[House Hearing, 109 Congress] [From the U.S. Government Publishing Office] S CORPORATIONS-THEIR HISTORY AND CHALLENGES ======================================================================= HEARING before the SUBCOMMITTEE ON REGULATORY REFORM AND OVERSIGHT of the COMMITTEE ON SMALL BUSINESS HOUSE OF REPRESENTATIVES ONE HUNDRED NINTH CONGRESS SECOND SESSION __________ WASHINGTON, DC, JUNE 27, 2006 __________ Serial No. 109-57 __________ Printed for the use of the Committee on Small Business Available via the World Wide Web: http://www.access.gpo.gov/congress/ house _____ U.S. GOVERNMENT PRINTING OFFICE 30-281 PDF WASHINGTON : 2006 _________________________________________________________________ For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001 COMMITTEE ON SMALL BUSINESS DONALD A. MANZULLO, Illinois, Chairman ROSCOE BARTLETT, Maryland, Vice NYDIA VELAZQUEZ, New York Chairman JUANITA MILLENDER-McDONALD, SUE KELLY, New York California STEVE CHABOT, Ohio TOM UDALL, New Mexico SAM GRAVES, Missouri DANIEL LIPINSKI, Illinois TODD AKIN, Missouri ENI FALEOMAVAEGA, American Samoa BILL SHUSTER, Pennsylvania DONNA CHRISTENSEN, Virgin Islands MARILYN MUSGRAVE, Colorado DANNY DAVIS, Illinois JEB BRADLEY, New Hampshire ED CASE, Hawaii STEVE KING, Iowa MADELEINE BORDALLO, Guam THADDEUS McCOTTER, Michigan RAUL GRIJALVA, Arizona RIC KELLER, Florida MICHAEL MICHAUD, Maine TED POE, Texas LINDA SANCHEZ, California MICHAEL SODREL, Indiana JOHN BARROW, Georgia JEFF FORTENBERRY, Nebraska MELISSA BEAN, Illinois MICHAEL FITZPATRICK, Pennsylvania GWEN MOORE, Wisconsin LYNN WESTMORELAND, Georgia LOUIE GOHMERT, Texas J. Matthew Szymanski, Chief of Staff Phil Eskeland, Deputy Chief of Staff/Policy Director Michael Day, Minority Staff Director SUBCOMMITTEE ON REGULATORY REFORM AND OVERSIGHT W. TODD AKIN, Missouri Chairman MADELEINE BORDALLO, Guam MICHAEL SODREL, Indiana ENI F. H. FALEOMAVAEGA, American LYNN WESTMORELAND, Georgia Samoa LOUIE GOHMERT, Texas DONNA CHRISTENSEN, Virgin Islands SUE KELLY, New York ED CASE, Hawaii STEVE KING, Iowa LINDA SANCHEZ, California TED POE, Texas GWEN MOORE, Wisconsin Christopher Szymanski, Professional Staff (ii) ? C O N T E N T S ---------- Witnesses Page Sullivan, The Honorable Thomas M., Chief Counsel for Advocacy, U.S. Small Business Administration............................. 3 Alexander, The Honorable Donald C., Partner, Akin, Gump, Strauss, Howard & Feld.................................................. 5 Redpath, Mr. James, CPA, Partner, HLB Tautges Redpath, LTD....... 6 Porcaro, Mr. Gregory, CPA, American Institute of Certified Public Accountants.................................................... 8 Appendix Opening statements: Akin, Hon. W. Todd........................................... 21 Bordallo, Hon. Madeleine..................................... 22 Prepared statements: Sullivan, The Honorable Thomas M., Chief Counsel for Advocacy, U.S. Small Business Administration............... 23 Alexander, The Honorable Donald C., Partner, Akin, Gump, Strauss, Howard & Feld..................................... 30 Redpath, Mr. James, CPA, Partner, HLB Tautges Redpath, LTD... 36 Porcaro, Mr. Gregory, CPA, American Institute of Certified Public Accountants......................................... 40 Additional material: Roderick, Mr. Richard M., Senior VP and CFO, Dead River Company.................................................... 53 Employee-Owned S Corporations of America (ESCA).............. 57 (iii) S CORPORATIONS-THEIR HISTORY AND CHALLENGES ---------- TUESDAY, JUNE 27, 2006 House of Representatives Subcommittee on Regulatory Reform and Oversight Committee on Small Business Washington, DC The Subcommittee met, pursuant to call, at 10:00 a.m., in Room 2360 Rayburn House Office Building, Hon. W. Todd Akin [Chairman of the Subcommittee] presiding. Present: Representatives Akin, Kelly, Bordallo. Chairman Akin. The Committee will come to order. I'd like to open by saying good morning to everyone and welcome to the hearing entitled ``S Corporations--Their History and Challenges.'' And, obviously, providence is smiling on those of you who could make it through the rain clouds. I think we have one out of five witnesses that can't join us today because of the weather. This is about the history and challenges of these S Corporations, which was a bit of a new subject to me. So I think it may be of interest to others here as well. And I want to just thank you. I know that we have some really, really competent people that are going to be testifying. I want to thank you all for coming. We are here to take a look at this, the important business structure that has helped to foster an entrepreneurial environment since the late 1950's. Prior to the development of this corporate structure, entrepreneurs had two options in creating a business entity. They could form a partnership, which would allow for a single layer of tax on profits, but expose the entrepreneur to higher levels of risk. Or, they could form a C corporation, which would shield the entrepreneur from risk, but create a double layer of tax on profits. Neither business structure adequately addressed the needs of entrepreneurs and so in 1958 Congress and President Eisenhower acted to create the S corporation. The S corporation allows for limited liability and a single layer of taxation for small closely held businesses. The adoption of subchapter S was a huge step forward in encouraging small and family-owned businesses in America. Today, S corporations are the most popular corporate entity. The IRS estimates that there were 3.2 million S corporation owners in the United States in 2003, compared to approximately 2.1 million C corporations and 2.3 million LLCs and other partnerships. But while the S corporation community has grown and matured, the rules governing S corporations have remained largely the same. The number of shareholders is still limited, an S Corporation may have only a single class of stock, and the rules will still limit who or what may own shares in an S corporation. Today we will hear testimony expounding on: First, the history of S corporations and the role they have played in encouraging the rise of small and closely-held businesses and in the U.S. economy; Second, the unique challenges S corporations face with the rules governing subchapter S; Third, legislative proposals to modernize the S corporation structure; and Lastly, the IRS National Research Program study of S corporations. I look forward to learning more about how S corporations benefit the American entrepreneur and what more can be done to aid this important component of the U.S. economy. I now yield to the gentlelady from Guam, Madame Bordallo and for her comments. [Chairman Akin's opening statement may be found in the appendix.] Ms. Bordallo. Thank you very much, Mr. Chairman. And I join you, too, in getting to know a little bit more about the S corporations. I would like to welcome our witnesses this morning. In spite of the bad weather you are able to get here. We appreciate that. Small businesses drive our economy. And it is critical that our country's small businesses remain strong and vibrant. It is this Committee's responsibility to facilitate achieving that goal in any way that we can. Reviewing the benefits of and potential modifications to the S Corporation business model is important to our nation's small businesses, as many of them are indeed S corporations. Legal and regulatory structures must reflect the pressures of the modern business. And they must be written in a way that does not put small business at a disadvantage. Our country's small businesses must be allowed to remain competitive in today's fast-paced marketplace. The number of small businesses that have been organized as S corporations has tripled from around 1 million to 3.25 million over the last 20 years. Among other things, the S corporation offers a number of appealing tax benefits and protections against personal liability. And I am sure we are going to learn a great deal more about that today. For instance, the S corporation classification allows entrepreneurs to avoid a ``double tax'' on their corporate and shareholder dividend earnings. The S corporation also provides a form of insulation for small businesses to be more confident in moving forward with their innovative ideas and their ventures. S corporation classification is a proven way for small businesses to achieve the benefits of corporate ownership. But there are still a number of barriers preventing S corporations from reaching their full potential for growth. And I look forward to hearing today's discussion on how we can work to ensure that the S corporations remain a strong and viable option and to learn about some of their concerns. I thank you very, Mr. Chairman. [Ranking Member Bordallo's opening statement may be found in the appendix.] Chairman Akin. Thank you. And I know that a few of you here, at least, Tom, you know the rules and what we try to do. I think this makes it easiest for our hearing to proceed in an orderly fashion if we take a statement from each of you. If you would like to submit a written testimony, that would be fine as well. And what we would like to do is to hold you to five minutes each. We will go straight across. And then that will allow us to get to asking some questions. I think we can wrap things up usually in close to an hour or so. So that would be a reasonable thing in terms of time expectations. So our first witness is no stranger, the Honorable Tom Sullivan, Chief Counsel for Advocacy United States Small Business Administration, Washington, D.C. And a friend of the Committee and a friend of small business. Tom, please lead off STATEMENT OF THE HONORABLE THOMAS M. SULLIVAN, U.S. SMALL BUSINESS ADMINISTRATION Mr. Sullivan. Thank you, Mr. Chairman, Congresswoman Bordello. It is truly an honor to appear, not only before this Committee, but also as part of this distinguished panel. My name is Tom Sullivan, and I am the Chief Counsel for Advocacy at the U.S. Small Business Administration. I would like to submit my complete written statement. And as the Chair referenced, just briefly summarize in five minutes. Chairman Akin. Without objection. Mr. Sullivan. The Office of Advocacy, is an independent office with the Small Business Administration. Therefore, the comments expressed here don't necessarily reflect the position of the Administration or the SBA. Small businesses are a driving force in the United States economy. They compromise 99.7 percent of all employer firms, employ half of all the private sector workers and have generated 60 to 80 percent of the net new jobs annually over the last decade. Small firms pay 45 percent of the total U.S. private payroll, and create about half of the non-farm private gross domestic product. Small businesses also tend to innovate at a higher rate than medium or large businesses, producing up to 14 times the patents per employee than their larger business counterparts. And finally, during economic downturns small businesses fair better than their larger counterparts. Increases in small business employment and self-employment often help steer the economy out of recessions. Just as small businesses are the cornerstone of the U.S. economy, S-corporations are the cornerstone of the small business economy. According to IRS Statistics of Income for tax year 2002 there were approximately 3.1 million S-corporation returns filed, making up 59.6 percent of all corporate returns. Those same S-corporations generated $3.9 trillion in annual revenue. The written testimony discusses the history of S-corps, the complexity by which S corps can be started and operate and the need to update laws for S corps to continue to grow as a viable business structure. My office is supportive of legislative efforts that will enhance the growth of S corps. We are concerned, however, as the small business community is concerned, with what some view as unfair scrutiny of S corps by the IRS. The National Research Program has been described by IRS as a program that will fill data gaps needed to ensure efficient tax enforcement and prioritization. That is far different from what small businesses say is an audit initiative focused on S corps. I'm all for IRS proceeding with better information, but I share the concerns of small businesses with how IRS appears to be focusing its in depth, and I might add painful, audits on S corps. Research sponsored by my office continues to show that the cost of tax compliance costs $1304 per employee per year for firms with under 20 employees. That's 67 percent higher than large firms. Facing an audit, obviously, increases the costs of tax compliance by requiring business owners to incur the expense of representation and it takes time away from their business to answer IRS inquiries. Small businesses take their responsibility to pay their fair share of taxes seriously. No one wants to defend those that deliberately cheat the system. However, IRS's approach may punish those that voluntarily comply with the law based on the failures of those who do not. In summary, small businesses have a long history of contributing greatly to the American economy. S-corporations play a critical role in keeping the economy strong. To ensure their continued success, government has to be wary of taking steps that may stifle the entrepreneurial growth of S- corporations. Legislation introduced to reform S-corporation provisions should be based on tax policy that enhances entrepreneurial competitiveness H.R. 4421 accomplishes this. As the IRS strengthens tax compliance efforts, attention should be given to why taxpayers become noncompliant so that recommendations are tailored to meet those challenges. Thank you for allowing me to present these views. And I am happy to answer questions. [The Honorable Thomas Sullivan's testimony may be found in the appendix.] Chairman Akin. Tom, you are starting off pretty well. You redeemed 30 seconds there. Good job, and what you said raises a lot of interesting questions. I appreciate your coming out and chatting with us on the subject. Our next witness is the Honorable Don Alexander. And Don is a partner at Akin, Gump, Strauss, Howard & Feld and former IRS Commissioner from Washington, D.C. And as he has told me earlier this morning, he's probably forgotten a lot of what he once knew but I suspect still knows a lot more than a lot of other people. Don, we are just delighted to have you here. Please share what your thoughts are on the subject. STATEMENT OF THE HONORABLE DONALD C. ALEXANDER, AKIN, GUMP, STRAUSS, HOWARD & FELD Mr. Alexander. Delighted to be here. I have a long statement to make, it's historical. And I request that it be inserted in the record. I don't intend to read any of it. Chairman Akin. No objection. Mr. Alexander. 1958 was the year which sub S appeared as legislation adopted by the House and Senate and signed by the President. 1958 happened to be one of my better years. Chairman Akin. If you could slide that mike just a little closer. Mr. Alexander. I will. Chairman Akin. Thank you very much. Mr. Alexander. Two mikes. Wow. Well, that takes me back to 1958. I didn't have two mikes in 1958. But we had sub S in 1958 because the Eisenhower Administration thought that there ought to be a way for small business to have a vehicle, a way of conducting their business that would give them the corporate limited liability, which you really have to have these days. Even then you had to have. And at the same time not have a double tax. Once when the vehicle itself paid a tax and then when it distributed some of its profits to its owners, and low and behind there was another tax. Well, we still have that today. We do not have the same rates that we had then. We had a rate on individual income that went to 91 percent. Very few people paid it, willingly anyway, or unwillingly for that matter. Because IRS didn't do very much about it. Then in the Reagan Administration we got the rate down to 70 percent, 70 percent that is on unearned income and got to 50 percent finally on earned income. We treated earned income better than unearned income then, far different than what we do today. Anyway, sub S was enacted to try to help small businesses carry out their role as essential to the U.S economy as Mr. Sullivan as just pointed out and as you pointed out in your opening statements, in a simple form. Well, the idea was a simple structure for simple people. The problem is that Sub S through the years and in my statement I mentioned the changed that have been made, almost all of them except one in the right direction since 1958, tried to alleviate the shackles that were put on sub S corporations back in 1958, and that still exists. Shackles to try to make the corporate structure simple, but shackles which now make the corporate structure rigid and rigidity is not simplicity. They are two different things. Originally only ten stockholders could own stock in a sub S corporation. Now, thanks to a number of remedial actions by the Congress, that ten has risen to a 100. It ought to be about 150 so that small banks which have to adopt the sub S form because they can't go into the fancy things like partnerships and LLC, can have a sufficient number of member stockholders to survive in competition with the giant banks that we have today. Other changes should be made. You will hear more about these from the other witnesses. But in my litany of history I point out while the rules governing sub S corporations have been modified over the years and improved over the years, sub S corporations although numerous are not the vehicle of choice anymore. They're not the vehicle best suited from the tax standpoint for a small business to use. Instead, we have limited liability corporations, limited liability partnerships and we have something called check the box where you can decide whether you want to be a tax nothing or a tax something when you go into business. Whether those regulations are valid or not is another question, but they are with us and who is going to contest them. All this has worked to the disadvantage of sub S corporations. While they are numerous, and as you pointed out they are competing with LLCs and others that don't have the strictures still limiting sub S corporation. [The Honorable Donald Alexander's testimony may be found in the appendix.] Chairman Akin. Thank you very much. I appreciate your testimony. We will look forward to getting back to you with some questions. Our next witness is James Redpath, CPA, partner, HLB Tautges Redpath, LTD., is that somewhere close? Mr. Redpath. Close enough, yes. Chairman Akin. From White Bear Lake, Minnesota. Did you fly in? Mr. Redpath. Last night. Chairman Akin. Did you? That was a treat, was it not? Mr. Redpath. Yes, it was. Chairman Akin. Yes. Well, we appreciate your braving the weather and joining us here, James. Please proceed. STATEMENT OF JAMES REDPATH, CPA, HLB TAUTGES REDPATH, LTD. Mr. Redpath. Chairman Akin, Ranking Member Bordallo, thank you for the opportunity to testify. My name is Jim Redpath. I am a certified public accountant and an officer at HLB Tautges Redpath, Ltd., a 100 person full-service accounting firm serving clients in the greater Minneapolis/St. Paul metropolitan area. Our firm, like many others, work with several hundred S corporations. I also serve as Chairman of the Advisory Board to the S Corporate Association. My goal is to provide you with a firsthand account of how the rules governing S corporations are outdated, and how those rules might be improved. I ask that my full written testimony be placed in the record. Chairman Akin. Without objection. Mr. Redpath. Thank you. Last year, our firm was involved in creating more than 100 business entities for clients. Of those, virtually all were LLCs and only a select few were S corporations. When S corporations were created in 1958, their benefits were tied to the following restrictions, as earlier stated: The number of shareholders was limited; the types of shareholders were restricted, and; only one class of stock was allowed. Failure to comply with those rules result in the loss of S corporation status and unexpected double taxation. In contrast, the LLC was created by states beginning around 19977 and evolving through 1997. And the LLC is encumbered with none of the rules governing and limiting S corporations. When an entrepreneur sits down in my office to discuss starting a business, these differences play a leading role in our conversation. Why would someone subject themselves to the S corp restrictions and the possibility of inadvertent double taxation? Therefore, most new businesses choose to be an LLC. But what about the existing 3 plus million S corporations? Should they convert to LLCs? Generally the answer is no. Converting from an S corporation to an LLC is a taxable event where you pay taxes on any appreciated property owned by the business. In my experience, no one is willing to go through the pain to gain LLC status. Therefore, I believe each of the S corporation rules need to be reviewed to determine their appropriateness for the 3 plus million S corporations in existence. Another area of challenge for S corporations occurs during the transition of the business from one generation to the next. If you have a family owned business with multiple shareholders and multiple generations, the ability to issue different classes of stock really helps keep family members involved in the family business. But S corporations cannot issue preferred stock or other classes of stock. Allowing S corporations to have multiple classes of stock would dramatically improve their ability to make this transition. Mr. Chairman, the tax code includes a number of provisions designed to ensure that businesses converting from C to S corporations do not enjoy a tax windfall when they make the conversion, mainly LIFO recapture, passive investment tax and built-in gains tax. I believe in certain circumstances these provisions go too far. For example, S corporations For example, S corporations are subject to a corporate level tax on certain income and gains recognized within 10 years after they convert from C to S corporation. I find the built-in gains provision causes many S corporations to hold onto unproductive assets and business lines that should be sold or converted and reinvested into the business. Ten years is a long time. Reducing the build-in gains tax period from ten to seven years, modifying the passive investment income limitation and eliminating the passive investment income determination event would eliminate an unnecessary advantage to S corporations. Mr. Chairman, raising capital is always a challenge for a closely held business, even without the additional limitation faced by S corporations. When S corporations were created, the idea was a simple corporate form for simple business. The business world has changed in the past 50 years, and the limitations imposed on those simple businesses are now restricting the ability of established S corporations to access the capital they need. Allowing S corporations to issue additional classes of stock, convertible debt and allowing non- resident aliens and IRAs as shareholders will enhance the ability of S corporations to access necessary capital. Mr. Chairman, the S corporation is the only business structure where you can where you can inadvertently lose your entity tax status. An S corporation election is terminated whenever the S corporation has excessive passive income, too many shareholders, an ineligible shareholder, or an arrangement that may be considered a second class of stock. Often, businesses are unaware that they have violated these restrictions and it is discovered too late. This rule has tangible impact on S corporations. In the last year I was involved in three transactions where the remote possibility of the entity failing to satisfy it S corp requirements since the day of its inception stopped the transaction or resulted in major modifications to the terms. Allowing S corporations without IRS consent to rectify an ineffective election or a terminating event, increases tax status certainty to S corporations and puts them on par with all other entities. The S corporation has proven to be a huge success, but times have changed, and the rules governing S corporations need to change as well. Legislation like Representative Shaw's bill H.R. 4421, Representative Ramstad's bill H.R. 2239, and others would greatly improve these rules and enable S corporations to continue to compete with LLCs and other business structures on a more even footing and promote economic investment and growth for S corporations. By contrast, S corporations remain concerned about-- Chairman Akin. James, your time is getting a little close here. Can you summarize things here? I mean, I think you have been summarizing it, but just cap it off. Mr. Redpath. Yes. In summary there was a proposal relating to an increased tax on S corporations relating to payroll taxes. This for small corporations would result in a 15 percent increase in their tax. We believe the Treasury has the ability to enforce the existing rule that prohibit abuse. Thank you for your time. [Mr. Redpath's testimony may be found in the appendix.] Chairman Akin. Thank you, James. And our next witness is Gregory Porcaro. Do you go by Greg or Gregory? Mr. Porcaro. Greg is fine, thank you. Chairman Akin. Okay. And Greg is with the American Institute of Certified Public Accountants from Warwick, Rhode Island. Mr. Porcaro. Sir. Chairman Akin. A pleasure to have you here this morning, Gregory. STATEMENT OF GREGORY PORCARO, CPA, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS Mr. Porcaro. Thank you. It's a pleasure to be here. Good morning, Chairman Akin, Ranking Member Bordallo and other distinguished members of this Subcommittee, the American Institute of Certified Public Accountants appreciates this opportunity to present testimony on the place of S corporations in our society and on the need to keep them vital and competitive by continuing to modernize the laws that govern Subchapter S of the Internal Revenue Code. We request that a written copy of this testimony be included in the official record of this hearing. Chairman Akin. Without objection Mr. Porcaro. Thank you. My name is Gregory Porcaro and I am the Chair of the AICPA S Corporation Technical Resource Panel. AICPA members assist S corporations of all sizes and in all industries nationwide, and their shareholders, with choice-of-entity decisions; transactional planning, return preparation; and many other services required daily by S corporations. It is from close involvement with our clients that we have developed insight into the impact of S corps on our society and into needed changes that will enable S corps to continue to be a primary vehicle for both start-ups and existing businesses to achieve operational growth, expanded employee ownership, and simplified and practical family succession planning. Personally, I am a majority shareholder and tax principal in a small CPA firm in Rhode Island PA who serves S corporation clients ranging in size from $50,000 in revenue to $40 million in revenue. My firm annually prepares close to 600 S corporation tax returns, including our own. S corporations are active in just about every sector of our environment and economy from professional service, construction, manufacturing, retail and wholesale establishments; the majority of corporate businesses that we deal with everyday are, in fact, S corporations. Recent numbers indicate that there are 3+ S corporations that together have invested over $2.5 billion in assets, generated substantial revenue and contributions to our economy and employ millions of people. These engines of American entrepreneurship are not slowing down even with the fast growth of LLCs that still harbor certain advantages over S corporations today. Today, in our brief testimony I will cover some of the statutory changes that we believe should be made to Subchapter S. Collectively, these changes would eliminate needless traps, inequities, and complexities, indeed, may help many corporations actually make an S election. Subchapter S can and should be modernized to expand its reach, to simplify transactions and remove unintended consequences. Start-up business survivability is a critical concern. Census data indicates that 20 percent of start-up companies disappear after one year, and 70 percent disappear after ten. Small businesses that struggle with and file for bankruptcy over operational, financial, and tax problems may be able to prevent these problems if they have greater access to their CPAs. The AICPA, therefore, supports the Small Business Tax Flexibility Act of 2005, H.R. 4006, and its 2006 companion bill in the Senate, which would give most S corporations and partnership start-ups the flexibility to adopt a fiscal year- end from April through November. This flexibility would help spread start-up businesses' regulatory, financial, and tax burdens away from the busiest operational periods, thus increasing productivity; it will help spread regulatory, financial and tax workload of CPAs and other advisors throughout the year, thus promoting a more balanced family-work protocol for advisors; Increase the occurrence of non-extendable financial and regulatory deadlines, such as bank loan submissions or HUD filings outside of the tax season; Provide the same flexibility that C corporations, which are typically larger businesses, have in choosing the right fiscal year-end for the business, and; Provide certain start-ups with increased cash flow because both real and opportunity costs will be reduced as the result of performing these tasks outside of their busy portion of their business cycle.of compliance are reduced as such work is delayed to a less productive period of the business cycle. Another area of concern is a recent discussion to change the way S corporation shareholders pay employment taxes. The Joint Committee on Taxation has suggested that S corporation shareholders switch from the current withholding tax regime to the estimated tax payment system. Without addressing the merits and concerns of the Joint Committee at this time, we strongly suggest that if any changes are made, that they not be made to the S corporation regime, but rather that the issue should be studied carefully with extensive input from public to consider moving the partnership model closer to the S corporation model of payroll tax withholding. S corporation shareholders should not be brought into the less efficient system of self- employment and estimated tax system because the current payroll withholding system substantially decreases the likelihood that a taxpayer will underpay their tax liability as comprehension and compliance with that system is much easier and less burdensome. Next I will mention the few suggestions that we find are of particular importance: Removal of the tax on LIFP Recapture; Electing Small Business Trust should be able to deduct interest on debt expense incurred when it borrows funds to purchase S corporation stock. In conclusion, the AICPA has a number of other recommendations that we do not have time to mention today. We ask that a letter to Senators Hatch and Lincoln describing these recommendations in great detail be included in the record of this hearing. Chairman Akin. Without objection. Mr. Porcaro. We are pleased to be able to present this testimony before you today and will be delighted to answer any questions. Thank you, Mr. Chairman and Members of this Subcommittee. [Mr. Porcaro's testimony may be found in the appendix.] Chairman Akin. Thank you, Gregory, for your testimony. Maybe in asking some questions, I will start with you. Gregory, you are one of the few people that did not mention 4421. Are you familiar with that piece of legislation. I think it's Clay Shaw's bill? Mr. Porcaro. I am, sir. Chairman Akin. Does that bill help or harm the S corps in your opinion? Mr. Porcaro. We have been monitoring that bill at the AICPA since it first came about several years ago. And we believe those provisions are going to be significantly helpful in providing a lot of the flexibility that was referenced here today. Chairman Akin. So even though you did not specifically mention it in your testimony, you think it is going the right direction then? Mr. Porcaro. Yes, sir. Chairman Akin. Okay. And the better questions for Mr. Sullivan, do you dispute that we have a tax gap? Mr. Sullivan. No, I do not dispute that, Mr. Chairman. Chairman Akin. So we do have a tax gap? Mr. Sullivan. We do have a tax gap. I think there has to be some balance in figuring out how to try to fill to the extent practicable that tax gap. And I think from that perspective the small business community differs from IRS' approach. Chairman Akin. And then also, S corporations receive tax benefits for making an S election. Why should they receive more benefits? Mr. Sullivan. Mr. Chairman, the answer on why there should S corp reform to make them do better really is a broad economic answer. And that is an examination of the success of S corps reveals an incredible contribution to this economy. So to say why should they get benefits, the answer is because when they benefit, the entire economy benefits. Chairman Akin. Let me just sort of step back for what I am hearing and see if I am picking up, more or less, what is going on. We created S corps because we needed something to help get small businesses off the ground. We just didn't have the right legal mechanism, taxing mechanism to really encourage small business. So we created this S corp back under Eisenhower in the '50s. And at the time it was good technology, but when we look at it today it just created a whole lot of red tape and hassles and a tremendous liability. It is not a liability in the sense of some lawyer is going to sue you out of your house. It is not a tax liability--well, it is sort of a tax liability, but it is rather that if you make some little nitpicking mistake, all of a sudden you can lose the whole structure that you organized under. Not only that, you have to pay an incredible amount of back taxes, which I assume might even destroy the viability, the financial viability of your company. So it has got an awful lot of gotchas in it, a lot of complexity to the point that people are not even recommending it anymore if you are starting business up. So we have a certain number of people almost trapped in this antique system. And the question is whether we are going to get with the program and get this thing changed. Now, first of all, am I stating the problem more or less correctly? I see nods, more or less. Okay. Then why has it taken us so long to get the job done? Does anybody disagree with what I just said? I mean, what groups of people would disagree? IRS? Mr. Alexander. No. Mr. Chairman, I might try to answer that. If I were still back with IRS, I would be paranoid enough to believe that--oh well. Now, Mr. Chairman, you put your finger right on it. S corps were supposed to be simple, small structures for simple small people. The trouble with that is that it introduces not only the possibility of being wrong in many, many unnecessary ways, but also if you are not wrong, you know that you cannot have over, say back in 1958, ten stockholders and now a hundred. But you have that 101st stockholder and you suddenly are disqualified. You are disqualified because you have too many. Well, why too many? You mentioned benefits of S corps. What we are talking about detriments. The benefits go to a pass through entity, not necessarily an S corp, a partnership, an LLC that is not subject to any of these limitations that we are talking. You asked who might oppose relief from the limitations. The fact is my former Department of Treasury has opposed relieving S corp restrictions. Why? Because let us go back to the simple structures for simple people. They think that if you relieve S corps of some of these limitations, that we at this witness table have brought out, you suddenly are creating a problem for the economy, for IRS and for S corps because S corps suddenly get complicated. Oh, no, it does not make any sense whatever. If you look at the regulations under Section 701 code, and I hate to mention code numbers but I have got to here, you find that they tell you how to get that 101st stockholder and they tell you how to get the nonresident stockholder. What you do is you have your S corp join in a partnership with the excess stockholder or with the nonresident alien stockholder and suddenly that's okay. Well, that is not the way that mainstreet business should be conducted at all. Chairman Akin. More complicated than the other alternative? Mr. Alexander. It is much more complicated. And Treasury requires this complexity. Part of it is the fact that they like partnerships. They like LLCs; that is the wave of the future, that is the choice of today. So why should we do anything for S corps? Chairman Akin. So then the primary people that are opposed to change would be probably Treasury, would that be a fair assessment? Mr. Alexander. Well, there is another problem, too. Because any time that you do something good for S corps, the Joint Staff is going to put a big number on it and it is a revenue loss. And you got to figure out how to get some revenue to pay for that revenue loss under the PAYGO rules and whether under the current rules you still have to pick up that revenue, I do not know. But the other side of it is that the bills that you have heard about, and particularly Mr. Shaw and Mr. Ramstad's bill 4421 would do a lot to try to get rid of some of these shackles. But it might be expensive to do it. Chairman Akin. All right. Well, I would love to ask some more questions, but my five minutes has expired and I need to go to the fair lady from Guam. Ms. Bordallo. Thank you, Mr. Chairman. I have a question for Mr. Sullivan. How much of a competitive disadvantage are S corp operating at if they continue to be prohibited from seeking to sell stock to individual retirement accounts and nonresident aliens, and would these sources of capital be significant? And if so, how would they compare to the sources of capita that currently exist for S corp? Mr. Sullivan. Congresswoman, I do not know the dollars and the equations that would lead up to an exact figure to say this is the competitive disadvantage. What we do see is that without the reforms allowed in Mr. Shaw's bill that would allow for a preferred stock, for instance, for succession planning and so forth. What we do see is a modernization of S corp structures. And I guess the easiest way to answer the competitiveness question is that we really do not want to get to a point where all of a sudden we wake up and say ``Oops, we are at such a severe disadvantage that S corps are trapped and they are not able to elect out of the status without paying an enormous toll.'' We do not want to reach that point. And what we do see is that as the economy has evolved, the rules that were originally in place that would prohibit a nonresident alien ownership or different classes of stock really no longer apply in this marketplace. And so the reform is not only a competitiveness issue but also a modernization issue. Ms. Bordallo. Are there any other witnesses that would like to answer that question? Mr. Redpath. I do not know the answer to that question, but what I do see in my practice, you know I work in the trenches applying these laws to hundreds of S corporations. And what we do see is that our S corps' competitors are organizing as LLCs. And those competitors are not just domestic, they are international. And they are not subject to these restrictions. You know, one of the answers to the other question is my clients ask me the same question all the time. You know, why are we limited to certain number of shareholders? Why are we limited to a certain class of stock? You know, why are we-- things like that. And we do not have an answer because they ask us, the LLCs are not and those are their competitors. So I see the competitive disadvantage. I obviously don't have the numbers that they were asking for. Ms. Bordallo. I would like to ask Mr. Porcaro. Mr. Porcaro. Yes, ma'am. Well, that same question? Ms. Bordallo. Yes. Mr. Porcaro. Again, it is hard to quantify. The only aspect I can see is that with regard to IRAs, in particular, the issue of whether the IRA funds can be utilized in some form or another to invest in S corporations has come up several times over the years. So there is definitely a large pocket of resources tied up in IRAs that potentially could be used as the alternative source of capital. With regard to the international implications, in every situation where we had such a scenario, we have had to utilize LLCs in order to bring in any international capital. S corps just do not provide a mechanism for doing that. And that is, I guess, the way that situation is and how much more we would be able to do with S corps, I am sure there is a substantial amount. Because even in a firm my size we see more and more globalization of business activities even in smaller businesses. Ms. Bordallo. Mr. Alexander, would you like to put in your two cents? Mr. Alexander. Yes. Into a mike that works. Yes, my two cents. I agree with the statements of the other witnesses. And S corps, although the largest single number of business entities in this country, have not yet reached zero population growth, but they are almost there. Thanks to the fact that LLCs has been discussed coupled with the check-the- box rules that Treasury happily put out have created such a competitive tax environment as to greatly disadvantage the S corp to such an extent--did I do that? Chairman Akin. Well, that was a nonpaid advertisement. Go ahead. Mr. Alexander. We are a little distance from the Hart Building anyway. That is good. I was saying that the S corp now almost has a zero population growth. There are still a lot of them. Why are there a lot of them? Because getting out of them is so expensive, as the witnesses have pointed out. Maybe they will tell us again. Anyway, back to S corp. New S corps, in my experience anyway which is limited, of course, are not being created if the would be entrepreneur, the new business person has a choice. The far, far superior choice is the limited liability company or sometimes the ancient partnership where you are not subject to any of the limitations that we have described and where you have tax nirvana, S corps are far from that and they need not be. Ms. Bordallo. Thank you. Thank you very much. I have one other question, kind of a follow-up. Since you do not have the numbers, do you have studies or analysis that pertain to the value of the S corporation format that you would call to the Committee's attention? Any of you could answer that. Mr. Porcaro. I do not know of one. Ms. Bordallo. None of you? Mr. Sullivan. Congresswoman, in my testimony we do point out the economic benefits of S corps and the volume and number of those S corps are really tremendous. And I think what Don Alexander was pointing out is that if you have a choice in the future, it is likely that you will not choose S corps. But the numbers are so large for existing S corps that to ignore the need to modernize it will be devastating to the economy. Ms. Bordallo. Would SBA have any of this information? Mr. Sullivan. We do have information about the economic value of S corps. We also have information about the disproportionate regulatory burden on small business, but we don't segment out the disadvantage competitively of S corps versus other small business. Ms. Bordallo. And, Mr. Sullivan, I think you were--or I am sorry, Mr. Alexander? Mr. Alexander. I believe that there are some studies that could be helpful, although perhaps not exactly in point in your excellent question. I think the GAO has studied S corps, although not as recently as all of us would like. But Joint Committee on Taxation has also studies the S corp situation although sometimes they are not as concerned about these limitations as we at this table would hope that it would be. Ms. Bordallo. Thank you. Thank you very much. Mr. Chairman. Chairman Akin. Thank you. Let me ask a radical question. What would happen if we just said we are going to get rid of S corps and let everybody that has an S corp convert over to LLC with no penalties, no review of back taxes? Just say if you want to shift over, you can just go from one to the other. First of all, is that a radical idea? Would that be hard to do politically or financially, or how would that work? Would that make sense to do? Is there anything in an S corp that an LLC doesn't have? Mr. Alexander. Well, there are certain things for banks that an LLC does not have because a bank by law, as I understand it, has to operate as a corporation. So you would have to, I think, change the rules. Chairman Akin. You would have to deal with something relative to banks? It would be smaller banks then? Mr. Alexander. Yes. I think the banks, small banks would need to have sort of a special rule. A federal law could of course override or a federal law could replace that restriction. Because I think it is in federal laws, perhaps in state law. But apart from that, and I would like to hear the people that actually deal with this situation on the ground, but I think as far as I am concerned if there were no toll charge on moving from S to the faxed favored entity, LLC, I would strongly recommend that all the S corporations that I represent immediately move. Mr. Redpath. A couple of comments I have. And one would be relating to ESOPs and ESOPs owning S corporations. And there are many S corporations that have ESOPs as shareholders. And ESOPs, you know, currently could not be sponsored by partnerships or LLCs. So we would have to deal with that as an issue. The other thing is just applying the partnership rules to corporate structure may be difficult. There are a variety of different rules in the partnership area relating to the allocation of income, the allocation of debt, calculation of basis; many things in the partnership area which LLCs are taxed under. That would need to be addressed to determine how they be allocated at the corporate world. My personal opinion is these fixes that are proposed by H.R. 4431 and 1239 go a long way to helping the S corporation. They really do. I believe that many of my clients, given the option to convert to an LLC or if these rules may stay as an LLC just because of some of the things I just mentioned. Chairman Akin. In other words, there is a conversion cost just because you are doing some things a different way? Mr. Redpath. There is a conversion cost and there is the application of the tax law itself. Just simply indicating that a corporation now would be taxed as a partnership, there are many things that need to be addressed under the partnership tax regime as to how that applies to a corporation. Chairman Akin. If somebody wanted to do that, could that be defined before such a conversion were made? If you talk about simplification, which you know to some degree, simplification is a good thing. The LLCs are working pretty well, is there really a need to keep the S corps around? I am not opposed to making the modernizations, but I guess that was my question: Why do we really have two things doing the same job in a way? Mr. Porcaro. I would like to make a comment relative to what Mr. Redpath said or to emphasize it. The application to tax law for partnerships is substantially complicated than Subchapter S. And what I have found and people have converted or utilized LLCs without the proper guidance, have actually got themselves in the situation they did not anticipate. Contribution of property to partnerships, for example, carry with them a toll of up to seven years depending upon how that property is dealt with, either by sale or distribution. So there are reasons why Subchapter K works and there are reasons why Subchapter S works. So I have never really felt that I think there was a proposal was to do just that, make like either a smaller no-tolled charge to convert and just merge everything to Subchapter K. I believe the reason why we have the different subchapters is because they all do different things. And in certain circumstances the S corp is the way that a business should be functioning and in certain circumstances the LLC definitely has some aspects to it that are beneficial. And I do not know if we could sufficiently bridge the tax application and compliance from Subchapter K to S without more than just a nominal cost, outside of revenue costs. I mean just an administrative cost for taxpayers in general. It is not as simple, I guess, is the way I see it, as all that. Chairman Akin. I guess my question is one of the things that was argued when we cut capital gains and things was that when we create all these complicated tax rules, what we are starting to do is we are starting to force some corporate structure into some pattern which may not be economically the most efficient way to run the business. So that the more transparent that we can make the tax code, it gives the people that run the businesses the flexibility to be as productive as possible. And when we tie up all kinds of resources because if you touch this, you are going to get zapped with taxes on it, we basically have all this money sitting around which could be invested in a better way. So at least the concept that I subscribe to and that I think a lot of people have talked about is that when you back your tax code off and make it less specific so that people have flexibility to properly manage their resources, otherwise, people will not make the most appropriate investments. It just makes us more productive and more competitive. And clearly we are in an increasingly global environment where competition is critical that we are competitive. So, that was why I was asking that question. We have been joined by a fantastic Congresswoman from the great State of New York. And would Ms. Kelly want to make a question or comment? Ms. Kelly. Thank you. I appreciate your turning to me. I will just make a comment that I have started several Subchapter S corporations. And for the people who are just entering a small business who need the corporate shield which a Subchapter S, and I am talking about liability here, when you are looking for that liability corporate shield if you are true very small business, a Subchapter S is a very easy and economical way to get into a corporate position. It's not an impervious veil, but it is certainly something that does help. And I am concerned about changing some status. For instance, the single taxation status, I would be interested in your view on whether or not you think that ought to be changed. Limited shareholders, I would be interested in what you think about that. And I am very concerned about the liability protection. Liability protection is one of the most common reasons that people who start small businesses go into any kind of a corporate structure. You do not have to be a corporation to do business in this country. And so I would be interested to hear you address those couple of issues: Liability protection and single taxation and the shareholder limitations. And I wonder if I could just start maybe with you, Mr. Porcaro, and move this direction down. Mr. Porcaro. Well, with regard to single taxation, are you referring to just the pass through structure that we have now? Ms. Kelly. Yes. Mr. Porcaro. Well, it has been experience that that is a very efficient way to deal with the small business environment where many times the complication of a corporate structure are not always adhered to, and the manner of that would be in a larger entity. And so there is not always a fine line in the small business owner's mind as to the corporate pocketbook versus their own So in many cases having this ability to have this pass through limits their exposure to a tax liability they may not have had. It is basically all going to be taxed at one level. And if they erroneously classify an item, whether it should have been personal or business related, it will flow to them and they will pay that one tax because that is how it should have been in the first place. With regard to the limited number of shareholders, to be frank with you in my particular practice the current limitation of a 100 shareholders has been more than adequate. We do not have any S corporations with more than 10. And I just looked at some Internal Revenue Service statistics, and there are not that many S corporations with more than 50. So I do not know--and now with the single family, the family election which can bring in multiple generations, I do not see that as being a real restriction as it used to be. The steps that have been taken have been tremendous in helping avoid that problem in my experience. And the liability issue, I cannot really comment on not being an attorney because I have attorneys tell me that in some respects the LLC provides better liability protection depending on the state in which you are organized in than a corporation might. So I do not know if that is true. I know in Rhode Island the jury is really kind of still out because we have not had a case that has challenged the limited liability protection of an LLC. Ms. Kelly. Thank you. Mr. Porcaro. You are welcome. Ms. Kelly. Mr. Redpath? Mr. Redpath. Yes. Thank you. Single taxation is how we create virtually all new entities, small closely held businesses, whether we use an LLC or an S corporation; either one does that. It is a benefit of both and that is something that I believe just needs to be there for the small business to compete. Rarely do we ever create a S Corporation subject to double taxation. The number of shareholders, you know, is an issue that as Mr. Alexander pointed out people get around that. They get around that by creating partnerships with S corps as partners. And so there are ways to increase the number of shareholders with S corporations. What we are more interested in is the classes of shareholders and the types of shareholders. And allowing S corporations to benefit the same as LLCs with regards to who can own the stock and what your ownership rights are. With respect to a LLC and a corporation, I agree with you, a corporate entity structure has been around much longer, much simpler. If you read an LLC operating agreement or member control agreement, it is a very complicated document. When you read corporate bylaws, you can actually maybe understand them. So I agree with you from that standpoint. Ms. Kelly. Thank you. Mr. Alexander? Mr. Alexander. My two cents again. First, on the issue you raised on limited liability. I agree with Mr. Redpath, that is absolutely essential. Absolutely essential. And you have that in an LLC form in all the states that have adopted them. And I think all the states have at this point. You have it also in an S corp and you have it in a C corp. But why on earth would anyone use the C corp at least at the beginning of a business organization's life? No one. Single tax? Sure. Number of shareholders. I was interested to hear those that actually work more than I do in this area that a 100 is sufficient. I have heard from the community bankers that a 100 is great, but that more would be better. We do look back six generations now to find all the members of the family going back to a single ancestor six back treated as one shareholder. Think about that. You can sure bring in a lot of shareholders that way if you have a big family. So maybe the 100 shareholder limit does not create a real problem except in the very limited area of community banks. But it surely creates a huge problem when you are talking about the types of shareholders; nonresident aliens forbidden except through the mechanism that we have discussed of a partnership and an S corporation getting together. And of preferred stock, no mezzanine capital. That limitation never made much sense, but somehow Treasury thought it was appropriate. Why? I do not know, but maybe Mr. Sullivan can say what the Department was doing? Mr. Sullivan. Congresswoman Kelly, first of all on your question of limiting liability, I think actually that questions extends even far beyond the tax code. And I commend the Small Business Committee in the House particularly for continuing to push small business liability relief because it is a huge issue and transcends little different parts of the tax code into an overall threat and drag on the small businesses economy. So I echo the detailed tax related comments, but then also urge the Committee not to let up in your push for small business liability reform overall. You asked about expanded shareholders. I would defer really to this distinguished panel. And I think what has come out of this hearing is that the shareholder requirements of Subchapter S do need to be modernized, whether that be different classes of shareholders that Mr. Redpath mentioned or an expansion as Don Alexander talked about related specifically to community banks. The single tax system, and actually in the President's Commission on Tax Reform that was one area that they encouraged policymakers to look at and Subchapter S certainly prioritizes the single tax system. And for that reason I join the President's Commission and actually echo their recommendations that you do focus in on the single tax systems and enhance ways to make that even better through Subchapter S. Ms. Kelly. Thank you. That single tax system, as Mr. Redpath pointed out, sometimes it's a very, very blurred lined. An rather than set up an impossible rule that we cannot enforce or that is going to put a chill factor on our ability to form Subchapter S and appropriately pay the taxes, it is far better to have that line clear, defined and single I think. So I appreciate your comments on that. And I am sure that my time must be up, so I will yield back. Mr. Akin. Well, we are pretty good shape on time. I promised we would get out of here in about an hour, and I think we are pretty close to that. So things are working out. Anybody want to ask one more? Yes. Ms. Bordallo. I would like to ask this of Mr. Alexander. He seems to have such a long history on this subject. Do you expect that there is a significant tax gap? I know this was brought up earlier, but I do not remember really what the answer was, for filings from S corporations? And what do you believe the Internal Revenue Service will do in response if there is a significant tax gap for S corporations? What should American small business owners be expecting here? Mr. Alexander. Commissioner Everson is enforcing the law. The tax law was not enforced very well and very effectively, efficiently or fairly a few years ago. The problem is that IRS may be overdoing it a bit and Mr. Sullivan indicated his concerns about that in the S corporation field. Pass through entities do present a problem for the tax collector, and I used to be a tax collector. However, the fact that the problem is presented to the tax collector doesn't mean that the tax collector should not be fair and reasonable. But the tax collector needs to be thorough because we do have a very large tax gap in this country. The IRS estimate is about $300 billion yearly after taking into account--after netting out what the IRS will likely collect from those who had not made their full and proper contribution. Actually, the gap is a lot bigger than that because that includes only the legal sector and only part of the types of taxes that we impose in this country. For example, the estate tax ``gap'', whatever it may be, is not included in IRS' figure. If the laws were fully effective, our tax laws produced what they should produce, we would not have a deficit at this time. But you cannot make that happen in a democracy. There is bound to be some slippage, and there should be some because otherwise IRS' is bearing down on some people very hard indeed while missing others, particularly in the legal sector that, let us say, do not rush forward to pay their taxes on money that they obtained illegally in the first place. There is a problem. There is a problem in small business, regrettably. But largely in the businesses that deal in cash. If the business finds, and perhaps this does not rise to the level of calling something like that a business, that cash is the way that it handles its transactions, it is very unlikely to share with the tax collector the amount that should be paid. Ms. Bordallo. Thank you. Thank you very much. Thank you, Mr. Chairman. No further questions. Chairman Akin. With no further questions, with thanks to our witnesses, the Committee stands adjourned. 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