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Fifth Circuit Ruling Has Big Implications for Small Business

By Jackie Sauter

The Kogod Tax Center has weighed in on a major tax case by filing an amicus curiae brief with the U.S. Court of Appeals for the Fifth Circuit.

The Tax Center  asked the Fifth Circuit  to rehear the case and reconsider its ruling. 

In Southgate Master Fund LLC v. United States, the Fifth Circuit Court of Appeals affirmed a lower court's ruling that determined a partnership  formed by billionaire banker D. Andrew Beal was structured as a partnership purely for federal income tax purposes and, therefore, should be ignored for tax purposes.

In the brief, Tax Center experts Donald Williamson and David Kautter expressed reservations about the implications of the holding that an entity will be respected for federal tax purposes "only if it has a non-tax purpose for choosing to do business in one form rather than another."

This could hurt small businesses, they argue, especially those who choose to incorporate as an S corporation, a form created by Congress and chosen by many small business owners purely for its tax advantages. 

S corporations  do not pay federal income taxes, but instead divide their income and losses among shareholders, who then report the income or loss on their individual tax returns.

According to the Tax Center, the court's sweeping ruling creates a trap for unwary small businesses, and threatens the longstanding principle that an entity should be free to structure itself to minimize its tax burden.  The Tax Center concludes that many small businesses will not be able to pass the "litmus test" of having a secondary, independent business reason for being an S corporation, and could therefore be subject to greater tax liabilities.

The decision, Kautter and Williamson argue, could be fatal to tax status of many small businesses and may allow the Internal Revenue Service power to recast the operating structure of businesses at will.