A business entity that is treated as a “flow-through” for income tax purposes enjoys the benefit of a single level of tax – the entity itself is typically not subject to tax on its net income; rather, that income “flows through” to the entity’s owners, who then report it on their own income tax returns. This flow-through treatment occurs whether or not the entity has made a distribution to its owners. For that reason, partnership/LLC agreements and “S” corporation shareholder agreements often provide for so-called “tax distributions,” meaning that the entity will distribute, on an annual or quarterly basis, enough cash to enable its owners to satisfy their income tax liabilities attributable to their share of the entity’s income that is flowed-through to them.
By contrast, the income of a so-called “C” corporation is taxed twice: once to the corporation, and then to its shareholders to the extent the corporation distributes any part of its after-tax income to the shareholders in the form of a dividend. The “double tax” occurs because a corporation is not permitted to deduct such a distribution in determining its taxable income.
Historically, the tax laws have been concerned that corporations and their controlling shareholders would be reluctant to distribute their “excess” profit – meaning the profits remaining after the corporation has satisfied the reasonable needs of its business including, for example, the establishment of capital or other reserves. A corporation may decide to accumulate such profits, or it may decide to pay its shareholder-employees an amount of compensation that is unreasonable for the services rendered by such shareholders, but which the corporation will nonetheless claim as a reasonable and deductible expense.
The IRS views both of these strategies as tax avoidance schemes. As regards the accumulation of corporate profits beyond the reasonable needs of the corporation, the Code provides for a corporate-level “accumulated earnings tax” (“AET”). A recent Chief Counsel Advisory considered one corporate taxpayer’s attempt to avoid the AET solely on the basis that it lacked liquidity from which to pay dividends to its shareholders.
An Investment Company
Corp. was treated as a “C” corporation for income tax purposes. Shareholder was its sole owner, director and officer. Shareholder contributed to Corp. his entire interest in several limited partnerships and in LLCs that were treated as partnerships for income tax purposes (the “partnerships”).
Partnership served as the manager for all of the entities contributed to Corp. Partnership itself was managed by a board that included Corp. Each member of the board was a “Director” with power to vote on Partnership matters. In addition, Shareholder joined Partnership as a partner and became an officer thereof. In that capacity, Shareholder was responsible for overseeing part of Partnership’s operations, for which he received a salary during the years at issue.
Each of the partnership/operating agreements (the “partnership agreements”) contained a provision allowing the partnerships to make distributions to their partners/members (the “partners”) sufficient to pay the respective partner’s income tax liability, but the remainder of the respective partner’s distributive share of the partnership income was retained in the partnership.
Accordingly, Corp. reported its distributive share of each partnership’s income, but only received distributions sufficient to pay its tax liability.
All of the income and essentially all of the expenses reported by Corp. were flow-through items from the various partnerships. This flow-through income consisted of dividends, interest, capital gain, Form 4797 gain (for example, from oil, gas and other mineral properties), and certain other income.
Since its inception and during the tax years at issue, Corp. conducted no business activity other than holding and maintaining the various partnership interests contributed to it by Shareholder. Corp. had no employees and paid no wages or expenses, other than a minimal amount for accounting and other fees. Additionally, Corp. neither declared any dividends nor did it otherwise make any distributions to Shareholder. Furthermore, it appeared – based on its balance sheets – that Corp. had made loans or advances to Shareholder.
Corp. reported retained earnings for the tax years at issue. It also reported a federal income tax liability for those years.
Distribution of Corp.’s earnings and profits for the years at issue would have resulted in additional tax to Shareholder.
According to the IRS, no valid business purpose seemed to exist for Shareholder’s incorporation of Corp. According to Corp., Shareholder contributed his partnership interests to Corp. in order to avoid potential taxation by various state, local, and foreign tax jurisdictions. Corp. did not otherwise provide any information to show a business reason for the accumulation of its retained earnings, and a review of its board of director minutes for the years at issue did not contain or provide any plans or information relating to the reasons for the accumulation.
The IRS explained that the Code imposes a tax on the accumulated taxable income of every corporation formed or availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting its earnings and profits (“E&P”) to accumulate instead of being distributed. The avoidance of tax, the IRS noted, need only be one purpose for the accumulation; it need not be the only or primary purpose.
For purposes of this rule, the fact that the E&P of a corporation are permitted to accumulate beyond the reasonable needs of the business is determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation proves to the contrary by a preponderance of the evidence.
Although the term “earnings and profits” is not statutorily defined, it is generally described in rulings as referring to the excess of the net amount of assets of a corporation over the capital contributions of its shareholders. (See Sch. L of IRS Form 1120.) E&P is an economic concept that is generally based on taxable income, with certain adjustments set forth in the Code. The IRS pointed out that there are no adjustments relating to a corporate partner’s distributive share of a partnership’s income.
The IRS’s Analysis
The IRS has the burden of proving that all or any part of a corporate taxpayer’s E&P has been permitted to accumulate beyond the reasonable needs of the corporation’s business. Of course, the corporate taxpayer has an opportunity to establish that all or part of the alleged unreasonable accumulation of E&P was reasonable for the needs of its business.
Some reasons that the IRS has found are acceptable for accumulating E&P include: debt retirement, business expansion and plant replacement, acquisition of another business by purchase of stock or assets, working capital, investments or loans to suppliers or customers necessary to maintain the corporation’s business, and reasonably anticipated product liability losses.
Some grounds that the IRS has determined do not justify the accumulation of E&P include: loans to shareholders and expenditures for their personal benefit, loans to others which have no reasonable connection to the business, loans to a related corporation, investments that are not related to the business, and any accumulations (self-insurance) to provide for unrealistic hazards.
If a corporation is a mere holding or investment company, that fact is treated as prima facie evidence, the IRS stated, of the purpose to avoid income tax with respect to the corporation’s shareholders. A “holding company” for this purpose is a corporation having practically no activities except holding property and collecting the income therefrom or investing therein. If the activities further include, or consist substantially of, buying and selling stocks, securities, real estate, or other investment property so that the income is derived not only from the investment yield but also from profits based upon market fluctuations (appreciation), the corporation is considered an investment company.
Corp. had no activity other than holding and maintaining the various partnership interests contributed to it by Shareholder. Furthermore, none of the partnerships in which it owned an interest, controlling or otherwise, appeared to perform any activity other than investment activity. Accordingly, Corp. was a mere holding or investment company, it did not engage in any active business activity. Thus, there was prima facie evidence that Corp. was formed to avoid tax.
Corp. argued that it was not liable for the AET because it did not have control over distributions from the partnerships in which it invested. That is to say, because Corp.’s taxable income was derived solely from partnerships from which Corp. could not control distributions, Corp. did not have liquid capital from which to distribute earnings to Shareholder and, therefore, should not be subject to the AET.
Corp. suggested that an “accumulated surplus” must be represented by cash (liquidity) that is available for distribution. However, the Code computes the AET based on accumulated taxable income and, at least with respect to a mere holding company for which the reasonable needs of a business are not relevant, it is not concerned with the liquid assets of the corporation. The starting point for defining “accumulated taxable income,” the IRS continued, is “taxable income,” and none of the adjustments to taxable income address the undistributed income of partnerships.
In any case, Corp. could have availed itself, the IRS said, of the consent dividend procedures provided by the Code, which would have allowed Corp. and Shareholder to avoid the AET regardless of any lack of liquidity.
According to the IRS, the consent dividend election manifested a Congressional intent to provide corporations the same treatment as if they made distributions even when they lacked the liquidity to actually do so. In pertinent part, the consent dividend procedures provide that if a shareholder agrees to treat as a dividend the amount specified in a consent filed with the corporation’s tax return, the amount so specified shall constitute a consent dividend that is considered (1) as distributed in money by the corporation to the shareholder on the last day of the corporation’s taxable year, and (2) as contributed to the capital of the corporation by the shareholder on the same day.
Because consent dividends could have been used, the IRS stated, Corp.’s distributive share of partnership income should be taken into account in determining whether the AET should be imposed. Importantly, the availability of the consent dividend option does not depend or rely upon a controlling shareholder’s control of the partnership that retained all of its earnings.
Thus, Corp. remained subject to the AET in spite of its lack of liquidity and its lack of control over the partnerships in which it invested.
Although the foregoing discussion relates to a corporate tax issue, the key actors in the IRS’s decision were the partnerships in which Corp. was a partner.
The avoidance of double taxation that is afforded by a partnership is an important consideration in selecting the appropriate entity for a taxpayer’s business or investment activities. The partnership structure also affords the partners great flexibility in that there are no limitations upon who may invest in a partnership, and the partnership is flexible enough to accommodate many kinds of economic arrangements among its members.
That being said, the flow-through treatment can also present significant issues and surprises for the partners.
The AET issue discussed above is one such issue. Another is the tax imposed on S corporations that have E&P from years in which they were C corporations and that are invested in partnerships that generate substantial passive investment income. This could result in the imposition of a special tax on the S corporation and, eventually, in the loss of its S corporation status.
Another example may be found in the case of a flow-through entity that is invested in a partnership. The creditors of the flow-through entity may impose limitations upon its ability to make distributions to its owners, notwithstanding that the income of the partnership of which it is a member continues to be taxed to those owners.
Yet another instance where investment in a partnership may result in some “hardship” is in the case of a foreign partner. Its investment in the partnership may cause the foreign partner to be treated as engaged in a U.S. trade or business, and may also (where a treaty applies) constitute a “permanent establishment.” Add to that the withholding obligation imposed upon the partnership as to the foreigner’s distributive share of partnership income, and you may have one unhappy partner.
The bottom line, as always: these issues need to be identified in advance of the investment, they need to be examined and, if possible, the taxpayer and the partnership need to plan for them.