Integrating Subchapters K and S-Just Do it

Abstract

The Code contains two “pass-through” tax regimes for business entities. One is contained in Subchapter K, which applies to partnerships, the other in Subchapter S, which, unsurprisingly, applies to S corporations. In the main, both Subchapters tax the owners of the entities rather than the entities themselves. Having two pass-through tax regimes creates obvious administrative and other inefficiencies. There was a time when S corporations served a valuable purpose, particularly when taxpayers needed a fairly simple and foolproof pass-through entity that provided a liability shield. But limited liability companies (LLCs), which are usually taxed as partnerships, 1 in most contexts make S corporations obsolete. LLCs too can be fairly simple and foolproof, while providing the superior tax benefits of the partnership provisions of Subchapter K. The advent and popularity of LLCs means that the inefficiency created by two separate pass-through tax regimes can no longer be justified. I propose that a new pass-through regime be created that retains Subchapter K and incorporates the best parts of Subchapter S, with the balance of Subchapter S repealed. Integrating these two pass-through regimes requires that some changes be made to the C corporation provisions of Subchapter C as well. I also make Subchapter K available to most nonpublic C corporations, putting most closely held businesses on a level playing field.

Part II of the Article discusses the tax entity selection process generally, as well as the basics of the taxation of C corporations, S corporations, and partnerships. Part III explores the tax advantages and disadvantages of partnerships and S corporations. Part IV looks at the data on the relative popularity of the major business entities and provides a possible explanation for the continued popularity of S corporations. Part V discusses H.R. 4137, a bill that was ahead of its time (and not unflawed). Part VI asks whether we should repeal Subchapter K instead. Part VII recommends that nonpublic corporations also be allowed to elect Subchapter K. Part VIII proposes taxpayer-friendly methods for getting to my version of the promised land, and Part IX gives a brief conclusion.

Keywords: business entities, Subchaper K, Subchapter S, partnerships, S corporations, taxation, LLC's, limited liability companies, closely held businesses, H.R. 4137

JEL Classification: K34, K29, K39, H25, H29