Briefs

By Tom Noble
8080 N. Central Expressway
Suite 930
Dallas, Texas 75206
214-692-1888
fax: 692-8577
tnoble28@hotmail.com
www.tnoble.com

Wednesday, November 29, 2006

The Mysteries of Pass-through Income

When a businesswoman conceives a new venture, one of the first problems she confronts is what sort of business entity she should use. Her basic choices are: corporation, partnership, or limited liability company (“LLC”)?

If she selects “corporation”, she must then move to the next level, so to speak, and select: S Corp or C Corp?  If she opts for “partnership”, she must then select: limited partnership or general partnership?  If she ventures into an LLC, she then must decide whether to be taxed by the feds as a corporation or as a partnership.  Gets a little complicated, huh? 

While all of the factors our imaginary businesswoman should consider for every conceivable venture exceeds the scope of this puny little article, not to mention the author’s personal expertise, it is safe to say that one of the primary considerations when making these decisions is whether Annie Entrepreneur wants profits and losses to “pass through” to her for purposes of federal income taxes. 

If Annie selects S Corp, partnership, or LLC (taxed as a partnership), profits and losses will pass-through the entity to her for tax purposes as though the business were a filter, catching enough money to pay business expenses and allowing the profits and losses to flow through to Annie for tax purposes (even though it may actually stay in the business).  If Annie later marries (or forms entities of this ilk during a marriage and capitalizes one or more with her separate property), she will own what we can call, for purposes of this discussion, a “separate property pass-through 1 entity” or SPPTE 2 .  If Annie divorces or predeceases her husband (Danny? Why not?), a couple of interesting problems can arise.

Problem #1 : Annie loses her right to trace her separate property through the SPPTE.  Deeply embedded in Texas law we find the right of every person who marries to trace separate property, to prove in a court of law that what was once all her own is still all her own, albeit changed of form 3.  Indeed, after some prodding from good friends Jim Wingate and Dawn Fowler, the Texas legislature recently amended the Texas Family Code to clarify that divorcing spouses have the right to trace separate property through defined-contribution [retirement] plans.  Separate property can move through a retirement plan and come out all or part separate on the other side of a divorce decree - but not business capital. If you form a business and capitalize it with separate property, distributions to you during a marriage will be community property, even if all you are doing is taking out what used to be your separate property 4.  This can be good for Danny.

Problem #2 : The IRS taxes Annie and her husband on pass-through income even if the entity does not distribute it to them.  If the SPPTE distributes enough to cover those taxes, OK, no problem; but, if not - no fair for the spouse.  Those party lights starting to dim, Danny boy?

Some Dans have hollered “foul” and asked courts to determine that the community estate acquires an ownership interest in the retained earnings of the SPPTE.  Forget it, boys! 

In 1961, Texas adopted the Uniform Partnership Act, which employs the “entity theory” of partnerships (as opposed to the “aggregate theory”). The retained earnings of a partnership are not even marital property.  In the Thomas case 5, the court reached the same conclusion about an S Corp.  And, § 101.106(b) of the Texas Business Organizations Code says the same thing about LLCs 6.  In this scenario, Dan may owe taxes on income he never receives, especially if he files a joint return with Annie.

Problem #3 :  If Annie loses her separate property, the community gets the benefit.  How is Annie compensated for that? 

Reimbursement claims tend to pop up in these problems, and they can get complicated. But, enough for now.

Φ

Here’s wishing that life’s good stuff passes through to you in 2007!

¹ I am not answering any questions about whether “pass-through” should be hyphenated. It feels right to me, and that’s the end of it!
² Pronounced “Spit”! What is it with lawyers and acronyms?
³ What was once a technology stock is now half a CD.
⁴ Marshall v. Marshall, 735 S.W.2d 587 (Tex. App. – Dallas, 1987, writ ref’d n.r.e.) makes this point regarding partnerships.   There may be exceptions to the rule when it comes to LLCs or S Corps, but I have found no authority to support that.
⁵ Thomas v. Thomas, 738 S.W.2d 342 (Tex. App. – Houston [1 ^st Dist.] 1987, no writ).
⁶ “A member of a limited liability company or an assignee of a membership interest in a limited liability company does not have an interest in any specific property of the company”.