Corporate income tax on pass through entities creates slippery slope

June 3, 2011
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On May 25, Gov. Rick Snyder signed into law legislation replacing the Michigan Business Tax with the Corporate Income Tax effective for tax years after 2011. The legislation eliminates double taxation for many businesses operating in sole proprietorship, partnership (including multi-member LLCs) or S corporation form. Beginning in 2012, owners of these businesses will pay Michigan income tax only at the individual level.

This is a welcome change from paying at the business level and again at the individual level. For businesses operating as C corporations, the CIT rate will be 6 percent. The CIT will require corporations with Michigan and non-Michigan activities to apportion business income to Michigan based on the ratio of Michigan sales to total sales. For many businesses operating in non-C corporation format, the tax savings may be significant.

The move to a single level of tax for pass-through entity owners in Michigan is completely opposite where legislation in Washington, D.C., may end up. There were many reports in early May that the Obama administration is considering a proposal to levy an income tax on pass-through business entities that will result in such entities being taxed in a manner similar to C corporations. The reported proposal is to tax all business entities with gross receipts $50 million and higher as corporations. This will include S corporations and entities taxed as partnerships.

The proposal, if enacted, will undoubtedly add more complexity to a tax code that is already universally accepted as a very complex piece of work. This proposal may also be included in a set of larger tax reforms that may seek to broaden the tax base in an effort to bridge the gap between tax revenues and spending.

Such a change will likely continue to wage the class warfare between the so called “makers” and “takers” of tax revenue. The targets of the changes may be the partners and managers of private equity and hedge funds that now seem to be a regular target of the political rhetoric in Washington. Unfortunately, many other business owners will be impacted by this or similar proposals to institute a double tax on all business entities.

It is useful to look at the number of tax returns filed by pass-through entities. The latest IRS statistics on tax returns were released in early May for the 2008 tax year. In that year, more than 4 million S corporation returns and more than 3 million partnership tax returns were filed in the U.S. This compares with about 1.7 million regular or C corporation returns. In addition, there were nearly 22 million individual tax returns with a Schedule C (sole proprietor), 10 million with rental properties reported on Schedule E, and 2 million farms (Schedule F) included in Form 1040.

The danger is the slippery slope that the imposition of a corporate income tax on pass-through entities creates. In addition to the numbers mentioned above, there are other pass-through entities in the U.S. that could be caught in the new web of double tax. The bite of the changes may be more venomous than a black widow spider. Let me provide a few examples. This analysis may be taking it to the extreme, but it is worth mentioning.

There are many types of pass-through entities that do not generally pay a corporate level income tax. A recent article in the Tax Lawyer published by the American Bar Association and authored by Willard Taylor of Sullivan & Cromwell highlighted the many types of entities that exist in the U.S. Some of the information below is based in part on that article.

The use of pass-through entities is common in many situations of which we may be unaware. This includes entities where we have investments in personal or retirement funds. Allow me to walk through the types of entities and what could happen if an entity level corporate tax applies in the future to the entities and their owners.

Many public investment vehicles currently pay no corporate level income tax if they meet special criteria or distribute any taxable earnings to their owners. Most of us have investments either personally or through 401(k) or IRA retirement plans. A significant share of these investments is in mutual funds, closed-end funds, exchange-traded funds or unit investment trusts. Most of these entities qualify under the tax code as “regulated investment companies.” An RIC generally does not pay any income tax if the income of the RIC is distributed to its owners. This is typically why, in December each year, mutual funds make distributions of dividends and gains.

The Investment Company Institute recently published its 2011 Investment Company Fact Book. In the recap of assets and funds it reported that, for 2010, there were more than 13,000 mutual funds, closed-end funds, exchange-traded funds and unit investment trusts having total assets of more than $13 trillion. The fund assets jumped by nearly $1 trillion in 2010 from 2009. If for example, one half of that change was income and gains earned in 2010, that would be nearly $500 billion that could be caught under taxation of pass-through entities if any legislation enacted has a wide net. A 35 percent tax rate may generate nearly $175 billion in additional tax revenue on that theoretical $500 million of income. The potential windfall is an attractive bounty for those looking for new deep pockets to close the budget gap. Any taxation on the funds will impact the performance and returns of the funds. 

Next on the list of pass-through entities is real estate investment trusts. REITS are similar to RICs in that there is generally no entity level tax, as most of the income of the REIT is required to be distributed to the owners. REITs can be privately or publicly owned. The National Association of Real Estate Investment Trusts reports on its website that, at the end of 2010, there were 153 public REITS with a market capitalization of nearly $400 billion. Any corporate level tax will reduce income available for distribution to the REIT owners.

Additionally, there are pass-through entities such as publicly traded partnerships, Real Estate Mortgage Investment Conduits and fixed investment trusts that could also be impacted by any changes in pass-through entity taxation.

Changing the tax landscape and taxing some pass-through entities is a major policy change. You probably understand the far-ranging impact of such a tax policy. We all will likely be impacted in some fashion in either our business or investments. Luckily, it is only a proposal that was floated and may not come to fruition.

As the tide of tax reform comes washing ashore, we will watch what gets swept into the sea. Just as a beach disappears with a storm surge and the tide, so will the value of many business and investment assets if some level of corporate tax is instituted on pass-through entities. Nothing has happened yet, and perhaps the idea was a trial balloon to see what may happen. If there is serious discussion on some additional taxation on pass-through entities, there will likely be outcry from both Wall Street and Main Street.

William F. Roth III is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily those of BDO. The comments are general in nature and not to be considered as specific tax or accounting advice and cannot be relied upon for the purpose of avoiding penalties.

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