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The way jurisdictions design their tax systems for business operations can be a contentious issue, as they try to balance the competing goals of raising sufficient tax revenue without unduly inhibiting commercial investment and activities. Such tax design can be of particular importance for small and medium enterprises, which due to their size, inherent characteristics, and resources can struggle with tax compliance. Those attributes can also make business tax regressive. A number of countries around the world have adopted business entities that utilise corporate characteristics, such as liability protection for members and separate legal entity status, but have the characteristic of tax pass-through, with members assessed directly on the income and losses of the entity. Examples include limited liability partnerships (LLPs) in the United Kingdom, look-through companies in New Zealand, and limited liability companies (LLCs) in the United States.
In some jurisdictions, these tax pass-through entities have been extremely popular, which in part has been attributed to flexibility for the members in terms of governance and the facilitation of contributions and subsequent distributions. This flexibility is arguably a desired commercial feature of business entities. However, such flexibility with contributions and distributions is seen as a potential risk to tax revenue as there is concern with artificial engineering in order to lower the overall tax burden. This has led to tax integrity measures, which by their very nature can potentially restrict flexibility.
For example, LLCs and their members are subject to greater (and potentially more complex rules) when it comes to measuring the cost basis of their membership interests; this then influences members’ ability to utilise allocated losses and the tax treatment of distributions. The flexibility of contributions and distributions for LLPs in the United Kingdom has also raised concerns with the introduction of tax integrity measures. By comparison, the United States’ older tax pass-through entity, the S Corporation, with only one class of membership interest, has fewer integrity rules governing allocations.
This Article will critically assess how the flexibility of contributions and distributions by these tax pass-throug entities affects the tax rules that apply to their members. We argue that the flexibility of contributions and distributions appears to be a key characteristic demanded by business entities both for commercial and tax reasons. However, investors need to be cognitive of the inherent complexity and costs that this flexibility may entail. Additionally, it is important for governments and revenue authorities not to unduly restrict flexibility with complex tax integrity rules as it is a fine balance between commercial
and revenue needs.