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Celebrating the Festivus ‘airing of grievances’

Jim HamillALBUQUERQUE, N.M. — In today’s column we celebrate Festivus, or at least one part of it. Festivus was introduced to the general public as a fictional holiday practiced by the Costanza family on the old Seinfeld show. It was an actual celebration of the family (the parent’s first date) of the episode’s writer.

One aspect of the fictional Festivus was the “airing of grievances.” It is that aspect that I celebrate today. My grievance? The common statement made by tax advisers that “S corporations are corporations taxed like partnerships.”

I have a problem with you people! Both partnerships and S corporations are called “pass through entities,” which means the income is taxed to the owners rather than the entity. That is pretty much where the similarities end.

There is one common factor that explains the differences between the two business types. Corporations, including S corporations, use the “entity” approach to taxation. Partnerships use the “aggregate” approach.

The entity approach means the corporation is respected as a distinct taxpayer, even if it doesn’t itself pay tax. But it is “there.” The aggregate approach ignores the existence of the entity and determines the tax treatment as if the owners engaged in the activity themselves. The partnership is “not there.”

I’ll give you four examples. First, when the owners transfer property to start the business, both entity types generally allow the transfer to be tax free. But the requirements for corporations are more difficult to satisfy.

A contributing shareholder much “control” a corporation. A contributing partner need not control the partnership. Why the difference? Something must be there to determine control. If nothing is there, how can it be controlled?

Shareholders who receive something other than stock on this transfer are subject to some tax liability. Partners are not. How can you get something else if there is nothing there to give it to you?

Second, when income passes through, it has to be allocated to the owners so they can report it on their returns. The entity approach says the income belongs to the entity. So each owner is allocated a share based strictly on their ownership of the entity.

Partnership income belongs to the partners. Remember, there is no entity. If the income belongs to them then they get to decide how to allocate it.

Third, distributions of property from an S corporation to a shareholder are treated as if the separate entity sold the property to the shareholder. Gain may be recognized — taxed to the shareholders, but still taxed.

Partnerships do not report any gain when property is distributed to the partners. The aggregate approach treats it almost like the property simply passed from the partner’s right hand to the left hand. There is no transfer from one taxpayer (entity) to another (owner).

Fourth, when an S corporation borrows money from a bank, the shareholders cannot increase the tax basis of their ownership interest. The entity borrowed, not the owners. No involvement, no tax benefit.

Shareholders will tell you they were involved — they had to guarantee the debt. But the tax law still says that the entity is separate and if it borrowed the money that has to be respected.

If a partnership borrows from a bank we pretend it did not. After all, there is no entity that could borrow. So we pretend the partners borrowed the money. But how did the money make it to the partnership? Easy — we pretend the partners contributed it.

So whenever a partnership borrows money the partners increase the tax basis of their investment as if they borrowed the money. This is an aggregate view — if there is no entity then the owners must have borrowed.

I have more examples, but it is only fair to leave some time for others to air their grievances. So I’ll detour to why this all matters.

The choice between a partnership and an S corporation to handle your business or investment affairs is an important one (the choice requires two owners since partnerships must have two). Too important to act as if the two are interchangeable for tax purposes.

Sorry if my grievance brought you down. Now on to the feats of strength and surrounding the Festivus pole.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at


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