Nobody likes paying taxes. The only thing that makes people madder than a big tax bill is seeing big companies manage to avoid taxes. But a move to clamp down on zero-tax businesses could make victims out of regular investors like you, rather than corporate bigwigs.

A recent Wall Street Journal article highlighted an increasingly popular and totally legal way to avoid getting taxed as a corporation. But as lawmakers go through the agonizing process of trying to reform income tax laws and generate much-needed revenue, some want to take away those benefits.

Below, I'll describe in more detail the threat that investors in these entities face. But first, let's take a look at what caused the controversy in the first place.

Understanding tax pass-throughs
One of the biggest objections that Big Business has against the tax system is that it effectively taxes corporations twice on their income. Corporations pay corporate tax at a maximum rate of 35%, but they don't get a deduction for dividends paid to their shareholders. Then, the shareholders also have to pay taxes on the dividends they receive.

But some businesses have found ways to get around the corporate tax. By organizing as a pass-through entity, such as a partnership, limited liability company, or sole proprietorship, millions of business owners forgo having to pay corporate tax. Instead, all the tax liability for income the business earns passes through to its owners.

For small companies, the simplicity involved in pass-through status makes a lot of sense, and few people object to the concept as it applies to small business. Yet many much larger entities -- including quite a few public companies -- have taken advantage of it as well, and that's generating some controversy.

How to be tax-free
There are several ways you can get tax-free status at the business entity level. Here's just a sampling.

  • Real estate investment trusts are typically corporations. But by electing REIT status, they can avoid corporate tax -- all they have to do is pass out at least 90% of their taxable income in the form of dividends. For instance, Annaly Capital (NYS: NLY) has earned net income of $1.11 billion over the past 12 months, but it pays only minimal taxes stemming from its taxable REIT subsidiaries.
  • Master limited partnerships similarly have rules that require 90% of their income to come from certain specified activities including mining, timber, and energy production. Enterprise Products Partners (NYS: EPD) , which operates pipelines, was able to shelter almost $1.5 billion in profits this way. But not all MLPs are actually partnerships; Linn Energy (NAS: LINE) is organized as an LLC and had net income of $385 million over the past 12 months. The difference is that LLCs don't have to have general partners that are liable for management decisions; LLCs look more like corporations in that regard.
  • Investment and private-equity companies are often structured as pass-through entities. KKR (NYS: KKR) saved almost $450 million in corporate taxes in 2010 as a result of qualifying for pass-through status.
  • The biggest pass-through entities you're most familiar with are mutual funds and ETFs. The massive ETF SPDR Gold (NYS: GLD) passes through its tax attributes -- shareholders are taxed at higher collectibles rates as if they owned the bullion in the ETF's vaults. Similarly, every fund and ETF that's set up as a registered investment company avoids paying entity-level tax -- again by forcing their shareholders to pony up.

Is it fair?
In Congress, political parties have drawn the typical lines about whether to tax pass-throughs. On one hand, competitors argue that taxable entities are at a disadvantage against pass-through entities. But others say it's the corporate tax itself that's unfair, as other countries avoid the problem by having lower corporate tax rates or otherwise preventing double taxation.

Taking away pass-through tax status would be potentially devastating. Higher taxes would mean less income flowing through to investors. A similar tax change affecting Canadian royalty trusts in recent years resulted in dividend cuts for shareholders. Moreover, the uncertainty involved could lead investors to shun the companies, further hurting their share prices.

Of course, counting on Congress to get anything accomplished is always a dangerous thing to do. But investors in REITs, MLPs, and other pass-through entities need to keep their eyes squarely focused on Washington in order to make sure they don't lose the tax benefits they've come to expect.

Pass-through or not, investors have come to count on dividends. The Motley Fool's latest special report on dividends names 11 strong stocks for your consideration. Thousands have already gotten this free report, but don't wait -- get your free copy right now before it's too late.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

At the time this article was published Fool contributor Dan Caplinger wishes they'd just set the tax rules once and leave them alone. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management and Enterprise Products Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never taxing.

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I agree with the part about the part that corp profits are taxed twice. And we should either tax business after dividends or not tax dividends

January 13 2012 at 12:32 PM Report abuse rate up rate down Reply
John and Margaret

I dont see what the problem is. The income is taxed at the individual level. If i owned an LLC or a sub s corp and it made 50000.00 then that amount would go onto my tax return and I would pay taxes on it. Are you saying that all income should be taxes twice as in a c corp. Good grief, tax it once

January 12 2012 at 6:39 PM Report abuse rate up rate down Reply