Successes and Threats: How have S Corporations Fared in Washington?

October 23, 2015

The Subchapter S corporation (“corp.”) is one of the most prevalent and fast growing type of tax entity. According to the Tax Foundation, S corporations grew from about 800,000 in 1986 to 4.2 million in 2011, and partnerships grew from 1.7 million to 3.3 million. The corresponding decline in C Corporations as businesses seek better tax structures means more business profits are being taxed as individual income, creating complexity for tax collectors and practitioners. Consequently, S corporations receive a substantial amount of attention from lawmakers and regulators alike,

Below are highlights of key developments and how the AICPA has concentrated its advocacy efforts to ensure that S corporations are treated fairly.  

  • S Corporation Modernization --- The legislative history for this concept calls to mind Yogi Berra’s “deja vu all over again.” Over the years, members of Congress have introduced legislation to update the laws governing S corporations, but enactment remains an elusive goal. The bills vary but some common threads emerge, such as allowing S corps to deduct interest expense incurred by an electing small business trust that acquires S corporation stock, treating liquidating losses to shareholders as ordinary losses, and lowering the tax rate on passive investment income to 15%.
The AICPA has long encouraged passage of these proposals and others that would provide more favorable tax treatment and increase cash flow. Many of the modernization proposals are not controversial and enjoy bipartisan support, notes Kevin Walsh, CPA, member and former chair of the AICPA’s volunteer S Corporations Technical Resource Panel (TRP). However, it currently tends to get lumped in with tax reform, a much more controversial topic that may require years to become law.
  • Proposal to Tax Self Employment Income – One of the more controversial and significant proposals affecting S corps came from a provision in the American Jobs and Closing Tax Loopholes Act of 2010. It would have effectively raised payroll taxes on many S Corporations by treating the earnings of professional service S corps as income subject to payroll taxes if 80% or more of the business' gross income was attributable to the service of three or fewer shareholders or owners. 
The proposal met with serious opposition from professional service associations, including the AICPA. In a 2010 letter to congressional tax committees, the AICPA expressed its “serious concern” that the provision “not only threatens to result in a significant increase in taxes and complexity for S corporations and their shareholders, and for certain limited partners, but it continues the definitional blurring between capital and labor further expanding laws that were clearly established to tax only labor.”

The provision was ultimately struck from the bill but the idea is akin to the Whack-a-Mole game, repeatedly emerging in revenue raising proposals. “It pops up, we beat it back, it pops up again,” Walsh observed. The provision would generate a lot of revenue but Walsh commented it would also inflict enormous collateral damage on small businesses who are not the target of this “loophole closer.” The AICPA suggested alternative solutions to the issue but the lure of the revenue will continue to tempt future lawmakers looking for a "pay-for" provision.
  • Tax Reform – If comprehensive tax reform is enacted, it could both hurt and help S corps. Modernization proposals would certainly help but the proposal to require most service companies, such as CPA firms, farmers, and architects, with gross receipts greater than $10 million to change the accrual method of accounting, could severely restrict cash flow and add complex record-keeping burdens. The AICPA, in collaboration with state CPA societies and outside organizations, has launched a vigorous campaign to retain the option use the cash method, testifying before congressional panels and garnering support from over half of Congress to support its position. The AICPA also opposes creating a unified pass-through entity regime by combining existing Subchapters K and S, which has been proposed as part of a tax reform draft.

Recent Successes and Looking Ahead

While S corp. owners and shareholders may have to wait awhile for significant relief in the form of a reform or modernization, they can take comfort in the victories that have been achieved, such as clearer rules for shareholder debt (aka back-to-back loans) under IRC Section 1366. The law for whether a loan counted toward basis had been subject to judicial interpretation, creating considerable uncertainty and confusion. The AICPA began asking for relief in 2008 and in 2012, the IRS released proposed regulations ( supported with modifications by the AICPA) that became final in 2014. Input from the AICPA was also a significant factor in Treasury withdrawing, modifying, and re-proposing the regulation governing the application of the new 3.8% tax on net investment income to the sale of an interest in a partnership of S corporation.

The TRP also recently developed guidance to the U.S. Treasury on the treatment of worthless stock deductions under 165(g)(3), recommending that S corps be treated the same as C corporations. “This was a huge deal,” Walsh said, observing that not only is this one of three items on the Treasury’s Priority List for S corps, it is not common for Treasury to specifically request such input.

Given the complex rules surrounding S corps, the TRP has no shortage of issues to address; currently, it is exploring the high cost ($30,000) of an IRS private letter ruling for inadvertent terminations. Describing S corps as “continuing to be popular but not without plenty of interesting challenges,” Walsh anticipates a continued high level of interest at the AICPA as well as federal agencies in making the rules easier.