Passthrough Organizations Not Taxed As Corporations

Publication Date: August 2002

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

Type:

Abstract:

Corporations are treated as taxpaying persons separate from their owners and taxed under the corporation income tax rate schedule. Dividends and capital gains received by individual stockholders are taxed again under the individual income tax rate schedule. But some entities that conduct business or hold property escape this double taxation by passing their income through directly to individual owners. These are called "passthrough" or "conduit" entities.

Partnerships are unincorporated groups that conduct business or hold property jointly, but pass net operating profit or loss, portfolio income and deductions, and other tax attributes through to the partners. The partners are liable for any resulting income tax. However, if the partnership's shares are publicly traded, it is taxed as a corporation.

S corporations are incorporated businesses with no more than 75 shareholders who elect to be taxed as partnerships. Only individuals and certain trusts and nonprofit organizations may be shareholders. Like partnerships, they pass all of their income and tax attributes through to their shareholders, who are liable for the tax. This arrangement allows the shareholders the limited liability and other advantages of a corporation without paying the corporate tax. This form has become increasingly popular in recent years; more than half of all corporations now file their tax returns as S corporations (although they account for only 3% of corporate assets).

Limited liability companies are a relatively new form of organization that are corporations for all purposes except the federal income tax. They give their owners the protection of limited liability but are allowed to elect to be treated as partnerships for tax purposes. There are no restrictions on the number or type of owners they may have. They are subject to the partnership tax rules unless they elect to be taxed as corporations.

Regulated investment companies are mutual funds or venture capital companies that invest pooled funds in financial securities. They are subject to the corporation income tax, but are allowed to deduct amounts distributed to their shareholders if they distribute at least 90% of their income each year and meet other restrictions. Real estate investment trusts are similar organizations that invest in real estate or real estate mortgages. They also are not taxed on amounts distributed to their investors if they distribute at least 90% of their income. The investors are taxable on amounts credited to them each year (separately for ordinary income and capital gains).

Some cooperative and mutual organizations are treated as conduits (farmers' cooperatives, for example), some are taxed as corporations (e.g., mutual insurance companies), and some are tax exempt (credit unions and rural electrical cooperatives are the most important). Other entities that serve as conduits under the tax law are some trusts, real estate mortgage investment conduits (REMICs) and financial asset securitization investment trusts (FASITs).