Title: Jurisdictions Imposing Income Tax on Pass-Through Entities
Abstract: Tax practitioners and their clients have long recognized the federal tax advantages of pass-through entities. An S corporation affords its shareholders the traditional liability shield of a corporation, avoids corporate-level tax, and sidesteps the thorny legal and factual issues inherent in determining reasonable compensation of owner-officers. A partnership affords its partners not only freedom from entity-level tax, but also the ability to use partnership debt to increase the basis of their partnership interests, thereby enabling them to claim leveraged partnership losses on their own income tax returns. Use of a partnership also allows, within certain limits, division of economic and tax benefits on a basis disproportionate to ownership, thereby providing the partners great flexibility in tailoring economic arrangements to their respective roles and needs. The advent in the early 1990's of the federal regulation governing tax characterization of limited liability companies (LLCs) vastly expanded the utility of pass-through entities in general and of LLCs in particular. An LLC enjoys all the traditional tax advantages of a partnership but without its major business drawback - the fact that at least one partner must be a general partner with liability for the partnership's debts. Now, an LLC with only a single member (SMLLC) can elect to be taxed as a C corporation or be disregarded entirely for federal income tax purposes. As a disregarded entity, the SMLLC has no obligation to file fedeal income tax returns. An LLC with more than one member can elect to be taxed as a partnership. Moreover, the check-the-box regulation does not require the parent to be closely held to enjoy the benefits of LLC flexibility. Even the largest publicly-held corporations can form wholly owned SMLLCs that neither pay federal tax nor file a federal income tax return. These goals are accomplished without the complexity and inflexibility inherent in the federal consolidated return regulations. Similarly, two related or unrelated corporations can form an LLC joint venture, which avoids federal income tax at the joint venture level without exposing either parent to liability. Largely as a result of the flexibility afforded by the federal check-the-box regulation, in just over a decade LLCs have emerged from near-obscurity to become the dominant form of new business organization. The fact that many state and local jurisdictions do not follow, or fully follow, federal treatment is sometimes forgotten or not fully factored into tax planning for pass-through entities. For example, some states - even those that recognize S corporations - impose corporate-level tax at a reduced rate on S corporations. Others refuse to recognize an out-of-state S corporation unless it registers and files an in-state S corporation election in the shareholder's state of residence. Even more significantly, some jurisdictions - usually large cities with broad-based privilege or other taxes on net income from a business - either do not distinguish between federal pass-through entities and other business organizations or make the distinction only for SMLLCs that are disregarded federally. This article focuses on four such municipal taxes: New York City's Unincorporated Business Tax (UBT), the District of Columbia's Unincorporated Business Franchise Tax (UBFT), Philadelphia's Business Privilege Tax (BPT), and Philadelphia's Net Profits Tax (NPT). We will review the nature of each tax, its tax base, types of businesses subject to it, procedural and compliance issues, and, in particular, how the municipality deals with the potential for multiple taxation inherent in the fact that the income of the pass-through entity is also included in its parent's federal taxable income, normally the starting point for determining the parent's municipal taxable income. The goal of this article is to provide the practitioner with an overview of these taxes so that the practitioner takes them into account in tax planning, budgeting, and compliance.
Publication Year: 2002
Publication Date: 2002-11-13
Language: en
Type: article
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