INTRODUCTION 351 II. TAX PASS-THROUGH ENTITIES 355 A. United States 358 B. United Kingdom 365 C. Small Closely Held Businesses 370 III. FLEXIBILITY 371 A. Types of Contributions 378 1. Contributions of Money 381 2. Contributions of Property 381 3. Contributions of Services 384 4. Performance-Adjusted Interest Determination 386 5. Contributions of Promises 386 B. Types of Membership Interests 387 C. Multiple Entities 398 D. Types of Allocations and Distributions 398 1. Losses 401 2. Further Membership Interests 401 E. Capital Protection 404 F. Compensation: Non-Equity Distributions 408 G. Calculation of Distributions 412 IV. THE EFFECT OF FLEXIBILITY 413 A. Tax Integrity Rules About Contributions and Distributions 413 B. Complexity 425 C. Compliance Costs 427 V. CONCLUSION 430 I. INTRODUCTION
At the close of the twentieth century, there was a considerable movement internationally towards providing alternative business entities, including some with tax pass-through treatment. (1) The reasons for these new business entities are varied, including facilitating venture capital investment, tax neutrality, response to lobby groups, jurisdictional competition, and efficiency arguments. (2) These new pass-through entities can provide a unique combination of what might be described as partnership and corporation characteristics. For example, the internal governance rules may be based on concepts that relate to general partnerships (such as member-management) but with the corporate characteristics of separate legal entity status and liability protection for members. Additionally, the tax rules that apply to these new business entities can be more akin to those that traditionally apply to general partnerships, that is, a tax aggregate (or tax pass-through) approach, with the income and losses of the business directly attributed to members. (3)
There have been numerous arguments that tax pass-through entities are advantageous for closely held businesses. (4) Prominent examples of tax pass-through entities include the United States' Limited Liability Company (LLC) and the United Kingdom's Limited Liability Partnership (LLP). These two structures represent the introduction of new business entities (5) and can be contrasted with tax regimes providing tax pass-through treatment to existing corporate structures that meet special eligibility requirements--for example, the United States' S Corporation and New Zealand's look-through company. (6)
The utilisation of these tax pass-through entities has been attributed to numerous factors, with their tax pass-through treatment featuring prominently. Other touted benefits include improved governance regimes, separate legal entity status, and liability protection, all combining to lead to an improved (or evolved) business entity. (7) Another related concept is the flexibility that they can provide. This flexibility can relate to the governance rules that apply, as well as to contributions, membership interests, and distributions. (8) This flexibility provides commercial advantages, in particular allowing different investors to come together for the business operation, as well as the potential to lower the overall tax burden to provide greater after-tax profits to be reinvested in the business. However, such flexibility is seen as a potential concern to tax revenue; it could be used to artificially manipulate tax positions (especially year-on-year, tax profiles of members, (9) and conduit distributions (10)). Figure 1 illustrates how the concept of flexibility could apply to member contributions and to distributions to members. Such flexibility has led to a number of tax integrity rules to ensure that flexibility does not lead to excessive revenue leakage.
Given that many of the tax pass-through entities provide members some liability protection, tax rules try to take account of member's equity contribution as a proxy for their risk exposure. This is especially an issue for the tax pass-through of losses to members, but it is also important for income allocations as well. The concern with the tax pass-through of losses is that unfettered allocation of losses to members with limited liability exposure to the business operations could potentially distort investment decisions. This is because access to tax losses (and tax preferences) can result in a country's tax system funding (or decreasing) the effective cost of capital for an investor, thereby distorting investment decisions. (11)
Evidence suggests that tax pass-through entities with greater flexibility could have greater compliance cost and complexity (compared with pass-through structures with lower flexibility--such as S corporations, which allow for one class of membership interest). (12) It is suggested that the concept of flexibility is an important consideration when it comes to choice of business entity. However, such flexibility can appear as a concern to revenue authorities as it can give the impression of artificial manipulation rather than genuine commercial endeavours.
It is critical for tax rules to strike the right balance of protecting tax revenue while allowing flexibility. Otherwise, the tax rules could adversely impact these tax pass-through entities with the tax law dictating "how parties must carry on their economic affairs." (13)
Prior research about this international trend has considered the reasons and process of their introduction, (14) the loss restriction rules that apply to protect tax revenue, (15) compliance cost evidence, (16) the financing effect, (17) and governance. (18) To date there has been little detailed analysis of the contribution and distribution flexibility and what part it has played with tax pass-through entities, particularly as a possible threat to tax revenue. This Article analyses why this flexibility is an important commercial characteristic for business, highlights the concerns about flexibility, and considers the advent of tax integrity rules.
Part II of this Article will provide a broad summary of the tax pass-through entities and their utilisation. Part III will then describe what is meant by contribution and distribution flexibility Part IV will show why flexibility may be a desirable commercial characteristic, especially to address the financial constraints that can confront small and medium closely held businesses. Through this analysis, it will be argued that it is important for governments and revenue authorities not to unduly restrict this flexibility with complex tax integrity rules but instead to aim for the right balance between commercial and revenue needs.
TAX PASS-THROUGH ENTITIES
The introduction of formal business entities was an important part of the industrial revolution; (19) they facilitated the drawing together of equity, the sharing of risk, as well as shielding or limiting of liability, and accommodating management rules. Some of these business entities were given legal personality, with an entity established at law that separated its equity members from the people that managed it.
A key issue is whether tax should be imposed on these separate legal business entities, their members, or a combination of both. In this context, taxation models can be perceived in terms of a continuum from an entity approach to an aggregate approach for business entities. National jurisdictions have sought to implement tax regimes that have been reflective of different points along this continuum. (20) Tax regimes can extend from the entity (classical) tax system, (21) to systems that tax the entity but provide for tax relief on distributions (an integrated approach), (22) and to an aggregate approach (tax pass-through).
Tax pass-through entities can be perceived as a hybrid of business entities with the attributes of a corporation's separate legal entity status (23) and limited liability, (24) and a general partnership's tax pass-through treatment. (25) For tax purposes, all of the tax pass-through entity's income (whether distributed to members or retained) is allocated and assessed to members each year. When the tax pass-through entity generates losses, as when deductions exceed assessable income, these are similarly directly allocated to members. However, to be able to utilise losses members may need to satisfy a series of requirements, such as the outside cost basis rule, the at-risk rule, the passive activity rule, and the substantial economic effect rule. (26)
This Article will use various terms important in relation to tax pass-through entities. The term "member" is used in this Article to describe an equity investor in the business entity, even though they might be known as "shareholder" or "partner" or otherwise. "Contribution" refers to what members have contributed to the business entity in return for their equity interest (member interest), and such contributions could consist of money property services, or promises. (27) Generally, equity contributions describe contributions made by a member to a business entity, which is not guaranteed a return and instead is contingent on the performance of the business.
In comparison, a debt contribution by a member, such as the lending of money to the business entity, would describe a contribution that effectively has a non-contingent obligation for the business entity to repay the financial benefit. A "member loan" describes transfers of money to an entity by equity members in exchange for payment for such use in the form of interest. Parties who lend money to an entity typically have distribution priority over equity members when an entity liquidates.
"Compensation" is used to describe an amount paid by an entity to an equity member in exchange for services of the member or for the use of their assets. The term can be used broadly to cover amounts paid for use of property (rent), money (interest), and services (wages).
"Allocation" refers to allocating income or losses directly to members for tax purposes...
CONTRIBUTION AND DISTRIBUTION FLEXIBILITY AND TAX PASS-THROUGH ENTITIES.
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COPYRIGHT GALE, Cengage Learning. All rights reserved.
COPYRIGHT GALE, Cengage Learning. All rights reserved.