Nobody likes paying taxes
. The only thing that makes people madder than a big tax bill is
seeing big companies manage to
taxes. But a move to clamp down on zero-tax businesses could make
victims out of regular investors like you, rather than corporate
Wall Street Journal
article highlighted an increasingly popular and totally legal way
getting taxed as a corporation
. But as lawmakers go through the agonizing process of trying to
reform income tax laws and generate much-needed revenue, some
want to take away those benefits.
Below, I'll describe in more detail the threat that investors
in these entities face. But first, let's take a look at what
caused the controversy in the first place.
Understanding tax pass-throughs
One of the biggest objections that Big Business has against the
tax system is that it effectively taxes corporations twice on
their income. Corporations pay corporate tax at a maximum rate of
35%, but they don't get a deduction for dividends paid to their
shareholders. Then, the shareholders also have to pay taxes on
the dividends they receive.
But some businesses have found ways to get around the
corporate tax. By organizing as a
, such as a partnership, limited liability company, or sole
proprietorship, millions of business owners forgo having to pay
corporate tax. Instead, all the tax liability for income the
business earns passes through to its owners.
For small companies, the simplicity involved in pass-through
status makes a lot of sense, and few people object to the concept
as it applies to small business. Yet many much larger entities --
including quite a few public companies -- have taken advantage of
it as well, and that's generating some controversy.
How to be tax-free
There are several ways you can get tax-free status at the
business entity level. Here's just a sampling.
- Real estate investment trusts are typically corporations.
But by electing REIT status, they can avoid corporate tax --
all they have to do is pass out at least 90% of their taxable
income in the form of dividends. For instance,
) has earned net income of $1.11 billion over the past 12
months, but it
pays only minimal taxes
stemming from its taxable REIT subsidiaries.
- Master limited partnerships similarly have rules that
require 90% of their income to come from certain specified
activities including mining, timber, and energy production.
Enterprise Products Partners
) , which operates pipelines, was able to shelter almost $1.5
billion in profits this way. But not all MLPs are actually
(Nasdaq: LINE) is organized as an LLC and had net income of
$385 million over the past 12 months. The difference is that
LLCs don't have to have general partners that are liable for
management decisions; LLCs look more like corporations in that
- Investment and private-equity companies are often
structured as pass-through entities.
) saved almost $450 million in corporate taxes in 2010 as a
result of qualifying for pass-through status.
- The biggest pass-through entities you're most familiar with
are mutual funds and ETFs. The massive ETF
) passes through its tax attributes -- shareholders are taxed
at higher collectibles rates as if they owned the bullion in
the ETF's vaults. Similarly, every fund and ETF that's set up
as a registered investment company avoids paying entity-level
tax -- again by forcing their shareholders to pony up.
Is it fair?
In Congress, political parties have drawn the typical lines about
whether to tax pass-throughs. On one hand, competitors argue that
taxable entities are at a disadvantage against pass-through
entities. But others say it's the corporate tax itself that's
unfair, as other countries avoid the problem by having lower
corporate tax rates or otherwise preventing double taxation.
Taking away pass-through tax status would be potentially
devastating. Higher taxes would mean less income flowing through
to investors. A similar tax change affecting Canadian royalty
trusts in recent years resulted in dividend cuts for
shareholders. Moreover, the uncertainty involved could lead
investors to shun the companies, further hurting their share
Of course, counting on Congress to get
accomplished is always a dangerous thing to do. But investors in
REITs, MLPs, and other pass-through entities need to keep their
eyes squarely focused on Washington in order to make sure they
don't lose the tax benefits they've come to expect.
Pass-through or not, investors have come to count on
dividends. The Motley Fool's latest special report on dividends
names 11 strong stocks for your consideration. Thousands have
already gotten this free report, but don't wait -- get your free
copy right now before it's too late.
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