Pass-through Entities Research Articles

Passthrough Entity Tax Scandal

Three dozen states have enacted laws since 2018 that are designed to provide passthrough entity owners with an unlimited federal tax deduction for state and local business income taxes. These “passthrough entity tax” regimes respond to the December 2017 federal tax law, which imposed a $10,000 cap on the state and local tax deduction. The new state laws generally allow passthrough entities to opt into paying an entity-level state income tax in exchange for a dollar-for-dollar benefit on their owners’ state personal income tax returns. The optional tax has proven to be immensely popular among passthrough entity owners across the country. But there is a problem with the passthrough entity tax concept: under the plain text of the Internal Revenue Code, the workaround does not work. The December 2017 law clearly precludes passthrough entities and their owners from deducting state and local income taxes beyond the $10,000-per-individual cap. And the legislative history of the December 2017 law—read in context—aligns with the statutory text. Surprisingly, the IRS has chosen to permit passthrough entity owners to utilize the workaround anyway. The IRS has not provided a plausible legal rationale for its position, but no one has standing to challenge the IRS’s position in court. Meanwhile, the IRS’s decision to allow the workaround is likely to cost the federal government more than $50 billion by the end of 2025, with most of the federal tax benefits flowing to passthrough owners with incomes of $1 million or more. In effect, the IRS has created a special tax preference—unauthorized by Congress—for hedge fund managers, law firm partners and other passthrough entity owners. And the Biden administration, notwithstanding its professed commitment to tax fairness, has acquiesced in this massive giveaway to the rich. The Biden administration and the IRS should reverse course immediately and apply the $10,000 state and local tax deduction cap to passthrough entity owners. As long as they permit passthrough entity owners to take advantage of the workaround, the Biden administration and the IRS will be abdicating their duty to enforce the law.

Nebraska Approves Pass-Through Entity Tax Bill

In 2023, the Nebraska Legislature passed a bill that allows a partnership or S-Corp to elect to pay its state income taxes. Previously, because the income from the partnership or S-Corp is passed through to the owner, the owners of the entity paid the taxes at their own individual tax level. In 2018, the federal government passed the Tax Cuts and Jobs Act (TCJA), which limited the itemized deduction for state and local taxes in the individual’s return to $10,000. This prompted many states to adopt laws like the new Nebraska law to work around this limitation. Federal tax law allows entities to deduct state income taxes paid as an ordinary business expense, but for most states this has only been allowed for C-corporations since they are the only entity to pay their own taxes. The pass-through entity tax law expands that option.

Is Section 199A's Qualified Business Income Deduction Good Tax Policy?

ABSTRACT The qualified business income deduction under Section 199A, which was enacted as part of the Tax Cuts and Jobs Act of 2017, was intended to provide a reduction in federal taxes for businesses operating as passthrough entities commensurate with the rate reduction allowed to corporations. While the Section 199A deduction does achieve its intended objective of reducing taxes on passthrough entities, it does so with unnecessary complexity. In this article, we briefly review the rules governing the deduction and evaluate it critically against nine principles of good tax policy. Our evaluation reveals shortcomings in the structure of the deduction that prevent it from achieving the goals of equity, certainty, convenience, administrative effectiveness, simplicity, neutrality, efficiency, compliance, and revenue predictability. However, with respect to the principle of visibility, the deduction succeeds.

Innovations in IPO Deal Structure: Do Up-C IPOs Harm Public Shareholders?

This paper examines an innovation in capital formation that has spurred contentious debate: the Umbrella Partnership Corporation (“Up-C”) IPO. Advisors and underwriters argue that the Up-C deal structure is a driver of post-IPO value and, thus, is a value-enhancing means of raising capital that may be one solution to concerns regarding the drop in the number of publicly traded companies. Consistent with these claims, recent research suggests that organizing soon-to-be public businesses as pass-through entities (as is the case for Up-Cs) leads to superior future performance. Yet, broadening the analysis to consider abnormal stock performance and post-IPO litigation of a larger and more recent sample of exclusively Up-C IPOs, we conclude just the opposite. While the Up-C deal structure increases IPO valuations and predicts positive post-IPO operating performance, the return performance of Up-C IPOs indicates that Up-C deals harm public shareholders. Further, despite their superior earnings performance, Up-C IPOs face a significantly higher rate of post-IPO litigation as compared with non-Up-C IPOs. Because IPO investors seemingly do not anticipate the myriad ways in which the Up-C deal structure might facilitate opportunism by pre-IPO owners, they frequently turn to litigation as an ex-post settling-up mechanism. Consequently, our paper offers the first empirical evidence of downsides associated with the Up-C deal structure for public shareholders and, in so doing, affords the rarity of having academic evidence lead (as opposed to respond to) a controversial debate. This paper was This paper was accepted by Victoria Ivashina, finance. Funding: The authors gratefully acknowledge the financial support of the NYU Stern School of Business, the J. Reuben Clark Law School, and the Marriott School of Business. Supplemental Material: Data are available at https://doi.org/10.1287/mnsc.2022.4454 .

Shareholders’ tax incentives and changes in the organizational form of foreign operations

This study examines whether the tax incentives of home-country shareholders influence the organizational form changes of foreign operations. While a corporation and a limited company (LC) in South Korea are treated the same for Korean tax purposes, an LC can be treated as a pass-through entity for U.S. tax purposes. This tax treatment of LCs can create incentives for U.S. owners to convert their Korean corporations to LCs. We find that private corporations owned by U.S. shareholders are more likely to convert to LCs than those owned by non-U.S. shareholders. We also find that the tax costs and benefits of conversion affect the likelihood of LC conversion for U.S.-owned firms. Overall, our results suggest that multinational corporations use organizational form changes as a tool for international tax strategies.

PASS-THROUGH BUSINESS ENTITY CHOICE AND EARNINGS MANAGEMENT: EVIDENCE FROM UK REAL ESTATE INVESTMENT TRUST CONVERSION

This empirical study innovatively investigates how the choice of a pass-through business entity and corresponding regulatory regime influence firms’ earnings management (EM) behaviors by testing on the UK Real Estate Investment Trust (REIT) conversion. A substantial proportion of UK non-REIT publicly traded property companies (LPCs) have chosen to become REITs since the UK REITs were launched in 2007. We conduct a series of tests on a database containing UK LPCs and REITs from 2000 to 2019 and find that conversion into pass-through business entity regimes like REITs that enjoy more favorable tax treatment but face more restrictions leads to more accrual earnings management (AEM) activity, but less real earnings management (REM) activity.

Too Much SALT? The Nuanced Impact of the State and Local Tax Deduction Cap on Pass-Through Business Taxpayers

Perhaps the most controversial provision of the Tax Cuts and Jobs Act of 2017 is the state and local tax deduction limitation (or SALT cap), particularly with respect to how the cap impacts pass-through entities in high-tax states. This particular provision of the tax law has been criticized by opponents as deliberately punitive to small businesses in blue states, while proponents maintain that eliminating the SALT cap would primarily benefit high income taxpayers. Politicians from blue states have called for the repeal of the SALT cap, and some states have enacted various workarounds with questionable prospects of success. Still, many taxpayers will not benefit from a SALT deduction irrespective of the SALT cap, particularly taxpayers that either take the standard deduction or are subject to the alternative minimum tax (AMT). We examine the developing law around the SALT cap and provide descriptive empirical evidence of its disparate impact on closely held business taxpayers. Consistent with prior economics literature, we find that the impact is indeed most pronounced among high-income taxpayers in blue states. However, we note that the impact is substantially less than the furor over the limitation would suggest because many high-income taxpayers are subject to the AMT and so are not significantly affected by the limitation. These findings suggest two underemphasized points. First, the imposition of the SALT cap was not the drastic financial hit to blue state taxpayers that policy makers and commentators have suggested. Second, with a new administration that favors eliminating the SALT cap, Congress could consider whether the repeal of the cap alone is enough because further changes would be needed to return the SALT deduction to its earlier prominence.

Benefits and Burdens of Subchapter S in a Check-the-Box World

The Treasury's issuance of the check-the-box regulations (CTB) in late 1996 has intensified debate about whether there should be a single federal income tax regime for all private business firms (PBFs), including passthrough entities, whose equity interests are not publicly traded. This revived concern for parity in tax treatment among the various forms of passthrough entities arose because the CTB regulations generally allow a business entity with two or more owners to be taxed as a partnership for federal income tax purposes, regardless of its organizational structure and corporate-like characteristics under state law. Before the CTB regulations, unincorporated entities were required to maintain at least two noncorporate characteristics in order to avoid the double tax regime of Subchapter C. Revenue Ruling 88-76, which permitted limited liability companies (LLCs) to achieve partnership tax status under the former regulations, inspired state legislatures to jump on the LLC bandwagon by adopting LLC statutes and amending existing LLC statutes to conform to liberalized federal income and transfer tax interpretations. All states now have limited liability company laws, and many have added the limited liability partnership (LLP), which is a hybrid form of organizational structure, between the LLC and the limited partnership (LP), intended primarily for professional service organizations. The primary benefit of the LLP is that it insulates partner-members in professional service organizations from vicarious liability for malpractice errors and omissions.

Partnership Distributions: Options for Reform

The rise of new forms of limited liability business entities, coupled with changes in the federal tax rules for classifying such entities, has precipitated an influx of businesses that are treated as partnerships for federal tax purposes. Some commentators welcome what they perceive as a process of de facto integration that promises eventually to make an elective regime of pass-through taxation available for all nonpublicly-traded businesses. To the extent that the partnership model, as currently embodied in Subchapter K, represents a coherent and well-functioning body of law, such a sanguine view may be justified. However, as the preliminary work of the American Law Institute (ALI) project on pass-through entities suggests, the intricate provisions of Subchapter K may be "dysfunctional" in important respects.Indeed, Subchapter K may have reached an important turning point. The 1954 Code drafters stressed simplicity and flexibility while allowing partners considerable latitude in allocating tax benefits and burdens among themselves. With the benefit of hindsight, this tolerant attitude toward shifting tax consequences among partners appears to undermine broader tax policy goals. Concern about the flexibility of partnership taxation-particularly the ease of entry and exit-has led some partnership reformers to veer in the opposite direction. Recent legislative attempts to confine the broad nonrecognition policy of section 72 1-especially with respect to contributions of property with built-in gain or loss, disguised sales, and distributions of previously contributed property-signal Congressional ambivalence about Subchapter K's unrivaled flexibility.

Book Review

Book Review

Firm Value and Entity Choice in Closely Held Business Organizations: Do Taxes Play a Role?

This paper examines the role of tax on firm value of closely held businesses. Using sales transactions of closely held business organizations as a proxy for firm value, the double tax system applicable to C corporations versus the single level of tax on passthrough businesses is expected to result in lower firm value for passthrough entities than comparable C corporations. This theoretical assumption is based on increased pricing flexibility available for firms facing a single level of tax over that of entities subject to double taxation. A dataset of nearly 30,000 closely held business sales was evaluated to find that passthrough entities are associated with lower firm value than comparable C corporations. This finding is important since prior research has produced conflicting results. This study contributes to the literature by examining a more comprehensive dataset, including all forms of passthrough entities, and improving the methodology used in earlier studies.

Entity Structure and Taxes: An Analysis of Embedded Pass-Through Entities

ABSTRACT We examine the effect of pass-through entities embedded in corporate structures on tax avoidance, tax uncertainty, and tax noncompliance using unique, confidential tax return data that link corporations and pass-through entities together through Schedules K-1. We develop measures of the use of pass-through entities such as the number and “connectedness” of pass-throughs within the structure, the presence of loss pass-throughs or asymmetric allocations of such losses, and connections to entities external to the firm. We predict and find that these features are associated with lower effective tax rates, higher current-year additions to tax reserves, and larger amounts of proposed IRS audit adjustments, controlling for probability of audit selection. This large-sample evidence could help the IRS understand how pass-throughs affect compliance and financial statements users anticipate the tax effects related to entity structure. JEL Classifications: H20; H26; L22; M41.

The Tax Gap's Many Shades of Gray

The “tax gap”—the difference between the amount of “true tax” and the amount of tax actually paid—has garnered widespread attention in recent months. Much of the commentary on the subject equates the tax gap with “tax evasion,” a term broadly understood to connote intentional (and potentially criminal) underreporting. This paper cautions against conflating the tax gap with tax evasion. The tax gap includes substantial gray areas where the law is ambiguous and the IRS’s determination of “true tax” is debatable. On top of that, the IRS’s methodology for measuring the tax gap includes upward adjustments that are recommended by front-line examiners but reversed on administrative appeal or judicial review. Moreover, a substantial portion of the estimated tax gap is derived from a statistical technique called “detection controlled estimation” that potentially magnifies the impact of later-reversed recommendations on the ultimate tax gap measure. Weighing in the opposite direction, the IRS’s approach to measuring the tax gap excludes some amounts that clearly constitute tax evasion (most significantly, underreporting of tax on illegal-source income). Understanding the tax gap’s shades of gray can inform discussions of tax law and policy. We explain how proposals to use the tax gap as a performance target may produce perverse incentives for the IRS. We further explain how additional IRS funding—though necessary to improve the agency’s ability to enforce the tax laws—may have counterintuitive effects on the estimates of the tax gap. We also illustrate—using examples from the taxation of passthrough entities—how legislative reforms can reduce the size and scope of legal gray areas that contribute to the tax gap. Our analysis highlights the importance of increased IRS funding levels and substantive tax law changes as complementary strategies for improving tax compliance.

Amicus Brief of Tax Scholars in Support of Appellants

It is hard to describe tax law succinctly. The federal Internal Revenue Code is over 6,000 pages and contains over 4 million words. As scholars who write about taxation, we are well aware of this challenge. Nevertheless, the 100-word summary that appeared on Invest in Education’s petitions accurately describes its proposed change to Arizona tax law. Arizona's Invest in Education initiative would establish a new, separate surcharge of 3.5% on taxable income above certain threshold amounts. This new surcharge shall be imposed “[i]n addition to any other tax imposed by this chapter” and, it will be “collected regardless of whether the income tax rate brackets in this chapter are changed, replaced or eliminated by an act of the legislature.” Invest in Education’s 100-word summary described this provision as “establishing a 3.5% surcharge on taxable income above $250,000 annually for single persons or married persons filing separately, and on taxable income above $500,000 annually for married persons filing jointly or head of household filers.” This description straightforwardly describes the tax law change proposed in the initiative text. The Arizona trial court held there were three tax-related problems with the 100-word summary. The trial court concluded that the use of the term “surcharge” rather than “tax” was misleading, and it held that the description omitted two principal provisions: the relative percentage change in the marginal tax rate and the fact that the definition of taxable income includes income that individuals earn as owners of pass-through entities. The trial court’s conclusions are based in confusion about tax law and a misreading of the Arizona Supreme Court's decision in Molera v. Reagan. As this brief explains, there is nothing misleading about the 100-word summary, and it accurately described the principal tax provision.

Revisiting The S-Corporation Premium: Further Evidence

ABSTRACT Financial and accounting professionals, the IRS, and the legal community continually deliberate the value of a business based on its legal structure—most often comparing the value of a C-Corporation to pass-through entities such as S-Corporations and limited liability companies. Despite the continued deliberations and various court rulings, the cleavages of thought have not converged on a single hypothesis of value. We provide an empirical analysis on M&A transaction data that spans nearly two decades. Specifically, we conduct multiple ANOVA tests, and a programmatic matching analysis of nearly identical pass-through entities and C-Corporation transactions that occurred in the same industry. The results validate the premise that there exists no pass-through entity valuation premium. JEL Classifications: C60; G12; G32; G34; H29; K22.

Introduction

Introduction

The Troubling Case of the Unlimited Pass-Through Deduction

Updated 6/29/20. This paper dissects section 2304 of the CARES Act, which temporarily suspends § 461(l), a limitation on deducting certain business tax losses. Enacted by Congress less than three years ago as part of the 2017 Tax Act, § 461(l) prevented individuals from deducting business losses from pass-through entities against more than $500,000 of other ordinary income. The suspension of this provision in the CARES Act, which I refer to as the unlimited pass-through deduction, allows taxpayers with extremely high incomes to deduct tax losses and thus to reduce or even totally zero out their income tax liability, including retroactively. Combining distributional estimates of other provisions of the CARES Act with estimates from the unlimited pass-through deduction, I show that the unlimited pass-through deduction inverts the perceived progressivity of the cash rebates that were the primary individual-focused element of the federal government’s response to the COVID-19 crisis. I detail how the deduction operates, including how it interacts with other provisions of the CARES Act and other provisions of the Tax Code, in particular bonus depreciation. I also examine the legislative backstory of how the limitation came to exist as part of the 2017 Tax Act and how it came to be repealed in the CARES Act. The context explored here sheds light on the current political economy of federal tax legislation generally, and in particular on the political economy of hastily enacted tax legislation, which should perhaps be viewed as a regular mode of tax legislating. The high-income beneficiaries of the unlimited pass-through deduction will receive cash rebates in 2020 based on losses they realized long before the COVID-19 crisis hit, as detailed below, and there are no particular indicators that these taxpayers have faced particular challenges due to COVID-19 or are in any current need regardless of the cause. Further, the deduction payouts are not conditioned on taking any future actions or using the funds received in a way that might have positive spillover effects for the broader economy or for populations that are particularly vulnerable to suffer negative economic consequences of COVID-19. Thus, the unlimited pass-through deduction cannot be justified as a targeted response to circumstances created by the spread of COVID-19. And, it is definitively not a minor technical fix that should be accepted as necessary or ignored as inevitable given the circumstances.

Contribution and Distribution Flexibility and Tax Pass-Through Entities

The way jurisdictions design their tax systems for business operations can be a contentious issue, as they try to balance the competing goals of raising sufficient tax revenue without unduly inhibiting commercial investment and activities. Such tax design can be of particular importance for small and medium enterprises, which due to their size, inherent characteristics, and resources can struggle with tax compliance. Those attributes can also make business tax regressive. A number of countries around the world have adopted business entities that utilise corporate characteristics, such as liability protection for members and separate legal entity status, but have the characteristic of tax pass-through, with members assessed directly on the income and losses of the entity. Examples include limited liability partnerships (LLPs) in the United Kingdom, look-through companies in New Zealand, and limited liability companies (LLCs) in the United States.In some jurisdictions, these tax pass-through entities have been extremely popular, which in part has been attributed to flexibility for the members in terms of governance and the facilitation of contributions and subsequent distributions. This flexibility is arguably a desired commercial feature of business entities. However, such flexibility with contributions and distributions is seen as a potential risk to tax revenue as there is concern with artificial engineering in order to lower the overall tax burden. This has led to tax integrity measures, which by their very nature can potentially restrict flexibility.For example, LLCs and their members are subject to greater (and potentially more complex rules) when it comes to measuring the cost basis of their membership interests; this then influences members’ ability to utilise allocated losses and the tax treatment of distributions. The flexibility of contributions and distributions for LLPs in the United Kingdom has also raised concerns with the introduction of tax integrity measures. By comparison, the United States’ older tax pass-through entity, the S Corporation, with only one class of membership interest, has fewer integrity rules governing allocations.This Article will critically assess how the flexibility of contributions and distributions by these tax pass-throug entities affects the tax rules that apply to their members. We argue that the flexibility of contributions and distributions appears to be a key characteristic demanded by business entities both for commercial and tax reasons. However, investors need to be cognitive of the inherent complexity and costs that this flexibility may entail. Additionally, it is important for governments and revenue authorities not to unduly restrict flexibility with complex tax integrity rules as it is a fine balance between commercialand revenue needs.

Section 199A and Choice of Passthrough Entity

In 2017, Congress drastically reduced the corporate tax rate and provided an unprecedented deduction under section 199A for qualifying passthrough business income. Although purportedly necessary to maintain tax parity between income earned in corporate and noncorporate form, section 199A encourages active high-income passthrough owners to misclassify labor income as business profit, thereby reducing both income and employment taxes. This Article considers how section 199A is likely to affect choice of entity among different passthrough forms. Prior to the 2017 legislation, S corporations had an advantage over other passthroughs because of their ability to convert owner compensation into S corporation income not subject to employment taxes (or the section 1411 tax). Under the 2017 legislation, it is unclear whether S corporations will continue to represent the superior choice of passthrough entity. Section 199A provides a perverse incentive for S corporations to understate or overstate owner compensation depending on which technique minimizes combined income and employment taxes. The Treasury’s decision to limit the reasonable compensation guardrail to S corporations highlights the anachronistic employment-tax treatment of passthrough entities, as well as the lack of any coherent rationale for preferential treatment of passthrough income. The Article concludes that section 199A offers a fertile field for income-shifting and potentially undermines the rationale for maintaining Subchapter S.

Tax and Corporate Governance: The Influence of Tax on Managerial Agency Costs

This chapter of the Oxford Handbook on Corporate Law and Governance canvasses a broad range of ways that tax influences managerial agency costs, focusing especially on the United States. In doing so, this chapter has two goals. The first is to help corporate law experts target managerial agency costs more effectively. The analysis here flags when tax is likely to exacerbate agency costs, and when it is likely to mitigate them. Armed with this information, corporate law experts have a better sense of how vigorous a contractual or corporate law response they need. In some cases, a change in the tax law may also be justified. This chapter’s second goal, then, is to enhance our understanding of tax rules, shedding light on a set of welfare effects that are important but understudied. After all, tax policy is more likely to enhance welfare if policymakers weigh all possible welfare effects, including managerial agency costs. Overall, the U.S. tax system’s record in influencing agency costs is not encouraging. After all, a tax system’s priority is not to reduce agency costs, but to raise revenue efficiently and fairly. Government tax experts do not usually have the expertise or motivation to tackle corporate governance problems. Tax also is a poor fit because it typically applies mandatorily and uniformly, while responses to agency cost should be molded to the context. For example, promoting stock options or leverage will be valuable in some settings, but disastrous in others. There also are political hurdles to be overcome. Accordingly, when tax rules target agency costs, the results often are poorly tailored or even counterproductive. Even so, the effects are not all bad. On the positive side of the ledger, U.S. tax rules encourage performance-based pay, albeit in blunt ways. In addition, by taxing intercompany dividends, the U.S. keeps block-holders in one firm from indirectly controlling other firms. U.S. tax rules also encourage leverage, which usually (but not always) mitigates managerial agency costs. Likewise, some tax rules favor long-term ownership, which can motivate shareholders to monitor management more carefully. The need to disclose financial information on a corporate tax return can also discipline management. Discouraging the use of offshore accounts and off-balance sheet entities can keep managers from cheating shareholders, as well as the fisc. On the other side of the ledger, U.S. tax rules can be a reason (or excuse) for flawed pay. Managers also can use tax as a pretext to retain earnings, and also to oppose takeovers that put their jobs at risk. Tax also can be invoked to justify “empire building” acquisitions as well as hedging, each of which appeals more to undiversified managers than to diversified shareholders. U.S. tax rules also encourage firms to incorporate offshore or to use pass-through entities, even though these steps can weaken shareholders’ corporate law rights.