Tax reform in the US is still being formed in the abattoir of Washington DC. Since the reform proposal has a lot to say about the relative roles and tax rates applied to corporations and partnerships, it is time to take a quick look at the history of these.
The early years of corporate law in the United States suggest some mistrust of the role of corporations. Companies such as the Massachusetts Bay Company, the Hudson’s Bay Company and the East India Company had reputations for being corrupt, exploiting their workers and exerting excessive influence on government and politicians.
In the century after American independence was won, there was a keen focus on limiting the power of corporations. Corporate charters were granted by states for limited purposes and for a limited duration. The political goal of limited corporate power was undermined by the inexorable rise of business to accomplish societal needs such as railroads, the mining of natural resources and organized trade on an increasing scale. Those who provided the capital to finance these endeavours wanted limited liability and permanent capital vehicles to carry on trade for the long term in a predictable legal framework not subject to revocation at the whim of state politicians.
Corporations were the vehicle of choice. They offered limited liability, the ability to raise equity financing that could be traded and legal personality (the latter enshrined by the 1886 court case of Santa Clara County vs. Southern Pacific Railroad).
The rise of trade and commerce and, especially during the Civil War years, the dramatic rise of government spending in many areas of the economy, led to a familiar arc for corporations: accumulation of wealth and power for their managers and their shareholders; the tendency to become self-serving and the urge to use corporate resources to shape a favorable political landscape.
As corporations began to proliferate, individuals looked to corporations as a way to operate their businesses with limited personal liability. Unfortunately, the price of the corporate form was two layers of taxation. Corporations must first pay tax on their taxable income before distributing that income, net of tax, to their shareholders who must then pay tax on the dividends they receive – the so-called classical system of taxation.
Until 1958, the alternative form of business ownership – other than simply a sole proprietorship where individuals conducted business in their own names – was partnership.
The original partnership form involved two or more individuals acting together through a vehicle for which they had joint and several liability. It was a natural form of business and one consistent with aligning the responsibility of the individuals involved with the consequences of their business decisions by making them responsible for the liabilities they created.
In contrast to corporations, partnerships do not pay tax; rather they pass the tax liability through to their partners in proportion to the shares of profits and losses that the partners agree upon. When partners contribute capital to the partnership, they are given a capital account that keeps score of what the partners are owed by the partnership and how the profits and losses are divided at various points during the life of the partnership.
The partnership form evolved as a popular means of raising and deploying capital – the so-called capital-labour partnership on which the private equity business has been built. Typically, a general partner with unlimited liability raises capital from limited partners whose liability is limited to the amount of capital they contribute. The general partner runs the business and takes a management fee and a share of the profits.
General partners took steps to ensure their liability was limited by making sure that the general partner was a corporation. Eventually, corporate law developed the concept of a limited liability partnership where none of the partners, including those responsible for operating the business of the partnership, had unlimited liability.
Many states developed the concept of a limited liability company that had the characteristics of a partnership for tax purposes but still had limited liability. In 1997, the IRS passed regulations that permitted taxpayers, with certain limited exceptions (the PLC in the UK and the Inc in the US), to choose passthrough or entity level taxation by simply filing a form and making an election – widely referred to as the ‘check-the-box’ regulations.
The tax liability of partners is reported to them on Form K-1. This form appears as part of the partners’ individual tax Form 1040. It functions to report income earned at the partnership level as income of the individual taxpayer. K-1s are not always distributed to taxpayers in time for them to file their taxes by the April deadline and cause many partners to file for an automatic six-month extension.
Partners are liable for the tax on partnership income even if they receive no cash distributions from the partnership. This is one example of what is referred to as “phantom income”: tax must be paid but the taxpayer has received no cash with which to pay it and must meet the tax obligation from elsewhere.
Another problem for foreign partners in a US-based partnership is the possibility they may have to file a US tax return or suffer withholding of US tax by the partnership on distributions. This issue was discussed in an earlier article.
Before the development of LLCs and limited liability partnerships, individuals sought the benefit of corporate limited liability without suffering two levels of taxation. This led to the birth of the S corporation. S corporations have been described as a hybrid entity having some of the characteristics of corporations and some of the functionality of partnerships.
S corporations were breathed into life in 1958, twelve years after the Treasury Department proposed them as a solution to a couple of significant problems. The impetus to act was driven by political considerations: President Eisenhower was under pressure to curb the growing power of corporations and there was widespread scepticism about trickle-down economics. In 1958 there were only two ways in which entrepreneurs could set up a business: they could set up a corporation and suffer two layers of taxation, or they could set up as a sole proprietor or as a partnership, pay only one level of taxation but sacrifice the umbrella of corporate liability protection.
In 1958, the highest corporate tax rate was 52% and the highest individual tax rate was 91%, a combined rate of 96% for an individual doing business through a corporation. By doing business through an S corporation, individuals could enjoy limited liability and save 5% on their taxes. It was an attractive proposition.
S corporations were limited in some important ways. They are limited to 100 shareholders; the shareholders must, with limited exceptions, be individuals; those individuals must be US citizens or residents and there can only be one class of stock. Income, as it is for partnerships, is reported on Form K-1.
Absent some careful structuring for partnership distributions, S corporations can offer their shareholders an advantage on the self-employment taxes – FICA. Whereas partnership distributions are fully subject to FICA (maximum rate of 15.3%), FICA is only owed on wage distributions from an S corporation. Provided shareholders receive a “reasonable wage,” distributions beyond the wages are not subject to FICA. The IRS is aware of the potential for abuse and polices the concept of a reasonable wage.
S corporations have proven popular and, while arguably superseded by the development of the LLC together with the flexibility of the check-the-box regulations, there are approximately 4.6 million in existence – twice the number of C corporations.
The business forms described above all have their unique tax custom and practice. They are taxed under separate subchapters (C, K and S) of the Internal Revenue Code. Each area has its specialist advisors. The proposal to impose tax at a separate rate on small businesses – sole proprietorships, partnerships and S corporations – is ill-considered. It is not clear under which subchapter such income would be taxable and, therefore, how it would be administered. This, however, is not the greatest of the problems the administration’s proposal presents. The rest of the year will be interesting.