Congress seems to be waking up to the long-evolving scenario that perhaps as many as half of all U.S. businesses and companies that employ half of the private sector workers are not federal income-tax-paying entities. They are so-called “pass-through” entities, better known as partnerships, limited liability companies and S Corporations.

In fact, the IRS recently published statistics for corporate tax return filers for tax years 2005 through 2008, and it showed the number of C Corporation returns declined year after year while the number of S Corporation returns increased steadily over the same period.

Senate Finance Committee Chairman Max Baucus (D – Montana) recently asked, “Why not have the large pass-throughs … pay a corporate rate?”

Under current US tax law, the size of the business generally does not dictate the choice of tax status or entity type. Rather, the type of investor dictates the entity or tax status of the business.

For example, publicly traded companies are not normally pass-through entities but rather so-called C Corporations. Tax exempt investors typically avoid pass-through structures when investing because of a surrogate income tax the exempt organizations may be subject to as a result. They often prefer a C Corporation structure. Tax exempt investors may include charities, IRAs and retirement plans. S Corporations may only have certain types of and numbers of shareholders.

What Baucus meant by “large” would be left to much debate, along the lines of What is “wealthy”? and What is “fair share”? What are the likely implications of imposing a federal income tax on a pass-through entity?

Today, an S Corporation that was once a C Corporation may be subject to certain entity-level income tax considerations in several years following a conversion in status. Similarly, an S Corporation that acquires a C Corporation may be faced with these taxes, also – even if the S Corporation itself was never a C Corporation. A large partnership may electively be subject to a federal income tax in lieu of imposition of a federal income tax on its investors, or if the large partnership has ownership units that trade on a securities exchange it will be taxed as a C Corporation.

C Corporations pay federal income taxes at graduated rates. Pass-through entity investors generally bear the income tax burdens of such business profits on their personal income tax returns. C Corporation shareholders pay an income tax on certain corporate distributions as well as on gains on sale of such shares they sell. Pass-through entity investors may be subject to an income tax on the sale of their interests, but through complex rules their gain is generally lessened by virtue of accumulated earnings previously taxed to the pass-through entity investor.

Many pass-through entities distribute at least enough cash to their investors to cover the investors’ income tax liabilities on the pass-through entity’s taxable income. However, the accumulated earnings increase the investors’ tax (or cost) basis in their investments.

Many closely held pass-through entities aren’t necessarily “small businesses.” Many have revenues in the billions of dollars. Closely held refers to the relationship of the owners to one another; these might include family members.

The large pass-through entities often have owners that are subject to substantial estate taxes.  Often, in anticipation of such taxes, the owners strategically plan to pass some ownership to family members while the current investor is still living in an effort to reduce income and estate taxes. Many of these plans were implemented quite some time ago and may not be totally reversible. These plans typically rely on the notion that only a single level of income tax is to be paid.

What becomes of unique pass-through entities such as real estate investment trusts (REITs), real estate mortgage investment conduits (REMICs) and regulated investment companies (mutual funds)?  Would such a proposal draw those structures in to entity-level income taxation as well?

Should a Baucus-type proposition come to fruition, the closely held business would likely shift to more owner-employee compensation to drive entity-level taxable income lower. Under current law, the IRS is routinely on the lookout for this tactic as a device to void or reduce a corporate level tax for a non-pass-through entity. The IRS is inclined to characterize such situations as non-deductible dividend payments to shareholders.

The preference for debt in capital structures would likely increase. Interest payments are tax-deductible, but distributions to equity holders are not.

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