Will Pass-Throughs Pass Out?

From the potential year-end expiration of the Bush tax cuts to proposals to tax them as corporations, the owners of pass-through business entities have a lot to think about, and perhaps a lot to plan for.

It's not as though they are the favorite whipping boys and girls of the federal government, because there is a good deal of bipartisan congressional support for maintaining their pass-through status.

But when their status potentially becomes a political poker chip, and the pot is the size of the federal budget, they might be forgiven if they feel like part of a daring bluff.

As their name suggests, pass-throughs such as S-Corporations, limited liability companies, and other partnerships are taxed at the individual rate, meaning they pass income on to owners and investors and have a single level of taxation. While C-Corporations (traditional corporations) are generally taxed on income at the corporate level, with any distributions to shareholders taxed again at the individual level, pass-throughs typically are not taxed at the entity level, but their income instead is "passed through" and taxed only at the individual level.

Their economic impact is increasingly significant. According to Internal Revenue Service tax returns from 2008, the most recent year available, for every C-Corp, more than four businesses are now organized as pass-throughs. The latter entities represent more than 34% of all business receipts, up from just 7% in 1980.

As part of "revenue neutral" tax reform proposals, some have suggested treating large pass-through entities as corporations. In addition to mechanical issues involved with determining what size pass-throughs would trigger the corporate tax, policymakers would have to determine whether the tax treatment should be asset-based, receipt-based, profit-based, or employment-based.

The Congressional Research Service has crunched some numbers based on older (2003) data, but it indicated the potential number of pass-through entities that could be taxed as corporations. Among S-Corps, there were 62,655 with more than $10 million in business receipts, and 9,757 with more than $50 million. With partnerships, there were 25,019 with over $10 million in receipts and 5,603 with over $50 million.

Also among S-Corps, the industries with the highest number of firms potentially subject to the corporate tax are manufacturing, wholesale trade, mining, transportation, and construction. Among partnerships, the most impacted industries are utilities, manufacturing, information, wholesale/retail trade, and health care.

Businesses can choose to treat this tax proposal like a trial balloon and ignore it, as some pass-through entities are doing with the more realistic possibility that the Bush tax cuts will be allowed to expire, or they can plan for such a contingency.

"I don't believe, at least at this stage, that it is a vital part of anybody's agenda," said Mel Schwarz, director of tax legislative affairs for Grant Thornton's national tax office in Washington. "There have been some suggestions that if we are going to look at a significant decrease in the corporate tax rate, that doing away with the current treatment of pass-throughs would be an offsetting revenue raiser.

"I don't see significant support for that on a policy basis, but it's clearly something that's out there, and something that affected taxpayers would do well to stay focused on. If something happens, it is most likely going to be focused on either larger entities or situations where the money is being passed through to essentially wealthy or well-compensated individuals. Whether you define that as $250,000 a year or $1 million a year, they continue to debate that."

Scott Harmsen, a tax partner with Grant Thornton in Wisconsin, noted that his firm has advocated equal tax treatment for pass-throughs and corporations, and that they share in any rate reduction that is part of tax reform. "That means that if the corporate tax rate is reduced, there should be some type of cap or maximum put on pass-through income so that such entities are not taxed at a much higher rate than corporations," he stated. "If the government wants to tax large pass-throughs at a certain rate, then it should impose that rate on the individual return so that it's comparable to the corporate rate."

Another concern is that if pass-throughs are taxed as corporations, some of the other advantages of such business entities would either be limited or taken away. For example, eliminating pass-through status could dilute the incentives and rewards designed into their compensation and retirement plans.

Combined with the potential for higher tax rates by Jan. 1, 2012, business owners have a lot of possible scenarios to plan for. One course of action would be to evaluate the choice of business entity, not in a knee-jerk fashion, but with a long look at meaningful business restructuring that serves the organization's long-term interests.

"I think you would see practitioners taking a hard look at restructuring to either not be subject to those rules or to have business arrangements with other entities or related entities to perhaps not have that group of companies viewed as a large pass-through," Harmsen said. "It's going to depend on how they define a large pass-through. Are they going to look at it through a family-of-companies type of test or on an individual, stand-alone basis?

"If they allow us some latitude from an aggregate test standpoint, you can certainly have business relationships, contractual relationships, and other entities involved to help stay below that large, pass-through test."

The restructuring options also would depend on short- and long-term business objectives – whether the objective is to buy and hold, or sell in the near future. If the choice is to not change the entity to a C-Corp, then owners can look at the traditional techniques of accelerating income into the current year, deferring deductions, and otherwise saving what they can during this transition period.

The reason S-Corps, for example, would convert to a C-Corp is to attract investors that are not allowed to be S-Corp shareholders. With S-Corps, there are a number of restrictions on how to raise capital – generally, they have a 100-shareholder limit, and they are not allowed to have preferred shares or have a corporate shareholder. Yet they may want to bring in mezzanine financing that is best handled through a preferred structure, or they might have been approached by a venture capital fund that must structure their investments in a way that is inconsistent with S-Corp rules.

If a tax reform package calls for companies with a certain level of gross receipts to be taxed as a corporation, they should not automatically assume they no longer need to be an S-Corp. Schwarz said the more thoughtful reaction is to make no change unless it provides access to something necessary, such as otherwise nonqualified investors or the ability to set up preferred stock.

Schwarz also reminded flow-through business owners of the advantages of their structure. "One thing you need to keep in mind is the beauty of an S-Corp is that you only have a single level of tax," he noted. "You don't tax the income once when it is earned and a second time when it's distributed as income. That is very important if you are distributing most of the income currently. In the case of many smaller companies, which are essentially incorporated personal businesses, you need to make current distributions because that is the money the owner pays his rent and bills with, and sends his kids to college with."
The wild card is the ultimate level of the corporate tax, especially if it's set lower than the current rate of 35%. President Obama has proposed lowering it to 28% as part of tax reform, and Congressman Paul Ryan, R-Wisconsin, would lower it to 25%. If a pass-through can get a lower rate by converting to a C-Corp, a switch would be justified.



Rate increases? What rate increases?

While strategizing for this longer shot, our expert panel said entrepreneurs are beginning to realize there is a more likely scenario: namely, that all or a combination of the Bush tax rate cuts will expire unless Congress, most likely the lame duck Congress that will remain after the election, takes action.

Set to expire are current income tax rates, capital gains and dividend rates, the payroll tax rates, the Alternative Minimum Tax patch, and more favorable expensing for bonus depreciation and Section 179 of the tax code.

Rick Welsch, a partner in the tax and business services department at Wegner LLP, CPAs and Consultants, isn't convinced the uncertainty over federal tax rates is having a major impact on businesses. "Frankly, I'm not sure that a lot of businesses are aware of the significant change that's coming," Welsch said. "People in the accounting industry and others have started to bring this up. We're really starting to swing into full gear right now about what's coming down the road."

What awareness there is might not be well informed. While attention is focused on high-income earners and whether they pay their fair share of taxes, they are not the only people who would be impacted. "The people who are not paying attention are actually the lower-tax-bracket people because the 10% tax bracket we've got today is going to go to 15%," Welsch noted. "That does not sound like a lot, but that is a 50% tax increase."

The lack of awareness might be caused by the hope that Congress, as it did at the end of 2010, will extend the tax rates or find a compromise between President Obama's plan to extend rate cuts for the middle class and Republican calls to extend the entire package. However, there is no excuse for businesses not to monitor events on Capitol Hill and the fall election, or to plan for different scenarios.

"That hope is not a strategy," Welsch noted.

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