Pass-through entities, such as partnerships, limited liability companies, and S corporations, are one of the main components of President Trump’s tax plan. Under his proposal, income from these types of entities would be taxed at a rate of no more than 15 percent. A lower tax rate would add to another major advantage, which is that pass-through entities avoid the double taxation problem faced by C corporations.
Stockholders in C corporations are generally subject to two levels of tax: First, directly on the profits of the C corporation itself and then on distributions to the shareholders (or capital gain on their sale of their shares). For federal income tax purposes, pass-through entities escape tax at the entity level. Instead, income is allowed to flow through to the owners (e.g., partner, LLC member, or S corporation shareholder) before it is subject to tax.
Even if Trump’s pass-through tax break is enacted, these entities must still navigate through an elaborate maze of state taxes, some of which are at the entity-level. Since each state sets its own tax rates and rules, they are likely to continue taxing income that passes through to the owners of these entities at the highest marginal rate, which can be as much as 15 percent.
Another problem is the way states impose tax on pass-through entities. Most states conform to the federal tax classification of pass-through entities, but several provide for levies to be imposed on the distributive share of pass-through entity income allocated to nonresident owners or directly on the pass-through entity itself. States like Maryland, Ohio, and Virginia impose a special pass-through entity tax computed at the entity level but is applied to the share of income distributed to nonresident owners.
Still other states impose tax directly on the pass-through entity. Notably, Texas, which doesn’t have a personal income tax, imposes its “corporate franchise” or “margin” tax not only on C corporations but also on S corporations, LLCs, and limited partnerships and all at the same rate. “The Texas Constitution prohibits a direct income tax on ‘human beings’ and the state’s Legislature struggled with determining whether an LLC was a corporation or a partnership,” said Steve Wlodychak, a principal with EY in Washington, D.C. “The solution was to treat all entities which provide limited liability to their human owners as ‘corporations’ for franchise tax purposes,” he said.
Another example is the District of Columbia, which imposes an unincorporated business tax on pass-through entities doing business in the District and ignores S corporation elections for purposes of its corporate franchise tax entirely. The unincorporated business tax was likely a response to a congressional statutory prohibition on the District imposing personal income taxes on nonresidents, Wlodychak told Bloomberg BNA.
Pass-through entities are also subject to a multitude of non-income-based taxes at the state level. Many jurisdictions disregard federal pass-through entity income tax treatment for purposes of imposing levies such as the franchise tax, gross receipts tax, or real estate transfer taxes, but these rules vary widely from state to state (and even within some states, from local jurisdiction to jurisdiction). This is because most state tax codes include pass-through entities within the definition of a “taxable person,” Wlodychak said.
While a lower federal tax rate would add to the reasons to operate as a pass-through entity, the benefit would only go so far. It would be unlikely to reduce state tax bills. Also, it will have no impact on the array of non-income based taxes that states impose on these businesses, and the proposed elimination of the federal deduction for state and local taxes would elevate the importance of state and local taxes in business tax compliance.
Did you know that some states have franchise taxes that act as corporate income taxes? Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn.
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