LLC tax proposal stirs up sound, fury and competing statistics

Busloads going up to Plymouth to protest. Outrage on editorial pages. Anti-tax petition drives.The state’s limited liability tax, as it has become known, has “generated more heat than any issue in the last five years,” said Jim Roche, president of the New Hampshire Business and Industry Association.The new LLC tax (or more accurately, the expansion of the 5 percent interest and dividends tax to cover LLC distributions), was literally inserted in the middle of the night as conferees tried to cobble together a final version of last June’s state budget compromise. It was later passed by lawmakers without a hearing.Now there have been hearings galore, as rules are being written to govern the change, and legislation filed either repealing the law or making it more palatable.Meanwhile, there is some evidence that businesses are shying away from forming LLCs.LLCs, on the rise since they were first allowed in the state in 1993, had finally topped trade names as the leading business filing in the state. But in the latter half of the year – after the new tax was passed – the advancing LLC retreated to second place again, declining to 45.4 percent of all business filings, a full percentage point below the previous year.

Disputed effectSo what do the sound, fury and statistics signify? That depends on whom you talk to, even when using the very same revenue projections from the state Department of Revenue Administration: $15 million raised by the new law via 18,000 LLC shareholders.For opponents leading the charge, like House Minority Leader David Hess, R-Hooksett, who is sponsoring a repeal bill, the “midnight raid” was a major hit on business. That $15 million is 5 percent of a very big number: $300 million, the amount of distribution that once was tax-free, perhaps taken as salary and now in Hess’s terms “re-characterized” as dividends. And, he said, 18,000 investors and entrepreneurs are nothing to sneer at.But the figures could be taken another way. The 18,000 figure doesn’t represent LLCs, but those receiving distributions from them. The actual number of businesses being taxed could be a lot smaller. According to Susan Almy, chair of the House Ways and Means Committee, the number represents 10,000 businesses – less than a quarter of the total 44,000 LLCs in New Hampshire.And the $15 million? That figure represents about a fifth of what the state currently collects through the I&D tax, a tenth of what it collects under the business enterprise tax and a 20th of what it collects under the business profits tax.“There is a huge variety of LLCs. It could represent a single individual all the way to a huge hedge fund,” Almy said. “The ones who will be paying this tax will be ones earning a comfortable profit, not the small businesses who have been scared to death by this whole thing.”Accountants and lawyers representing LLCs appear to agree with Almy.“Most of them (LLCs) don’t make distributions,” said Dick Samuels, an attorney with McLane, Graf, Raulerson & Middleton. (Samuels also is a member of the board of the BIA, which now says it hopes to “lead the charge” for a fast-track LLC repeal, but Samuels stressed he was speaking as an individual attorney who specializes in business law.)Instead of distributions, those in LLCs usually take any excess income as salary because they want to avoid paying the state BPT. They might still have to pay the state BET on it, as well as federal Social Security taxes, but that still comes out to a lot smaller bill than they would receive through the 8.5 percent BPT.“This doesn’t affect your average working small business LLC, that typical electrician, ‘Joe the Plumber’ if you will,” said Steven Feinberg, principal of Appletree Business Services in Londonderry and an occasional contributor to NHBR. “I have clients calling me left and right, and when I run the numbers, I say, ‘Yes, this is not going to affect you.’”But Hess said that because the DRA hasn’t audited any LLCs yet, adding that there will be limits on how much salary an LLC owner can take. The compensation has to be “reasonable” – a word that is largely left up to the department to interpret.“With the language as currently written, and the current budget situation, the DRA will be looking at every nook and cranny, and make the federal [government] look like the biggest weenie of the world,” said Hess.

Anatomy of a ‘quagmire’Whatever the impact of the LLC, its midnight beginning, a series of ill-timed and ill-placed rule hearings has only served to foment anger and suspicion.“It has become a political and rhetorical quagmire,” said Roche. “This discussion is beyond the hope of being rational.”Indeed, the “environment is so charged” that the BIA, which originally flagged the tax change when it first appeared last June but then adopted a wait-and-see attitude until the rules were written, came out for repeal before the hearings were even over.Those hearings were supposed to start and end with a Dec. 16 forum in Concord – a date too soon before Christmas to satisfy most people still incensed that there was no hearing on the original tax change proposal to begin with.In response, the DRA scheduled hearings for the first week of the new year, but they were all planned in the North Country – Berlin, Plymouth and Conway.This decision caused even more consternation among groups like the Greater Nashua Chamber of Commerce, which promised to send busloads up north in protest. The DRA said it had already heard plenty from people in the south, and wanted to make sure they go some input from the north.Adding more pressure to this cooker is that the bill is apparently retroactive as of Jan. 1, 2009. (Hess said the legislative intent was that it start July 1, but most are assuming that it will encompass the entire tax year of 2009), meaning that the returns will come due on April 15.“Even if the rules are going to be issued next month, it is going to be a very compressed time frame to get the returns right,” said Karl Heafield, a principal in the Manchester office of the Baker Newman Noyes accounting firm.But while the rules might prove important to accountants, the most important issues – the law itself and what is reasonable compensation – are being left to lawmakers. And those are the issues that most people who attended the rules hearings went to vent about.“The public hearings have become a joke,” said Feinberg.

Nagging questionsIt isn’t as if nothing is at stake. Critics of the law said that it’s unclear how far back the DRA could go to discover how much accumulative profit is being distributed, which would require small-business owners to dig through records going back years to avoid paying taxes on them.In addition, many investors simply don’t have access to the records of the business to know exactly what their taxable distributions are, compared to stockholders who receive a 1099-DIV.“That places a significant recordkeeping burden on small business,” Heafield said. That’s why most lawyers and accountants want a cutoff period dating back no more than a few years.Then there’s the question of debt: When do payments from a debt constitute a distribution?Hess said there are other questions that should be addressed as well: When exactly does the bill go into effect? Should there be a threshold, a safe harbor small business, that shouldn’t be affected? And what about the issue of reasonable compensation? Shouldn’t it be the burden of DRA to prove compensation is unreasonable, rather than the LLC to prove the opposite?DRA Commissioner Kevin A. Clougherty said that he is working on all of those issues. The final rules – which he said he expects will be completed in the next few weeks — will be different from the draft rules now being criticized, and it will spell out in detail what the department summarized to the BIA when the organization first brought up some of these issues in June.“We are going to get it right,” he said.The reasonable compensation issue will be addressed in a bill introduced by Almy on behalf of the department, Clougherty said. It is not a new issue, since the department makes similar determination for S corporations and the like, but it is thornier for LLCs because the line between personal and the business is not as clear.Currently the DRA defines reasonable compensation as the amount you would have to pay a worker to do the same task. But, said Hess, there is a “zillion dollars worth of difference between an owner who puts his sweat and soul into a business and an employee who is just showing up to collect a paycheck.”Clougherty agrees, to a degree. “The department needs to take that into consideration,” he said.And he said he supports a threshold number for compensation before the department goes after it. In Almy’s original bill, that figure is $50,000, but in an amendment – that has yet to be disclosed before deadline – the figure could be augmented with various special circumstances, Almy said.Others, however, said the $50,000 figure is far too low. Hess said he was worried that the department would go after doctors and lawyers and other professionals who are in the $200,000 and $300,000 range.However, in the past, the DRA has been unlikely to challenge figures that are much larger than the $50,000 amount, Feinberg said.“I only had one challenge of reasonable compensation in 20 years,” he said.Feinberg did, however, say that there will be some small businesses that will be hit hard, particularly LLCs that rent out vacation homes. They couldn’t justify a large salary and are likely to pay the 5 percent interest and dividends tax on their distribution on top of the 8.5 percent business profits tax. That might be one of the rare cases where the 13.5 percent tax rate cited by critics might be justified, he said.But attorney Samuels said you could argue that the owner of a corporation that pays a business profits tax and a federal tax on the income he receives from that corporation has a 70 percent tax rate, which is “clearly ridiculous.”The biggest question, however, remains whether the tax change will survive at all.Defenders simply say it is closing a loophole. Those getting dividends from corporations have to pay dividends, so why shouldn’t those who receive similar payouts from LLCs?Indeed, as Clougherty pointed out (while saying he is neutral on this legislation), the $15 million in revenue could be raised another way – adding another percent on the 80,000 who are already paying LLC taxes.“A bunch of people paying that tax are saying, ‘Why am I paying it and nobody else is?’” he said.Another way to account for the money is to cut the state budget, but “we are in a recession and we can’t afford to cut any more services,” said Almy, adding: “You don’t open up a budget in the second year.”But it’s also an election year, said Roche. Add that to the uproar about the process and concern about more taxes in the middle of a recession.“I don’t think it matters what the rule says any more. The Legislature needs to repeal this,” Roche said. “There is a plausible case for success of a repeal effort.”Bob Sanders can be reached at bsanders@nhbr.com.