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Corporate & Tax Client Update

February 12, 2016

by Shaun R. Eisenhauer

On December 31, 2015, after a 15-year phase-out (originally intended to last only nine years), Pennsylvania’s 171 year-old capital stock tax finally expired.

While few will mourn its passing, that expiration may take with it the formation of new limited partnerships in Pennsylvania.  Let’s see why.

The capital stock tax was an annual charge based on a combination of an entity’s income and assets.  It applied to corporations and limited liability companies but not to partnerships.  A purchaser of real estate or other significant assets, who also wanted limited liability, was therefore faced with a difficult calculation:  Would avoiding the annual cost of the capital stock tax justify acquiring the assets in the complicated limited partnership structure?  For every other purpose, the more user-friendly limited liability company would do just fine.

To limit the effect of the capital stock tax, an acquirer would use a limited partnership where the limited partners could own 99% (or more) of the limited partnership and a limited liability entity like a corporation or LLC would own the remaining 1% (or less) general partnership interest.  In this way, only the general partner’s percentage of the limited partnership’s assets would be affected by a capital stock tax.  All ultimate owners would be insulated from liability by virtue of their status as either (i) limited partners of the partnership or (ii) stockholders/members of the general partner.

Unfortunately, this locked the assets into the limited partnership model.  That model requires maintenance of two separate entities:  The limited partnership itself and the general partner entity.  This necessitates dual filings, meetings, reporting, ownership tracking and potentially licensing.  Because many states have no capital stock tax on limited liability companies, out-of-state investors were often surprised by this complication.

Absent the capital stock tax, acquiring assets in a new limited liability company provides limited liability to its owners and pass-through taxation in a single, flexible, customizable entity.

Are there ANY remaining reasons to form a limited partnership in Pennsylvania?  Four have been suggested and each are rebuttable.

Point:  There is a much more robust body of common law demonstrating the limited liability features of limited partnerships and corporations than for limited liability companies, which have existed in the United States only since 1977.  Counterpoint:  While that is certainly true, it is also semantically evident that limited liability companies are designed to provide, well, limited liability!

Point: For leveraged limited partnerships, partnership taxation generally allows for higher basis to the general partner, and therefore more deductions.  Counterpoint:  Members of a limited liability company can achieve the same result through express guaranties by designated members.

Point: If the capital stock tax is resurrected, it may be better to own property in a limited partnership once again.  Counterpoint:  Yes, the capital stock tax could be resurrected.  But if it is, there is no telling which entities will be affected under a new tax regime.

Point: A limited partnership allows for active control by a general partner and passive investment by limited partners.  While that same dichotomy can be achieved through good drafting of an operating agreement with a strong manager-managed overlay, this last reason may prove to be the limited partnership’s salvation.  Just as the corporate entity has survived the advent of limited liability companies thanks to historical comfort with the familiar officer/director/shareholder structure, a limited partnership provides an off-the-shelf active management/passive investment structure.  That hard-wired result avoids the necessity of negotiating the many details of a limited liability operating agreement.  Counterpoint:  When a thorough consideration of those details is embraced, the limited liability operating agreement provides many planning opportunities, which allows for all the benefits and is burdened with virtually none of the limitations or complications of a limited partnership.

In sum, when determining how to acquire assets in 2016 and beyond, the limited partnership offers few remaining advantages in Pennsylvania.  As a result, the long-awaited expiration of the capital stock tax makes limited liability companies king of the entity-formation hill.

© 2016 McNees Wallace & Nurick LLC
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