Massachusetts Uses LLP Structure to Avoid MBT Problems

Massachusetts currently imposes a corporate-level tax, known as a sting tax, on large S corporations. As result, S corporations with over $6 million in gross receipts are subject to tax of 3%4.5% on taxable income, calculated as if the S corporation were a C corporation. This tax is in addition to the income tax due on each of the S shareholders respective share of the corporations income.

Many practitioners believe that this is an unfair burden and have developed strategies to avoid this entity-level tax, including the use of a Massachusetts Business Trust (MBT). However, over the last few years, they have discovered several problems with this structure.

Background

Letter Ruling 99-17, issued by the Massachusetts Department of Revenue (DOR), approved a reorganization in which an S corporation would be classified as a qualified subchapter S subsidiary (QSub) and would be a wholly owned MBT. According to the ruling, the reorganization would occur when the S shareholders formed an MBT, which would then elect S status. Although MBTs are S corporations for Federal tax purposes, they remain corporate trusts for Massachusetts purposes, and are not subject to the sting tax, but only to the favorable individual rate of 5.3%.

In the ruling, the operating corporations shareholders would exchange their S stock for that of the MBT, which is an F reorganization. The operating S corporation would then make a QSub election. For Federal income tax purposes, this structure collapses into one entity, filing as an S corporation. However, it is two separate entities for state income tax purposes.

How MBT Taxation Works

An MBT is taxed as if it were a resident individual; in general, no state tax will be due on trust distributions to the extent they were previously taxed at the trust level. An MBT is not subject to any corporate-level tax. The existing operating S corporation continues to pay a corporate-level excise tax on the greater of the property measure of the corporate franchise of $2.60 per $1,000, or a $456 minimum. Thus, this type of reorganization eliminates the tax on large S corporations at the state level, while preserving the flowthrough nature of S corporations at the Federal level.

Problems with MBTs

Although the MBT structure has gained popularity over the last few years, it has several disadvantages. One involves out-of-state shareholders. A shareholder who is not a Massachusetts resident might face state double taxation of income and might have to report S income to his or her home state and to Massachusetts. Most states will allow a tax credit if the taxpayer pays Massachusetts income tax, but others will not.

A slow economy has brought another disadvantage to light. A taxpayer with several passthrough entities may want to offset the income of one entity against the losses of another. An MBT structure traps any losses at the trust level, resulting in greater overall state income taxes.

Finally, it is uncertain whether a shareholder owning shares in an MBT would have limited liability, as a trust is not a limited-liability entity.

LLP Structure

The DOR issued Letter Ruling 02-7, which solved the aforementioned problems by allowing a limited liability partnership (LLP) in place of an MBT. Under this ruling, a general partnership would form under Massachusetts law and register as an LLP. The existing S shareholders would then contribute their S stock to the LLP. The LLP would elect to be treated as a corporation, then elect to become an S corporation and finally elect to become a QSub.

For Federal income tax purposes, the LLP partners are S shareholders. For Massachusetts income tax purposes, they are partners, which the ruling specifically addresses. As with the MBT structure, the existing operating S corporation continues to be subject to the corporate-level excise tax, measured against tangible property or net worth at $2.60 per $1,000 of book value.

The LLP structure avoids double taxation of out-of-state partners, because the partners are the taxpayers in their state of residence and in Massachusetts. Additionally, the partners can offset any income or losses of passthrough entities for both Federal and state income tax purposes. Finally, the LLP preserves the limited liability available through an S corporation, because an LLP is, by definition, a limited-liability entity.

From Shannon E. Lynch, CPA, Quincy, MA