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S. HRG. 110–1049

C, K, OR S: EXPLORING THE ALPHABET

SOUP OF SMALL BUSINESS CHOICES

IN ADVANCE OF TAX REFORM

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

SECOND SESSION

JUNE 5, 2008

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

MAX BAUCUS, Montana, Chairman

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

DEBBIE STABENOW, Michigan

MARIA CANTWELL, Washington

KEN SALAZAR, Colorado

CHUCK GRASSLEY, Iowa

ORRIN G. HATCH, Utah

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

PAT ROBERTS, Kansas

JOHN ENSIGN, Nevada

JOHN E. SUNUNU, New Hampshire

RUSSELL SULLIVAN, Staff Director

KOLAN DAVIS, Republican Staff Director and Chief Counsel

(II)

C O N T E N T S

OPENING STATEMENTS

Page

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

on Finance ............................................................................................................ 1

Grassley, Hon. Chuck, a U.S. Senator from Iowa ................................................. 2

WITNESSES

Shackelford, Dr. Douglas A., Meade H. Willis distinguished professor of taxation and accounting, UNC Kenan-Flagler Business School, Chapel Hill,

NC ......................................................................................................................... 4

Toder, Dr. Eric J., senior fellow, Urban Institute, Washington, DC ................... 6

Starr, Samuel P., tax partner, PricewaterhouseCoopers LLP; and adjunct

professor of law, Georgetown University Law Center, Washington, DC ......... 7

Martin, Dewey W., CPA, CMA, professor and chair of the Accounting Department, Husson College, Hampden, ME ................................................................ 9

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Opening statement ........................................................................................... 1

Grassley, Hon. Chuck:

Opening statement ........................................................................................... 2

Prepared statement .......................................................................................... 27

Martin, Dewey W., CPA, CMA:

Testimony .......................................................................................................... 9

Prepared statement .......................................................................................... 29

Roberts, Hon. Pat:

Prepared statement .......................................................................................... 36

Salazar, Hon. Ken:

Prepared statement .......................................................................................... 37

Shackelford, Dr. Douglas A.:

Testimony .......................................................................................................... 4

Prepared statement .......................................................................................... 38

Snowe, Hon. Olympia J.:

Prepared statement .......................................................................................... 45

Starr, Samuel P.:

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 46

Toder, Dr. Eric J.:

Testimony .......................................................................................................... 6

Prepared statement .......................................................................................... 59

COMMUNICATION

Women Impacting Public Policy (WIPP) ................................................................ 69

(III)

(1)

C, K, OR S: EXPLORING THE ALPHABET

SOUP OF SMALL BUSINESS CHOICES

IN ADVANCE OF TAX REFORM

THURSDAY, JUNE 5, 2008

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10:07 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Wyden, Salazar, Grassley, and Snowe.

Also present: Democratic staff: Bill Dauster, Deputy Staff Director and General Counsel; Cathy Koch, Senior Advisor, Tax and Economics; and Rebecca Baxter, Tax Counsel. Republican staff: Mark

Prater, Deputy Chief of Staff and Chief Tax Counsel; and Jim

Lyons, Tax Counsel.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The committee will come to order.

The poet Archibald MacLeish once wrote, ‘‘The business of the

law is to make sense of the confusion of life, to reduce it to order,

and at the same time to give it possibility, scope, even dignity.’’

Today we consider the laws governing the taxation of small businesses. Do those laws bring order out of confusion or do they bring

confusion out of order? How far are they from the ideal of giving

businesses possibility, scope, or even dignity?

Small businesses play an important role in keeping our economy

strong. They are a vital source of job creation, economic opportunity, and technological innovation. There are about 26 million

small businesses in America. Businesses with fewer than 500 employees represent more than 99.9 percent of all American businesses.

Small businesses pay nearly half of total American private payroll. They have generated 60 to 80 percent of the new jobs annually

over the last decade, and small businesses employ 40 percent of

high-tech workers, such as scientists, engineers, and computer

workers.

Small business is particularly important in rural States like

mine in Montana. In our State, even the large businesses are generally small businesses. Rural communities generally do not have

big corporate employers. Rural families rely on small businesses for

jobs.

2

* For more information, see also, ‘‘Tax Reform: Selected Federal Tax Issues Relating to Small

Business and Choice of Entity,’’ Joint Committee on Taxation staff report, June 4, 2008 (JCX–

48–08), http://www.jct.gov/publications.html?func=startdown&id=1291.

So I am happy today that we are looking at small business tax

issues as we prepare for tax reform. The way that a business chooses to organize has a significant effect on its taxes. The principals

of a business can choose to have their income taxed as part of individual income tax or they can choose to have their income taxed

separately at the level of the business in corporate form.

The income of sole proprietorships, partnerships, and S corporations is all taxed as individual income, after it is allocated to the

business owners. People call these types of businesses ‘‘passthrough entities.’’

Each of these pass-through entities has its own unique features.

Some of these features can create barriers to growth and innovation. Others can provide financial advantages and incentives for

the business to grow and create jobs.

When we think about tax reform, we have to consider whether

the tax code meets all of these different models. We also have to

keep in mind that the needs of different small businesses are different.

‘‘One-size-fits-all’’ does not work when choosing a business model.

The needs of a sole proprietorship may differ from those of an S

corporation. We need to keep these differences in mind so that all

businesses have a fair shake and can benefit from reform.

Today we will explore these differences. We will look at the way

that the Federal Government taxes the income of domestic noncorporate businesses. We will seek to identify the benefits to the

American economy provided by partnerships and other passthrough entities.

And we will examine entity classifications. We will hear about

the background of current entity classifications, the purpose behind

each classification, and the issues and problems that arise from

them.

The witnesses we have here today have a breadth of knowledge

and experience dealing with business entity choices. They know the

effect that taxes have on small business. And they know the way

that small businesses choose to do business.

So let us examine the laws governing the taxation of small businesses. Let us try to bring some order to the confusion. And let us

work toward the goals of giving businesses possibility, scope, and

even dignity.*

Senator Grassley?

OPENING STATEMENT OF HON. CHUCK GRASSLEY,

A U.S. SENATOR FROM IOWA

Senator GRASSLEY. Thank you very much, Mr. Chairman. I am

glad to be with you on a subject that we always hear about from

our constituents at town meetings, why don’t you get rid of this tax

system? The trouble is, nobody really has their mind made up

about what ought to take its place. Today we are looking at business, whereas most of my comments come from people who pay

taxes as individuals.

3

Taxpayers have a wide variety of entities to choose from when

starting a small business. These small business owners can operate

as a limited liability company, as an S corporation, a partnership,

a limited liability partnership, sole proprietorship, or a farm sole

proprietorship. And over the years the number of entities keeps increasing. The tax laws relating to small businesses have also grown

increasingly complex over time.

Some of this complexity exists because we give partnerships a lot

of flexibility when allocating income, losses, and deductions to partners. However, a lot of the complexity found in the partnership tax

rules arose in response to abuse by partnerships that were trying

to unfairly take advantage of rules.

In response to this complexity, a lot of taxpayers’ gut reaction

happened to be that the tax system should be simplified. However,

taxpayers usually want the tax system simplified unless it means

that they have to pay more taxes. Another thing that taxpayers

care about is having the freedom to conduct their business the way

that they want, so the wide variety of entity choices currently

available allows small business owners much freedom.

One of these choices, the limited liability company, has become

increasingly popular. The LLC offers the best of all worlds: limited

liability, a single-level tax, and great flexibility in allocating income

deduction losses. Even though an LLC provided these attractive

features, people were originally hesitant to form an LLC because

the case law relating to LLCs was not as developed as the case law

relating to S corporations and partnerships. However, as this case

law has developed, small business owners have used the LLC with

greater legal certainty.

Similarly, the LLP has been utilized to a greater degree in recent

years. I should also note that the S corporation remains a very popular entity choice for new businesses. With the growing number of

entity choices comes, of course, complexity. This complexity imposes large administrative costs on hardworking business owners

who must comply with these complicated laws.

Also, the complexity means small business owners cannot be confident that they received all the benefits coming to them or that

they have not paid more than they owe. When looking at simplifying our tax laws for small businesses, then, we must consider the

fact that taxpayers like having choices and flexibility in arranging

business affairs and they do not want to get hit with a tax increase

just for the sake of simplification.

While we all agree something should be done and we should be

open-minded about reform, I would like to remind everyone that,

if we allow the bipartisan tax relief plans of 2001 and 2003 to expire in 2010, it will result in a huge tax increase, particularly on

small businesses.

We just had the Treasury Department publish a paper titled

‘‘Topics Related to the President’s Tax Relief,’’ released just last

week. About 74 percent of tax returns that will benefit this year

from lowering the top rate from 39.6 percent to 35 percent are flowthrough business owners. Also, about 82 percent of the $29 billion

in tax relief this year from lowering the top rate will be received

by flow-through business owners.

4

If we fail to act to prevent this bipartisan tax relief from expiring

at the end of 2010, we will be taking money from the pockets of

small business owners. This is money these small business owners

could use to hire more workers or spend in our economy on goods

and services.

According to the U.S. Small Business Administration, small businesses employed over 58 million workers in 2005, which is more

than all other firms combined. Our small business owners, including farmers, are of course the backbone of the economy. We should

not break our economy’s backbone by hammering it with dramatic

tax increases.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator, very much.

Our first witness is Dr. Douglas Shackelford. He teaches taxation

at the University of North Carolina at Chapel Hill, and is a research associate at the National Bureau of Economic Research.

The second witness is Dr. Eric Toder. Dr. Toder is a senior fellow

at the Urban-Brookings Tax Policy Center, and just recently

worked as Director of the Office of Research at the IRS.

Then we have Mr. Samuel Starr, who is the tax matters partner

for PricewaterhouseCoopers, and is a professor of law at Georgetown.

Finally, Mr. Dewey Martin, who is the owner of a tax practice

and a tenured professor and chair of the Accounting Department

at Husson College in Bangor, ME.

Thank you all for coming. We customarily have all of your statements included in the record automatically, and ask that you speak

for about 5 minutes.

Dr. Shackelford?

STATEMENT OF DR. DOUGLAS A. SHACKELFORD, MEADE H.

WILLIS DISTINGUISHED PROFESSOR OF TAXATION AND ACCOUNTING, UNC KENAN-FLAGLER BUSINESS SCHOOL, CHAPEL HILL, NC

Dr. SHACKELFORD. Senator Baucus, Ranking Member Grassley,

and other members of the committee, thank you for inviting me to

testify on this hearing on small business tax reform.

One of the most important decisions that businesses face is

choosing their legal organizational form. There are many organizational forms that a business may choose, including pass-through

entities. Pass-through means that the entity serves as the conduit

through which the profits of the business pass-through to the investor’s tax return, escaping taxation at the entity level.

Pass-through entities include sole proprietorships, general partnerships, limited liability partnerships, S corporations, and limited

liability corporations, or LLCs. Every pass-through entity has different requirements. Presently, the most popular pass-through entity for new companies is the LLC.

Another organizational form is the C corporation. The profits of

a C corporation are taxed first at the corporate level, and then

shareholders are taxed when they receive dividends. Only C corporations face double taxation, that is, both entity and investor taxation, since pass-through entities are only taxed at the investor

level.

5

Since the purpose of this hearing is to focus on small business

tax reform, and specifically the entity choices that small businesses

face, I will focus my comments on this principal tax difference between C corporations and pass-through entities, that is, whether

the income of the business is taxed at the entity level. To demonstrate the cost of double taxation in the C corporate form, assume a 35-percent corporate tax rate, a 15-percent dividend tax

rate, and a 35-percent individual tax rate, which are our current

maximum tax rates.

If the C corporation earns $1 of income, it pays 35 cents in tax.

If it pays the remaining 65 cents as the dividend, its shareholders

are left with slightly more than 55 cents. In contrast, if a privately

held firm adopts the pass-through entity, its investors are taxed on

the entire $1, leaving its investors with 65 cents. No further tax

is levied on the pass-through entity or its investors.

This difference of nearly a dime, or 10 percent, in after-tax returns to investors provides a major tax incentive to avoid the C corporate organizational form. Even if the C corporation never pays

dividends, fully avoiding the investor-level taxes, it still pays the

same 35 cents of tax at the corporate level alone that the investors

in the pass-through pay in total. Therefore, at best the C corporate

form yields the same after-tax outcomes as the pass-through entities.

Given these incremental tax costs to C corporations, it is not surprising that pass-throughs have naturally evolved to provide the

benefits of the corporate form—for example, legal liability—while

avoiding the corporation’s double taxation.

Furthermore, the demand for a simple level of taxation is so

strong that privately held C corporations commonly distribute their

profits in a tax-deductible manner—for example, year-end bonuses—to mitigate their entity level tax, a form of what I call

‘‘homemade pass-through.’’

Here is my bottom line. If you do not intend to address the primary tax issue motivating pass-through entities, that is, double

taxation, then I recommend making no changes. Each of the passthrough entities has different nuances that appeal to businesses in

different situations. They are well understood in the legal and accounting communities. Changing the rules that apply to business

entities will likely create additional unnecessary transition costs

for small business. Of course, as always, there may be minor

tweaks, either legislative or regulatory, that would marginally improve the system.

Let me close with three final thoughts. First, note that double

taxation only applies to dividends. All of the payments to shareholders and stakeholders of the firm, such as interest and compensation, pass through, that is, they are deductible at the entity

level and only taxed to the recipient.

Second, publicly traded businesses are always taxed as a C corporation and thus must face double taxation. Consequently, our

present tax policy levels higher taxes on firms simply because they

access the public capital markets. If the purpose of this distinction

is to provide tax relief to small business, it is a clumsy means because, while almost all small businesses are privately held, not all

privately held firms are small. There are many large businesses

6

that are privately held and enjoy favorable pass-through status

compared with their publicly traded competitors.

Third, pass-through entities are even more advantageous when

business generates taxable losses which often occur in the early

years for the business. In the C corporation the losses are carried

forward until positive taxable income is generated, if ever. With the

pass-through, the investors can immediately use the losses from

their business to offset other income that they may have.

Thank you very much.

The CHAIRMAN. Thank you, Dr. Shackelford.

[The prepared statement of Dr. Shackelford appears in the appendix.]

The CHAIRMAN. Dr. Toder?

STATEMENT OF DR. ERIC J. TODER, SENIOR FELLOW,

URBAN INSTITUTE, WASHINGTON, DC

Dr. TODER. Chairman Baucus, Ranking Member Grassley, and

members of the committee, thank you for inviting me to testify

today on tax reform and small business.

A tax code that is fair, simple, and conducive to economic growth

is in the interest of all businesses, large and small. Today I will

discuss how provisions of the tax law affect how businesses organize themselves and whether economic activity occurs within small

or large business enterprises, and then comment on how tax reform

may affect these choices. I will just say parenthetically, I am only

going to cover selected aspects of this very, very broad subject.

My testimony makes the following points. First, while several

provisions of the tax law explicitly favor small business, such as

section 179 expensing, more general provisions are much more important for determining business size and structure. Double taxation of corporate equity income encourages businesses to organize

themselves as flow-through enterprises—partnerships, sole proprietorships, and subchapter S corporations—in favor of smaller over

larger businesses which are more likely to be taxable corporations.

Changes in tax laws and regulations that make it easier for businesses to gain the advantage of limited liability without paying corporate tax have facilitated a large growth in the share of business

receipts going to flow-through enterprises in the past decade.

Second, provisions that affect labor income and deductions also

affect business structure. Small business owners benefit from being

able to use more work-related deductions than employees of larger

businesses, but working in the other direction, the tax exemption

for health insurance favors larger businesses that are better able

to pool employee health risks.

Third, the technology of tax compliance and administration affects small and large businesses differently. Small businesses face

higher compliance costs per dollar of receipt than larger businesses,

but also have more opportunities for non-compliance, especially if

paid in cash. So, there are a lot of things going on that affect business structure.

I will comment on a few tax reforms under consideration that

could affect these incentives. First, proposals to lower the corporate

rate and finance the revenue loss by eliminating or reducing some

business tax preferences would, on balance, reduce the relative tax

7

burden on corporations. Among business forms, taxable corporations alone would benefit directly from a corporate rate cut, while

all forms of businesses would pay more tax if business preferences

were scaled back.

Second, proposals to reduce or eliminate the double taxation of

corporate dividends could have widely varying effects on the cost

of corporate capital, income distribution, and economic growth and

efficiency depending on how double-tax relief is designed, and I will

not go into those details. But in all cases, double-tax relief would

reduce the incentive to organize businesses as flow-through enterprises instead of taxable corporations, and also reduce incentives

for corporations to finance themselves with debt instead of equity

and to retain earnings instead of paying dividends.

Health care reform, now under consideration, as you know, will

also involve major changes in Federal tax law. Although there are

big philosophical differences between those who would rely mainly

on mandates and regulations and those who would emphasize

changing market incentives, both broad approaches to health reform would reduce the relative tax advantages to large employers

that the current unlimited tax exemption of employer-provided premiums provides, and I think ultimately will reduce labor costs to

small businesses.

In conclusion, the current income tax influences the distribution

of businesses by size and forms of business organization in many

ways, including many I have not mentioned. Lower tax rates, a

broader tax base, removal of the double taxation of corporate dividends, and reform of our health care finance system would make

the tax law more even-handed in its treatment of different businesses and encourage use of the most productive forms of business

organization.

The CHAIRMAN. Could you say that last statement again, please?

Dr. TODER. I am sorry. Lower tax rates, a broader tax base, removal of the double taxation of corporate dividends, and reform of

our health care finance system would make the tax law more evenhanded in its treatment of different businesses, businesses of different sizes, and thereby encourage use of the most productive

forms of business organization.

Thank you very much.

The CHAIRMAN. Thank you. That was very interesting.

[The prepared statement of Dr. Toder appears in the appendix.]

The CHAIRMAN. Mr. Starr?

STATEMENT OF SAMUEL P. STARR, TAX PARTNER, PRICEWATERHOUSECOOPERS, LLP; AND ADJUNCT PROFESSOR

OF LAW, GEORGETOWN UNIVERSITY LAW CENTER, WASHINGTON, DC

Mr. STARR. Chairman Baucus, Ranking Member Grassley, Senator Snowe, Senator Salazar, good morning.

The CHAIRMAN. Good morning.

Mr. STARR. First, I thank the committee for the opportunity to

testify before you on the way businesses choose to organize and the

tax consequences that result from that choice. Second, I applaud

the committee for exploring this issue, as it is economically significant to many taxpayers. My comments largely will focus on smaller

8

businesses and the tax issues surrounding their choice of business

form. It is the smaller businesses that commonly use the passthrough tax regimes authorized under the code.

Over the past 2 decades, the percentage of businesses using the

pass-through regimes, including sole proprietorships, has increased

significantly. Data shows that larger businesses tend to operate in

regular corporate form, while smaller businesses tend to choose

pass-through forms like limited liability companies and S corporations.

A few of the more significant changes over the past 20 years contributing to this shift in favor of pass-through entities are: first, the

differential between the marginal tax rate imposed on corporations

and individual taxpayers has been narrowed or eliminated; second,

the amount of the double tax imposed on corporate dividends has

remained high until relatively recently; third, the enactment of the

LLC statutes by all 50 States; and fourth, the adoption of the

‘‘check-the-box’’ regulations by the IRS which simplify entity classification and the movement into pass-through tax regimes.

An objective of our tax system should be to create tax parity

among the various business forms so that one taxpayer is not disadvantaged over another simply because of its choice of business

form. Because of the double tax imposed on regular corporate earnings—once at the corporate level, once on dividends—businesses

that choose the regular corporation are disadvantaged compared to

the single tax pass-through entities. Marginal income tax rates imposed on corporate and non-corporate taxpayers play an important

role in what business form business owners decide to use.

For instance, if a small business operates in the LLC form, taxable as a partnership, the LLC’s business earnings are reflected directly in the individual LLC member’s taxable income. Therefore,

small business owners can quickly find themselves at the current

maximum 35-percent marginal income tax rate for individuals with

as little as $358,000 of taxable income for married individuals filing jointly in 2008.

As marginal individual income tax rates change, small businesses react accordingly in their choice of business form. Significant shifts in marginal tax rates and the relative differential between the corporate and individual tax rates can likewise trigger

significant shifts in choice of business entities.

The pass-through regimes effectively allow small business owners to integrate their businesses for Federal income tax purposes

through a choice of an appropriate business form. For instance, the

only practical exit from the corporate double tax is for the eligible

regular corporation to make an S corporation election to treat itself

as pass-through for income tax purposes. In this regard, the S corporation serves much the same purpose today as it did in 1958

when it was first adopted, allowing corporations to move into the

single-tax regime to eliminate the distortive effect of the double tax

on small businesses organized as corporations.

Over the years, Congress has enacted a number of improvements

and refinements, making the S corporation easier to use and available to a broader base of taxpayers. In addition, the IRS has been

very responsive to S corporation needs and has interpreted the S

9

corporation rules reasonably and fairly. For this, the S corporation

community is grateful.

Over the last few decades, more small businesses have chosen to

organize under the code’s pass-through regimes. As noted earlier,

a number of factors have contributed to this migration from the

regular corporate form. Until the distortions created by the double

tax can be resolved, the current pass-through regimes provide a

valid integration function allowing for a more efficient tax system,

at least to that segment of the economy that can use pass-through

tax regimes. Therefore, subchapters K and S should continue to coexist while Congress works out a comprehensive corporate integration model.

Thank you for the opportunity to join you today at today’s hearing. It is, indeed, an honor. This concludes my remarks.

The CHAIRMAN. Thank you, Mr. Starr, very much.

[The prepared statement of Mr. Starr appears in the appendix.]

The CHAIRMAN. Mr. Martin, you bat clean-up here.

Mr. MARTIN. Well, as a fantasy baseball freak, I can appreciate

that.

The CHAIRMAN. All right. Good.

STATEMENT OF DEWEY W. MARTIN, CPA, CMA, PROFESSOR

AND CHAIR OF THE ACCOUNTING DEPARTMENT, HUSSON

COLLEGE, HAMPDEN, ME

Mr. MARTIN. Chairman Baucus, Ranking Member Grassley, Senator Salazar, and from the great State of Maine, Senator Snowe,

thank you for inviting me here today. It is an honor to be here.

I also want to thank the NFIB for their support in getting me

here and helping me with my presentation.

If I appear uncomfortable to you, it is partly because, before I left

Bangor yesterday, Homeland Security took my aftershave, my

toothpaste, and my deodorant. [Laughter.]

The CHAIRMAN. I think that is because, if I am correct on this—

maybe I am incorrect; I guess I am incorrect, now that I think

about it—that in 9/11, the terrorists started from the Northeast before they went to New York.

Mr. MARTIN. Maine had a problem with that. I do not know how

you bring down a plane with toothpaste. Somebody knows more

about that than I.

The CHAIRMAN. I have the same problem in Bozeman, MT. I

think the smaller airports are much, much more strict than the

larger ones.

Mr. MARTIN. This one was.

The CHAIRMAN. Yes.

Mr. MARTIN. My comments come from a background of 37 years

in a public accounting practice, focusing in great part on tax law

because that is why my clients want me to come in the door. I have

a very small client base of about 280 clients, 90 percent of whom

are pass-through entities, very few C corporations. The double taxation of income at the C corporation and the dividends being taxed

at the shareholder level has already been addressed, but one point

that has not been addressed which affects the small business community significantly is when a business changes hands, that the C

10

corporation sells their assets and then distributes the proceeds to

their shareholders.

There is also significant double taxation on those two transactions, and now we are not talking about maybe a couple thousand dollars a year in tax costs, we could be talking about hundreds of thousands or more in tax costs because of the elimination

of what used to be called the Kimbell-Diamond Rule back in the

Tax Reform Act of 1986. That is a very significant issue with regard to C corporation taxation. That is the primary reason why I

attempt to funnel my clients towards a pass-through entity. About

the only advantage today, to me, for C corporation status is fringe

benefits. They still have to follow ERISA, they still have to follow

discrimination rules, but they do not have a lot of the other problems that the pass-through entities have with fringe benefits.

As has already been said, most partnerships formed today are

LLCs. A lot of attorneys that I deal with are recommending LLCs

to sole owners, and I am just sorry I do not go along with that recommendation, so a lot of times I do not recommend that they do

that, for simplicity’s sake.

Partnerships do allow the free flow of cash in and out. It is very

easy to do, the cash going in, the cash going out when any partner

needs it. That is a very important way to handle an individual’s

personal cash flow advantages, and a lot of the partnerships that

I have as clients are real estate developers that have big money

going in, big money going out, and the partnership form works for

them.

But subchapter K in the Internal Revenue Code is virtually unintelligible. Luckily, we have had a lot of support from the IRS in

helping us with how to do things, but it is some of the toughest

tax law there is to deal with. No double taxation of income or on

liquidation for partnership. One thing that bothers me with the

partnerships is that they are not allowed to have wages, and I happen to think that partnerships ought to be allowed to have wages.

My clients who are partners would like to have withholding taken

out of their pay so that they have less of an issue with estimated

tax payments, and I think that would be a simplification that

would help things.

An S corporation is very easy to set up. I have clients who set

them up themselves. The attorneys in the audience would not like

for me to say that, but they can easily do it themselves in Maine,

and I encourage them to do so. Easy transfer of ownership. LLC

has easy transfer of ownership as well.

But in terms of succession planning, it is very easy for me to go

to a client and say, all right, transfer this number of shares to your

children December 31 to January 1 to take care of the gift tax exclusion. It is very easy to do with S corporations. There is no double taxation on income or liquidation, as long as you do not run

afoul of the built-in gains tax problem, which I have run afoul of

several times.

Just a note on the way the IRS has ruled that we have to handle

health insurance for shareholders of S corporations. Someone needs

to take a look at that. I do not have one client who understands

how that is supposed to be done.

11

Another thing that I think that ought to be fixed is the basis for

S corporation shares for guaranteed loans. Right now, the S corporation shareholder does not have basis for loan guarantees, only

for direct loans. Partnerships do, and I think S corporation shareholders should as well.

My client base basically does not have accountants: I am their

accountant. I effectively function as their part-time comptroller for

their businesses. I do not have one client that has someone, I

would say, qualified as an accountant. I also do not have one client

that has a human resource person, so I pretty much answer most

of the human resource questions. That is a shame. Their retirement plan issues, their health plan issues, and how to deal with

them, the myriad of the tax laws, is very, very difficult for them

to deal with. Complexity is the single biggest problem for my small

business clients.

In closing, I would like to say, remember that small business has

generated 60 to 80 percent of all the net new jobs over the last decade, so please consider small business when enacting any tax law

changes.

Oh. And just as an aside, please enact the extenders before December. [Laughter.]

Thank you for inviting me, and thank you for listening.

The CHAIRMAN. Thank you very much, Mr. Martin. We deeply

appreciate your approach.

[The prepared statement of Mr. Martin appears in the appendix.]

The CHAIRMAN. I just have a general question, but I think it is

a fairly important one. I suspect that the next President will submit a major health reform proposal to the country, whether it is

Barack Obama or John McCain. At the same time, we have a potential collision coming down the track in the tax code with the

2001 and 2003 provisions expiring, Federal estate tax zeroed in

2010, AMT, $10,000 down the road in 2010. So there is going to

be kind of a nexus between the two, health care reform and tax reform.

I would like your impressions, your thoughts, your recommendations on how we think about that intersection, I guess, with respect

to small business. That is, health reform and how small businesses

can provide health insurance for themselves, their employees, along

with tax reform. I know you have not had a lot of time to think

about all that, but Dr. Toder, you made some comment along those

lines. I would like each of you to just give us some basic recommendations as we approach health reform and tax reform.

Some of you alluded to the employer-provided exclusion for

health care costs. Many of you suggest that that is too high, particularly because there is no limit on it currently. Some of you suggest that that tends to favor big business, the current law, as opposed to small business.

So I would just like your thoughts on how we might begin to approach that. I will begin with you, Dr. Toder, because you raised

the subject.

Dr. TODER. Well, I am being punished for raising the subject.

The CHAIRMAN. No, no. [Laughter.] You are being rewarded for

raising the subject.

12

Dr. TODER. That is a difficult question. Let me say, I am not a

detailed expert on health care reform, so you will have to go somewhere else for those answers, maybe within your own committee.

The CHAIRMAN. Right. I am just thinking, your general thoughts.

Dr. TODER. But in general, it is clear that the way most Americans get health care is through their employers. The employer deduction that we have now is a key aspect of the tax code that

makes that possible, so, even though it favors large businesses over

small businesses, I think just simply getting rid of it, or severely

curtailing it without doing anything else would be very inadvisable.

The CHAIRMAN. And why does it favor large businesses?

Dr. TODER. Well, basically because, if you are a small business

in today’s insurance market and you have only a small number of

employees, it is very difficult to get good rates. It is very difficult

with the risk pooling situation that we have. So it is really much

more efficient if you can have a large pool of people who are working for you for reasons other than their need for health insurance,

and then you can get an adequate group in which to buy coverage.

So, having that kind of agglomeration is very advantageous.

Now, that would be true without the tax code in place, but the

tax code we have has encouraged Americans to get health care coverage through their employers as opposed to through other ways.

So to the extent that that has happened, it has made it a little

easier for large employers. Now, large employers are also concerned

about rising health care costs.

The CHAIRMAN. You are talking about the pooling availability,

the larger number with respect to big business?

Dr. TODER. Yes. Yes. Right. And if you look at the data, the

health insurance coverage is much higher in large business.

The CHAIRMAN. Who wants to go next? Mr. Starr?

Mr. STARR. I will comment that, although I am not a health care

expert, I would recommend that whatever we do with respect to

health reform, that it be a reform proposal that would create parity

across all business forms. You want to treat all taxpayers equally,

large and small, and basically create parity between them.

The CHAIRMAN. Any thoughts on how we do that? What is the

discrimination now, as you see it?

Mr. STARR. No. Right now I think there is not discrimination

against any of the business forms. There would be a concern on my

part if you went into health care reform that potentially might not

take into account the fact that we need to have parity among all

entities, large and small.

The CHAIRMAN. All right.

Mr. Martin?

Mr. MARTIN. My issue with health care is the complexity of the

options that are available: flexible spending accounts, cafeteria

plans, health reimbursement arrangements, health savings accounts. It is extremely hard for small business to figure out which

one is the right option. The big corporation has the human resource

officer and they decide, this is what we are going to do.

If you allow partnerships to have partners be employees and you

allow S corporation shareholders to have fringe benefits like C corporation employees do and have those partner employees have the

13

same fringe benefits, we would kind of have an equal playing field,

and these same type of plans will work for all those entities.

The complexity of dealing with choice of entity is affected by

what is available for health insurance options. We have benefits expiring, the estate tax, in 2010, December 31. If your grandparent

is plugged in, there is no estate tax if they die December 31, there

is an estate tax if they die January 1. Hopefully we will enact some

laws so there are not any post-mortem plannings about whether we

pull the plug or not because of the estate tax. Interesting classroom

discussions.

The CHAIRMAN. Right. Yes. But figuring on all the complexity in

health care plans, is there that much difference between the plans

or the options, or on the margin is there that much difference? I

understand all the complexity and it causes a lot of businessmen

to pull their hair out, it is so complex, and you too when you are

working with them.

Mr. MARTIN. Right.

The CHAIRMAN. But I am just curious whether, given all that,

and given our system in which there is going to be complexity because different health insurance companies are going to offer different plans, different options, and so forth, is it tolerable? Could

you deal with it? That is my question.

Mr. MARTIN. We have to deal with it. I am the one who deals

with it for my clients because they do not have anybody who can

deal with it. It does not have to be as complex as it is. I do not

know why we need to have HSAs and HRAs. I think those fringe

benefit plans can be boiled down into one account. I happen to be

a big fan of HSAs because it encourages individuals to manage

their own health care with their own money, and I think that is

a good thing to be doing.

The CHAIRMAN. Well, we are trying to do that in another area,

and that is in education. There are so many different ways to——

Mr. MARTIN. Boy, is that the truth.

The CHAIRMAN. Yes. And trying to make it that much more simple by boiling them down into a couple——

Mr. MARTIN. That would be wonderful.

The CHAIRMAN. All right.

Dr. Shackelford? My time has expired, but go ahead. Just very

briefly, the interplay between the two, any recommendation you

might have?

Dr. SHACKELFORD. I will be very quick because I do not have

much to add to what they have said. I cannot even understand my

own health care options, and I would say that I am glad I am sitting behind this desk instead of behind your desk, given the tsunami of tax issues that are coming, and health care, and the other

issues in the very near future.

The CHAIRMAN. Thank you. [Laughter.]

Senator Grassley?

Senator GRASSLEY. I have several paragraphs of background information here that talk about how, when the tax bill of 2001 and

2003 expire, how taxes are going to go up. I want to get immediately to the question for at least two or three of you to answer.

You do not have to repeat each other, but I would like to have more

than one view.

14

As you know, the vast majority of our small businesses are taxed

on their business income at the individual owner’s level because

the vast majority of our small businesses are operated as either

sole proprietorships or pass-through entities.

If we let these tax relief provisions expire at the end of 2010,

what effect would these tax hikes have on small businesses? Somebody jump in, and maybe a couple of you comment. Do not fight

over it. [Laughter.] Mr. Martin?

Mr. MARTIN. The only way a business can grow its business is

with cash, and, if we take more money out of their pocket, out of

the business owner’s pocket and put it into government’s stream of

revenues, then we have less money to expand the business and add

more employees.

Senator GRASSLEY. All right.

Dr. Toder, you were going to jump in.

Dr. TODER. Sure. I would just like to share a little data with you,

because there are a lot of numbers that are thrown around. One

number which I think you cited in your statement is—and I have

a comparable number—in the top two tax brackets, 78 percent of

tax units report some form of business income. However, many of

those people are not small business people in the sense that you

would normally think. Only about 40 percent of those have business income that is above half of adjusted gross income.

Another thing that we need to consider is, when you look across

the scope of people who have business incomes, many of them

would not be affected by increases in the top brackets. In fact,

while only less than half of 1 percent of tax units are in the two

top brackets, more business units are, but it is still a small number. Only 1.4 percent of tax units with some business income are

in the top two brackets and 2 percent of tax units with over 50 percent of AGI from business income are in the top two tax brackets.

So while certainly a rise in the tax rate will burden high-income

individuals if those top tax rates’ cuts expire and many of those

high-income individuals have some business income, it is also the

case that most people with small business income are not in those

tax brackets.

Senator GRASSLEY. Let me clarify that I was citing Treasury Department figures when I gave those figures out.

Dr. TODER. No, no. That is absolutely right. I think it is just a

question of what figures are cited. As I said, our figures on the percent of high-income taxpayers who report some business income are

very close to the Treasury’s, Senator. I am not contesting those figures; I am just saying that there are different ways of looking at

this.

Senator GRASSLEY. Next, for Professor Starr about general partners of various forms of partnerships paying self-employment tax.

It is uncertain under current law whether a member of an LLC is

treated as a general partner or a limited partner. With respect to

S corporations, in contrast to LLCs, wages are subject to employment tax. Only the amounts an S corporation pays its shareholders

as compensation are wages for those shareholders.

We had the Joint Committee on Taxation putting two proposals

before us to modify the employment tax provisions for S corporaVerDate 11-MAY-2000 14:28 Jul 23, 2010 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 57345.000 TIMD PsN: TIMD
15

tions, LLCs, and partnerships. The Bar Association has had some

recommendations.

So my question to you is, what changes would you recommend

to employment tax laws governing S corporations, LLCs, and partnerships?

Mr. STARR. Thank you, Senator.

First, I would clarify for purposes of the Internal Revenue Code

what is a general partner and what is a limited partner for purposes of the self-employment tax. Right now, we have proposed regulations from the IRS that give us guidance, but they are only proposed regulations. It is important to know whether you have a general partner. If you have a general partner, that general partner,

under our current rules, is subject to the self-employment tax on

all their earnings.

If you have a limited partner under our current code, they are

only subject to self-employment tax to the extent that they receive

guarantee payments for services rendered. Under the current rules,

we just are not clear with respect to an LLC member, for example,

whether they are a general partner or whether they are an LLC

member.

Aside from that issue, I would also recommend that the committee consider the AICPA–American Bar Association proposal

whereby we would create parity between the pass-through entities

with respect to the self-employment tax. I recognize that S corporations and their shareholder-employees are paying employment

taxes on their wages.

I think a similar rule in the area of partnerships and in the LLC

arena would be very workable. In other words, you would subject

to self-employment tax, in an LLC or in a partnership, the amount

of payments to that partner for services rendered. To the extent

that income coming to that partner is attributable to capital, it

would not be subject to self-employment tax, very much akin to the

S corporation regime.

Senator GRASSLEY. Thank you, Mr. Chairman.

The CHAIRMAN. Senator Salazar?

Senator SALAZAR. Thank you, Chairman Baucus and Senator

Grassley.

My sense from the testimony of the panel is that you like these

pass-through entities, that they have worked well. They have been

around for a long time, the subchapter S, subchapter K partnerships, the LLCs, et cetera.

So my question to you is—and if you would take about 15 seconds, each of you, to respond—if there was one thing that you

would do to try to improve these pass-through entities under the

tax code, what would the one thing be? I will ask you to just take

15 seconds to do that.

Why don’t we start on this side of the table since you are closer

to me, Mr. Martin?

Mr. MARTIN. Well, the critical part is simplification. Mr. Starr’s

statement a minute ago about symmetry between the taxation of

self-employment income at the different pass-through entity level

would be huge for my clients.

Senator SALAZAR. So self-employment income for the different entities.

16

Mr. MARTIN. Symmetry. Right.

Senator SALAZAR. All right.

Mr. STARR. Senator Salazar, I was going to say the same thing.

So, thank you, Mr. Martin. I think we need to fix the self-employment tax issue with respect to pass-through entities.

Senator SALAZAR. All right.

Dr. Toder?

Dr. TODER. Actually, I was also thinking the self-employment tax

and the different treatment of sub-S and corporations is an issue

that needs to be addressed.

Senator SALAZAR. All right.

Dr. Shackelford?

Dr. SHACKELFORD. I think what you are trying to achieve is a

corporation without double taxation, so I believe in the liberalization of the rules that will get you there more quickly. If I look at

something that has evolved over time, the S corporation has gone

from a very restrictive entity to a less restrictive, and I think you

should continue down that path. One example would be relaxing

the current restriction that you can only have one class of stock.

That would be an improvement.

Senator SALAZAR. Let me ask a question, following up on Senator

Baucus’s questions related to health care. It is a big issue here in

Washington. It is a big issue related to small business because everybody struggles with health care, but I think particularly small

business, trying to figure out whether they can afford it, whether

they cannot.

So as we look at taxation matters with respect to health care

benefits and changes in that area, what advice would you give us

to make sure that we do not run afoul of the great desire that I

think most small businesses have to provide health insurance to

their employees? Dr. Toder, you are the one who raised it in your

summation. You said ‘‘lower tax rates, eliminate double tax, a

broader tax base,’’ but you said ‘‘reform of the health care system’’

on taxation is something we might be able to do.

Why don’t each of you take a stab at that?

Dr. TODER. All right. I thought I got away with that with Senator

Baucus. [Laughter.] I think what ultimately you need to do is some

combination of individual mandates and subsidies, that basically

without some kind of incentive—whether it is through individual

mandates or some kind of reform where everybody has access to insurance on an equal basis, and the system is not dependent on the

group of employees you happen to be associated with—you are

going to have problems down the road. So if you are going to blow

up the current system, you need to put something in its place.

Senator SALAZAR. Would you agree that we ought to blow up the

current system and eliminate employer-based health insurance and

the tax deductibility that is the incentive for that to be created, in

connection with some conversations I have been having with one of

my wonderful colleagues on this committee?

Dr. TODER. I think, ultimately, the current system is going to

erode. If you want to take a stab at that, my only caution would

be, and this is my personal view, I would hope we would eventually

get to a situation where we have universal, or near universal,

health insurance coverage for Americans. We are the only adVerDate 11-MAY-2000 14:28 Jul 23, 2010 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 57345.000 TIMD PsN: TIMD
17

vanced nation that does not have that. That is not going to happen

within the current framework.

Senator SALAZAR. All right.

Are there other members of the panel who want to respond to

that question?

Dr. SHACKELFORD. I think you have to ask, how did we get to

where we are, that one had to be an employee or an employer to

have health care? I think if you go back to that, I believe if we

started from scratch and we did not have wage and price controls

many generations ago, we would not have ended up where we are.

Blowing up the system is a radical concept and would impact

every person in the country. I do not really know how we get from

where we are to there in that kind of radical mode. It seems to me

there have to be some incremental steps that would get us toward

a better policy.

Senator SALAZAR. All right. Thank you very much.

Dr. TODER. I do not disagree with that.

The CHAIRMAN. Thank you all very much. This is a provocative

conversation here.

Senator Snowe?

Senator SNOWE. Thank you, Mr. Chairman. We welcome all of

our panelists, and most especially a fellow Mainer, Mr. Martin.

Thank you for being here. I would say, Mr. Chairman, he has the

depth and breadth of experience, both as a certified public accountant, a certified management accountant, and he also is chair of the

Accounting Department at Husson College, and he is in State and

national leadership with NFIB. He has been named SBA Champion

of the Year for Small Business as an accountant in Maine, New

England, and nationally. So I want to welcome you.

The CHAIRMAN. I might say too, he reminds me of a Montanan.

[Laughter.]

Senator SNOWE. He does, eh? [Laughter.] Straightforward, right?

The CHAIRMAN. Straightforward. I think he is somewhere between Maine and Montana.

Senator SNOWE. Exactly. Thank you. So I welcome you here

today, Mr. Martin. Thank you for being here.

I want to begin with respect to exactly what we should focus on

in terms of simplification. Obviously there are a number of initiatives that you have already discussed that are so critically important to small businesses. I am Ranking Member of the Small Business Committee, and previously chair, so I hear the common and

most frequent complaint about the complexity of the code, and also

the cost of compliance.

There are some critical issues that are so important to the vitality of small business and to this country. So we could use the reform of the tax code as a means by which to make sure that we

preserve this sector of the economy that is the net job generator in

America. So what would you recommend in terms of where we

should do no harm and where we can provide simplicity with respect to some of the tax initiatives?

For example, we have small business expensing. That one is set

to expire in 2010, very critical, frankly, for small businesses. It is

going to go from $250,000 that is in the economic stimulus package

that was recently enacted down to $25,000 by 2010. The tax issue.

18

They have an option of a calendar year versus another year. They

do now, but it is obviously very costly.

Offering the cafeteria plans. Again, it is very complex to offer

simple cafeteria plans because they have to comply with antidiscrimination rules that are very complex for small businesses.

So where should we focus our attention, to make sure that we

preserve what we have, or change—consolidating the pass-through

entities? Should there be some kind of approach to consolidate

these entities by ensuring that we maintain the flexibility and the

advantages that they offer depending on which entity that they

choose? Mr. Martin?

Mr. MARTIN. Well, I have addressed the fringe benefit issue. I

wholeheartedly agree with you, it is way too complex and needs to

be simplified. I think there are some other areas. The section 179

direct expensing. We need to come to a number and leave it there

for a while so that businesses can plan. It does not make sense for

them to have to call me every December and say, how much can

I expense this year?

Consistency is a big thing. The cash basis method of accounting.

We have revenue rulings that say some businesses that have

$1 million in sales, some businesses that have $10 million in sales,

can use a cash method. I think any business that has $10 million

or less in gross receipts ought to be able to use the cash method

of accounting, recognizing that an inventory cannot be deducted

until it is sold. That single exemption would be a huge simplification.

In the proprietorship arena, the home office deduction should be

simplified. It would be very easy just to write a law that says $10

a square foot. You still have to meet other rules to deduct it, but

the recordkeeping associated with it is huge. So, $10 a square foot

for a home office, and then they do not have to keep all those

records.

Senator SNOWE. Mr. Starr?

Mr. STARR. I would like to comment on the idea of potentially

simplifying the code and the small business owners’ compliance by

consolidating the two pass-through regimes. I personally believe

that, as the code stands now, it is important to leave those two regimes outstanding to co-exist with one another because I think it

creates tax efficiencies for the small business owner. The choice,

the option to choose subchapter K, go subchapter S, I think is important for tax efficiencies.

Senator SNOWE. Dr. Toder?

Dr. TODER. I do not really have much to add on this.

Senator SNOWE. Dr. Shackelford?

Dr. SHACKELFORD. Yes. I was just jotting down a few things that

they have already said. I think cash accounting. You can expand

that.

Senator SNOWE. With $10 million? I know Senator Bond had that

legislation introduced as $10 million that would be the basis.

Dr. SHACKELFORD. I do not really have a figure in mind.

Senator SNOWE. All right.

Dr. SHACKELFORD. But more is better than less. I think widespread expensing makes lots of sense. I think, though I would respect the way some of my fellow panelists make their living, I

19

think almost anything that reduces the need for an accountant or

lawyer to help you with your taxes is good policy.

Now, having said that, there is a point at which you cross the

line—and it is not very far—until you have to have professional

help. When you have the sort of entities we are looking at here,

that is not a layman’s job, and never can be.

My fear on the ‘‘do no harm’’ thing is that, if you go in and you

create a new entity, or even if you reduce the ones you have, you

may create more complexity than you do simplification. One of the

good things about these that we have is that there is a long history

that has gotten us to where we are and that in some sense brings

simplification.

Senator SNOWE. Well, I just mentioned ‘‘do no harm’’ because I

was serving in the U.S. House of Representatives when we engaged

in the last tax reform effort that ostensibly was supposed to be tax

simplification, and obviously we learned, unfortunately, otherwise.

It created a lot of unintended consequences. Since then we have

had 15,000 different changes to the tax code, and we have had 100

different pieces of legislation during that period of time since, so

obviously that is a real hardship, particularly for small businesses,

but for all Americans, frankly.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator Snowe.

Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman. This has been a

great panel.

Let me ask this health care issue a different way, and it plays

off, I think, a couple of the comments. When I think about the

employer-employee relationship in health care, the way I would

characterize the future is trying to find a way to modernize that

employer-employee relationship rather than to ‘‘blow’’ it up. I have

been listening to some of these characterizations. It really relates

to the point that you made, Dr. Shackelford, that we got into the

wage and price controls and there was no way to do it, so we essentially said, let us just tie health care and employment together.

My question to you, Dr. Toder, is, if we create more options for

employers and employees—which is what we have sought to do in

the Healthy Americans Act, now with 14 sponsors, 7 Democrats

and 7 Republicans—and we say, look, employers can continue to

offer coverage if they choose to, but we are not going to automatically tie health care and employment together the way we pretty

much did in the 1940s, would that not be one way to start the process of leveling the playing field for the small business person? Because it seems to me that that would be one way to start us down

the road of an approach that worked for both employers and for

workers.

Dr. Toder?

Dr. TODER. Well, I guess it really depends on what you mean by

choice. As I understand what you are trying to do, it is to have

some kind of a mandate to purchase insurance coupled with subsidies for those with low incomes who could not otherwise afford it,

and then say to them, they can get insurance wherever they can.

Obviously you would need to, as I think you do, combine that with

some kind of insurance market arrangements that would ensure

20

that insurance companies are not cherry-picking and just picking

the healthy people to sell insurance to. So this is a complex process. I think what you do if you do go that way, you are expanding

choices, but you then are in some sense taking away the employer

position as the dominant——

Senator WYDEN. No, we are not. We have filed an amendment,

Senator Grassley and I, the Ranking Republican here, that specifically says that, if the employer wants to keep doing what they are

doing, they can keep doing it. If the worker wants to stay with the

employer, they can stay with them. We are simply creating more

options for both the employer and for the employee.

I think you made a very thoughtful comment about how we need

to level the playing field for the small business person, and that

is why it seems to me, if we do not automatically say that we have

to tether health care and employment together, we start moving in

the direction you are talking about.

Dr. TODER. Well, I think you are right: you are creating more options. But in some sense, in creating those options you are taking

away the advantage large employers have as a supplier of health

insurance, so you are radically changing the system in doing that.

Senator WYDEN. I do not want to repeat myself, but we are not.

The fact is, if——

Dr. TODER. It might be a good way to do it.

Senator WYDEN. If Intel and Microsoft and large employers want

to keep doing what they are doing, the amendment I filed with

Senator Grassley says absolutely nothing changes. Absolutely nothing. But in giving particularly more options to small employers,

which is, I think, a very important point that all of you have made,

it seems to me we get the upside of what you are talking about of

trying to help the small employer without the down side of ‘‘blowing’’ something up.

But you all have been very good. This has been a great panel.

Dr. Shackelford, thank you for bringing up the history here, because what we are doing in 2008 does not make a lot of sense for

1948. I want any employer in America who wants to keep doing exactly what they are doing to have the chance to do it, and Senator

Grassley and I made that explicit. We filed a separate amendment

so there was not any confusion about it. But I hope that we will

also walk away saying we have to modernize this relationship, and

we will be asking the counsel of you four on how to do it.

Mr. Chairman, this has been a great panel, a great series of

hearings on tax reform. Thank you.

The CHAIRMAN. Thank you, Senator.

I would like you to comment on the 1986 tax reform changes and

the degree to which it helped or hurt small business, and what has

happened. Who wants to go first?

Mr. STARR. I will jump in. The Tax Reform Act of 1986. I thought

at that time—I was very actively engaged with clients—that it was

beneficial to small businesses. For example, there were a number

of ‘‘incentives’’ in the Tax Reform Act that turned out in favor of

moving from the double-tax regime, the regular corporation, to

making S corporation elections, which helped closely held private

businesses to move out of the double tax into a single-tax regime.

21

The CHAIRMAN. Now, since 1986 has there been erosion or have

there been more changes that helped?

Mr. STARR. I would say, net-net, since 1986, over the past 20

years all the changes, I would say, pretty much have favored moving into the pass-through regime. So I do not think we have actually eroded since 1986; we have progressed since 1986.

The CHAIRMAN. All right.

Anyone else? Dr. Toder, what do you think?

Dr. TODER. Well, I think I would comment on the 1986 Act as,

it was enormously beneficial to the economy to drop the rates and

eliminate many of the tax shelters. I think anything that is good

for the economy is probably good for small businesses as well. So

beyond that, I do not think I have much to add to what Mr. Starr

said.

The CHAIRMAN. Dr. Shackelford?

Dr. SHACKELFORD. I agree. I think it was a great advancement.

I would add that it did trigger an extraordinary shift from C corporations to S corporations in a relatively short period immediately

following the enactment, and it was because you suddenly went

from a regime that potentially favored C corporations or did not

particularly disadvantage them, to a situation where the C corporation was highly disadvantaged because you had a 28-percent rate

for individuals, you had a 34-percent rate for corporations, plus an

additional rate on the dividends.

Whether that is good or bad for the economy is different from

whether it is good or bad for small business. It was definitely good

for privately held businesses and those who could opt for flowthrough relative to businesses that did not have that option.

The CHAIRMAN. You had said earlier that you see a trend, a shift

toward flow-throughs, S corporations and whatnot, and there is

more opportunity. It is easier to form and it is advantageous to

small business. Could you comment on that a little more, please?

Dr. SHACKELFORD. Well, I think what has happened is, everybody wants to get to a flow-through status. They do not want the

double taxation of corporations. We do not have an integrated corporate and individual tax system right now, so companies are looking, business is looking, for opportunities to get to what we should

have, which is a single level of taxation.

The CHAIRMAN. And you are implying that we should continue

down that road?

Dr. SHACKELFORD. I’m sorry?

The CHAIRMAN. You are implying that we should continue down

that road?

Dr. SHACKELFORD. Yes.

The CHAIRMAN. All right.

Mr. STARR. I would say that we ought to move as quickly as we

can to a corporate integrated tax system. I think that would be a

first priority for tax reform: an integrated tax system.

The CHAIRMAN. And how would that work? I am a little confused.

Mr. STARR. There are a number of different models out there in

terms of what would be an integrated tax system. You could have

an exclusion of the dividend at the individual level. You could have

a full deduction of the dividend at the corporate level. There are

various approaches to an integrated system. I would say my reacVerDate 11-MAY-2000 14:28 Jul 23, 2010 Jkt 000000 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 57345.000 TIMD PsN: TIMD
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tion is, I would be open to whatever the committee can consider,

but I think as a first priority we would like to move towards an

integrated tax system. Once we get that parity created between

regular corporations and the pass-through regimes, I think then we

can progress on other reform.

The CHAIRMAN. Mr. Martin?

Mr. MARTIN. Well, I think, first of all, what is good for small

business, I think, is good for the economy, since small business creates the jobs. I guess I think the liberalization of the rules regarding S corporations has been very positive since 1986. The addition

or increase in the number of shareholders that are allowed, the

ability of some trusts to hold S corporation shares, have both been

very beneficial. I think the second class, the preferred stock issue,

is a great thought for Dr. Shackelford. That would be a big increase

as well.

I think the pass-through entities—I do not even talk to my clients about C corporations any more. I only talk to them about S’s

and pass-through entities.

The CHAIRMAN. And what is the down side of moving in that direction? That is, do we shift more towards changes in the law

which make it easier to form as a non-C corporation? Are there any

disadvantages?

Dr. TODER. I think what you have done is leveled the playing

field among different types of small business organizations and reduced the transaction costs in going into an S corporation or limited liability form, and I think that is terrific for small business.

But what has happened is, you have really sharpened the difference between the taxation of small businesses and the taxation

of publicly traded companies that have to face the double-tax regime.

So I think you need to ask yourself the question about whether

it should be public policy to advantage one type of business over

another, and I think at some level you have made things more neutral among different types of small business, but on the other hand

you have set out this publicly traded corporation more by itself

than in terms of a heavily taxed plan.

The CHAIRMAN. My time has expired. I see Senator Snowe maybe

is not totally prepared to ask a question yet, so let me ask one

more, unless she is ready right now. Are you ready now?

Senator SNOWE. Go ahead.

The CHAIRMAN. All right.

Different subject: tax gap. Many say, and I think Treasury has

said, or IRS has said, that maybe our tax gap is, who knows, $300

or $400 billion a year annually, and about $60 to $80 billion might

be payroll tax, that is, taxes legally owed but not paid. Some say,

gee, a lot of that is small business and a lot of that is a cash-based

economy. Your thoughts about simplification and changes to help

small business and help with the nexus of the tap gap.

Mr. STARR. I would not suggest necessarily that the small businesses are contributing to the tax gap, but I would suggest that,

if we could give them more clarity in the area of the self-employment tax, employment taxes, parity between the entities, that

would help them with their tax compliance and maybe ultimately

would contribute to what we call the tax gap.

23

The CHAIRMAN. All right.

Dr. Shackelford?

Dr. SHACKELFORD. I think we have to recognize that some of the

tax gap is caused by the fact that the Schedule C, or the sole proprietorship form and what flows there, there are an awful lot of opportunities for non-compliance: there is barter, there is the person

who comes to your house and is willing to do various tasks as long

as you pay in cash, and similar type things.

Now, I am not implying that that is the entire tax gap, but there

certainly are opportunities there for avoidance of taxes that are not

necessarily around when you have basically a reporting system, as

we do with wages, interest, or dividends.

The CHAIRMAN. I think the basic question is, how do we have

small business, but in a way also kind of plug up the gap a little

bit? Mr. Martin?

Mr. MARTIN. I think a lot of the tax gap is illegal income. I do

not know how you approach that. That is a completely different

issue.

The CHAIRMAN. Right.

Mr. MARTIN. My experience is that most of the unreported income, which is what the IRS and I am sure you folks want to get

at, is from individuals making payments to businesses where the

individual does not have to report that payment to anyone. And I

hesitate to say that, because I know that would lead to some kind

of reporting mechanism.

The CHAIRMAN. Right.

Mr. MARTIN. And frankly, one of the scariest things I read about

recently was the credit card reporting process that has been proposed. It just scares me to death. But I do not know. Child care

payments. I think there is huge unreported income in child care

that is being paid, and I do not know how you get to it.

The CHAIRMAN. Mr. Starr, any thoughts?

Mr. STARR. On the tax gap?

The CHAIRMAN. Yes. That is right, you did speak.

Mr. STARR. I did comment.

The CHAIRMAN. I had forgotten. Dr. Toder, did you speak?

Dr. TODER. On tax gap? No, I did not.

The CHAIRMAN. Would you like to? [Laughter.]

Dr. TODER. Sure. Certainly the IRS studies show that a large

percentage of the tax gap comes from the Schedule Cs and sole proprietors and so forth, and a lot of it is cash income. It is extremely

hard to get at that because, as another panelist said, you really are

much more effective in compliance where you have document

matching and you are not going to ask individuals to supply 1099s

to the IRS every time they go to the store and buy a screwdriver.

So, it is very difficult to get at.

I think there are some areas where the administration has proposals for somewhat more expanded document matching which

would not be too burdensome that would help a little bit. I think

somewhat greater audits of partnerships, more emphasis on that

could help a little bit. I think, in addition, simplification certainly

could do something about the very high compliance costs that small

businesses face, so, even if it does not do that much for the gap,

it will be helpful in other ways.

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The CHAIRMAN. Thank you very much.

Senator Snowe?

Senator SNOWE. Thank you, Mr. Chairman.

To follow up on the issues regarding the 1986 Tax Act, obviously

one of the major issues that evolved from that process was the Alternative Minimum Tax. As I well recall at the time, that was expanded and developed to obviously target those who were evading

taxes at the high-income levels. Now it has become a mass tax, I

mean, exponentially so. Just with the forecast between this year

and next year and how many millions of Americans are going to

be affected by the Alternative Minimum Tax, that obviously includes small businesses.

Can you talk, Mr. Martin, about what impact that has had on

your clients, and all the other expiring provisions? I mean, we have

41 provisions that are set to expire this year, and many more between now and 2010 and even as far as 2020. What impact does

that have on the certainty and predictability for small businesses

to plan? If you think about it just in the immediate future beyond

what we have in the extenders, you have the estate tax, we have

expensing, and we have the marginal rates, all of which are scheduled to change between now and 2010. They are going to have a

profound impact.

So can you speak to that issue, Mr. Martin, from your standpoint

in dealing with your clients? And Mr. Starr, as well.

Mr. MARTIN. The AMT is a big hammer, and it is so complex.

You really cannot tell when a client is going to have an AMT problem unless you run the whole tax return through software. It is virtually impossible to tell, it is so complex. And I do not have an easy

solution. I am not a big fan of eliminating the AMT and eliminating the State income tax deduction to pay for it because I come

from a State where that is huge.

But I think my recommendation would be to put in the exemption on a permanent basis and index it at some $75,000 level to get

rid of the people you did not really intend to get with the AMT a

long time ago. But index it. If it was indexed back when it was put

into effect, we would not have that problem today, and it would be

a creeping revenue problem instead of a massive one today.

Mr. STARR. Senator Snowe, I have never been a fan of the Alternative Minimum Tax. I was very technically engaged in the Alternative Minimum Tax in the late 1980s and early 1990s, and I was

an early proponent of repeal at that time when it was not popular

to suggest that. My personal opinion would be that we ought to

have a broader tax base, and therefore we would not need to have

an Alternative Minimum Tax.

Senator SNOWE. All right. Thank you.

Do you care to comment, Dr. Toder and Dr. Shackelford?

Dr. TODER. Well, the only thing I would say is, if you were designing a tax system from scratch, you would never have a provision like this in the law, and I think everyone knows that. The only

problem is, since you kind of built the revenues from the expanding

AMT into all of the budget projections, the question is how you pay

for either indexing it or getting rid of it. But I would hope that you

would try to seek a permanent solution sooner rather than later,

25

because the 1-year fixes are going to get more and more expensive.

I think you know that.

Senator SNOWE. Yes.

Dr. SHACKELFORD. I agree with everything they said, but I will

mention one thing. I would hate to be known as the defender of the

AMT. I believe no one supports it. It does, however, have a broad

base and a lower rate and there is so much to be said for that. The

top rate is where it was in 1986. So it is almost like there are elements of the AMT that you should consider when you go through

a total reform. Now, the components of income and expensing have

no rationale and are really abysmal; however, get a broad base,

which is what the AMT gives you—a broader base, I should say—

and get a lower rate, which it also gives you.

Senator SNOWE. Thank you.

I would also like to ask a question on behalf of Ranking Member

Grassley. Apparently 3 million American businesses are C corporations. Current law allows a conversion from C corporations to S

corporations with no immediate tax consequences. On the other

hand, if the C corporation converts into a partnership or an LLC,

the C corporation is immediately taxed on all built-in gain at the

time of conversion.

Should C corporations not be allowed to convert to a partnership

or LLC with no tax consequences the same way they can convert

into an S corporation? What are your views on that?

Mr. MARTIN. Yes, I think they should be allowed to convert to

partnerships. And remember that it is only tax-free at an S corporation level if you do not sell any of those assets for 10 years,

and that is pretty rare. If you have a cash basis entity, for example, that converts to an S corporation, they collect the receivables

the next year, and then they do pay the tax. It is not a tax-free

transaction. But, yes, I do agree that that should be a symmetry

that we should adopt.

Senator SNOWE. Mr. Starr?

Mr. STARR. Senator, my comment there would be, if our clients

were able to exit the regular double-tax regime without any tax, I

am confident all my clients would be in favor of that.

Senator SNOWE. All right. You agree? All right. Thank you.

The CHAIRMAN. Thank you all very much. This has been very,

very constructive. Some of the Senators may have questions which

they will present to you, and I would urge you to respond very

quickly.

The hearing is adjourned. Thank you.

[Whereupon, at 11:23 a.m., the hearing was concluded.]

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