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  • Tax reform draft aimed at pass-through businesses

    April 2, 2013 by Andrew Osterland

    Financial advisory firms and other businesses set up as so-called pass-through entities could be among the most dramatically affected if Congress adopts a comprehensive tax reform bill.

    The discussion draft on small-business taxation put forth by House Ways and Means Committee Chairman Dave Camp, R-Mich., on March 12 cites high tax compliance costs and the “patchwork of complex and often inconsistent rules” that produce disparate results for different business structures as reasons for undertaking reforms.

    “As far as the details go, we’re still digesting them, but it’s a good attempt to focus on the complex taxation of pass-through entities,” said Chris Whitcomb, tax counsel for the National Federation of Independent Business. Seventy-seven percent of the group’s members are structured as pass-through organizations, which include sole proprietorships, S corporations, partnerships and limited liability corporations (the most popular form of legal structure for registered investment advisers).

    Data collected by the Investment Advisers Association last year found that 5,331 RIAs were structured as LLCs as of last July, up from 1,331 in 2001. The LLC structure now represents more than 50% of advisers registered with the Securities and Exchange Commission.

    TREATMENT OPTIONS

    Mr. Camp offered two potential options for reforming the tax treatment of pass-through entities. The first would undertake various changes to the rules for both S corporations and partnerships, making the former structure relatively more attractive and the latter less so. The favorable changes for S corporations included in the proposal are making the Section 179 deductions for capital investments permanent, expanding the use of cash accounting for businesses with up to $10 million in gross receipts, and increasing the deductibility of expenses for startup businesses.

    The rules on partnerships, on the other hand, would be tightened to limit “the use of partnerships as tax avoidance structures,” as the draft summary explained. Essentially, the new rules would place limits on the ability of partnerships to allocate tax benefits and income to different partners in the business, thereby minimizing tax liabilities.

    “In general, S corporation people are probably happy with the proposals, and partnership people not so much,” said Mark Luscombe, principal tax analyst for consulting firm CCH.

    Mr. Camp’s second proposed option would pursue a more radical overhaul of the rules to achieve a unified taxation regime for all pass-through entities. It would greatly simplify the regulations, but it also likely would force some major changes on financial advisers and others structured as partnerships or LLCs that elected to be taxed as partnerships.

    “Most people feel that Option 2 will be dead on arrival,” said Neal Weber, managing partner of the Washington practice of accounting firm Cherry Bekaert LLP. “It’s too draconian for industries like real estate and hedge funds.”

    Not to mention financial advisers. Unless the reforms are accompanied by significant rate reductions, partnership structures could be looking at higher taxes and/or significant restructuring of business models.

    “The Option 2 proposal would have a profound effect on both S corporations and partnerships,” said Neil Simon, vice president for government relations at the Investment Adviser Association. “It would remove much of the flexibility of the partnership rules, and could result in higher taxes and reduced value of advisers’ businesses. It could also force owners to restructure their business models.”

    STRUCTURE OF CHOICE

    While advisers may not like the complexity of the tax code, they have learned to live with it — if not game it — critics argue. The limited liability corporation has become the legal structure of choice because it provides a high degree of flexibility when it comes to allocating deductions and income among business partners.

    It also makes transitions in advisory businesses far easier in terms of cashing out retiring partners and bringing in new owners. With so many advisers nearing retirement age, new tax rules could complicate their succession plans.

    Depending on how the proposed rules would apply to new and existing businesses, Mr. Camp’s Option 2 could reduce the attraction of the partnership structure dramatically.

    “I think it would remain viable, but I expect we would see a lot less investment through the partnership structure,” said Mel Schwarz, a partner in the national tax office of accounting firm Grant Thornton LLP.

    Originally Posted at InvestmentNews on March 31, 2013 by Andrew Osterland.

    Categories: Industry Articles
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