Corporate Structure and Taxation

Taxation Discussion

Under Section 706, a partner cannot "change to a taxable year other than that of a partnership in which he is a principle partner unless he establishes a business purpose therefor." Section 444 elaborates. The general rule is that "except as otherwise provided in this section, a partnership may elect to have a taxable year other than the required taxable year." If the deferral period is less than three months. A scenario under which a business might use a different tax year would be tricky to establish, but if there is a business purpose, it can be done. What constitute a "business purpose" is not established under these sections of the code. There could be situations where a business has revenue accrued at the end of the calendar year, but payment in the early part of the next year. That might be a reason why a business would be able to defer, to better align revenues and cash flows. Another concept might be if the business is seasonal, and runs over the new year. Not that these would be partnerships, but a hockey team or a ski hill, for example, run seasonal businesses that would more naturally have a fiscal year ending at the beginning of summer.

For tax purposes, an LLP is fairly straightforward. The partners each accrue earnings based on the partnership agreement, and pay taxes on those earnings. Tax law recognizes that income flows through to the partners, and all partnership are equally responsible for their income. The IRS does not view an LLP as a distinct legal form because the distinguishing feature of an LLP is the limited liability, which is not a taxation issue. For the IRS, the LLP is a partnership.

State laws different, but the key to an LLP is that there is limited liability for some or all of the partners. What this means for practical purposes is that if one of the partners does something that brings about legal action, the other partners are protected from that. So if one partner in an LLP is sued, the others are likely to have limited liability in that case. The suit would only affect the one partner and his/her stake in the partnership. So for liability purposes, the LLP creates a barrier between partners where for tax purposes no such barrier exists.

Week 7: To create a bigger deductible pass through loss, the shareholder in an S corporation would need to either invest more in the company to increase his/her share, or would need to increase the size of the loss overall for the corporation. The latter is not necessarily a smart move, but the former might be worthwhile. Investing more into a company that is facing a loss will bring about a greater loss pass through if the shareholder then owns a larger percentage of the company. This is especially useful if the corporation is expected to be profitable in the future, in other words if that greater investment in the company is going to have a payoff in the future and taking the bigger loss is valuable in the short run. It becomes a win-win situation.