Hearing on the Treatment of Closely-Held Businesses
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TWELFTH CONGRESS
COMMITTEE ON WAYS AND MEANS
WALLY HERGER, California
|SANDER M. LEVIN, Michigan
CHARLES B. RANGEL, New York
FORTNEY PETE STARK, California
JIM MCDERMOTT, Washington
JOHN LEWIS, Georgia
RICHARD E. NEAL, Massachusetts
XAVIER BECERRA, California
LLOYD DOGGETT, Texas
MIKE THOMPSON, California
JOHN B. LARSON, Connecticut
EARL BLUMENAUER, Oregon
RON KIND, Wisconsin
BILL PASCRELL, JR., New Jersey
SHELLEY BERKLEY, Nevada
JOSEPH CROWLEY, New York
JENNIFER M. SAFAVIAN, Staff Director and General Counsel
C O N T E N T S
Mr. Mark Smetana
Chief Financial Officer, Eby-Brown Company
Mr. Dewey W. Martin, CPA
Testifying on the behalf of the National Federation of Independent Businesses
Mr. Stefan F. Tucker
Partner, Venable, LLP
Mr. Jeffrey L. Kwall
Kathleen and Bernard Beazley Professor of Law, Loyola University School of Law
Mr. Tom Nichols
Meissner Tierney Fisher & Nichols S.C.
Mr. Martin A. Sullivan
Contributing Editor, Tax Analysts
Hearing on the Treatment of Closely-Held Businesses
in the Context of Tax Reform
U.S. House of Representatives,
Committee on Ways and Means,
The committee met, pursuant to notice, at 10:04 a.m., in Room 1100, Longworth House Office Building, Hon. Dave Camp [Chairman of the Committee] presiding.
[The advisory of the hearing follows:]
*Chairman Camp. Good morning. Before we begin, I just wanted to say that I was saddened to learn that a former staff member of the Joint Committee on Taxation, Cyndi LaFuente, passed away earlier this week. I know she was a valued colleague and friend to many people in this room, and I want to express my deepest condolences to her family and her friends for their loss, and just to say Cyndi will be missed.
Today we are continuing our series of hearings on comprehensive tax reform and how a flatter, simpler, and fairer tax code can lead to economic growth and job creation. Our last hearing focused on publicly traded companies’ use of generally accepted accounting principles, GAAP, when compiling their SEC‑required filings. For these companies, both earnings results and cash flow are important to investment decisions and performance measurement.
During today’s hearing, we will shift gears to examine the other side of the coin, closely‑held businesses. The complexion of these businesses varies greatly. They range from mid‑size manufacturers to local law firms to the Main Street restaurants that sponsor local Little League teams. In this hearing, we will examine the rules that dictate how these entities should be organized for purposes of taxation, as well as general burdens imposed on closely‑held businesses such as high compliance costs and tax rates.
The difference between individual and corporate tax rates has an important effect on a business and how it is organized. For example, if individual income tax rates are substantially higher than corporate income tax rates, there is a clear incentive for taxpayers to organize business activity in corporate form. In addition, businesses that are subject to the higher individual rates may face a competitive disadvantage.
There is little doubt that economic distortions can be created by a tax code that tilts too much in any one direction, and naturally one of the most effective ways to prevent that distortion is to create a neutral tax code in which the individual tax rates are similar to corporate tax rates.
This is an approach that the Republicans have taken by calling for a top rate of 25 percent for both individuals and corporations. It also mirrors one of the most important achievements of the 1986 Tax Reform Act, cementing the principal of closely aligning individual and corporate rates to eliminate abuse and economic distortions related to business structures.
According to the Joint Committee on Taxation, in 2007 pass‑through entities earned 56 percent of total net business income, which is taxed under the individual tax rate structure. Census data reveals that in 2008, pass‑through entities employed more than 54 percent of the private sector workforce. Both statistics point to the strong role pass‑through entities play in our economy, and recent proposals have raised concerns from many in the pass‑through community.
For instance, under the President’s budget and other corporate reform proposals, the top statutory rate on individuals would rise to roughly 40 percent. At the same time, however, President Obama proposes to lower the corporate rate to 28 percent. Corporate taxpayers would enjoy a tax rate that is 12 percent points lower than the top rate faced by pass‑through businesses, and this will create more harm than good.
As we continue to consider ways to transform the code from one that inhibits to one that spurs job growth, we must take steps to ensure that corporate reform is not financed on the backs of those who we have historically depended on the most to move us out of recessions, and that is small business.
Adding to the challenges posed by a disparate rate is the ever‑increasing tax complexity facing closely‑held businesses. Unlike large, publicly‑held companies that have armies of accountants and lawyers, the complexity of the tax code disproportionately hits small businesses, which tend to be closely‑held businesses.
The Small Business Administration found that small businesses face a tax compliance burden at $74.24 per hour. That is 67 percent higher than that faced by large businesses. This burden results from reporting requirements, such as 1099s, as well as complex accounting rules for inventories, depreciation, and other business activity.
In addition to the many tax rules a business must contend with, it is the first tax‑related decision that businesses make, the manner in which they should organize themselves. That will affect all other tax decisions from that day forward.
Whether a business organizes as a C corporation, an S corporation, a partnership, or some other form of business entity, that decision should not be driven by tax considerations. Instead, it ought to be driven by what form of organization best suits that business and its needs.
As we move forward on reform, this committee should ask when it is appropriate to tax business income on a pass‑through basis and when, if ever, it is appropriate to subject business income to entity‑level taxation. And given the importance of pass‑through entities to the U.S. economies and the prevalence of closely‑held businesses, the treatment of job creators is critical to tax reform.
Our goal with comprehensive tax reform remains clear, to create an environment that is ripe for economic growth and job creation. And I look forward to hearing from our witnesses about how we can best achieve that goal.
And I now yield to Ranking Member Levin for his opening statement.
*Mr. Levin. Thank you very much, and welcome to all of you. And I know the chairman always wants you to have your testimony in in advance, and you all did that, and that was really helpful, though in one case your testimony was 12 pages and I am curious how you are going to do that in five minutes.
*Mr. Levin. But it let us read rather late into the evening. Again, welcome, all of you knowledgeable people.
Today’s hearing on closely‑held businesses covers a vitally important topic. One of the measures of tax reform should be how well it promotes economic growth and job creation. So‑called pass‑through businesses represented over a third of business receipts in 2008 and just under half of business income. They are a major part of our economy and a major source of growth and jobs.
Because pass‑through entities do not pay corporate income tax at the entity level, and because they range in size from very small businesses to very large ones, they face a different set of issues with respect to tax reform than do C corporations. To understand how pass‑through businesses will be affected by reform, we have to understand ‑‑ and that is one of the purposes of the hearing today ‑‑ who exactly they are.
It used to be that pass‑throughs were a reasonable proxy for small businesses. But with the growth both in number and size of S corporations and especially LLCs, this identity is breaking down. This is vitally important, among other issues, as we debate the question of whether to continue the upper income Bush tax cuts.
Some have sought to continue to draw a straight line between pass‑throughs and small business to justify continuing the tax cut for the highest earners. But pass‑throughs are often quite large. For instance, in 2008, 64 percent of partnership income was earned by partnerships with more than $100 million in assets.
Small business income is also a small fraction of the income that would be affected by an expiration of upper income tax cuts. Only a small fraction, 8 percent, is associated with small business employers.
This has implications for how this committee approaches the universal, or nearly universal, desire to encourage small businesses. We need to keep in mind that if this committee contemplates the repeal of provisions that affect the cash flow of small businesses, such as accelerated depreciation or the domestic manufacturing deduction, in order to finance a corporate tax reduction, pass‑through entities will not benefit from a reduction in the corporate rate. Pass‑throughs also would not benefit from some of the international changes that the committee has discussed.
One area where I think most of us agree where we can help small business is complexity. In reading through your testimony and the excellent Joint Committee pamphlet, I think there is plenty of complexity for us to explore. I look forward, therefore, and all of my colleagues on the Democratic side do, to your testimony. Thank you.
*Chairman Camp. Well, thank you very much.
We are pleased to welcome the excellent panel of experts assembled before us today. And as we tackle the special challenges faced by small and closely‑held businesses, I believe their experience and insight will help us to shed some light on this complex area of the tax code.
To introduce our first witness, from Naperville, Illinois, I yield to the chief deputy whip, Mr. Roskam.
*Mr. Roskam. Thank you, Mr. Chairman. And Mr. Chairman, I want to thank you for extending an invitation at my request to Mr. Mark Smetana. Mark is the chief financial officer of Eby‑Brown, a 100‑year‑old family‑owned business, that is a wholesale distributor to the convenience store industry. And they are located in Naperville, Illinois, and they operate out of seven locations throughout the United States. They employ roughly 2500 employees, distribute goods to over 13,000 retail locations, and have $4.5 billion in annual sales.
Mark previously served as the chairman of the Private Company Policy Committee of Financial Executives International, a 15,000‑member company organization. And of course, he is a proud graduate of the University of Notre Dame.
*Chairman Camp. All right. Thank you, Mr. Roskam, and welcome, Mr. Smetana.
Second, we will hear from Mr. Dewey Martin. Mr. Martin is a licensed CPA, the sole owner of a public accounting practice, and the director of the School of Accounting at Husson University in Maine. He is testifying today on behalf of the National Federation of Independent Business.
Third, we welcome Mr. Stefan Tucker, a partner at Venable LLP here in Washington, D.C. Mr. Tucker is a former chair of the ABA Section of Taxation and has lectured as a professor at the George Washington University Law School and the Georgetown University Law Center.
Fourth, I would like to yield to Mr. Gerlach to welcome our next witness.
*Mr. Gerlach. Thank you, Mr. Chairman. I appreciate it very much. We are pleased to have today Dr. Jeffrey Kwall with us on the panel. Dr. Kwall is the Kathleen and Bernard Beazley Professor of Law at the Loyola University School of Law in Chicago, Illinois. He also teaches at Northwestern University School of Law.
He specializes in corporate and pass‑through taxation, and has authored many publications on the subject. He is an undergraduate from Bucknell University in Pennsylvania, as well as getting his J.D. and his Masters in Business Administration from the University of Pennsylvania.
But what is extra‑special about the opportunity to introduce Dr. Kwall this morning is that he and I grew up in the same home town in Western Pennsylvania. We are boyhood friends. We were in the same Cub Scout troop, and we have many memories of our childhood. And I have sworn him to secrecy on any of those stories, Mr. Chairman.
*Mr. Gerlach. But we are really pleased to have Dr. Kwall with us, and I appreciate the opportunity to introduce him this morning. Thank you.
*Chairman Camp. Well, thank you, Mr. Gerlach. And you come very well credentialed, Dr. Kwall.
Fifth, we will be hearing from Mr. Thom Nichols. Mr. Nichols is a shareholder at Meissner Tierney Fisher & Nichols in Milwaukee, Wisconsin, and serves as the vice chair on the Committee on S Corporations for the ABA Section on Taxation.
And finally, we do like to welcome back Mr. Martin Sullivan. Mr. Sullivan has served at the Treasury Department, the Joint Committee on Taxation, and since 1995 has been a contributing editor for Tax Analysts.
Thank you all again for your time today. Thank you for being here. The committee has received each of your written statements and they will be made part of the formal hearing record. Each of you will be recognized for five minutes, and I will hold you pretty tightly to those five minutes, for your oral remarks.
So Mr. Smetana, we will begin with you. You are recognized for five minutes.
STATEMENT OF MARK SMETANA, CHIEF FINANCIAL OFFICER, EBY‑BROWN COMPANY, NAPERVILLE, ILLINOIS
*Mr. Smetana. Good morning, Chairman Camp and Ranking Member Levin and members of the committee. It is a privilege to testify at today’s hearing regarding the treatment of privately‑held businesses in the context of tax reform. This hearing comes at an important time as America’s businesses continue to struggle with lingering economic uncertainty. This proves especially true for the thousands of privately‑held and family‑owned businesses in the United States.
As Mr. Roskam noted, I currently work for a privately‑held company. The current family ownership is in its second generation, and it employs about 2500 people. The longevity of the company has largely resulted from the family’s reinvestment of its after‑tax earnings and traditional financing.
America’s privately‑held businesses are the backbone of our economy. Forbes Magazine estimates that the 441 largest private companies in the United States employ 6.2 million people and account for 1.8 trillion in revenue. Recognizing the importance of private companies is vital since any workable tax reform must address businesses, regardless of their form of organization.
All forms of business use GAAP‑based financial statements to measure financial performance and the financial position of the business. However, there are fundamental differences between privately‑held businesses and corporations.
Owners of privately‑held companies are typically limited in number and have long‑term investment horizons, years to generations, whereas investors in publicly‑held corporations are short‑term renters of the securities they own, frequently trading them for cash. Capital used to finance privately‑held businesses are after‑tax cash earnings and transactional forms of debt financing. Public corporations raise capital via offerings of debt and equity‑traded securities to the public.
The owners of privately‑held businesses typically measure the value of their business in terms of free cash flows the business generates, EBITDA or earnings before taxes, interest, depreciation, and amortization, times a market multiple; whereas public companies measure valuation in terms of market capitalization, price‑to‑earnings ratio, and earnings per share.
Most privately‑held companies evaluate investment opportunities on an after‑tax cash flow basis, whereas public companies evaluate the impact on the price of its stock. Tax policy plays a material role in evaluating those investment decisions for privately‑held businesses.
The recent framework for business tax reform released jointly by the Administration and Department of Treasury strongly implies that those organized as pass‑through entities are advantaged in the current tax code over corporations. This is simply not the case.
According to a report from Robert Carroll and Gerald Prante of Ernst & Young, America’s pass‑through businesses reported 36 percent of all business net income but paid 44 percent of all Federal business income taxes.
Furthermore, the pass‑through tax regime recognizes that there is a fundamental difference between closely‑held businesses enterprises and corporations, especially publicly traded ones. Among them are:
Owners of pass‑through privately‑held companies are taxed on business income, whether distributed or retained in the business, at one level of taxation, whereas corporations pay taxes on all income; and their owners pay a second tax on after‑tax earnings that are distributed to its owners, creating a double‑tax event.
Pass‑through entities are flexible, allowing a disproportionate allocation of earnings to its owners based upon the agreed‑upon equity contribution among them. Corporations are inflexible in the allocation of earnings to its stakeholders.
In order to fairly treat all businesses and provide a consistent policy with which business can operate in the U.S. economy, tax reform must address both forms of organization. The stated goal of providing a competitive business tax environment is important. However, it should not result in discriminating against closely‑held businesses by widening the amount of marginal taxes the pay on business source income, forcing them into an inappropriate investor/owner relationship with their business, double‑taxing their business income as if they were merely an investor trader of the business, or forcing them to pay a second level of tax on the sale of their business.
Financial professionals are already making decisions based on increases in marginal rates set for January 2013, expiring AMT fixes, increases in the tax rate on investment income, and an increase in death taxes on closely‑held companies. Certainly none of these prospects can be welcome at a time when our economy desperately needs increased private sector investment.
In closing, it is vital that private companies are recognized as critical for America’s economic future. When tax reform does take place, we hope that their importance in our economy is understood and not penalized.
I want to thank the chairman and ranking member for giving me the opportunity to speak before the committee today. I am happy to discuss these issues further and answer any questions you may have.
[The statement of Mr. Smetana follows:]
*Chairman Camp. Thank you very much.
Mr. Martin, you are recognized for five minutes.
STATEMENT OF DEWEY W. MARTIN, CPA, HAMPDEN, MAINE, TESTIFYING ON BEHALF OF THE NATIONAL FEDERATION OF INDEPENDENT BUSINESS
*Mr. Martin. Good morning, Chairman Camp, Ranking Member Levin, and members of the committee. I am very pleased to be here on behalf of NFIB as the committee continues its series of hearings on tax reform. I appreciate that the committee invited me here today to discuss tax reform from the perspective of someone who is a small business owner, a tax advisor to many closely‑held businesses, and a university professor of taxation for 32 years.
I would like to discuss how taxes affect small business structure and propose a number of ideas for reform. Additionally, I will lay out some goals that I believe the committee should adopt when considering the impact of tax reform on small businesses.
Nearly 75 percent of small businesses choose the pass‑through business structure. And, by the way, that occurred because of the Tax Reform Act of 1986; prior to that time, you could have one level of taxation at the time of liquidation of a C corporation. The Tax Reform Act of 1986 enforced double taxation that pushes everybody towards S corporation status.
From a from a tax perspective, the pass‑through model makes sense for the typical small business. But while many small businesses start as sole proprietors or as partnerships, the liability protection that a corporation offers is not available to these business structures. As a small business grows in size, they are very likely to elect to change to an LLC or a corporate form.
While there are important liability protections offered to incorporated businesses, taxation that pushed C corporations troward ongoing costs associated with that structure versus non‑corporate structures, such as filing articles of incorporation, paying registration fees with States, drawing up corporate bylaws, and establishing a board of directors.
Incorporation makes sense for some businesses and would serve as a barrier to entry for other businesses. The various models provide the business owner with more flexibility and choice to organize their business in a way that best suits their needs.
As I discuss in my written testimony, I believe that three changes to the current law would provide additional flexibility to small businesses in choosing that alternative:
First, allow corporations to own shares in S corporations, or at the very least, allow S corporations to own shares in S corporations.
Second, allow owners of S corporations to have fringe benefits, just like employees of C corporations can have fringe benefits.
And finally, reduce the holding period for built‑in gains. For 2011, it is five years, 2012 going back to 10 years. Reduce it. Eliminate it. But take care of it. It is a difficult problem for conversions.
Regarding tax reform, as the committee considers various proposals, I would encourage you to keep these goals in mind: Permanent reduction of tax rates. Do not create disparities between the various forms of entities. Reduce complexity ‑‑ big one for me, especially in the classroom. And do not separate the business owner from the business; they are really one and the same.
Small businesses need permanency in the tax code to make important business decisions, such as when to hire workers and when to make capital investments. And one of the main sources of capital for expanding a business is earnings retained from business profits.
While small businesses would no doubt welcome the opportunity to reduce individual income tax rates from their current levels, at a minimum, NFIB members overwhelmingly support extending the current tax rates. In addition, NFIB members strongly support repeal of the AMT and the estate tax.
Pass‑through businesses must be included in any reform of the Internal Revenue Code. If the rates were to go down for C corporations but remain unchanged for pass‑through businesses, it would put pass‑through businesses at a competitive disadvantage or encourage businesses to change to a less favorable business structure simply for tax reasons. Additionally, this could lead to higher taxes for pass‑throughs, perhaps as much as $27 billion a year.
NFIB strongly recommends that tax reform be pursued comprehensively, addressing both individual and corporate taxes. The typical small business spends about $18 billion on tax compliance costs, some of it to me, a small piece. There are some areas of the tax law that are significantly more complex than necessary, such as the small business health insurance credit, which requires me to do a five‑page worksheet in a tax return before I can even tell whether the business qualifies for the credit or not. Ridiculously complex, in my opinion.
Additionally, in recent years, the IRS and Congress have attempted to close the tax gap by forcing small business owners to become information collectors for the IRS or through increased withholdings. Two such efforts, the 1099 paperwork mandate in the health care law and the 3 percent withholding requirement, were so onerous that they were rightly repealed in 2011 before even going into effect. Both of those requirements would have significant impact on my clients.
Congress can build on the success of some reforms to the code that have made tax filing easier for small business. Two examples are the increased Section 179 deduction to the $500,000 level, making it permanent, and expanding the use of cash accounting, making it available to any business with less than $10 million in sales. That would be a big help to my clients.
Finally, do not think of the business owner as separate from the business itself. Attempts to tax small business or pass‑through income and salary income at different tax rates would have a significant problem for small business owners. The recordkeeping required to determine qualified income and to allocate expenses would increase the cost and burden of compliance for small businesses.
Thank you very much for the opportunity to testify here today. I very much appreciate the fact that the Committee on Ways and Means is taking a serious look at reforming the Internal Revenue Code, and I urge you to keep in mind the unique challenges that face small businesses. And I very much look forward to hearing your questions at the end of our presentations. Thank you.
[The statement of Mr. Martin follows:]
*Chairman Camp. Thank you, Mr. Martin.
Mr. Tucker, you have five minutes, and your written statement is part of the record.
STATEMENT OF STEFAN F. TUCKER, PARTNER, VENABLE LLC, WASHINGTON, D.C.
*Mr. Tucker. Chairman Camp, Ranking Member Levin, and members of the committee, thank you very much for the opportunity to appear before you today to testify in an area to which I have devoted my professional career for almost five decades ‑‑ that is, the legal aches and pains that are facing closely‑held business owners.
I am the senior tax lawyer at the Venable law firm in Washington, D.C. My practice specializes in closely‑held businesses, from the inception to the end of the business. I have a teaching career; I have been teaching at law schools for 42 years, since 1969. I am currently an adjunct at the Georgetown University Law Center and at the University of Michigan Law School, and I teach business planning at Michigan.
By the way, Chairman Camp and Ranking Member Levin, I am a Michigan native. I was born in Detroit. (Mr. Levin: You may remember the Richton and Dexter intersection in Detroit; that is where I lived.) I grew up in Flint, Michigan. I am a graduate of Flint Community College, which is now Mott Community College, the University of Michigan Business School, and the University of Michigan Law School.
I have absolutely no political agenda today. My purpose is to share with you the concerns that, in my experience over the decades, closely‑held business owners face on a daily basis, and suggest Federal tax reform that you should consider to address these concerns.
In my experience on an everyday basis, closely‑held business owners are particularly concerned with four issues: first, growing their businesses, specifically capital access and capital formation; secondly, protecting their personal assets from business risk; thirdly, protecting the business and its personnel from adversity; and fourthly, business succession. And in fact, Federal tax policy impacts on all of these concerns.
I would suggest that this committee consider four fundamental reforms of the tax system that would enable owners of closely‑held businesses to concentrate on what they do best, which is actually running their businesses. And these are: a single‑tax regime for all electing entities; secondly, an entity‑level tax for non‑electing entities, with dividends paid deduction; thirdly, simplify compensation rules; and fourthly, tax rate parity. And everything else is detail. Let me amplify. Okay?
First, on the single‑tax regime, I would make this elective integration. I would have it apply to any entity, whether a corporation, a limited liability company, or a partnership. And I would leave the choice of entity to be determined by the business owner based on non‑tax considerations such as State law issues. Effectively, we would have a check‑the‑box. And this is because many of them are concerned about State law concerns, and should not be concerned about tax law concerns.
The guidance for all of these pass‑through entities would be the partnership rules under subchapter K. And in fact, I would eliminate subchapter S altogether and, therefore, eliminate all the traps under subchapter S of the Internal Revenue Code.
I believe that anyone who works for the entity and is an owner of an interest in the entity, irrespective of the size of the ownership, should be subject to withholding, FICA and FUTA, and receive a W‑2 and not a 1099. And of course there would need to be a transition period to move from that taxable corporation into the single‑tax entity.
Secondly, on the entity‑level tax for non‑electing entities with a dividends paid deduction, I would let every entity decide not to elect affirmatively to be a single‑tax entity but to be a taxable entity. But I would give them a dividends paid deduction for dividends passed through to shareholders, which is effectively what REITs do today but with special rules governing REITs.
It would apply only to dividends paid out of the current year’s income. To the extent income is retained, I believe the following should occur. If it is retained to acquire assets, tangible assets to be used in the trade or business within the United States, I believe that they should have a fast writeoff on those assets, no more than five years or the current useful life, if shorter, thus giving them an inducement to grow their business within the U.S., not outside of the U.S.
If the retained income is used to acquire tangible assets in the trade or business outside the U.S., let them use the longer current useful lives. And if it is later distributed, there would be no dividends paid deduction, and it would be taxed to the shareholders at their level.
I think there should be simplified compensation rules. I think you should not have to worry about reasonable compensation because, in a pass‑through entity, you would not have that issue. It would be a single‑tax entity, and in big entity. And, in big double tax entities, golden parachutes and the like could be eliminated because that should be a shareholders concern, not a tax/IRS concern.
Finally, there should be tax rate parity. The top rate for corporations that are taxed and for pass‑through entity owners should be exactly the same. You should not have a gaming issue as to where you are and come up with deductions that you do not need.
Thank you very much for your time, and I am glad to answer questions at any point.
[The statement of Mr. Tucker follows:]
*Chairman Camp. Well, thank you, Mr. Tucker. And I think your personal background might even trump Dr. Kwall’s.
Dr. Kwall, you are now recognized for five minutes.
STATEMENT OF JEFFREY L. KWALL, KATHLEEN AND BERNARD BEAZLEY PROFESSOR OF LAW, LOYOLA UNIVERSITY SCHOOL OF LAW, CHICAGO, ILLINOIS
*Mr. Kwall. Chairman Camp, Ranking Member Levin, and distinguished members of the committee, thank you for inviting me to testify at this hearing. I would like to make a couple of suggestions today, with a goal of trying to reduce the extent to which the tax law distorts business decisions, and to simplify the law.
As you are aware, there are three principal closely‑held business entities, corporations, partnerships, and limited liability companies. In addition, there are three alternative tax regimes that these enterprises can select from ‑‑ two pass‑through regimes, subchapter S, the S regime, and subchapter K, sometimes known as the partnership regime. I am going to call it the K regime.
And pass‑through entity treatment, of course, means that the business does not pay tax. Instead, the income of the business is allocated among the individual owners. Each owner reports his or her share and pays tax at his or her marginal rate.
In addition to the two pass‑through regimes, we also have a separate entity regime, the C corporation regime, that publicly traded companies are taxed under. But in addition, closely‑held enterprises can also elect that regime, whereby there is a corporate‑level tax, an entity‑level tax on the business when it earns its income, and then a second tax on the owners of the business when profits are distributed.
I want to focus on the two pass‑through systems, the S regime and the K regime. They both impose a single owner‑level tax, but accessibility and the operation of the two systems are very different.
The S regime is a very restrictive regime. It only accommodates businesses where the owners agree to share economic profits consistently. In other words, each ownership interest has to have identical economic rights, meaning identical rights to distributions as well as liquidation proceeds. As a consequence, it is relatively easy to allocate the income of an S corporation among the owners. It is just a straight proportionate allocation. Everybody picks up their percentage share.
By contrast, the K regime, the partnership regime, accommodates any economic arrangement regardless of what the owners agree to. The owners can agree to splice and dice profits and losses however they want to do it. As a consequence, the K regime imposes on the tax law the burden of unraveling the economic arrangement of the owners to figure out what the proper tax reporting should be. That is difficult, if not impossible, because the partnership does not distribute its profits each year. You have got to be guessing in terms of how those profits would get distributed based on difficult agreements.
The tax rules attempting to ensure that the tax reporting matches the economic arrangement are complex and difficult to comply with. So by virtue of this situation, my proposal is that rather than having two pass‑through systems, the tax law should have a single pass‑through regime that applies to what I call simple enterprises, and a single entity‑level tax, imposed on complex enterprises.
Now, ideally, all business income should be allocated among the owners and taxed at each owner’s individual marginal tax rate. That ideal can be accomplished for simple enterprises, meaning a business entity with one class of ownership interests, regardless of whether that entity is a partnership, a corporation, or a limited liability company.
In the case of a simple enterprise, all you have to do is allocate the income and deductions proportionally among the owners unless the owners elect out; I would allow them to elect out of that system. And you would implement that system by simply refining the existing S corporation regime, which works reasonably well and has a long history.
The ideal of taxing the income to the owners, though, cannot be accomplished for complex enterprises, meaning any business entity with more than one class of ownership interests, regardless, again, of whether the entity is a corporation, a partnership, or a limited liability company.
In the case of a complex enterprise, my suggestion is that you tax the income to the entity when it is earned. If you tax the entity, then the tax law does not have to be concerned with how the owners are going to split up the profits and losses. And you can implement that by creating an entity‑level tax and effectively eliminating the partnership regime.
So in conclusion, I would suggest replacing the current system of three elective alternative regimes with a pass‑through system for simple enterprises and an entity‑level tax on complex enterprises because I believe that would both reduce the impact of the tax law on the choice of business form decision ‑‑ it would make it purely a business decision ‑‑ and simplify the law.
Thank you for inviting me to participate in this hearing. I welcome your questions.
[The statement of Mr. Kwall follows:]
*Chairman Camp. Well, thank you very much. Appreciate your testimony.
Mr. Nichols, you are recognized for five minutes.
STATEMENT OF THOMAS J. NICHOLS, MEISSNER TIERNEY FISHER & NICHOLS S.C., MILWAUKEE, WISCONSIN
*Mr. Nichols. Thank you. Chairman Camp, Ranking Member Levin, members of the committee, thank you very much for the opportunity to testify today on the important topic of the treatment of closely‑held businesses in the context of tax reform. My testimony today reflects the views that I have developed over 30 years as a tax professional, working with closely‑held business entities, as well as my role as an advisor to the S Corporation Association.
When I first started practicing law in 1979, the top individual tax rate was 70 percent and the top income tax rates for C corporations was only 46 percent. This rate differential provided a tremendous incentive for successful business owners to elect C corporation status. The devil’s bargain was that those lower taxed earnings were supposed to be taxed again when distributed out to the shareholders, resulting in an aggregate cumulative tax burden of 84 percent.
This tax dynamic set up a cat‑and‑mouse game between the IRS and taxpayers, whereby shareholders sought to pull money out of their corporations in transactions that avoided the ordinary income tax rates, or to accumulate wealth inside corporations and indefinitely delay the second layer of tax. This is described in more detail in my written comments. The only winner in this struggle was the tax lawyers.
The bipartisan Tax Reform Act of 1986 changed all this. It altered the relative C corporation and individual rates so that businesses were no longer forced into C corporation double‑tax status.
This allowed most closely‑held business owners to migrate into the more rational single‑tax pass‑through system, which eliminated the need for all of that gaming that I described. This system has worked well for businesses and the country in the intervening years, and retaining these benefits will be critical to the success of any future tax reform efforts.
Unfortunately, this favorable relative rate structure is now at risk. Right now, the top rate for C corporation and S corporation retained earnings is 35 percent. However, unless there is a change in the law, as shown in chart 4 in my materials, the top rate for pass‑throughs will rise to nearly 45 percent next year for partnerships and S corporations in certain circumstances, while the top rate on C corporations will remain the same. There are also proposals for a C corporation‑only tax rate reduction, which would make the wedge between C corporations and pass‑through businesses even larger.
Instead, I believe that Congress should build on the reforms started in 1986, including continuing to move businesses toward a single‑tax system, keeping the top rates for corporate, pass‑through and individual income the same, and implementing tax reform on a basis that is comprehensive and not piecemeal.
Focusing merely on the headline C corporation marginal rate and broadening the tax base for all businesses unavoidably increases the tax burden for closely‑held pass‑through entities. Since pass‑through business owners employ over half the workforce in this country, lowering the marginal rate for all businesses should be the goal of comprehensive tax reform.
In light of that, it would be appropriate to facilitate the continued transition away from the C corporation double‑tax system for as many entities as possible, including maintaining the holding period for the built‑in gains tax at five years, as proposed in H.R. 1478, introduced by Representatives Reichert and Kind, and several other proposals that are described in my written testimony. Adopting any or all of these changes would continue the trend begun with the Tax Reform Act of 1986 toward a more transparent, less artificial single‑tax system for closely‑held business.
A couple of other observations. Probably the most important reform for closely‑held businesses would be the possibility of extending and/or expanding the option of expensing investments in capital equipment.
Most closely‑held business owners intuitively evaluate their business on the basis of cash flow rather than financial statement net income; that is a matter of survival for them. For companies without access to capital markets, expensing is important.
Others have suggested forcing the double tax on large pass‑through entities, say, entities with gross receipts over $50 million. My written testimony outlines a whole host of problems with trying to implement such an arbitrary rule. Here I would just observe that if the goal of reform is to make American businesses more competitive, why would you force more employers into the punitive double‑tax regime?
One last tax reform proposal is the possibility of forcing all pass‑through entities into a single, uniform structure. If I were designing a system from scratch, I would consider doing this.
However, we already have roughly 4 million S corporations and 3 million partnerships. Any such proposal would unavoidably impose substantial additional tax and compliance costs on a substantial number of ongoing businesses, either the partnerships or the S corporations. I do not see any benefits that would necessarily justify such substantial a cost.
That concludes my oral comments. Once again, I would like to thank the committee, and answer any questions you may have.
[The statement of Mr. Nichols follows:]
*Chairman Camp. Thank you, Mr. Nichols.
Mr. Sullivan, you are recognized for five minutes.
STATEMENT OF MARTIN A. SULLIVAN, PH.D., CONTRIBUTING EDITOR, TAX ANALYSTS, ALEXANDRIA, VIRGINIA
*Mr. Sullivan. Mr. Chairman, Ranking Member Levin, members of the committee, thank you for this opportunity to testify. It is a great honor for me to be here today.
Mr. Chairman, over the last three decades, we have seen a fundamental transformation in how America does business. Pass‑through businesses have grown rapidly in number and in size. This growth is almost entirely due to an exploration in the use of limited liability companies and subchapter S corporations. Here are the facts.
In 1992, LLCs were virtually nonexistent. By 2008, there are 1.9 million of them. Between 1980 and 2008, partnership revenue grew from 4 to 14 percent of all business revenue, and over the same period, the share of total business revenue claimed by S corporations grew sixfold, from 3 to 18 percent.
The United States has an unusually large non‑corporate sector compared to other countries. A recent study found that the United States ranks second only to Mexico in the size of its non‑corporate sector.
On April 1st, when Japan cuts its corporate tax rate, the United States will have the highest statutory corporate rate in the world. There is widespread agreement that we should lower our rate; the issue is how to pay for it.
One approach would be to eliminate some or all business tax expenditures. This approach, however, would hurt pass‑through businesses that would lose their tax breaks and not receive any benefit from the rate cut.
Pass‑throughs depend most on two tax expenditures: accelerated depreciation, worth about 8 billion a year, and the Section 199 manufacturing deduction, worth about 4‑1/2 billion. Eliminating these tax benefits would be particularly harmful to smaller pass‑throughs for which cash flow is critically important.
Many pass‑through businesses are large businesses. Here are the facts. In 2009, there were 14,000 S corporations with more than 50 million in sales. They accounted for 29 percent of all S corporation profit. There were 18,000 partnerships with more than 100 million in assets. They accounted for 64 percent of all partnership profit. Clearly, we can no longer equate pass‑through businesses with small businesses.
As the search continues for revenue to pay for lower corporate rates, we should consider extending corporate taxation to large pass‑throughs. It is really no different than any other base‑broadening option. It would level the playing field and raise revenue that we could use to lower the corporate rate.
Now, some tax experts worry about the effect on small business job creation if current rates are not extended for the top two brackets at the end of 2012. I believe, however, that the question of extending high‑end rate cuts should not pivot on the effect they will have on small business owners, but on larger issues such as the need for deficit reduction, the effect on tax fairness, and their effect on the overall economy.
If I could call your attention to the screen. Well, I am sorry, we are having technical difficulties. But the chart I am referring to is on page ‑‑ oh, thank you. Thank you very much. Sorry about that.
The figure on the screen shows a box. The box represents all the income affected by a rate change on the top two brackets. Only 30 percent is pass‑through income. Only 21 percent is related to pass‑through employers. And only 8 percent is related to small business employers.
If we want to promote small business job creation, providing tax relief to all income in that big box is a very inefficient way to do it. By targeting tax relief to pass‑through employers, we can promote small business job creation at a lower cost.
Now, to this end, Majority Leader Cantor is proposing a 20 percent cut for pass‑through businesses with fewer than 500 employees. Unfortunately, this proposal has some serious technical shortcomings, as I explain in my written testimony. A better way to spur small business job creation would be to provide a permanent tax credit equal to a percentage of wages with a cap on the number of employees who can qualify. That would create more small business jobs than a rate cut for high bracket taxpayers at a fraction of the cost.
Finally, a recent IRS study confirms what most of us already know: Small businesses are subject to a massively disproportionate compliance burden. I think all of us on this panel agree that Congress should aggressively modify provisions of the code that impose a large compliance burden on small business. That would provide significant tax relief, with little impact on the budget deficit. And I believe the proposals by Professors Kwall and Tucker on my right, about choice of entity, would be an excellent place to start.
Thank you, Mr. Chairman and members of the committee, for allowing me this opportunity.
[The statement of Mr. Sullivan follows:]
*Chairman Camp. Thank you very much. And again, thank you all for being here and for your testimony.
With most active business income and most of the private sector jobs coming from pass‑through entities, it seems clear to me ‑‑ and some of you articulated this ‑‑ that for reasons of competitiveness and fairness, that tax reform should connect the corporate rate with the individual rate, that reduction. And I think somebody used the words “tax parity.”
We did that in the House‑passed budget last year, and I know that the President’s tax reform framework that he released recently, when connected with his budget, would raise marginal rates on pass‑through entities to 40 percent while cutting the rate on corporations to 28 percent, as I said in my opening statement, which is a spread of 12 points.
I would ask each of you to respond. Do you think it is good economics to try to keep the top corporate rate and the top individual rate as close together as possible? And what are the risks of having a spread between those two? And I will start with you, Mr. Smetana.
*Mr. Smetana. Thank you. I think that we need to recognize, in the pass‑through regime, you have got two sources of income on the tax report. You have the earned income, wages, and then you have the business income. And I think the big distinction in terms of pass‑throughs is that that earned income is different.
It is taken out. It is used. The business‑sourced income is kept in the business, typically. And, as I mentioned in my comments, it is the primary source of capital to sustain the business and to grow the business along with traditional financing.
So I think it is vitally important that whatever policy that we adopt in terms of marginal rates, we try to retain as much of the capital in the businesses to sustain and grow as we possibly can.
So therefore, any rate regime which causes an increase in the amount of taxation paid on that business source income will retard growth, and it will retard the ability for those pass‑through entities to be competitive in an international and even a national scene. So therefore, I believe that one of the things we should try to make a distinction on is not where the income shows up on a tax return, but what the source of that income is. And I think that is very important.
*Chairman Camp. Mr. Martin?
*Mr. Martin. Well, I think it would increase my fees a lot of they did that. I would make a lot of money because I would be involved in the very difficult tax planning arena of helping my clients pay the least amount of taxes. And it would really harm the form of business that they wanted to operate in.
By the way, I played golf at Oakland Hills and the country club at Detroit and couple other courses, but that is the best I can do on this.
*Mr. Martin. I think it would be very harmful to force small businesses to operate in a form that saves them the most tax liability when it is not the form they really should be operating in. So I think that would be a huge mistake.
*Chairman Camp. Okay. Mr. Tucker?
*Mr. Tucker. I think one of the things we need to be aware of is that small business pays an enormous amount of fees to accountants and lawyers to deal with the complexities that they have to deal with ‑‑ the discrepancies in the law, deductions versus capitalization, and the like.
I think a tax parity ‑‑ and I am the one that used the words tax parity ‑‑ would help immensely. I think the top rate for corporations that are not pass‑through entities and for individuals should be the same top rate.
*Chairman Camp. Mr. Kwall?
*Mr. Kwall. Chairman Camp, clearly, under existing law, I would agree that it is very important that there be a balance between the maximum individual rate and the maximum corporate tax rate or else, we have seen in the past, when corporate rates were much lower than individual rates, there is pressure to use a corporation as a tax shelter.
However, under my proposal, I would not allow closely‑held businesses access to the C corporation regime. I do not think they belong in that regime. And if they are outside of that regime, then there are two independent regimes and it would not be a problem.
*Chairman Camp. Okay. Mr. Nichols?
*Mr. Nichols. I would certainly endorse the whole tax parity approach that I think everybody is advocating soon here. I do not think there is any question that if you change the rates to be significantly different for C corporations and for pass‑through entities, you are going to go back to the game‑playing that I did experience at the beginning of my career between the lower C corporation tax rate, and the devil’s bargain of trying to get that money out in some form or another without paying the nasty double tax.
Any system that enhances the gaming is ‑‑ at the end of the day it is going to start a dynamic between the IRS and taxpayers that, frankly, just benefits the people sitting at this table but does not benefit the country.
*Chairman Camp. All right. Mr. Sullivan?
*Mr. Sullivan. As Professor Kwall pointed out, the gaming is mainly a result of the ability of small businesses to use C corporation status. And that should be eliminated. I look at it from a different perspective.
In the rest of the world, the clear trend is to reduce corporate tax rates to improve competitiveness; and then because there are tight budget deficits everywhere in the world, they have to make up the revenues somewhere else. And where they are making up the revenue is increasing rates on individuals.
S I think we have to look at this more broadly. We have budget deficit problems. We have competitiveness problems. And the rest of the world, when they have had this problem, what they have done is lowered their corporate rate and increased their individual rates. And I believe those problems can be ‑‑ the borderline can be policed with effective anti‑abuse rules, and very simple rules.
*Chairman Camp. Okay. I just have one other question. We have had suggested by some, and I think it is in the President’s tax framework, that certain large, closely‑held entities should be subject to a corporate tax rate or the double tax that comes with that. And they use the threshold, I believe, of gross receipts.
My question is for Mr. Martin and for Mr. Nichols. Is it not better to have fewer business entities subject to double taxation than more? And if we cannot eliminate the corporate income tax, would it not be better to determine who can get pass‑through treatment by using a business distinction, I think such as Dr. Kwall described, whether the entity is complex or whether it is publicly traded. And I would like to get your thoughts on that.
*Mr. Martin. Well, to me, the elimination of double taxation would be an answer to all kinds of simplification problems. If we allowed corporations to liquidate with one level of taxation and made dividends deductible, as has been mentioned here, many, many S corporations would go away because that is why they were created to begin with.
And certainly I do not think that we should be using the Internal Revenue Code to decide, based on a level of revenues, who should be a C corp and who should not be. As long as the tax rates have parity, I do not see any reason to have a forceful choice of an entity for anybody.
*Chairman Camp. All right. Mr. Nichols?
*Mr. Nichols. I would have a of couple comments on that, and my written testimony deals with that in more detail. The $50 million test, for example, is extremely arbitrary. Theoretically, you could have one dollar of additional gross receipts that could trigger literally millions of dollars of additional tax because you are in the C corporation system rather than the S corporation system.
And as I go into more detail in my written testimony, you are going to have to have numerous rules to deal with simultaneous where there are multiple entities. We have something like 440 pages of regulations of consolidated return rules to deal with corporations that voluntarily group together to treat themselves as one entity.
But you would effectively have to come up with ‑‑ if there were, let’s say, two dozen affiliated entities in this structure you would have to come up with rules that were at least as complicated and probably many times more complicated in order to deal with that situation. That’s on top of the fact that double‑tax C corporation treatment is not the preferred alternative, I think, on the part of anybody here.
So I think it would turn out to be much more unworkable than it may appear on its face. And I would be happy to follow up with more detail on that.
*Chairman Camp. All right. Thank you very much.
Mr. Levin may inquire.
*Mr. Levin. Again, welcome. And Mr. Tucker, we will not do it here, but let’s compare notes; where we grew up, it was pretty close, including some of the markets we went to.
Mr. Kwall, congratulations. Your five minutes was very succinct, really, very much so. In fact, all of you have been. And I think as we proceed with tax reform, which we must, I think it is useful to have a discussion like we are having here.
I went back and looked at some of the Joint Tax materials that we received earlier, and it was really interesting. Some of it was a bit surprising. For example, on the distribution of these various entities by asset size, for C corporations, 97 percent of assets are held by those with over 100 million. So we are dealing mostly with C corporations that are rather large.
And it was interesting, that was more mixed as to S corporations, quite a bit more mixed. But as to partnerships, 75 percent of assets are held by those with over 100 million in assets. So I think we need to look at facts like that.
In terms of business shares, it was also interesting that now pass‑throughs, this is, I think, given to us by Joint Tax, have 49 percent of the net income and C corporations 51 percent. And of that, the partnerships have the larger part, though not a vastly larger part, of the business shares.
Also, there was a recent article in the New York Times, based on figures from the Bureau of Labor Statistics that I think all of us should look at that. In terms of job growth, between April 1990 through March 2011, it said that over that period, employment at larger companies rose 29 percent while employment at smaller companies rose by less than half as much.
But also, and the data will become, I think, clearer, they said, later this year, that small companies seem to be more nimble when it comes to various economic impacts. So I think as we go forth and talk about tax reform, that all of us should look at the materials from Joint Tax and the Bureau of Labor Statistics.
Let me just ask you, Mr. Martin, in terms of the position of NFIB, whose members overwhelmingly support permanently extending the current 2001 and 2003 tax rates, has the organization spelled out how it would pay for that extension?
*Mr. Martin. If they have, they have not told me.
*Mr. Levin. We are talking about trillions.
*Mr. Martin. I understand that.
*Mr. Levin. When they tell you, let us know. No, seriously, it is a major, major issue, and I think everybody has the responsibility of indicating how they would pay for these items in view of our deficit challenge. So maybe you could ask them to be in touch.
*Mr. Martin. I will ask them to get in touch with you.
*Mr. Levin. Thank you.
Mr. Sullivan, just quickly, I just want you to emphasize this. On page 9, and your chart shows this, you say, “Only about 8 percent of ordinary, high‑bracket income is generated by small business employers. The bottom line is that most income affected by the rate change has nothing to do with small business employment. If the goal is to promote employment at small businesses, providing tax relief to all income in high brackets is an extremely inefficient way of achieving that objective.”
Could you elaborate?
*Mr. Sullivan. Yes. This data is actually ‑‑ as people who work through pass‑through data know, it is very hard to work with. It is very hard to interpret. There has been a new study that came out in August of last summer, a technical study from the Treasury Department, that made this type of linkage between small businesses and small business owners possible. And so we really weren’t able to ‑‑ this is new data. You have not seen anything like this before.
And one thing that comes out of it is wealthy, high‑income households, most of their income has nothing to do with ‑‑ it is wages. It is interest income. Most of it has nothing to do with small business. And that is what comes out clearly in this data.
*Mr. Levin. Thank you.
*Chairman Camp. Thank you. Mr. Herger is recognized.
*Mr. Herger. Thank you, Mr. Chairman.
Mr. Martin and Mr. Nichols, both of you mentioned in your written testimony the importance of Section 179 expensing rules for small businesses. Coming from a small business background, I have long supported the expansion of Section 179 so small business owners can write off their investment in the current tax year rather than depreciating them over an extended period of time.
Could you comment further on why this policy is important and how small businesses would be affected if the expensing allowance were reduced to 25,000, as is currently scheduled to occur next year?
*Mr. Martin. Well, I can address it from the perspective of my client base. I think 500,000 is high enough. I don’t think it needs to be raised, even though I think NFIB would support, I think, would support an increase in that expensing election. 500,000 is high enough in my tax base.
It is not just the complexity issue. The complexity of keeping depreciation records is not a big deal. I don’t have one client that knows how to calculate depreciation; I do it for every one of them. So putting it into software, it is not really a complexity issue for me, although that is argued by a lot of people.
It is the availability of capital. If you can get a deduction for equipment that you are buying, you are much more apt to buy it, for one thing. You are more apt to be more efficient in your business, generate more profits, put investment in the capital equipment industries. There are just a tremendous number of benefits to increasing that expensing election. I would be very much in favor of maintaining it at $500,000.
*Mr. Herger. Thank you.
*Mr. Nichols. I think that is a critical provision. Frankly, it was brought home to me early in my practice. A client called me up. He had just made his first million bucks, and he had quickly invested that million bucks buying capital equipment and all sorts of other things he needed in his business. He called me up and said, “We have got a problem. My accountant tells me I owe taxes.”
And I started to explain to him all of the depreciation rules and that he does not get an immediate deduction for all of that.
Well, he did not let me finish. He said, “Tom, you do not understand. I have no cash,” and that, frankly, is for a lot of closely held business how they look at things. That is a matter of survival for them. That is what they look at. That is how they analyze their business. That is how they analyze the success of their business.
So obviously, having the expensing rules available at the current levels or maybe even increased is very important, I think, for closely held business.
*Mr. Herger. Thank you.
That is certainly my experience, and as I talk to small businesses I do not think that these points can be emphasized enough.
In looking at the data on privately held companies, one thing I found somewhat surprising is the number of very small companies that are organized as C corporations and subject to the entity level tax despite the apparent advantages of pass‑through status. According to the Joint Committee on Taxation, about one in four C corporations had less than 25,000 in total receipts in 2009. My sense is that many of these companies may be trapped in C corporation status by overly restrictive tax rules for companies who want to convert to S corporations.
I would like to get your thoughts on why so many small businesses are organized as C corporations. As part of tax reform, should we look for ways to make it easier for closely held C corporations to transition into a pass‑through regime? And starting with you, Mr. Smetana.
*Mr. Smetana. My opinion is that the fundamental reason you see so many of them is that they are not getting good tax advice. Really for an entity, especially a small receipts entity, the double level taxation and the marginal rates of approximately 60 percent really are inappropriate for reinvestment.
The other cause that we typically see is just longstanding small companies that were originally formed as Cs before they had options typically do not switch. Built in gains considerations are certainly a factor if they are on the LIFO method of accounting. They have a catch‑up tax payment due. So there are economic reasons as well that I believe prevent them from converting to a more appropriate tax regime for their business.
*Mr. Herger. Mr. Martin.
*Mr. Martin. Since the Tax Reform Act of 1986, I think I have only had two clients come to me where I advised them to be C corporations, and that was because of fringe benefit reasons. There are some fringe benefits only available to C corporate level employees, not to S corporate level employees, and that was going to be a significant benefit to them.
Other than that, they have all elected to be S corporations. There was a forgiveness year when the Reform Act of 1986 was passed, which allowed people to convert without built‑in gains. The built‑in gains burden is significant. My policy is to ask my client are you going to retire within ten years. If they expect to retire within ten years, we try to elect S corporation and get out of it.
There are some cases, like a cash basis business, you really cannot elect to be an S corporation from being a C corporation because you have to pay tax on all of the receivables in the next year. You really cannot do it. So they are locked into that position.
*Chairman Camp. All right. Thank you. The time has expired.
Mr. Johnson is recognized.
*Mr. Johnson. Thank you, Mr. Chairman.
Mr. Martin, you testified that an important simplification measure for small business would be to increase the threshold for cash accounting from five million to ten million in revenue. Can you explain how doing so would ease the administrative burden for small business?
*Mr. Martin. Accrued income and accrued payables could just be completely ignored. Calculation of the wages that are due for vacation pay payable or sick pay payable, it takes me an hour at least at the end of the year to do that for a client if they are on full accrual method. If they are on cash method, we just ignore it, do not have to deal with it at all.
So simplicity‑wise it is a great benefit. The IRS has been pretty, I guess, accepting of small businesses because they passed revenue procedures for one million dollar levels for all businesses and $10 million levels for some businesses. I would like to make that $10 million for all businesses. It would save my clients a lot of cash flow.
*Mr. Johnson. Yes. Would it require some other changes to the code or just that?
*Mr. Martin. No, all you would have to do is just that. The phase‑in last year, the last time they did it, they were very accepting in terms of how the phase‑in was done. It was very easy to do, and if they did the same thing again, it would be a huge benefit to small business.
*Mr. Johnson. Thank you.
Now, Mr. Nichols, you testified the proposal in the President’s corporate tax reform framework to increase the threshold for small business to use cash rather than accrual accounting from five million to ten million in revenue would not benefit the vast majority of closely held businesses. Can you elaborate on why you think that is the case?
*Mr. Nichols. I must admit that I am not as familiar with the President’s proposal.
*Mr. Johnson. Neither am I. Do not worry about it.
*Mr. Nichols. But just to be honest, I think there are a lot of closely held businesses that for banking and other reasons, end up using generally accepted accounting principles anyway, and they get used to using the generally accepted accounting principles in terms of analyzing their business and their profits and losses.
I would not want to say that it would not help anybody, because there are no doubt situations where it would. On the other hand, there are many businesses for whom I do not think it would make a great deal of difference, and there are some that will actually affirmatively elect accrual basis treatment simply because it is easier to keep both their tax accounting and their regular books on the same basis.
So in terms of the list of things that would be useful and helpful for closely held business, I cannot say that this would have no value, but I do not think it would be at the top of my list.
*Mr. Johnson. Thank you, sir.
Thank you, Mr. Chairman. I yield back.
*Chairman Camp. Thank you.
Mr. Neal is recognized.
*Mr. Neal. Thank you, Mr. Chairman.
Since 1986, the number of corporations has dropped 28 percent while the number of pass‑throughs has grown by 102 percent. The 1986 pass‑throughs earned 40 percent of all business income. Today they account for nearly 60 percent of the income earned by all businesses.
Some have suggested that this change is in large part due to tax considerations, as Mr. Herger noted, and others have taken a different position, indicating that multiple reasons exist for this shift, including the growth of the service sector, ease of administration, and the fact that you can get limited liability and still get pass‑through treatment.
To the witnesses here, what are your views on the reasons behind this shift? Mr. Sullivan, you touched upon this. And what do you think about the trend and whether or not it is a problem?
What implications does the increasing proportion of business income that is being taxed as individual income have for an issue that is close to all of us, and that is the issue of tax reform?
We will perhaps start with you, Mr. Sullivan.
*Mr. Sullivan. The invention of the limited liability company was in the mid‑1990s or the early 1990s, and that after the 1986 Act just made it open season for larger businesses to have the advantages of limited liability and the exemption from the corporate income tax. The problem that this causes, it is a benefit for these companies, but there is a disparity. Some large businesses pay corporate tax. Some do not, and that is an arbitrary distinction with no economic basis.
*Mr. Neal. The other members of the panel? Yes, please, Mr. Nichols.
*Mr. Nichols. I think the treatment of closely held businesses is a matter of critical importance, but if we start to focus on having different systems for the two, that is problematic.
And I would want to respond to something that was said earlier. If we start to focus and we essentially allow publicly held and larger corporations to essentially retain earnings at a lower rate, which is what I think has been suggested, and we do not allow pass‑through entities to retain their earnings at that same lower rate, that to me is an arbitrary advantage that you are giving to the larger corporations, and I see no reason to do that.
Another thing is the pass‑through system itself: it is the most logical one I have seen. I have seen business owners convert especially around the Tax Reform Act of 1986 convert from a double tax system to a single tax system, and they literally stopped spending as much time worrying about taxes because they paid taxes once. They pay them right away. They reserve for them, and then they are done. And then they think in terms of their business.
So from the standpoint of moving forward on tax reform, pushing toward a single tax system is very beneficial and at the end of the day constructive in my opinion.
*Mr. Neal. Mr. Kwall?
*Mr. Kwall. In terms of the shift, I think a large part of it was attributable to the 1986 tax reform and two changes that occurred at that time. One was the parity between individual and corporate tax rates that was created because prior to 1986, corporate tax rates were much lower. It was aspirational to use the C corporation regime to get the advantage of those lower corporate tax rates.
Secondly, after 1986, you could no longer sell a C corporation business without the imposition of a heavy corporate tax on the gain. It used to be just one shareholder level tax on the gain when you sold a C corporation business, but now there is a big tax at the corporate level. It is a capital gain, but there is no reduced capital gains rate for corporations. So it is a prohibitive cost on any business that thinks it is going to be successful.
*Mr. Neal. Mr. Tucker?
*Mr. Tucker. I think you are seeing two things. Number one, the Internal Revenue Service recognizes the limited liability company would be taxable as a partnership, not a corporation. It started in Wyoming in 1977, but it wasn’t until the late 1980s that the Revenue Service allowed it. That enabled your client to have a shield from liability as a limited liability company, even if they were managers, even if they were the business people running the business.
Corporations have enormous risk of complexity, equity versus debt, reasonable compensation, audits on a continuing basis, and you need simplicity, lack of complexity and the ability to run the business, not to be afraid of taxes at all times.
*Mr. Neal. Mr. Smetana, you had your hand up and then we will come back to Mr. Martin. Just a few seconds.
*Mr. Smetana. Quickly, again, it goes back to the fundamental economic principle of business. Privately held companies, closely held companies elect this form and it is increasingly so because they get to retain more cash in the business. That is a fundamental economic driver of growth and maintenance and jobs and economic activity at these corporations.
I would also make a comment that whether you are in a pass‑through regime or a corporation, the entity is still covering the tax. So I think it is an important distinction to make that that cash does still come out of the business regardless of which regime you are taxed on.
*Chairman Camp. All right. Thank you. The time has expired.
Mr. Brady is recognized.
*Mr. Brady. Thank you.
I would like to follow up with Chairman Camp’s questioning in favor of taxing income of closely held businesses only once. The White House often speaks of the pass‑through business form as if it is some type of loophole that is used to avoid the double taxation business income that applies to C corporations.
In fact, in the corporate tax reform framework, the President recently proposes to double tax the income of certain unspecified large pass‑throughs. So my question: in this struggling economy, as we look for companies to invest and create jobs, what would the President’s proposal do by proposing double taxing some of our pass‑throughs?
Mr. Smetana, and we will run down the row.
*Mr. Smetana. Sure. We actually did an analysis of the President’s proposal. First of all, the increase in the marginal tax rates would cause our company to only retain approximately 40 cents of every dollar of profit we earned versus 60. That would certainly decrease our opportunities in terms of reinvestment and growth.
Secondly, the provisions related to lengthening out the depreciation schedules also moving us to the corporate regime and the elimination of the last in, first out accounting method for companies that hold inventory would create an additional five to $6 million a year in taxes to our corporation, again, reducing our ability to fund the business and invest in the business.
And certainly the LIFO impact on us, on a business that holds inventories in an inflationary environment over the last three decades would cause roughly an $18 million tax burden on our company that we would have to pay over some amount of time, again, money that we would have to find either out of future earnings or borrow against, which again would limit our ability to grow and maintain the company.
*Mr. Brady. The President or at least the White House views LIFO as some type of accounting gimmick, some type of subsidy loophole that businesses apply to. It is a traditional form of accounting, and that change would, in my understanding, hit companies with inventories in a major way.
Your thoughts? Is that a loophole?
*Mr. Smetana. I believe that is a sound economic principle if our objective is for companies to maintain a sustained inventory investment, and simply put, the LIFO method of accounting allows a company to reinvest every dollar of profit on the increase in that inventory cost back into inventories.
Otherwise companies would have to find either 40 or 60 cents, depending on which tax regime they are, in our case 40 cents of every dollar of profit. We would have to either borrow or take out of other economic activity just to maintain the same amount of inventory investment.
*Mr. Brady. Thank you.
Mr. Martin, on the original issue of taxing pass‑throughs in a double sense.
*Mr. Martin. I have already expressed that I am very much opposed to double taxation. I like to think of the word “fairness,” and when I stand up in front of my classroom and I am teaching 30 students about the tax law, I am very quick to tell them that certain things in the law are fair. Some of them have no equity at all and it does not make any sense, but are there maybe for social reasons or whatever. There have been allusions today to generally accepted accounting principles. Generally accepted accounting principles recognize what is known as the matching principle. LIFO very much adopts the matching principle which says that we match current cost with current revenues. The non‑LIFO methods of accounting do not, and they are very expensive for companies to adopt. LIFO has not been a big deal because inflation has not been rampant over the last ten years or so, but there are some heavy industrial companies that have been using LIFO for a long time. If LIFO were disallowed, they would pay a heavy penalty.
*Mr. Brady. That is what I understand. Thank you.
*Mr. Tucker. I think one thing that people forget is in a pass‑through entity, the owners are taxed irrespective of whether they receive distributions and, therefore, very often they are being taxed without receiving the cash, as somebody noted before, but the cash is being used for the business. They have elected to do that. They are willing to do that.
To penalize them either because they are bigger or to penalize them because of some other reason would result in double taxation, and they are already paying the taxes on the income. But taxing the companies that grow these businesses because the growth has been in pass‑through entities is wrong. It is just erroneous.
*Mr. Brady. At the end of the day the economy suffers.
*Mr. Tucker. Everybody suffers, the economy and workers.
*Mr. Brady. Thank you.
*Mr. Kwall. You really need a rationale for double taxation, and under current law, the rationale seems to be public trading. If you are publicly traded, you are subject to double taxation.
So if the line is to be moved, there should be a rationale for the movement, and you also want a line that is going to work well and work as a good division.
I think public trading historically has worked reasonably well. So if you are going to substitute some other standard, you need to make sure that it is going to do the job and actually ‑‑
*Mr. Brady. Rationale is not necessarily a prerequisite to policy changes as you know in Washington.
Thank you all very much, Mr. Chairman.
*Chairman Camp. Thank you.
Mr. Tiberi is recognized.
*Mr. Tiberi. Thank you, Mr. Chairman.
Just two questions if the panelists could answer them quickly, and some of you talk about them in your testimony, the two questions. The Chairman has been quite clear that he believes that we should provide comprehensive tax reform or go in that direction. Some in this town believe that we could just do corporate only and that would be fine.
If we could start from the left and go to my right, what would your opinion on that be?
*Mr. Smetana. We need to have comprehensive reform, period.
*Mr. Tiberi. Mr. Martin?
*Mr. Martin. I agree we need comprehensive reform as well. We cannot have divergence of tax systems. You just add tremendous burden on small business.
*Mr. Tucker. I like being in the center. I am neither on the left nor the right. On the other hand, I truly believe we need comprehensive tax reform. It is time for it. It is really time.
*Mr. Tiberi. Thanks.
*Mr. Kwall. I would agree with my colleagues. We are definitely in need of comprehensive reform.
*Mr. Tiberi. Mr. Nichols?
*Mr. Nichols. My guess is we are going to have unanimity on this one. I do not think there is any question that comprehensive tax reform makes sense. Comprehensive tax reform makes sense, and anything other than that essentially risks us going back to the game playing that we had before the Tax Reform Act of 1986. There is no need to go backwards.
*Mr. Tiberi. Mr. Sullivan.
*Mr. Sullivan. Let me put it even a little more strongly than the panel has put it. I believe you should start with small businesses and then move to the larger businesses because I have been around a few years. There is a tendency to forget small businesses once the big issues come up. To prevent that bias from occurring, start with the small and the large will take care of itself.
*Mr. Tiberi. Thank you.
I met with a group of farmers from Ohio yesterday. In your testimony, Mr. Smetana, you mention about privately held companies and their need for planning, long‑term planning, and these farmers were talking about that. In fact, as you probably know, farmers sometimes plan not only decades but generations, and one farmer in particular was distressed over the tax code and how complicated it had become to him and his family.
Can you talk about the differences in comprehensive tax reform ‑‑ we can start again from my life ‑‑ and how we should apply the differences between closely held family enterprises versus publicly held companies and the differences between long‑term planning versus short‑term planning?
*Mr. Smetana. Sure. I think it is a very important distinction because, as I said in my testimony, most privately held or closely held companies have time frames that are years or even generations, and so, therefore, there are several considerations.
One is certainly the sustainability of the business, and that is largely based on the amount of cash flow that the company can generate on an annual basis and over a period of time and retain in the business to sustain itself.
On the longer term basis, the shift in generation to generation is extremely important, and you need closely held companies, particularly family owned ones. Because of the onerous level of taxation at the time of death of an owner, we have created a situation in this country where the mere form of organization creates a distortion between a company that is one owned by a closely held family versus one that is owned in a different form of structure to the point where the family owned business, in effect, has to have enough liquidity or try to plan if they possibly can for enough liquidity to pay the tax at the time of death of one of the owners.
What typically results is that, as some of my colleagues in FEI have said, we end up doing unnatural acts to try to prevent a catastrophe at the time of death and the loss of jobs and economic activity, and that typically results in diverting economic activity away from the business to try to preserve that.
It just do not seem to make sense to me that at a time when we are trying to preserve jobs and trying to preserve economic activity that the death of an owner should cause some interruption in that activity, especially on a going concern.
*Mr. Tiberi. Thank you.
*Mr. Martin. I think most of you received a copy of a study by Mr. Carroll who basically identified the agricultural industry as the hardest hit industry in this country if we had different tax rates for businesses whether they are owned as C corporations or are owned as pass‑through entities, so a very, very unfair result I think.
My clients operate from the checkbook. Small businesses want to know if they have enough money to pay the payroll every week. They are only thinking about succession if I force them to or if they get to the age where they really have to or if they have children who are kind of pushing the issue on them to deal with it. They do not want to talk about it. They do not want to deal with it. It is a closely held situation with families.
Small businesses are on a short‑run decision making process. They fire people last. They hold onto them because they believe in them. They trust them. When they hire them, they have longevity. If you work for a small business, even though there is very rarely a union, you have longevity with that business. They support you in that position.
*Chairman Camp. All right. Thank you.
Mr. Davis is recognized.
*Mr. Davis. Thank you, Mr. Chairman.
I would like to follow along a little on that line of questioning, just having worked in the manufacturing world and its various tiers before coming to the Congress. I think that the underlying premise in this discussion is we want to address the rate issue, which is very real, but there is another other tier of issues underlying that. I have an example I want to put out and seek some comment on how we harmonize this, knowing that our premise for discussion is a revenue neutral reform.
And it is very exciting to be part of the dialogue to try to change the underlying process to stimulate the creation of job, especially encouraging small business owners.
Let’s look at the automotive industry as an example. The OEM or their Tier 1 suppliers invariably are international businesses. They will be located in multiple sites, integrated information and financial systems, supply chains that transcend the borders. Rates become a big issue. Those companies are operating on an accrual basis by and large. They are dealing with capital investment in a different way than, say, the Tier 2 or Tier 3 suppliers might be addressing the issues, to Mr. Martin’s point, functioning from the checkbook.
I have worked with a lot of suppliers that, in fact, did that, very successful businesses, but they were much more cash oriented. They were often cash basis accounting. They did not like the idea of rates, but for the most part, they were pass‑through entities for all practical purposes because you typically had a family or a collection of families that had started this business and grew it, where LIFO is a huge issue.
Capital investment for machine tools, I watched a number of businesses, two in particular, that walked away from, say, purchasing five axis vertical mill technology because they were uncertain about what their depreciation schedules were going to be, you know, dealing with that aspect.
England has tried some interesting approaches in harmonizing these issues at some various reforms. There is a lot of talk around the world about different schedules, you know, and how to deal with these issues. I am going to premise my question as someone who wants to see us go got a territorial system, have the ability of this rate issue to be addressed, but what I would like you to comment on in terms of reducing complexity, especially for small business: how do we address this issue of maybe giving the smaller businesses some options to address the issues like LIFO, to address the issues like depreciation, to encourage capital investment when they are functioning on the checkbook or cash basis and still hit revenue neutrality?
Maybe start with Mr. Smetana first and then open it up to the panel.
*Mr. Smetana. Sure. A couple of quick comments. First of all, I think there are a lot of allusions to the size of the corporation, and I will just say I think in the case of deciding policy, in this case size does not matter. It is really the form of organization and what we are trying to do with the economic activity within that business.
You know, me and my colleagues compete with companies of different sizes. So I think the level playing field is to create all businesses, regardless of their form or size to be able to have the same advantage.
With respect to simplicity though, I do think that we can recognize that smaller formed companies do have some more complexities than larger ones in terms of maintaining current tax code and compliance, and I do think that it would be appropriate to look at levels and limits that are appropriate and typically used by smaller entities to have access to quicker deductions than perhaps larger companies with respect to recognizing that fact without changing the fundamental text related to the form of the organization.
*Mr. Davis. Thank you.
*Mr. Martin. I would say that I do not know how to make it revenue neutral, but for a small business to have ‑‑
*Mr. Davis. Let’s imagine CBO actually has formularies that reflect the way you actually do business for a moment.
*Mr. Martin. Okay. When I was a representative to the White House Conference on Small Business in 1986, the number one issue voted by the representatives there was to have no changes in the tax laws for two years. Small businesses would love to have no changes in the tax law for two years or more in terms of managing their business. That just gets it out of their mind completely. They do not have to worry about it. They do not have to call me once a month to ask me what the issues are.
I would say adopt the changes you are going to adopt, and then somehow put limitations on some future Congress. I know that is not something that is done, but small business would love to have that fixed right.
*Mr. Davis. Mr. tucker.
*Mr. Tucker. I would like to concur with what was just said. One of the worst things that we face every single day is not knowing what the law is going to be next year or the year after, and therefore, are you embarrassed because you made an investment this year and only got to write off 25,000, but if you had just waited until next year, it would have been 100,000 or 500,000?
You need to bring stability into the Internal Revenue Code for all business.
*Chairman Camp. All right. Thank you.
We do have the prospect that we are facing of all tax policy expiring at the end of this year. So we really do not have the option of not doing anything.
Mr. Reichert is recognized.
*Mr. Reichert. Thank you, Mr. Chairman.
So‑called flow‑through entities or those businesses that pay taxes through individual codes play a huge role in our economy, as you all know. Fifty‑six percent of the jobs in Washington State where I am from are sustained and created by these businesses, and they account for 69 million people across the United States, and they cannot be neglected in the tax reform effort that we are involved in here.
So, Mr. Nichols, first I want to thank you for your comments supporting the extension of the five‑year built in gains holding period. This shorter, more reasonable holding period unfortunately expired along with other tax extenders at the end of last year, and as you mentioned, I have introduced bipartisan legislation, H.R. 1478, with Mr. Kind from Wisconsin, to improve many of the rules governing S corporations, including making permanent an extension of the five‑year built in gains holding period.
And, Mr. Martin, you mentioned this is one of the issues that you pointed out would be very important for us to address going forward also.
The IRS statistics suggest that thousands of U.S. businesses should be sitting on appreciated assets that could be put to better use. In an economy short of capital, it just makes sense to allow these businesses increased access to their own capital.
Mr. Nichols, can you explain the purpose of the built in gains tax and why the five‑year holding period is more reasonable than the ten‑year holding period?
*Mr. Nichols. Well, the built-in gains tax was originally adopted primarily to prevent people in C corporation status to convert and avoid essentially the double tax on the sale of the business, and I have never been convinced that paying only one tax is a tax loophole and paying two taxes is appropriate policy, but that was the policy, it seems, behind the built-in gains tax.
In terms of how the built-in gains tax works to free up capital, essentially I have got a situation. Fortunately it is a client who has already been an S corporation for a while, but they have got a piece of property, and they want to buy a new, bigger piece of property, expand their business, hire more employees. If they were subject to the built-in gains tax, what they would have to do is sell their old property, pay double tax on that property, and then essentially turn around and invest those proceeds in the new property.
Now, they cannot qualify for Section 1031, the like-kind exchange rules, because they have got to operate their old facility for a period of time before they can move into the new facility. And so as a consequence, if they were seriously considering doing exactly that, but if they were in a position where they would have to pay double tax, which is what the built in gains tax regime is, they would essentially be trapped into that for five years or ten years.
Obviously, five years is a heck of a lot better than ten years in terms of waiting to utilize this capital.
*Mr. Reichert. Thank you.
Mr. Martin, would you like to comment?
*Mr. Martin. I had a client that I asked when he was going to plan to retire at age 50 and he said age 60, and then at age 55, he decided that he had had enough. He had converted on my advice at age 50 to be an S corporation, and I said to him at the time, “You know, when you convert, you cannot sell your principal piece of real estate here which is fully depreciated and worth a lot of money for ten years.”
And that is what happened. He sold the rest of his business. He did not sell the real estate until the ten‑year time frame was up. That was not good for him. That was not good for the economy. It was not good for the buyer who bought the piece of property, but here was the tax law dictating what would happen in his operation of his business. It was kind of crazy.
You know, five years is a whole lot better than ten years. Five years kind of takes into account unusual things that happen unbeknownst to all of us.
*Mr. Reichert. Well, thank you, gentlemen, for your answers, and I yield back.
*Chairman Camp. Thank you.
Mr. Roskam is recognized.
*Mr. Roskam. Thank you, Mr. Chairman.
And, again, Mr. Smetana, thank you for coming at our invitation to give a perspective.
In our district in suburban Chicago, we have got a tremendous amount of pass‑through entities who are job creators and employers and just a tremendous amount. I was at a company not long ago touring the plant floor, and the owner said to me, “Congressman, the smart move is for me to put three‑quarters of a million dollars into this production line, but I am not going to do it, and one of the reasons, not the only reason, but one of the reasons,” he said, “was Washington tells me I am rich, and I am not going to do it.”
You mentioned sort of the long‑term planning in terms of the pass‑throughs. You mentioned the generational aspect. Could you reflect on that, just be a little bit more expansive on it?
What is the impact when Washington tells Eby-Brown you are rich?
You know, Congressional Research Service a couple of weeks ago reported that nearly 60 percent of all business income is reported through the individual income tax system, and 62 percent of that amount is reported by those that the President calls wealthy.
Can you give us the lay of the land on how that has an impact at your end of the rainbow?
*Mr. Smetana. Sure. As I said, you know, we were a family owned company for, you know, decades, and we were not big at one time, but we became big, and the reason we became big is because the family was able to reinvest its after tax cash flows back into the business, with a little help from the banks from time to time to finance the business to grow.
So you know, the fact that we are big and the fact that the family has been able to commit to the business and grow its employee base, grow its asset base, grow economic activity, you know, is really the fundamental point about it. The fact that we are large should not really dictate whether the family can keep 40 cents or 60 cents of its profits. In fact, I would clearly tell you that if the family only got to keep 40 cents of its profits, we would be a smaller business than we are today with less employees, less assets, less economic activity.
I also think that fundamentally, as Mr. Kwall talked about, there is an important distinction between the double taxation regime over corporations which is mostly public formed corporation. An investor in a public corporation is really a trader of securities, and if the government wants to tax that trading activity as a separate economic activity, I suppose it can decide to do so.
But to try to equate that with the income derived out of a closely held business which is left in the business; closely held owners do not actively trade the business as a holder of a C corporation stock does, a publicly held C stock; so, therefore, I think you have to make that distinction in tax policy, and I think that distinction helps those privately and closely held investors make decisions to reinvest in their business.
Clearly, from our perspective as we look at our business planning, the most important things to us are the ability to retain as much cash as we can in the business on an after tax basis and the certainty which we have when looking out forward when we make decisions. And our investment decisions in business are not typically a quarter at a time or a year at a time, but multi‑year in nature.
It has been very difficult over the last several years to make those decisions, and I would submit to you that many investment decisions are not being made because the fear of the marginal rate increase, which has been delayed from time to time, but only at the last minute, which has really put a crimp in making good economic decisions for the long term.
*Mr. Roskam. This Committee and this Congress in the coming months are going to have decisions to make as it relates to the extension of the 2001 and the 2003 tax cuts and those rates. What is the impact on your business if those individual rates go up?
*Mr. Smetana. As I mentioned before, Mr. Roskam, we are facing an increase in our marginal rates of four or five percent. Certainly under the President’s proposal, if we lose AMT preferences, it could go higher, especially with sourced income from higher taxed States.
We have been able to take advantage of the faster depreciation rules over the last few years, and our owners have invested tens of millions of dollars back in the business because the after tax cash flows of those investment decisions have been aided.
So from our perspective it would reduce our after tax cash flows, and it would certainly make an impact on the kinds of investment decisions that we make going forward.
*Mr. Roskam. And the employee opportunities, I would assume?
*Mr. Smetana. Absolutely. We have been fortunate that we have been able to grow our business. We are in a relatively stable industry, and our business has been successful. We have been able to add jobs over the last several years and increase that economic activity accordingly.
*Mr. Roskam. Thank you for waving the Sixth District flag. I yield back.
*Chairman Camp. All right. Mr. Gerlach is recognized.
*Mr. Gerlach. Thank you, Mr. Chairman.
My question really is sort of a follow‑up to what Mr. Roskam just asked. If I heard correctly from the panel a number of minutes ago, there seemed to be some general consensus that in our tax reform efforts we ought to sort of try to align the maximum marginal rate for corporations and individuals and make that as consistent and comparable as possible so that you do not have an inappropriate shift of entities.
If that is the case, there seems to be a developing consensus in Congress and within the Administration that perhaps the maximum tax rate for corporations ought to be around 25 percent.
The House passed a budget last spring calling for a maximum rate of 25 percent. I think just looking out ahead, perhaps we will do the same again this spring. The President just put forward a corporate reform proposal which I think is a maximum rate of 28 percent with maybe on manufacturers of 25 percent, so clearly within the same ballpark of discussion.
So based upon that, if we can have all the panelists answer the question, would you agree then that the maximum individual rate of taxation under any tax reform proposal ought to be 25 percent?
And just start maybe with Mr. Sullivan. You are the closest, and then just work up the panel.
*Mr. Sullivan. Well, I think I am going to be the contrarian here. I think this line‑up of the rates, which my attorney and CPA friends obsess on, is the tail wagging the dog. We have larger considerations: deficit reduction and competitiveness. We need to lower our corporate rate. When we do that, we have to find revenue elsewhere.
One place that you may have to look is at raising taxes on individuals to make up that difference. We do not want to do it, but there are not many options.
*Mr. Nichols. I would go in the other direction. It is absolutely critical on a marginal basis that we have a low marginal rate, and I think we proved up until the Tax Reform Act of 1986 that if you have varying rates for varying types of income, that it is going to essentially cause tax lawyers and tax accountants to intermediate between those two rates to prevent the government from essentially getting the full benefits of the various differing rates that it wants to achieve.
The simpler the tax system you have the better. I would make one other important point, and this is virtually universal for the taxpayers that I represent. Their biggest fear is that there is going to be an attempt to essentially solve all of our fiscal problems and, frankly, many of the world’s problems, by essentially, quote, taxing the rich and they today worry about how much their marginal income tax rates are going to go up.
What you need to have is a system whereby everybody is paying taxes. Everybody is paying taxes maybe not at the same rate, but at similar rates, and everybody is benefitting from government so that essentially there is buy‑in both as far as revenue and also as far as expenses so that people are similarly motivated.
*Mr. Kwall. I do not really have a view as to what the rate should be, but if current law continues, it is clearly destabilizing to have a corporate rate that is significantly lower than the individual tax rate. We have been there before, and what happens is it puts a heavy burden on the government to preclude taxpayers from trying to shift income to corporations and to resurrect penalty taxes that require the business to justify its needs for its earnings. The Government has to find these cases and try to pursue them to avoid the tax avoidance.
Again, in my view the better solution is to keep closely held businesses out of the C corporation form. If you do that, then you have really got two separate systems, but if you are not going to do that, then I would agree that you want to maintain that parity.
*Mr. Tucker. I am an advocate of parity. I would also like to remind everyone that we also have an estate and gift tax. Whatever these people have earned and have left after taxes is going to be subject to an estate or gift tax, and you go back, unless the law is changed rather quickly for next year, to about a million dollar exemption and a 55 percent estate tax rate, and I think you need to take that into account as well for small businesses and small business owners.
They are not rich at that kind of level. They are simply not.
*Mr. Martin. Well, we have expressed several times that parity is important. I do not know what the rate should be either, but as close as it can possibly be I think is better for business planning, and let’s have some permanency, like the extenders that we deal with every year or every two years. Let’s do some things on a permanent basis so small businesses can plan.
*Mr. Smetana. I think you are in an unenviable position of having to try to correct a fiscal situation with only working at one side of the equation. As financial professionals, we can hardly ever turn around our companies and improve them if we are only dealing with revenue and not dealing with spending.
But to your point, I think the policy and goal of our Government should be to take the least amount of taxes from its people to sustain the Government for the spending that it feels it is required to do. So whether that is 25, 28, 15 percent, I think you have got to look at it on balance with the total expenditures of this Government and what we should be providing to our citizens.
*Mr. Gerlach. Thank you very much.
Thank you, Mr. Chairman.
*Chairman Camp. Mr. Buchanan is recognized.
*Mr. Buchanan. Thank you, Mr. Chairman.
I want to thank our witnesses today.
As a guy that has been in business 35 years and started in 1976, I remember my first entity was a C corporation, and then they came to me, the tax professionals, in the 1980s with an S corporation because it gave you the liability protection, and then they came to me and all of our entities lately have been LLCs because it gives you flexibility and distributions and all of the other things.
But I want to make one point that Mr. Smetana mentioned. Let’s just take a bank or a lot of times you have got a lot of people who are franchisors or they are dealers, and the factories or the banks require even if you made 500 and even if you want to take it out, you cannot take it out.
Now, many people believe that in the end they might make 500, and they have got 100 employees. That is a lot of exposure and risk, but they might take 100 out and leave 400 in, but many times my experience has been that people require you to keep the capital in. So it is almost like a C corporation.
Now, all of that being said, I hear up here that, you know, all we talk about, even the White House and the Administration talk about lowering the corporate income tax to 27 percent or, our thoughts here in terms of the corporate to be more competitive in the world 25, but again, I want to get back to the point. I do not know how you can lower the taxes for corporate entities without dealing with Sub S and LLCs because of their growth. Because people will go back and the tax professionals will come back in and tell you to be a C corporation.
So we have got all of this discussion about raising taxes, but all of these pass‑through entities are going to be tied to the tax rate. So you have got them going down to 25, and you have got the guy who is running the company going up to 39, many times in the same entities.
So I guess, Mr. Martin, I will start with you. Dealing with a lot of businesses, do you see under any circumstances where you could lower C corporations without really lowering it for small businesses and medium size businesses that are pass‑through entities?
*Mr. Martin. Well, I think the lowest C corporation rate, a huge company, multinational level, probably brings more taxable income back to this country because right now big companies do their planning to ship business overseas where tax rates are lower. So hopefully that increased revenue would somehow offset that.
What we need to keep in mind is the point that was made earlier. The typical pass‑through entity takes out their salary at a reasonable level; takes out of that pass‑through entity the amount of money they need to pay their taxes; and leaves the rest of it in there. Sometimes that is because creditors require it. Most of the time it is because that is the only way that growth is going to come about.
If you think about an accrual basis entity, you are required to use the accrual method. You cannot grow if you do not have cash because you have got to invest in receivables and inventory. One of the biggest problems small businesses have is growing too fast. If you grow too fast, you cannot find the increased receivables in inventory and you can go out of business.
*Mr. Buchanan. I have one thing to add to that. In today’s environment, in the last three or four years a lot of banks ‑‑ I am from Florida ‑‑ especially in Florida, but in other parts of the country, are not lending. So they have to leave the money in there.
Mr. Tucker, anything you want to add to that?
*Mr. Tucker. Two things. One is my clients are all small business people. They all leave money in the entity even though they are taxed on the money.
The second thing is a lot of them have debt that is being paid down, and when you pay down debt, because my clients do not like to be in debt, you get no deduction. So you are doing it with after tax dollars. To keep taxes for entrepreneurs up here and to have C corporations’ taxes down here without parity is truly inequitable.
*Mr. Buchanan. I want to add a second question. I know a lot of these guys that are in the top tax brackets. Most of them I know, most of them I have known for 30‑some years. They are usually the job providers in the community. So really what are we doing if we want to grow?
The talk up here is three things: jobs, jobs, and jobs. Well, who provides those jobs? Most of the folks that, you know, have 25 to 200 employees are these pass‑through entities. So if we are going to have them pay more in taxes, all we are going to do, in my opinion, is hurt more jobs.
Mr. Kwall, do you have any thought on that? Yes, go ahead.
*Mr. Kwall. In evaluating the consequences of creating a system where the corporate rate is lower than the individual rate, you really have to take account of in terms of estimating revenue, the potential fleeing from pass‑through entities in that situation. In 1986 what ended up happening is everybody fled from the corporate tax when individual rates came down and heavier burdens were put on the corporate tax. So that has just got to be done.
*Mr. Buchanan. Mr. Nichols, anything?
*Mr. Nichols. Just a quick point, and that is there is a temptation, of course, to not essentially tax everybody all at the same rate. If you are going to raise rates, raise rates on some and not necessarily on others, but frankly, that is what got us into the hodge‑podge that we have got in the tax code now. I think it is much better to take the courageous approach and essentially face the revenue needs we have and get a system that works over the long term.
*Mr. Buchanan. Thank you, Mr. Chairman. I yield back.
*Chairman Camp. Mr. McDermott is recognized.
*Mr. McDermott. Thank you, Mr. Chairman.
I could not help it. I was watching this down in my office, and I came up because I wanted to ask a question. I felt like Russell Long had come out. I was looking around for his picture, but I think he is over in the Senate. His theory of taxation, as you know, was do not tax you; do not tax me; tax that guy behind the tree.
And I have a feeling that we are sitting here talking about where the guy behind the tree is. Then I thought about the fact that former Ways and Means member, who must have learned something on this Committee; I mean, I cannot assume that he sat here and did not learn a thing, Mr. Cantor, presented an interesting tax proposal that he hopes to jumpstart the economy. He says the provision would provide a 20 percent reduction on small business income.
But then I read what is going on in the press, and the Small Business Association and the independent business people, they are not throwing their arms around this proposal and saying it is a good idea.
So tell me about Mr. Cantor’s proposal. Why is the small business community not just in here beating down our doors to have that happen?
Anybody can answer that.
*Mr. Sullivan. Well, I do not have any idea why because it seems like a proposal which would be highly beneficial to them.
*Mr. McDermott. Does anybody else have anything? Why are the small business organizations not endorsing this?
*Mr. Martin. I think primarily because of ‑‑ nobody has told me this ‑‑ but added complexity in the tax law and how you define what that number is going to be that they get to deduct. I just do not know how that number is calculated. I have not even seen the proposed legislation. So I do not know what he is putting through.
*Mr. McDermott. You took the words out of the mouth of Chris Waters. He said, “Just for our members, the top two important issues are keeping the marginal rates low and reducing the complexity.” That is NFIB, right?
And what you are saying is the Majority Leader of the House has introduced a bill that is making people more anxious because it introduces more complexity. That is his solution to this problem it sounds to me like.
I mean, I was here under Clinton when we set the Clinton rates. Okay? I was here in 1993 when we did that vote, 1994, and the country was booming, and so now everybody says we have got to reduce the rate somehow because that is the only way we can get the country going again, and what I hear also is from Mr. Buchanan and others, the banks are not lending.
I mean, let’s talk about what the real problem here is. Small business people’s problem is the banks will not lend to them unless they have got ‑‑ I just tried to get my loan refinanced on my house because I thought a 3.9 percent interest rate was pretty interesting. They wanted to have my pay stubs for the last three months, and they wanted to have proof that I had ‑‑ you know, I can see why a small businessman would go crazy dealing with this, and I do not understand why the Minority Leader would put one out to make it more complex.
I mean, what would be the purpose of that? Has anybody got an answer?
*Mr. McDermott. I yield back the balance of my time.
*Chairman Camp. All right. Mr. Smith is recognized for five minutes.
*Mr. Smith. Thank you, Mr. Chairman.
Certainly I can appreciate this discussion about the complexity of the tax code and adding new preferences in the tax code. The last I checked, there has been more than one bill introduced or suggestions for our tax code that would add more complexity, which certainly does concern me.
But in a broad sense, I mean, we talk about confusion and frustration and instability of the tax code, but for the CPAs here on the panel, how often do you encounter someone, aside from the instability and the short‑term nature of a lot of these tax policies; how often do you encounter a client who would say, “Gosh, in going back I wish I could go back and redo some planning perhaps”? But how many of them think retroactively and then would apply that moving forward?
*Mr. Tucker. I am not a CPA, but I can tell you that in my practice my clients both look back and look forward. The problem with looking forward is you cannot assure the client of any stability looking forward. It is not just complexity. It is stability, and they do not understand what is going to happen next year, for example, extenders, non‑extenders, tax rates, and everything else.
So they look back and they say, “If I had done this at that time, I could have saved taxes. I could have done something different. I could have paid less taxes in the long run.”
It is a balancing act, and very often my clients, being entrepreneurs, are, frankly, upset with planning we did before because the law changed, and they did not know it was going to change and we did not know it was going to change. So I think stability has to be part of focusing on complexity. You need to provide stability for the people in this country and the entities in this country.
*Mr. Smith. Okay. Anyone else? Mr. Martin.
*Mr. Martin. I would say that my client base does not look back. It is not profitable to look back. You cannot change things that have already happened. If they ask me about some advice that I gave them before, it is always on the basis of what we knew at the time.
It is a struggle enough to get my clients to look forward far enough to make huge business decisions that will affect them in the long run. They are operating today. Do not look back. It is fruitless to look back.
*Mr. Smith. Mr. Smetana.
*Mr. Smetana. I would concur. We are forward looking. You need to be in your business. I would say that over the last several years we have tried to make behavior by the tax policies we have instituted particularly around depreciable lives and fast expensing, and I think what we run the risk of is similar to a shopper in a retail store. They keep looking for the sale. So they defer their purchases until that sale occurs, and I have a feeling that we continue down this path of just short‑term policy fixes and short‑term incentives to try to change behavior and what we are really deferring are the kind of long‑term investments that are necessary for business to thrive and survive and grow.
*Mr. Smith. Okay. Mr. Nichols.
*Mr. Nichols. And I would certainly concur in everything that was said on the subject before. I would add one other thing, and that is clients, good clients that are running successful business, do not want to do tax planning. They would be very comfortable and would be delighted to have a stable system and, frankly, they want to work on that next sale. They want to get sales to go up. They want to figure out that new technique that is going to reduce cost. That is what they want to focus on, and they resist the idea of, frankly, paying people like us and others because of the complexity or the uncertainty of where things are going to be.
They want to do their business, and if we could just let them do that, we would all benefit.
*Mr. Smith. Now, I guess in light of this topic though, you know, we know that the tax code has so many tax preferences, hundreds, many of which are temporary in nature, and there are more proposed as we have heard several times this season. Obviously, the beauty of a tax preference is always going to be in the eyes of the beholder, aside from the rate, but perhaps a rate can impact that a little bit.
How high of a priority should reducing preferences in the tax code be as we tackle tax reform? Mr. Sullivan.
*Mr. Sullivan. Thank you.
Well, it should be an extremely high priority. It simplifies the tax code, and it will allow much lower rates, make the system fairer and promote economic growth. As you say, the benefit is in the eyes of the beholder. The hard part is the politics. The economics are very simple.
*Mr. Smith. Mr. Kwall.
*Mr. Kwall. The most stable tax would be a low rate, broad based tax. So to the extent that preferences can be reduced and rates can be brought down, that approach is the ideal.
*Mr. Smith. Perhaps we should resist adding further preferences in our tax code.
*Mr. Kwall. Definitely.
*Mr. Smith. Okay, and Mr. ‑‑
*Chairman Camp. I think we are out of time.
*Mr. Smith. Thank you.
*Chairman Camp. Ms. Jenkins is recognized.
*Ms. Jenkins. Thank you, Mr. Chairman, and thank the panel for being here today. This has been very interesting.
Mr. Kwall, your testimony calls for requiring all complex businesses, those with one or more class of stock to be taxed at the entity level potentially, stating this would eliminate their ability to pass losses through to their shareholders. This would limit the ability of start‑up businesses to raise capital.
I am concerned that this rule that only the simplest of businesses be allowed to pass their income and losses through to their owners would make it harder for start‑up businesses to raise capital since they can only pass the losses they incur in the early years through to their investors if they have the simplest of capital structures.
So, Mr. Kwall, I guess for you might be: do you share this concern and could your proposal be modified to allow real economic losses to be used currently by those start‑ups that are in a loss position in their early years?
And then I would be interested if anyone else would like to comment.
*Mr. Kwall. Thank you, Congresswoman Jenkins.
That is actually a very good question. When I talk about simple enterprises my assumption is that system really govern the majority of closely held enterprises. In other words, a simple enterprise basically would mean that they are not going to have preferences with respect to distributions or economic preferences with respect to issuing different types of stock or membership interests so that some interests would be preferred and others would not be.
So first of all, hopefully the bulk of new enterprises would fit under that simple regime and losses would pass through.
*Ms. Jenkins. Okay.
*Mr. Kwall. To the extent that a more complicated ownership structure was used under my system, it is true the losses would not pass through, but that is a default regime. I guess that is a cost of choosing a more complicated economic arrangement.
So the real question would be how necessary a more complex arrangement would be to a business that thought it was in that situation.
But it is clearly something that needs to be thought through. I agree with you completely.
*Ms. Jenkins. Okay. Thank you.
*Mr. Tucker. I really disagree. I think the concept of two classes of ownership creating a complex business rather than a simple business is not focusing on the entrepreneur. Most of my entrepreneurial clients are very concerned about capital formation and capital access, about protecting their personal assets from the business risk, and business succession.
All of that goes to two classes of something. I would rather bring in equity than debt because I will have somebody who will have a share of the ownership, but will not have an obligation on my part to pay them. With business succession, I may have family members who are going to run the business, and they would have a voting class of stock, and I might have people who are going to be in the business and have a non‑voting class. I think the great bulk of my entrepreneurial clients would be caught under the definition of “complexity,” not “simplicity,” and I think we need to move away from that. We need to have pass‑through entities.
*Ms. Jenkins. Okay. Sure.
*Mr. Kwall. One point of clarification. A simple enterprise could have voting and non‑voting stock. It cannot have different kinds of economic interests, but you could have stock that was voting and stock that was non‑voting.
*Ms. Jenkins. Okay. That helps.
*Mr. Nichols. I would second Mr. Tucker’s comments, but I guess I would have a more fundamental comment, and that is I think we are clearly in a situation where we need to have rate parity. I think everybody agrees on that, and so as a consequence, that is something that we should not avoid by doing this and we should not try to avoid it by doing this.
The other principle I would apply here is “if it is not broke, don’t fix it.” At the end of the day I am not quite sure there is something that would be so bad policy‑wise or even at all bad policy‑wise, frankly, that would cause us to disrupt what people are doing today in order to get to something that might theoretically be better on the basis of theory I am not sure how much policy consideration is behind it.
*Ms. Jenkins. Okay. Mr. Sullivan, I know you made note of this in a recent Tax Notes article. Do you have any thoughts on this?
*Mr. Sullivan. Well, I think the details need to be worked out, but the theme keeps coming up over and over again. If you are starting up a business, all you want to do is your business. These entity choices are way too complex, and Professor Kwall is offering an easy alternative for a start‑up business that does not want to be concerned about taxes.
*Ms. Jenkins. Okay. Thank you.
Thank you, Mr. Chairman. I yield back.
*Chairman Camp. Thank you.
Mr. Paulsen is recognized.
*Mr. Paulsen. Thank you, Mr. Chairman.
I just want to raise a couple of points because it seems like there is pretty much unanimous agreement that parity is important in terms of comprehensive approach to tax reform for both large and small businesses. You know, we are not going to pass one bill that is going to address one side of it and then you can count on us passing another bill that is going to catch up with it, right? That is just not going to happen.
We talked a little bit about family ownership, but we have not talked much about employee ownership, and I just think it is important, too, that we make sure that employee ownership is also remembered as a key component of existing tax law, and I think it is important that we keep employee ownership actually in mind as we move forward through larger comprehensive tax reform because there are huge benefits to employee owned companies.
And I know that there are some of my colleagues that go back to 1994 when the rates were raised. You know, this is 18, 20 years ago. The world has changed. It is a lot more competitive. It is a lot flatter. Small businesses, in particular, have to compete on a global scale that they have never had to compete on before as well.
But let me ask you this question. I will start with Mr. Nichols. Can you highlight some of the restrictions on S corporations? And could we consider updating some of those restrictions?
It was mentioned, I think, a little bit earlier about the importance of a five‑year built in gains period, for instance, but are there any other proposals that could be considered outside of the context of larger comprehensive tax reform, such as the limits on the types of shareholders allowed for an S corporation to help open up opportunities for any businesses that are, for instance, trapped in that C corporation area?
*Mr. Nichols. There are a number of things that could be done, and I think they could be done without dramatic, perhaps not even significant, losses of revenue. A lot of the restrictions on S corporation status, such as on the nature of shareholders and actually even the types of entities that can elect S corporation status and various other things, have been in the code for some time, but they are not really need to be policy-based and do not need to be retained.
Let me give you an example. Nonresident aliens were excluded because, when it was originally enacted, people were worried that the nonresident aliens would not pay tax. So were partnerships and corporations and various other ineligible entities.
What we have done or what Congress has done for several of those is it has essentially said, okay, we are going to let a certain type of trust, an electing small business trust, or we are going to let certain tax exempt organizations, we are going to let you be a shareholder, but in return for that what we are going to do is we are going to tax you effectively at the top rate.
So is the same is done for these other restrictions, the Government gets its revenue, but essentially the corporation is enabled to have a partnership as a shareholder or a nonresident alien as a shareholder. I am not quite sure there is any loser in that transaction. It just essentially gives more flexibility to closely held business, and I do not think it would lose a lot of revenue.
*Mr. Paulsen. Okay. Mr. Tucker.
*Mr. Tucker. What I teach my students is that there are five things you could do to reconcile S corporations with partnerships within the S corporation regime. Number one, you could take out any limit on the number of shareholders.
Number two, you could let anybody be a shareholder, including not just the nonresident alien, but a partnership or a C corporation or an S corporation could be a shareholder.
Number three is you could reconcile inside basis and outside basis. Right now in a partnership, partners share inside basis for debt, but in an S corporation you only get basis if you put money in or lend money to the S corporation.
Number four, we have something in the partnership regime which says if you die and get a step up in basis on your partnership interest, there is an election to reconcile inside basis with outside basis, and we could do that for the S corporation as well.
And finally, we could allow any kind of stockholder, preferred, non‑preferred or anything, without having an issue if you wanted to do it. My proposal would be, fine, let’s eliminate S corporations and let them use the partnership regime, which would be the simpler way of doing it.
*Mr. Paulsen. Mr. Martin, let me just ask this before time runs out. You represent a large stakeholder group from a small business perspective. How much time do your members spend navigating the tax code?
I mean, you know, what is the best story, the best anecdote that really just paints the best picture of why this is so critical to address?
*Mr. Martin. They do not spend a lot of time because they call me on the phone.
*Mr. Martin. And, yes, I bill them for it, but what is stressful to them is the changing tax laws. I get numerous calls in November every year about Section 179. What is it this year? Is it likely to change before December 31, because they are thinking about capital investments now for things that they need to operate their business? Should they do them now or do them in the next six months? That is a huge issue for them, is just the stability.
My clients wrestle with payroll taxes like crazy because it is an abomination of the Small Business Administration. It is a huge cost to administering payroll taxes, but not the income tax law.
*Mr. Paulsen. Thank you, Mr. Chairman. I yield back.
*Mr. Herger. [Presiding] Mrs. Black is recognized.
*Mrs. Black. Thank you, Mr. Chairman.
There I think has been a really great discussion here and a lot of good questions that were asked. When you come down to the end of us last members all of the questions have just about been asked, but I want to follow up on what my colleague was just saying about how much time this takes, and, Mr. Martin, you said the timing is not really the biggest issue with the employer. It is more just the stress.
Obviously, we have talked a lot about complexity and the fairness and the uncertainty, but I do want to go to what is the actual cost. Can you determine the actual cost of this kind of complexity and what these businesses need to go through with the complication of the tax code?
Can you give me an idea of what this actually costs the business, a percentage of what it might cost them?
Is there a way to be able to evaluate that?
We can just go right down the line, whoever would like to answer that question.
*Mr. Smetana. I can just speak for our situation. So we are family owned. We have two shareholders, brothers, that own the company. We operate in seven states. We are U.S. domestic only. So we are not as complex as most larger businesses, but we spend hundreds of thousands of dollars a year on federal and State tax compliance. We do it both with internal staff people and as well as hiring experts from tax accounting firms to help us deal with all of the complexities.
In addition, there is a cost to compliance and recordkeeping by deploying sophisticated accounting systems, particularly those that have to track three or four different types of depreciation, records given the various regimes that are out there.
So in our case it is a big dollar, and that is money coming out of the business in reinvestment. My colleagues at FEI have similar experiences.
*Mrs. Black. And let me just follow up on that for just a second. Then I do want to hear from the rest of you, but just to draw to that conclusion, I think, down the line, would you be able to hire more people and expand your business?
Then ultimately I think at the end of the day what we have to consider on all of this is that the cost to the consumer of the product on the other end, and as we talk about this, I think so many times that is forgotten, that the cost of whatever the service of that product is is increased, and it is really harder for those at the lower income because the end result really impacts those at the very lowest income in purchasing that good or that service.
So would you say if you did not have this kind of complexity you could make things a little easier and you could use those dollars to grow your business and, therefore, grow jobs?
*Mr. Smetana. Absolutely. As we said, the key to business economic growth is after tax cash flows, and whether you spend it on income taxes directly or on the cost of preparing those taxes, it reduces the amount of money you have to sustain the business.
*Mrs. Black. Others? Mr. Martin.
*Mr. Martin. It is difficult for me to estimate what it would cost, but there are a couple of provisions. One I mentioned, the health care credit. It is crazy for me to have to spend the time that I do because the law is so complex I cannot figure out whether I need a benefit without spending the time.
The domestic production activity deduction is another one that the guidelines that we follow are extremely loose. Again, I feel like it is malpractice if I do not get my client the $300 deduction they should be entitled to. So I have to go through the calculations for it, incredibly complex, all of the job credits that are out there. I do not have any small business clients that hire people because they are going to get a job credit. They hire someone because they need someone to help run the business.
*Mrs. Black. Thank you. Thank you.
Others? Mr. Tucker.
*Mr. Tucker. I think there are two costs. One is the cost of planning, which takes both financial resources and human capital, which is often not measured, but two is for the clients who do not come in advance on planning. The cost of some foot fault is even much more expensive, and I think they do not realize that a lot of times until the foot fault occurs. And we need simplicity.
*Mrs. Black. Mr. Nichols.
*Mr. Nichols. I had really only two points. I know there is limited time, but, number one, in terms of complexity, there is no question on several of the things that have been raised. The items that actually on an ongoing basis affect how closely held business calculate their taxes and things like that, there is no question that that complexity could be improved upon, and in particular, it would be best in terms of tax reform to resist the temptation to micromanage and to have more global rules that are essentially applicable and rely on the economy to weed things out rather than to micromanage.
The only other thing that I would say with respect to complexity is we have talked about choice of entity and forcing people, let’s say, to a single pass‑through regime. I am not as worried about complexity there because essentially once a business has elected a particular pass‑through regime,that is its entity. It has got its entity, and you are actually adding to their complexity if you force them into a new entity.
There is complexity, but it is complexity for the law students. It is complexity for the tax advisors, but you are not helping closely held business if you force a disruption on their tax planning.
*Mrs. Black. Thank you.
And I think I am out of time, and I yield back. Thank you.
*Mr. Herger. Mr. Berg is recognized.
*Mr. Berg. Thank you, Mr. Chairman.
I really appreciate the panel being here. I started a small business from the ground up, and we worked our way through a lot of these things. The comments that we have heard today are really right on.
You have a small start‑up business. I mean, you do not have an accountant full time. You do not have an attorney that is looking at the regulations, looking at the rules, and quite frankly, a lot of the decisions on what type of organization you are going to be as a tax entity kind of are made at the last minute with some advice.
And talking about those people who went through a C corporation and for tax reasons cannot get out of it and have struggled and every year the tax liability gets more and more severe, you know, as I approach tax policy for business, my goal is to say that people will make business decisions based on business principles. And very secondarily or third they would say, “What are the tax implications?”
Instead I think we have reversed that where people are saying, “Before we make this business decision, what are the tax implications?” So it is almost backwards in terms of if you want to build a better mousetrap, beat the competition to do these things. There are all kinds of barriers within the tax code.
The least amount or I should not say the least, but one of the biggest is the uncertainty in the tax code. I mean, who knows what is going to be our tax come January 1 of 2013? You know, no one.
So I do not know where we are going or where I am going with my questioning, but there is a lot of frustration I have. I think probably the first thing would be to, you know, really look at the President’s budget and what kind of an impact that is going to have on business. Probably specifically is where we have a corporate rate that is lowered and a personal rate that is increased.
I would just like the panel to respond to how do you see that impacting the small business that we are talking about.
*Mr. Smetana. Sure. As I mentioned earlier in my statements, we analyzed the President’s and the Treasury’s proposal, and the impact of not bifurcating, you know, business source income out of closely held from the individual regime would cost our company literally millions of dollars both in terms of the loss of certain of the current tax preferences around capital and inventory investment as well as the material increase in the marginal rates that our businesses would pay in taxes in the pass‑through regime.
So it would certainly have a dampening effect with respect to the economic activity that we could plan going forward by having less capital with which to work.
*Mr. Martin. We are talking about less job creation. We cannot afford it.
*Mr. Tucker. We are talking about more complex here. We are going to go back to the personal holding company, accumulated earnings tax, and all the other things that are done to offset this, and it is just the wrong direction to go, sir.
*Mr. Kwall. I would start with an ideal income tax that would tax income to the owners at the owner’s marginal rate. So whenever you are trying to duplicate like that, it is just really inconsistent with the ideal.
*Mr. Nichols. To a great extent I am going to reiterate. When you stray from rate parity and the single-tax rate, corporate owners will respond to the incentives. They may not like them, but they will respond to the incentives, and at the end of the day if the next change incentivizes it, either as a result of complexity or otherwise, they will move to C corporation or other status just on a temporary basis. Then there is a lot of lawyer work to get them out, and if the tax rates are too high or they are different for other people, they will respond. They will adjust, and the people that will be hurt, I think, are the new entrants into the labor market or the newly unemployed, who are the last people that at the end of the day businesses would be hiring if things went well.
*Mr. Sullivan. Well, I am going to be the contrarian again. Again, that is the tail wagging the dog. We need a competitive tax system. We need to raise revenue. We have to lower our corporate taxes because those larger corporations are internationally competitive.
If there is not enough revenue, you may have to consider raising taxes on individuals. These rules are anti‑abuse rules. If businesses are not pushing the envelope, they do not have to deal with these anti‑abuse rules. There is no reason for a new business to seek C corporation status. So I have no sympathy for a corporation that goes in that direction.
*Mr. Berg. Clearly, in my mind if there is a 40 percent tax rate and a 28 percent tax rate, people are going to go to the 28 percent tax rate, which from my perspective, the way I started this is exactly opposite to what we want people to be doing.
I mean, I think if we want to raise revenue, we have got to grow jobs, period. And that is my concern with the President’s proposal on taxes. It creates more uncertainty, and it is not growing jobs.
I have got one more question.
*Chairman Camp. [Presiding] Well, your time has expired, and we have got one more person.
I would just say that lowering rates is not the same as lowering taxes. There is a difference there, and so you do not necessarily have to go somewhere else in the economy to raise taxes.
Mr. Reed is recognized for five minutes.
*Mr. Reed. Thank you, Mr. Chairman, and I am the last one. So that always brings a smile to the panel’s face whenever I get to ask the questions.
*Mr. Reed. Going last here, I will say I echo the sentiments of my colleagues, and also being one of the colleagues that started a small business like myself, and we talked a lot about the time pressures, obligations of starting a business and then having to deal with these issues. I can vividly remember in the beginning when my CPA called me and asked me to get a document, and it took me two days to find the document. I was so frustrated, and he actually did not need the document at the end of the time. So I was almost firing him on the spot, but you know, the bottom line is I have been there, and small business owners across America are frustrated with this tax code, and I am so glad to be part of an effort to try to reform it, and we will do our part on that.
What I am hearing is a general theme from each and every one of you that we should be focusing on the certainty and the stability in the code, looking at the rates to make them competitive, and combining the individual and corporate rate.
One thing that I do not know if we spent enough time on and I am interested in exploring and going down further is does anyone feel that the underlying business activity of the taxpayer, is that something that should be taken into consideration when we are setting tax policy.
And the reason I bring that up is as a new member down here in Washington, D.C., I hear a lot of politicians talk about bad guys, oil and gas industry, and there are provisions in the code that treat folks differently just because of the business activity upon which they are engaged when it comes to their tax burden.
Can anyone tell me is that something that is good policy to advance as we go through comprehensive tax reform, or is my gut telling me the right thing and that we should avoid looking at business activity as a reason why tax policy should be set?
Mr. Tucker, please.
*Mr. Tucker. Are we not really trying to look at the ability to create jobs? Do service businesses noted create jobs just as manufacturing businesses create jobs, just as real estate creates jobs?
If that is what we are looking at, I think the type of activity is totally irrelevant. Our objective should be to create jobs, be able to collect tax from the people who are earning money and go forward.
*Mr. Reed. I appreciate that. Anyone else? Mr. Nichols.
*Mr. Nichols. Well, I would say, and corresponding to and following up on that and certainly not disagreeing with it, and that is the trick, you need to be careful, but the trick is to treat all businesses, I think, comparably. Obviously they differ, but at the end of the day, there are certain fundamental principles.
If you follow the cash, people are making money. Then that is a good time and an appropriate measure of whether or not taxation is appropriate. Now, I realize that is an oversimplification, but in general, you should not favor, you know, insurance company taxation versus oil and gas taxation versus manufacturing.
I represent some of those. I do not represent all of them. Essentially the goal should be not favoring one industry over another, not picking winners and losers, and not micromanaging. The more simple, straightforward, then the economy, the capitalistic system, will figure out who is going to invest in what industry based on actual profits rather than tax considerations.
*Mr. Reed. I appreciate it.
*Mr. Sullivan. Well, I know you have been lobbied, and when I was on staff, I was lobbied, and every lobbyist comes in and tells you, “How can you raise my taxes when I am creating jobs?” And everybody says that. It is jobs, jobs, jobs.
We have to have the discipline to understand that when we help one person, we are taking something away from another, and that is just the balance sheet. It is just the math, and what we want to do is not provide anybody with special privileges because in the long run what you do not see is most job creation will be created by not giving that lobbyist the special tax break.
*Mr. Reed. I appreciate that.
With that I will yield back, Mr. Chairman. I have got a couple of seconds left and I will let you enjoy them.
*Chairman Camp. All right. Well, thank you.
And I want to thank all of our witnesses. This was an excellent hearing.
I appreciate your time and your testimony today.
And with that, this hearing is now adjourned.