A variety of tax-related issues commonly arise in connection with ownership of an interest in a business which files its tax returns as some form of pass through entity (e.g. a partnership or an S corporation). Some of these issues are more readily apparent than others. For example, having to wait until the business entity provides its owners with Schedules K-1 can delay the filing of the owners’ individual tax returns. This can be a particularly acute source of tension when owners are under pressure to complete their tax returns for use in non-tax settings such as a mortgage application or a child’s college financial aid application.
More subtle, but often just as important, are the indirect issues that can be involved with the ultimate payment of taxes due on the economic profits of a pass through entity. Most businesses have some differences in the way profit is measured for financial and tax reporting purposes.
A common example is depreciation, wherein the cost of assets may be expensed for financial reporting purposes using a straight line approach, but expensed for tax reporting purposes in a much more aggressive fashion through a combination of “bonus depreciation” and other accelerated write-off incentives available under the tax code. Another example is eligible businesses using the the cash method of accounting for tax reporting purposes while using the accrual method for financial reporting purposes.
Over time, the accumulated differences between financial and tax reporting can become quite substantial. The result is a buildup of a significant future tax liability, which will eventually be payable on current “financial reporting income” and which will be included at a later time in “tax basis income.”
A business that operates as a regular corporation (often referred to as a C corporation) generally addresses this situation by including a deferred income tax liability in its financial statements, allowing the owners to assess the impact of the eventual reversal of this liability in the form of a current payment of taxes. Since pass through entities are generally not subject to income tax at the entity level, there is no opportunity to disclose a deferred tax liability obligation and, as a result, owners often do not have a good handle on the potential future economic impact of the future reversal of tax deferral items. “How can I owe this much in taxes when the company only made a small amount of current income?” can be a common question posed by pass through business owners to their accountants at tax filing deadlines under such circumstances. Worse yet: “Where will I come up with the funds to cover this tax?”
This potential dilemma represents another ingredient in the age old debate over the pros and cons of choosing a pass through form of entity for business formation over a C corporation. While the ultimate tax costs over the entire life cycle of a business continue to lean toward the pass through option, future changes in tax law may alter the outcome.
In the meantime, it is a good idea for owners of pass through business entities to track accumulated financial/tax reporting differences and have a reasonable understanding of the circumstances that will likely trigger the reversal of same as well as the related economic consequences. Surprise is generally not a good thing when it involves taxes. A relatively modest amount of effort spent in this area can help you avoid potentially significant tension relating to cash flows involving future tax liabilities.
Have you dealt with this situation in the past? Any insight you can offer? Share in the comments.