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March 20, 2013
Camp's Unified Passthrough Regime Raises Questions
by Amy S. Elliott

Full Text Published by Tax Analysts®

This document originally appeared in the March 18 edition of Tax Notes Today.

Summary by Tax Analysts®

The latest discussion draft by House Ways and Means Chair Dave Camp, R-Mich., might be an attempt to move small businesses away from the corporate tax, but the plan's potential complexity has caused many practitioners to question its feasibility.

by Amy S. Elliott

The latest tax reform discussion draft from House Ways and Means Committee Chair Dave Camp, R-Mich., was an attempt in part to reduce the tax burden on small businesses, but the potential complexity of one aspect of the draft -- the proposed unified passthrough regime -- has caused many practitioners to question its feasibility.

Released March 12, Camp's third tax reform proposal comprises three pieces: core provisions designed to simplify small business tax rules; an incremental reform designed to achieve greater uniformity between S corporations and partnerships (Option 1); and a unified passthrough regime reform designed to provide a more simplified and efficient way to tax passthrough businesses (Option 2).

In a March 12 meeting with reporters, a Camp tax staffer said that at least one of the principles underlying Camp's proposal is the principle that the choice of entity faced by businesses shouldn't have a significant impact on their federal income tax consequences. By removing the single class of stock requirement, the limit on number of owners, and the foreign ownership prohibition in the S corporation rules, Option 2 would make the current S corporation form -- what under Option 2 is called a passthrough corporation -- more appealing to businesses that might otherwise form as C corporations, enabling more businesses to escape what many economists view as the worst tax -- the corporate tax. For perspective, the IRS Statistics of Income division has estimated that in tax year 2008 (the most recent year data were available), 12.8 percent of all business returns were filed by S corporations, 10 percent were filed by partnerships, and 5.6 percent were filed by C corporations.

But what's troubling practitioners is the way that Camp's Option 2 attacks some of the most fundamental subchapter K principles. It would not only largely end the ability of passthroughs to make special allocations, but it would also tax the distribution of appreciated property by a partnership.

According to 1954 legislative history, Congress enacted subchapter K to limit the area in which gain or loss is recognized upon a distribution to remove deterrents to property being moved in and out of partnerships as business reasons dictate (S. Rep. No. 1622 at 96 (1954)).

Eliminating special allocations and taxing distributions would contradict the intent of the 1954 act, said Phillip Gall of Ernst & Young LLP. "They're basically taking some of the most unfavorable aspects of an S corporation and imposing them onto a partnership," he said.

Unified Passthrough Regime

The tax community has been struggling with the concept of a unified passthrough regime for some time. Professor George Yin of the University of Virginia Law School and David Shakow of Chamberlain, Hrdlicka, White, Williams & Aughtry, spent seven years working on a plan to reform and simplify the taxation of private business enterprises.

"I give the chairman and his staff credit for trying to make some structural reforms beyond the headline-type issues," Yin told Tax Analysts. "This is the type of thing that is potentially a needed reform that doesn't capture the public's fancy but actually might improve the law."

But Yin said it was misguided for Camp to force the 4 million or so existing S corporations to learn a new, potentially more complex set of rules while removing some of the necessary flexibility provided to the 3.1 million subchapter K entities.

Yin said Option 2's restriction on special allocations would prevent "very pertinent, completely reasonable business transactions" that currently allow partnerships to do something as simple as allocating more risk and reward to one owner because, for example, that owner took the lead on developing a piece of real estate for the business. "I have some concerns that what they've tried to achieve is probably not really realistic at this point," he said.

Jerald David August of Fox Rothschild LLP agreed that Option 2 would impose additional burdens on S corporations. "Option 2 could end up creating more cost to small businesses to conform, [could] be inconsistent with state law norms and courts' interpretation of state law property rights, and is not needed," he said. "Subchapter S is easier to administer, it's easier to apply, and people are used to it. Now all of a sudden you're going to shift them over to another regime" under which entities that had been S corporations may now have to maintain capital accounts attributable to each individual owner, he said.

Aaron P. Nocjar of Steptoe & Johnson LLP pointed out that the newness of Option 2's unified passthrough regime means "it will be viewed as complicated." He said the reform is different from the broadening of the S corporation rules in 1986, which he said resulted in many conversions from C to S corporation status.

A direct way to make the S corp form more appealing "would be to eliminate the subchapter S barriers for the typical players in the market to invest in your business, such as private equity funds, foreign investors, tax exempts, and other corporate investors," Nocjar said. "The investment pool for S corps right now is essentially U.S. individual investors."

Distribution Nonrecognition Treatment

While Yin criticized Option 2's treatment of special allocations, he said he supports its requirement that gain be recognized at the entity level when an appreciated asset is distributed to an owner. It may not be clear under Option 2 whether the gain would be allocated to all owners and not just the owner who received the distribution. Traditional principles of subchapter K allow for the movement of assets into and out of a partnership without triggering gain recognition.

The abuse of nonrecognition events over the years has forced Congress to amend the statute many times, Yin said. He added that as the law stands now, "many distributions end up being taxable if people fully complied with the law. The truth is that . . . there's some degree of noncompliance."

Gall disagreed, saying that requiring passthroughs to recognize gain on all distributions of appreciated property "is a very, very radical change from what partnerships were supposed to be all about." He added that "although since 1954 there has been an erosion of the general nonrecognition rule to prevent specific abuses, to not permit a joint venture to unwind on a tax-deferred basis would be to knock down one of the pillars of partnership taxation."

Economic Interest Standard

Option 2 imposes very strict limits on special allocations and creates a new standard for determining the appropriateness of an owner's distributive share. The new standard states that the share must be consistent with the owner's economic interest in the passthrough.

Speaking on background about the plan, a Camp aide said that economic interest is "a new way of phrasing substantial economic effect." The aide said that because Option 2 would essentially eliminate special allocations, and many of the substantial economic effect rules in regulations under section 704 exist to address cases involving special allocations, economic interest was an attempt "to refocus" substantial economic effect. "In our mind, we cleaned that up and we're focusing more on what is your cash -- what is your waterfall," the aide said.

Bob Crnkovich of Ernst & Young LLP said that but for the so-called "bucketing" provision limiting special allocations, it appears that the economic interest standard in Option 2 is intended to achieve the same goal as the current section 704(b) rules, which he said are designed to force the tax to follow the economics. He praised Camp and his staff for taking on what he believes are "really thorny issues."

Monte A. Jackel of Monte A. Jackel Federal Tax Advisory Services LLC asked whether, under Option 2, an allocation of profits without a corresponding capital account would satisfy the economic interest standard. If it would, that option would preserve the current treatment of carried interest. (Related analysis.)

When asked whether Option 2 would preserve a passthrough's ability to issue a profits interest to an owner, the Camp aide said, "I don't see why not. What we envisioned is that you could have a bunch of different interests, and if what you're entitled to is a profits interest, you're entitled to basically a share of the cash, right? That would seem to us to be perfectly workable under this regime."

The aide said that if an agreement provides for limited partners to get a percentage of the income before any general partners receive income, that could be allowed. "As long as what we're ultimately allocating matches that economic reality, I don't see what the problem is," the aide said.

When asked about whether the proposal would change the law relating to some stuffing allocations -- specifically allocations of reverse section 704(c) amounts that are aggregated in a hedge fund context or other section 704(c) allocations -- Crnkovich said that proposed section 712(d) seems to be very similar to current section 704(c) but for certain changes, such as to the seven-year rule. He added that without addressing the efficacy of special allocations, "presumably the section 704(c) analysis currently undertaken would not change."

Small Businesses

The release announcing Camp's new draft proclaimed that the plan is about "strengthening the economy and increasing wages by making the tax code simpler and fairer for America's small businesses." While many of the proposals in the discussion draft, particularly those included in the core concepts portion, have received praise from the S corporation community, it's debatable whether all of them, including the one that would require mandatory basis adjustments of partnership assets, would actually make tax compliance easier for small businesses. It's also unclear whether the discussion draft is really focused on small businesses.

In a 2011 study by the Treasury Office of Tax Analysis, small businesses were identified as those with total receipts or total income less than $10 million. In 2003 -- the most recent tax year for which data were available from the IRS Statistics of Income division -- 96.7 percent of C corporations would meet that definition of small business in that their total business receipts were less than $10 million. However, 12.8 percent of S corporations and 10 percent of partnerships are large businesses, with total business receipts of $10 million or more.

And while about 7 million businesses would be affected by Camp's proposal, the Small Business Administration -- which identifies small businesses using the number of employees or average annual receipts thresholds by industry --- claims that the United States has 28 million small businesses.

Outlook

Camp's latest discussion draft raises some serious policy questions that could have far-reaching implications. The Camp aide was clear that the proposal in Option 2 was "very preliminary." For instance, although the option could be read as applying to a publicly-traded partnership that can show that 90 percent of its gross income is passive, the Camp aide said, "we made no policy decisions at all" regarding master limited partnerships or publicly traded partnerships.

Camp's spokeswoman, Michelle Dimarob, said, "Just because something isn't mentioned explicitly in any one discussion draft we've had out so far doesn't mean anybody should draw any conclusions about anything."


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