S corps prepare for tax-reform fight

A House Ways and Means subcommittee hearing last Thursday has momentarily allayed some fears in the investment adviser community, and the small-business world in general, that the Obama administration's plans for corporate tax reform could be disastrous for them. Treasury Secretary Timothy Geithner dropped a bombshell at a Senate Finance Committee hearing last month when he suggested that the government reconsider the tax rules that allow businesses to be taxed as partnerships, S corporations, limited liability corporations or other so-called pass-through entities. With these structures, which are commonly used by investment advisers, income from the business flows through to the entity's owners and is reported on their individual tax returns. “Congress has to revisit this basic question about whether it makes sense for us as a country to allow certain businesses to choose whether they're treated as corporations for tax purposes or not,” Mr. Geithner said during his oral testimony. His comments were originally reported by Bloomberg. Not surprisingly, tax experts were aghast at the proposition. “S corporations have been around for 50 years,” said Neal Weber, managing director in charge of RSM McGladrey Inc.'s Washington national tax office. “This would create havoc in tax planning for businesses.” The number of advisory firms with a limited-liability structure has grown dramatically over the past 10 years, according to David Tittsworth, executive director of the Investment Adviser Association. It would be chaotic for financial advisers were the option suddenly disallowed, he said. “Anything to do with corporate tax reform is a big deal for our membership,” Mr. Tittsworth said. “The details of it will be incredibly important.”

AVOIDING DOUBLE TAXATION

The Ways and Means Subcommittee on Select Revenue Measures, headed by Rep. Pat Tiberi, R-Ohio, doesn't seem inclined to throw out the concept of pass-through business entities. “It was encouraging,” Mr. Weber said. “The congressmen were asking witnesses for insights on how tax reform could benefit both C and S corporations. They expressed concern about reform hurting pass-through entities.” According to Robert Carroll, a principal at accounting firm Ernst & Young LP, who testified before the subcommittee, 90% of all business entities in the United States now use a pass-through structure. They employ 50% of the national work force and pay 43% of all business taxes collected by the federal government. The original reason for such a structure was to avoid the double taxation — on income and on dividend distributions — that C corporations face. This double taxation has serious effects on the economy. “It creates a tax bias toward debt financing, with the result that companies can become overleveraged,” Mr. Carroll said. “It also raises the cost of capital for businesses, and results in misallocation of capital throughout the economy.” The pass-through structures were created in large part to address these harmful economic effects, observers said. “If they want corporate-tax reform, the government should move the C [corporations] to the pass-through model, not the other way around,” said Brian Reardon, executive director of the S Corporation Association, which is devoted to promoting the interests of S corporations. It is a very long shot that pass-through entities will be legislated out of existence. However, they could still get hammered by tax reform efforts. The administration has indicated that it wants to tackle corporate-tax reform on its own rather than as part of a comprehensive effort that includes individual taxes. To date, very few details have been offered about what such an initiative would look like. The administration has made clear, however, that any reform effort will have to be revenue-neutral. If the administration sticks to this idea, pass-through entities will almost certainly suffer. The basic idea around revenue-neutral reform is to broaden the tax base and reduce the 35% corporate-tax rate — one of the highest among developed economies. That would be accomplished by eliminating so-called tax expenditures, or loopholes, that reduce taxable income. These include items such as accelerated depreciation allow-ances, LIFO inventory rules, Section 199 deductions for “qualified business activities,” charitable contributions, and a wide variety of incentives and disincentives in the tax code. The government hopes to bring corporate rates down to between 23% and 29%. It is far from certain, however, that the closing of loopholes can entirely finance that kind of rate reduction. Either way, S corporations and pass-through businesses would be hurt in this scenario. The top individual tax rate and the corporate tax rate are both 35%. Although C corporations would lose a good chunk of their deductions and credits, they would be taxed at the lower rate. Pass-throughs, on the other hand, would get slammed on both sides. Their taxable income would go up with the closing of loopholes, and the rates on the highest individual income brackets are set to rise to 39.6%, starting in 2013. Without some form of relief for pass-throughs — and that includes most investment advisers — they will be shouldering a significantly bigger share of the tax burden. One idea being considered, Mr. Weber said, is to enact a tax credit for owners of pass-through businesses to keep them from getting hit by the higher rates and lower deductions. That, of course, is against the spirit of reform that is motivating the debate. Small-business advocates, however, say that they have to be considered. “If the government takes a corporate-tax-reform-only approach, the effective tax rates on S corps [and all pass-through entities] will go way up,” said Mr. Reardon, whose organization plans to ramp up its lobbying efforts this year. “They have to look at both corporate and individual taxes; they can't bifurcate the two.” E-mail Andrew Osterland at aosterland@investmentnews.com.