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Current Changes of Pass-Through Taxation

19 Aug 2015
Much of the upcoming political conversation for the next year as we march toward the 2016 elections will revolve around changing of the current tax code, whether by “closing loopholes” or “simplifying the tax code”, most of which is targeted toward C Corporation taxation, despite its falling popularity. While it is true that most of the major American business are C Corporations, the most popular form of ownership in terms of number of returns filed has become pass through taxation entities, such as S Corporations & Partnerships.

In light of this shift in the business taxation paradigm, on July 31, 2015, President Obama signed the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 which implemented among other laws a change in the deadlines for certain tax returns. Most significantly, under the new law, the filing deadline for Partnership tax returns, Form 1065, has changed from April 15 (3 ½ months after year end) to March 15th, or 2 ½ months after the close of the year. This deadline is the same as the S Corporation deadline, which remains unchanged from March 15, 2 ½ months after year end. This change was made in an effort to speed up the timeline for owners of pass-through taxation entities to receive their K-1s, which they will need to file their personal tax returns, which will be discussed below.

The deadline for the filing of C Corporation returns has also changed. Previously, the deadline was 2 ½ months after the close of the year, or March 15 for calendar year filers. The deadline has now been moved to April 15, or 3 ½ months after the close of the year.

These changes will take effect for tax years beginning after December 31, 2015, so for the 2016 returns that will be filed in 2017.

Fundamentals of pass-through taxation

When discussing pass through taxation, this refers to entities structured as either a Limited Liability Companies (LLCs) or through S Corporations. These entities are relatively simple to set up and provide protection for assets of the owners of the businesses. They also only feature one layer of taxation, as the profits and losses are directly taxed on the owner’s tax returns, rather than on the business level, which is why it is known as pass-through taxation.

The benefits of this generally relate to owners taking profits out of the business, as the pass-through taxation eliminates the double taxation of dividends on both the business and shareholder level. For example, any dividend that say Apple pays to you as a shareholder will have been taxed twice; first via a corporate level income tax and then again to you as the individual shareholder. This double taxation can make the effective rates of taxation on profit upwards of 60% in some cases.

Despite their popularity, many business owners are still unfamiliar with the taxation of these structures, particularly on their personal returns. As mentioned above, the business income or loss is reported, or assigned, to the individual that owns the entity. Contrary to popular belief, the amount distributed to the shareholders does not represent the taxable amount onto the shareholders return (see below discussion of basis), but rather the full amount of the profit the business earned. Often, the business profit can be reinvested in the business or used to pay down debt, which leads to an increase in basis.

Basis & Distributions

Basis, in laymen’s terms, refers to how much “skin in the game” you have in relation to the business. Basis on your flow through income/losses is typically calculated in this manner (simplified):

                                                      Investment in Entity

                                                      + Current year income

                                                     Basis available for distributions

                                                      – Current year distributions

                                                      Basis available for losses

                                                      – Current year losses

                                                      Basis carried over to next year

As shown above, your basis is calculated in a prescribed order per IRS regulations and includes your investment, current year income, distributions and losses. This number carries over from year to year so that the net basis number on the bottom is your starting point for future years, meaning that your net prior year income, distribution and losses have an effect on your current year basis. Your starting basis, however, will never drop below zero.

Distributions and basis go hand in hand. As mentioned, distributions are amounts paid to the owner which represent his investment in the business, including the annual profits for which they paid tax on their personal returns. Distributions are not typically taxable events – a profitable pass-through business that takes no distributions will have the same tax burden as a profitable pass-through business that distributes all their property.

If the calculation above results in your basis number dropping below zero, you will then have an additional taxable event – the most common of these are distributions in excess of basis and basis suspended losses. A distribution in excess of basis means that your current year distributions are higher than the basis you have available for distributions – these distributions are considered a dividend or a return in excess of capital and taxed, unlike distributions which are not taxed. A basis suspended loss means that you have higher losses than your basis available for losses. When this happens, you are unable to take the full value of the loss on your personal tax return but rather only able to take the loss up to your basis, and the remainder is left suspended until your establish basis in the entity (for example, profitable years or capital infusions).

Pass-through taxation is designed for the small and medium businesses to have easy access to the business profits and losses while still providing strong asset protection and business resources. The entities are increasingly common and should continue to provide favorable tax treatment, despite whatever changes may be on the horizon.