When Congress passes a law, it is only the beginning of a long process of spelling out what is forbidden and what is permitted.
Regulatory agencies hammer out rules to explain the statute and translate its general language into specifics. Then those unhappy with the agency's interpretation routinely go to court, arguing that the regulations do not conform to what Congress meant, or, if it is what the lawmakers meant, that it goes beyond their constitutional authority.
Once regulations approved by the courts are in place, there often is a second round of litigation over whether a particular practice violates the regulations.
It can seem to take forever.
Right now, one of the most contentious issues between small business and the Bush administration involves regulations drafted by the Internal Revenue Service to implement a law passed in 1982. The IRS proposals are sure to be angrily denounced at hearings next week. Chances are good that they will be redrafted.
At issue is a seemingly simple standard for S corporations, so named because they are covered by Subchapter S of the Internal Revenue Code. These businesses, with few stockholders, are treated like partnerships. The companies do not pay income taxes (as do regular, or Subchapter C corporations,) but have their profit attributed to their owners, who declare profit as part of their personal income. It's a way to skip one layer of taxation. To ensure that S corporations really are like partnerships, the lawmakers nine years ago specified that they can have only one class of stock.
In fleshing out that nine-year-old proscription, the IRS has suggested that it means a lot more than merely a ban on preferred stock or on two classes of common stock with unequal voting rights. The measure will be, the proposed regulations say, not merely whether the stock documents give some holders different rights than are given others, but whether in practice benefits are unevenly distributed.
That could mean a lot of inadvertent violations, many commentators warn.
For instance, Lorin D. Luchs and Lewis J. Taub of the Washington office of BDO Seidman note that often some stockholders will also be executives of the corporation and may be treated very generously. Say the company reimburses the president for his country club dues, but in a later tax audit it is deemed that he uses the club for personal, rather than business reasons; the company may be denied a deduction for the expenditure, with the tax collectors saying that it is really more like a dividend to an owner than legitimate compensation. Under the proposed IRS guidelines, that would mean that there are two classes of stock because the president got treated better than other stockholders.
Chicago tax lawyers George Javaras and Jack Levin point to another common situation that could cause a problem under the IRS proposal. S corporations often pay year-end dividends just big enough to cover the tax bite to stockholders on the profits made by the business.If a stockholder sells some shares nine months through the fiscal year, the seller will be liable for profits made during the nine months and the buyer for those of the final quarter. Small companies routinely adjust their payouts to cover those tax liabilities, but that would mean that for the year in question, the selling shareholder would get a bigger dividend than the buyer. Again, the IRS would say that means there are two classes of stock.
The reason such an interpretation so upsets owners of S corporations is that the penalty for violating the rule is not a fine or the loss of a tax deduction -- it is the immediate conversion of the business into a C corporation. The result: Corporate income taxes are not only due, but are due for every year from the time the mistake was made.
"This could mean that many businesses chugging along happily as S corporations all these years could find themselves to have been C corporations since 1983," the Grant Thornton accounting firm is warning clients in its current tax adviser letter.
It's a "draconian approach," the accounting firm of Coopers & Lybrand complained to the IRS. Chicago lawyer Gregory G. Palmer said it is the tax law equivalent of imposing a death penalty for a parking violation. The National Screw Machine Products Association found that a significant number of its members will lose their S corporation status if the draft regulations go into effect.
Some lawyers and accountants are arguing that the regulation writers have to scrap the draft and begin again. "Put the whole thing aside for at least eight years," advised Georgetown University law professor Martin D. Ginsburg.
Other critics object less to the analysis of what constitutes more than one class of stock than they do to the penalty.
It's only fair, the critics said, if a company has made a mistake to give it a chance to rectify the situation and retain its S status. Palmer would let the IRS take away a company's S status if it treats some stockholders better than others, but only in cases where the evidence shows that the executives were intentionally trying to pull a fast one to circumvent the one-class-of-stock rule.
In other cases, courts ruled that:
A lot of small businesses are exempt from complex audit procedures. Subchapter S corporations -- those organized so that profits are taxed to the owners rather than the business -- are subject to the unified audit procedures of the Internal Revenue Service unless they have only a few stockholders.
The IRS set the number at one, meaning that even a company with only two shareholders are covered by the regulations. But the U.S. Court of Appeals in New Orleans found that the government was reading the law wrong, and that a Subchapter S corporation can have as many as 10 stockholders and still be exempt from the requirement. That means that 90 percent of all such corporations are exempt, according to the U.S. Tax Court.
Arenjay Corp. v. Commissioner, Jan. 4
Television reporters are not professionals. Were they, they would be exempt from federal wage and hour laws. But the U.S. Court of Appeals in New Orleans found that, at least at KDFW-TV, a Texas station ordered to pay reporters for overtime put in since 1983, the reporters are expected to exhibit intelligence and diligence, but not the creativity and imagination that are the hallmarks of a professionals.
The judges admitted that the outcome might be different at another station with different standards.
The same ruling, in the aspect of the case the station cared most about, found that news producers must also be paid overtime, because they are not administrators. They are merely overseeing the stations' product, the judges found, not setting policy or planning departmental objectives.
Dalheim v. KDFW-TV, Dec. 13
The Internal Revenue Service can subpoena personal financial records of someone who is not a target of an investigation. The U.S. District Court in Oklahoma City told a woman she had to open up her files to IRS examiners who suspect that her husband concealed corporate assets to block collection of taxes. The man's financial transactions with his wife may well be relevant to the probe, Judge Layn R. Phillips explained.
Gonzales v. United States, Dec. 18
It's generally not malpractice for a lawyer to have sex with a client. An Illinois Appellate Court agreed that lawyers have a fiduciary relationship with their clients, but found that going to bed with a client was not a breach of that duty as long as the quality of legal services was not affected. The judges did, however, suggest to the state legislature that it specifically authorize damage suits in such situations.Suppressed v. Suppressed, Nov. 30
Daniel Moskowitz is a Washington editor with Business Week newsletters.