberg, a tax analyst at the Tax Foundation, a think tank that leans conservative.

The five-year provision on built-in gains has been a priority for several years for the S Corp Association, which enlisted the help of Rep. Dave Reichert (R-Wash.) to introduce legislation in the House Ways and Means Committee.
Congress previously trimmed the threshold from 10 years to seven years in 2009 and 2010, then to five years in 2012, 2013 and 2014—but only temporarily, and that provision expired at the end of 2014.

New ‘Norm.'

Reichert and Rep. Ron Kind (D-Wis.), a legislative partner on the issue, have said the change would bring stability and simplicity to taxes, helping S corporations continue to generate jobs. Permanency was a big step for S corporations ahead of potentially more ambitious tax changes that could further shift the tax code's balance between the S and C corporations, said Kevin D. Anderson, a partner in the national tax office of BDO USA LLP.

“Now that Congress has made it permanent, that is the norm,” Anderson told Bloomberg BNA Dec. 22.

S corporations have multiplied since 1986, when the Tax Reform Act imposed the built-in gains tax to prevent C corporations that convert to “S” status from selling some or all of their business to avoid the double taxation on the corporate side of the code. At that time, Congress lowered top individual tax rates to 28 percent from 50 percent, and the top corporate rate to 34 percent from 46 percent. The S corporation became an appealing way to avoid the double taxation that comes when companies pay corporate tax, then additional taxes are collected on dividends and capital gains.

Individual tax rates are higher, but they are imposed just once, so companies have made the switch despite federally imposed restrictions on how S corporations function—such as limiting them to one class of stock.

S corporations and other passthrough entities—such as partnerships—accounted for 72.4 percent of all corporate tax returns in 2011, the Internal Revenue Service said. The number of S corporation returns filed grew from 3.2 million in 2002 to 4.2 million in 2012, with heavy concentration in businesses such as wholesale and retail trade, real estate rental and leasing, and professional, scientific and technical services, the IRS said. The number of returns in professional services topped 693,000 in 2012, the agency said.

Finding Their Voice

As their numbers have grown, so has the S corporations' voice on Capitol Hill. The S Corp Association was established in 1996. Its political action committee didn't exist until 2012. In the 2014 cycle, the S Corp Association PAC gave $20,500 in total to four Republicans on the Ways and Means Committee: Reichert and Reps. Charles W. Boustany Jr. (R-La.), Paul D. Ryan (R-Wis.) and Erik Paulsen (R-Minn.).

In addition to Venn Strategies LLC, which advocates for the association's members, the association's PAC is supported largely by executives with two companies: McIlhenny Co., maker of Tabasco brand hot sauce, based in Louisiana; and the Jeffrey Co., a Columbus, Ohio investment company that used to make machines for coal mining. McIlhenny's president and chief executive officer, Tony Simmons, is the association's chairman.

For 2016, the S Corp Association is focusing on rules that govern S corporations and on girding for a bigger tax rewrite in 2017, said Brian Reardon, the association's president and a lobbyist with Venn Strategies.

“Overall, I think extenders were a positive step,” Reardon told Bloomberg BNA.

Reichert, chairman of the Ways and Means Subcommittee on Trade, has emerged as a champion for S corporations. If his legislation, the S Corporation Modernization Act (H.R. 2788), is any measure, the next priority for tax writers may be to further loosen restrictions on S corporations. Those goals aren't all new; some have roots in recommendations the congressional Joint Committee on Taxation spotlighted in a 2001 report on tax simplification, an aide to Reichert told Bloomberg BNA.

Leftovers on the Menu

In addition to the built-in gains treatment and the charitable deductions, the bill contains provisions that didn't advance. Those include repealing the mandatory termination of S corporation elections for excessive passive investment income; allowing S corporations to increase passive investment income to 60 percent from 25 percent without incurring additional tax; allowing nonresident aliens to become shareholders; and allowing individual retirement accounts to become shareholders.

Those leftovers from Reichert's bill seem to be the next discussion point, Anderson said.

In a legislative update for its members, the S Corp Association said it would pay particular attention to the restriction on foreign investment.

“As for next steps, there are numerous ways to improve how S corps are taxed, including the rule prohibiting foreign investment in S corporations,” the association said. “That rule makes no sense, and precludes the S corporation community from an important source of capital. You can bet we'll be up on the Hill pushing for relief from that restriction and others with the goal of making it easier for S corporations to raise capital, hire new employees, and succeed at their business.”

Then comes a comprehensive tax overhaul, perhaps. Lobbyists told Bloomberg BNA they aren't sure whether that effort will help or hurt S corporations. Any broad paring of tax expenditures such as deductions in order to reduce corporate tax rates—which S corporations don't pay—probably doesn't help, said Steven M. Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center.

“The thing is, they don't gain anything from that bargain. They only lose,” Rosenthal said.

All the while, lawmakers will have to balance the interests of S corporations, which have proliferated, with C corporations, which have dwindled in relative number but are helpful to the Treasury because of the two levels of taxes they deliver—one at the corporate level, then again at the individual level for capital gains and dividends.
“No one's really solved the problem of how you make C's more competitive without hurting S's,” Rosenthal said.

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