FRAMINGHAM, 18 MARCH 2011 - Financial executives of companies that are organized as pass-through entities may want to pay attention to the recent goings-on in Washington. At several hearings earlier this month before both the House Ways and Means Committee and the Senate Committee on Finance, experts have testified on the roles -- both positive and negative -- that these companies play in American business. They've also offered their thoughts, pro and con, on the tax policies applicable to pass-throughs.
Organization as a pass-through -- that is, in the form of partnerships, limited liability firms, sole proprietorships and S-corporations -- generally avoids the double taxation with which C-corporations must contend. The income earned flows to the individual owner or owners, where it is taxed once at the individual rate. Profits in C corporations, on the other hand, are taxed both at the corporate level and again when earnings are distributed as dividends.
The role of pass-through entities "has become a flash-point," says Bill Rys, tax counsel with the National Federation of Independent Businesses. At a March Senate hearing on changes in the tax code since the 1986 Tax Reform Act, Senator Max Baucus (D-Mont.), chair of the Senate Finance Committee, noted that more than 94% of all businesses now are organized as pass-through entities, and that tax revenue received from pass-throughs surpasses that from traditional companies, or C-corporations. "We must consider how efficiently we tax business income, given that so much of it is taxed on an individual basis today," he said.
"The tax implications for various transactions for partners in a partnership are often very different from the shareholders in C-corporations or S-corporations, or even sole proprietorships. The result is that there is an inequality in treatment between the different entity types," said Patricia Thompson, a CPA speaking in March on behalf of the American Institute of Certified Public Accountants (AICPA), before the House Ways and Means Committee.
Several factors appear to be driving the current interest in pass-through entities. One is the larger discussion on tax reform that now is underway, Rys says. Given the amount of activity that now occurs within pass-through organizations, any changes to the business tax code needs to include these firms. "You need to look at this comprehensively," he says.
A Growing Form
Another likely driver is the sheer growth in pass-throughs. Between 1980 and 2005, the share of business revenue earned by these businesses nearly tripled, growing from about 13% to 36%, according to data from Robert Carroll, a principal with Ernst & Young who also testified before the Ways and Means Committee. One reason for this was the lowering of the individual tax rate through the Tax Reform Act of 1986, Carroll said. This boosted the financial benefits of the pass-through structure.
Moreover, while the pass-through structure is prevalent among mom-and-pop businesses, a small number of larger firms now choose this structure as well. In 2005, pass-through firms with annual revenues greater than $10 million accounted for 0.4% of all pass-through tax returns, said Donald Marron, director of the Urban-Brookings Tax Policy Center, in his testimony before the House Ways and Means Committee. Marron based his estimate on information from the Joint Committee on Taxes.
To be sure, these larger organizations account for a tiny percentage of all pass-throughs. However, in 2005, these firms rang up nearly 60% of all sales recorded by pass-through firms, and captured about 42% of net income.
The popularity of this type of business structure in the U.S. is unique. According to the 2007 OECD Survey on the Taxation of Small and Medium-Sized Enterprises, unincorporated entities accounted for roughly 82% of all businesses in the U.S. That compared with about 76% in the UK, 72% in Sweden, and 50% in Japan.
Limiting the Liability
The pass-through structure has several benefits aside from its impact on taxes, which appeal to many business owners. Perhaps most important, it limits the owners' financial liability, says Patricia Thompson of the AICPA. "If you're a sole proprietor, you are subject to unlimited liability. If anything happens to the business, your personal assets are at risk."
What's more, while some larger companies organize as pass-throughs, current regulations limit how many can take this approach. For instance, S-corporations typically can have no more than 100 shareholders, Thompson says.
Dennis Tarnay is CFO of Lake Erie Electric, a Cleveland-based electrical contracting firm with between $80 and $100 million in revenue. Tarnay, who also testified before Congress, notes in an interview that the company initially organized as a C-corporation in the 1950s, but switched to an S-corporation in the 1980s. "When the Revenue Act lowered the tax rate at the individual level, it made sense for small businesses that qualified for the pass-through structure," to become one, says Tarnay.
For many small business owners, their business is their primary asset, Thompson adds in an interview. "When they sell, they expect to live on it (the proceeds) the rest of their lives. If you double-tax it, there's less available for them to live on."
What's more, any concerns that elected officials may harbor about owners of pass-through entities shirking their tax obligations are unfounded, according to Rys. "The IRS has the ability to go after people who don't pay," he says.
At this point, it's difficult to say just how the regulations involving pass-throughs may change. CPA Thompson, speaking on her own behalf, predicts that any changes to the tax code will exclude pass-through entities. "As more discussion goes on, it will become clear how important they are for small businesses."
While it's perhaps too early for business owners to consider changing their corporate structure, CFOs will want to keep tabs on the talks occurring in Washington, Thompson says. "Watch what's happening."
If a decision is made to boost the rates charged to pass-through entities, "we will have a revolt," Lake Erie Electric's Tarnay says. That could be the result if the top individual rate jumps to 40%.
Tarnay adds that his real wish is for a tax code that is predictable, simple and fair. "Small business owners," he says, "can work with that."
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