How does a professional corporation holding multistate law firm partnership interest eliminate state income tax on the shareholder?
Premise
Professional associations, professional corporations, and professional limited liability companies, when properly formed and maintained under applicable state law, and when characterized as corporations under Internal Revenue Code Section 7701, all offer numerous financial and risk management benefits to their shareholders.
Background Information
For centuries, entrepreneurs and business persons have sought means to protect their personal holdings from the claims of creditors and others who may have recourse against the commercial enterprise in which they were engaged. The development of common law and the statutory recognition of third party entities to accomplish this objective are well documented. We accept this as a given for purposes of this discussion.
It should be no surprise that in the pursuit of protecting one’s personal holdings and to maximize wealth accumulation, creative business persons have devised means to utilize third party entities to accomplish both objectives.
At the same time, taxing authorities at the federal, state, and local levels have sought means of exacting a share of those entities’ profits with the objective of re-distributing wealth and funding costs that are for the common needs of all.
Thus, the exercise of individual freedom and liberty to pursue the fruits of capitalism conflicts with government’s need to secure funding for the purpose of providing certain goods and services for benefit of its constituents. Other objectives of organized government are irrelevant for purposes of this discussion.
On more than one occasion, Justice Billings Learned Hand opined that organizing one’s affairs to minimize taxes was a reasonable pursuit of personal liberty.
“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)
“Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.”
Commissioner v. Newman, 159 F.2d 848, 851 (2d Cir. 1947) – dissenting opinion
Discussion and Findings
Generally, for purposes of imposing income taxes, partnerships are not considered taxable entities. Rather, they are considered an aggregation of their partners. Consequently, taxes are imposed on the individual partners. However, Subchapter K of the Internal Revenue Code recognizes that for certain purposes, partnerships are treated as entities separate and apart from its partners. However, the basis for imposing income taxes is applied on the aggregate basis. This is consistent with the Revised Uniform Partnership Act.
Individual partners are taxable on their distributive share of partnership income, deductions, credits, etc. For state income tax purposes, applying the aggregate theory, each individual partner (regardless of his/her domicile) is taxable on those partnership items that are apportioned to the state(s) in which the partnership has nexus and conducts operations.
Corporations, on the other hand, are generally recognized as legal entities, separate and apart from their shareholders. Consequently, they are taxed accordingly.
When corporations are partners in partnerships, the corporations and not the shareholders, are taxable on their distributive share of partnership income, deductions, credits, etc.
For corporations, income tax is imposed on net taxable income from all sources, as adjusted for certain items, and then apportioned to the individual states, typically based on three factors. Generally those three factors are based on revenue, payroll, and property. There are numerous variations on this theme, but most states follow the overall scheme, as set forth under provisions of the Multistate Tax Compact.
Net taxable income, the base for imposing state income tax on the corporation, is computed in accordance with the Internal Revenue Code (IRC). Under the IRC, in computing net taxable income, Section 162 allows for the deduction of ordinary and necessary business expenses. Section 162 permits a deduction for reasonable compensation of employees who provide services.
Relevant Authorities
Under the Revised Uniform Partnership Act, the aggregate theory of partnership states that a partnership does not have a separate legal existence such as a corporation. Under the aggregate theory, partnership is only the totality of the partners who make it up. According to this theory, each partner is treated as the owner of a direct and undivided interest in partnership assets, liabilities and operations and is not viewed as a taxpaying entity. Tax is actually paid at the partner level. Partners are treated as a group of individual sole proprietorships for the purpose of tax rules that provide separate elections or limitations, such as IRC section 108 cancellations of debt (COD) income exclusions, itemized deductions, and tax preferences. All partners, under this theory, individually report their respective shares of income and deductions.
Charles Turner, TC Memo 1965-101
- PARTNERSHIPS — what constitutes — definition? A Corporation, not its sole shareholder, was taxable on its distributive share of income from partnership of which controlling shareholder was also a partner: corporation was bona-fide partner. Shareholder transferred most of his interest in partnership’s predecessor to corporation and his control wasn’t sufficient to treat corporation income as his.
- 162 Trade or business expenses.(a) In general.
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;
(2) travel expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and
(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
The relevant authorities cited above are subject to change. The findings establish a reasonable basis for the purpose of tax return filing positions. Generally, good faith reliance on a qualified tax professional’s opinion is sufficient to establish reasonable cause to avoid imposition of civil penalties for any underpayment of tax.