Distribution Flexibility and Pass Through Taxation: New partnerships Associate Professor Brett Freudenberg Griffith University, Australia Professor Bradley T. Borden Brooklyn Law School, USA E: b.freudenberg@griffith.edu.au T: +61 7 373 58071 R: http://ssrn.com/author=498263

Initial Thought ‘Flexibility’ has been one of the key attributes of new partnerships form – especially in relation to member contributions and distributions. Governments have been concerned that such ‘flexibility’ can be a potential risk to tax revenue (especially with a business structure that provides liability protection to members) What is the right balance of tax integrity rules so as to not adversely impact this flexibility? Brett Freudenberg Griffith Business School

Foreign examples There are several examples of foreign jurisdictions embracing a tax flow-through approach for new partnership structures with separate legal status and liability protection for members: the United States’ Limited Liability Companies (‘LLCs’), the United Kingdom’s Limited Liability Partnership (‘LLPs’); Compared to tax flow-through provided to corporate forms: the United States’ S Corporations New Zealand’s Loss Attribution Qualifying Company (‘LAQCs’) and Look-Through Companies. Calls for introduction in Australia but reluctance due to imputation system for corporations and use of discretionary trusts Brett Freudenberg Griffith Business School

Recent evidence Utilisation rates demonstrates that: excluding sole proprietorships, the transparent companies studied in the United States (S Corporations and LLCs) account for a majority of the business forms there. New Zealand’s transparent company, the LAQC, did represent approximately 12 per cent of business forms there in 2006 (excluding sole proprietors). The utilisation of the United Kingdom’s LLP is not as prevalent as the other jurisdictions, although this could be attributed to its recent introduction. Brett Freudenberg Griffith Business School

Estimated: 54% of private sector employment via tax flow-throughs Foreign examples

Foreign examples Approx 50,000 now Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms Governance: UK’s LLPs: ‘…It is very flexible, in many ways it’s more flexible than a straight company because you don’t have articles of association and memorandum in the same way you do for a limited company and consequently your legal structure is entirely up to you, so it is quite capable of being moulded to your own situation and we have four or five different styles of governing documents (Fletcher et al. (2013), p 35) Contributions and distributions to members: UK’s LLPs: ‘…It is very flexible, you can add and remove partners, you can apportion profits and losses any way you want and you can pretty well choose the timing of your expenditure’ (Fletcher et al. (2013), p 36) Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms This flexibility of governance rules could cover such concepts as: management structure (ie member-managed, manager-managed), ability to alter default rules that apply, voting rights, issue and cancellation of membership interest, responsibilities, board of directors requirement, audit requirements, meeting requirements, set-up procedures and annual fees. Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms This flexibility of member contributions and distributions New Partnership Forms Membership Interest Membership Cost Basis (+ -) Distributions (cf allocations) Can be: Money (equity) (cf loans and wages), Assets (revenue and capital), Losses, Tax Preferences   Also exiting members Contributions   Can be: Service, Assets, Money, Promises, Debt vs Equity Also new members Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms The reason for the flexibility in distributions can relate to: the original (and subsequent) equity contributions by members, the capital and liquidity needs of members, the ability to incentive active members or manager-members, the risk profiles of members (such as differences of opinions about different asset purchased/used in the business); as well as the tax profiles of members Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms This flexibility of member contributions and distributions can assist small and medium closely held businesses address the particular that they face, particularly finance: able to raise finance from equity members (compared to servicing a debt from a 3rd party); unpaid allocations to members (ie retain income in business) variety of types (and timing) of member contributions: Money, property, services, promises, performance-adjusted interest determinations Class of membership interests (rights to income (profits), capital, voting) (compared to tax flow-through companies: S Corp – 1 class of membership interest), Number of membership interests (compared to tax flow- through companies: S Corp limit of 100 members) Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms This flexibility of member contributions and distributions can assist small and medium closely held businesses address the particular that they face, particularly finance: raising equity from key employees; being able to stream certain income and capital receipts to equity members Using multiple new partnership forms for the one business venture (Series LLCs and multiple LLPs) Splitting income vs Streaming income Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms The price of this flexibility: Concern that the unfettered allocation of losses to limited members could potentially distort investment decisions. This is because access to tax losses (and tax preferences) can result in a country’s tax system funding (or decreasing) the effective cost of capital for an investor, thereby distorting investment decisions Loss restriction rules (as losses allocated to members with liability protection). Four broad categories of rules: Membership cost basis (UK applies to Trade LLPs – calculation of contributed capital) Risk rules Passivity Streaming (respect to attributing specific tax attributes) Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms The price of this flexibility: Appears to raise the compliance cost compared to other business structures (including tax flow companies – S Corporations) (DeLuca et al., Freudenberg et al., 2012) Concerns with valuations (ie how to value property contributed, services) and application of employment taxes to active members Potential taxing points on contributions and distributions of property from/to members (at times inconsistent between different business structures) Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms Flexibility is a desired business structure attribute: Being able to bring together different investors with different capacities to contribute, share risk. Reasons in choosing UK LLP (Fletcher et al. (2013) at pp 35-36): 1st Tax reasons/benefits: 35%; 2nd Limited Liability: 32%; 3rd Flexible structure: 13%) Brett Freudenberg Griffith Business School

The ‘flexibility’ of new partnership forms Flexibility is a desired business structure attribute: It is critical for tax rules to strike the right balance protection tax revenue but allowing flexibility. Otherwise the tax rules could adverse impact these new partnership structures. Yin warns (at p 362): don’t want to lead to situations that ‘tax law dictates how parties must carry on their economic affairs’, that is the tail wagging the dog. Brett Freudenberg Griffith Business School

Any questions? Distribution Flexibility and Pass Through Taxation: New partnership forms Griffith Business School