Contribution and Distribution Flexibility and Tax Pass-Through Entities

46 Pages Posted: 5 Sep 2020

See all articles by Brett Freudenberg

Brett Freudenberg

Griffith University - Griffith Business School; Griffith University - Griffith Law School

Bradley T. Borden

Brooklyn Law School

Multiple version iconThere are 2 versions of this paper

Date Written: December 4, 2019

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

Suggested Citation

Freudenberg, Brett and Borden, Bradley T., Contribution and Distribution Flexibility and Tax Pass-Through Entities (December 4, 2019). Florida Law Review, Vol. 23, No. 1, 2019: 349-431, Available at SSRN: https://ssrn.com/abstract=3649903

Brett Freudenberg (Contact Author)

Griffith University - Griffith Business School ( email )

Brisbane, Queensland 4111
Australia

Griffith University - Griffith Law School ( email )

Nathan Campus, GU
Nathan 4111
Australia

Bradley T. Borden

Brooklyn Law School ( email )

250 Joralemon Street
Brooklyn, NY 11201
United States

HOME PAGE: http://www.brooklaw.edu

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
23
Abstract Views
308
PlumX Metrics