Contribution and Distribution Flexibility and Tax Pass-Through Entities

Abstract

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 particularly important 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 utilize corporate characteristics, such as liability protection for members and separate legal entity status, but also have the characteristics of tax pass-through, whose members are assessed tax liability directly based on the income and losses of the pass-through 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 of America.

In some countries these tax pass-through entities have been extremely popular, which in part has been attributed to the flexibility members can benefit from with respect to governance and how contributions and subsequent distributions can be facilitated. 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, because there is concern that through artificial engineering the overall tax burden can be lowered. 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 utilize 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 US' 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-through entities affects the tax rules that apply to the allocations and distributions to their members. Here, 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; it is a fine balance between commercial and revenue needs. Firstly, the concept of tax pass-through entities is discussed, with particular attention on their utilization in the United States and the United Kingdom. This is followed by a description of why contribution and distribution flexibility are a desired feature for business entities and how this can be facilitated with LLCs and LLPs. The Article then critically analyzes the tax rules that apply to LLCs and LLPs due to their allocation and distribution flexibility, which will include comparisons to the rules for S Corporations. This analysis will consider relevant statutes, available case law, and regulatory rulings. This is followed by recommendations and limitations. It will be argued that there needs to be greater recognition of the need for flexibility, and tax rules should not adversely impact this characteristic.

Keywords: Distribution, Small business, tax, integrity, compliance, growth

JEL Classification: K34