Statement of Richard M. Lipton on the Subject of Tax Simplification
April 26, 2001

3.  Business Tax Provisions

6. Worker Classification

   Determining whether a worker is an employee or independent contractor is a particularly complex undertaking because it is based on a twenty-factor common law test. The factors are subjective, given to varying interpretations, and there is precious little guidance on how or whether to weigh them. In addition, the factors are not applicable in all work situations, and do not always provide a meaningful indication of whether the worker is an employee or independent contractor. Moreover, the factors do not take into consideration the differential in bargaining power between the parties. The consequences of misclassification are significant for both the worker and service recipient, including loss of social security and benefit plan coverage, retroactive tax assessments, imposition of penalties, disqualification of benefit plans, and loss of deductions. Legislative safe harbors provide relief only for employment taxes. The current complex and highly uncertain determination should be replaced with an objective test that applies for federal income tax and ERISA purposes. Alternatively, changes could be made to reduce differences between the tax treatment of employees and independent contractors. Judicial review by the United States Tax Court of worker classification disputes should be available to both workers and employers.

7. Provide Clear Rules Governing the Capitalization and Expensing of Costs and Recovery of Capitalized Costs

   Although the IRS clearly stated that the Supreme Court's decision in INDOPCO v. Commissioner, 503 U.S. 79 (1992), did not change fundamental legal principles for determining whether a particular expense may be deducted or must be capitalized, nonetheless, since INDOPCO, whether an expense must be capitalized has become the most contested audit issue for businesses. A future benefit test derived from the INDOPCO decision has been used by the IRS to support capitalization of numerous expenditures, many of which have long been viewed as clearly deductible. Almost any ongoing business expenditure arguably has some future benefit. The distinction between an "incidental" future benefit, which would not bar deduction of the expenditure, and a "more than incidental" future benefit, which might require capitalization, generally is neither apparent nor easy to establish to the satisfaction of parties with differing objectives. In addition, the administrative burden associated with maintaining the records necessary to permit the capitalization of regular and recurring expenditures is significant. It is imperative that this enormous drain on both Government and taxpayer time and resources be alleviated by developing objective, administrable tests. For example, repair allowance percentages such as those previously provided under the Class Life Asset Depreciation Range (CLADR) System would significantly reduce controversy regarding capitalization of repair expenditures. See Rev. Proc. 83-35, 1983-1 C.B. 745 (CLADR repair allowance percentages); see also I.R.C. § 263(d) (repair allowance percentage for railroad rolling stock). We suggest that Congress urge the Treasury Department and the IRS to issue regulations setting forth unambiguous principles to be applied in distinguishing between deductible and capital expenditures. We also suggest that Congress urge that IRS and Treasury seek to minimize the additional record keeping burdens and other costs of compliance for taxpayers when formulating these principles.

8. Modify the Uniform Capitalization Rules

   The uniform capitalization ("UNICAP") rules in section 263A are extraordinarily complex. Compliance with the UNICAP rules consumes significant taxpayer resources; yet, for many taxpayers, the UNICAP rules do not result in capitalization of any significant amounts not capitalized under prior law. Modification of the UNICAP rules to limit their application to categories of expenditures not addressed comprehensively under prior law (e.g., self-constructed assets) or to large taxpayers would reduce complexity for many taxpayers.

9. Simplify S Corporation Qualification Criteria

   The definition of an "S corporation" contained in section 1361 establishes a number of qualification criteria. To qualify, the corporation may have only one class of stock and no more than seventy-five shareholders. Complex rules provide that the shareholders must be entirely composed of qualified individuals or entities. On account of state statutory changes and the check-the-box regulations, S corporations are disadvantaged relative to other limited liability entities, which qualify for a single level of Federal income taxation without the restrictions. The repeal of many of the restrictions would simplify the law and prevent inadvertent disqualifications of S corporation elections.

10. Modify the S Corporation Election Requirement

    Section 1362(a)(2) requires all shareholders to consent to an S corporation election, as well as that the election be made on or before the fifteenth day of the third month of the taxable year. There are also election deadlines for qualified subchapter S subsidiaries and qualified subchapter S trusts, which add complexity. Late elections are common occurrences because taxpayers are unaware of or simply miss the election deadline. Section 1362(b)(5) permits the IRS to treat a late election as timely if the IRS finds reasonable cause for the late election. This provision has saved hundreds of taxpayers from the consequences of a procedural mistake; it has also generated considerable administrative work for the IRS as is evidenced by the hundreds of rulings granting relief. The election deadline was intended to prevent taxpayers from waiting until income and expenses for the taxable year were known before deciding whether to make an S corporation election. The differences that exist between the taxation of S and C corporations are so significant, however, that it is unlikely a taxpayer’s decision over whether to make an S corporation election would be determined by the events during a single taxable year. Even if that were the case, it is difficult to understand the compelling policy reason to require taxpayers to guess at their financial operations for the year in determining whether to make an S corporation election at the beginning of the year rather than making an informed decision. The ability to pass through losses has been substantially restricted by various provisions of the Code. Thus, concerns about passing through losses are likely more theoretical than real. In addition, as a practical matter, taxpayers cannot wait until the end of the taxable year to make a decision because the need to make estimated tax payments compels a decision before the date the first estimated tax payment is due. Thus, the separate filing of the election itself is a mere procedural requirement leading to frequent procedural foot faults, but little else.

    The most obvious time for the filing of an election is with a filing that is otherwise required. Significant simplification could be achieved by requiring the election to be made on the corporation's timely filed (including extensions) Federal income tax return for the year of the election. The same rule should apply to the qualified subchapter S subsidiary and qualified subchapter S trust elections.