171 and Done, Elimination of the Capital Stock and Foreign Franchise Taxes in Pennsylvania

On January 4, 2016, Pennsylvania Governor Tom Wolf announced the elimination of the capital stock and foreign franchise tax effective January 1, 2016. Prior to 2016, all domestic corporations formed in Pennsylvania, including limited liability companies, were required to pay Pennsylvania capital stock tax. The capital stock tax was based partially upon the net worth of the limited liability company, consequently requiring payment of the capital stock tax even if the limited liability company suffered a loss during the applicable tax year. Having a capital stock tax based upon the value of assets created an additional hardship for limited liability companies already struggling to make a profit. Considering the more advantageous tax treatment, setting up a business as a limited partnership instead of a limited liability company was common practice in the Commonwealth of Pennsylvania. Unfortunately, a limited partnership has disadvantages when it comes to the structure of the business entity. Specifically, limited partnerships require a general partner and a limited partner. In most cases, the general partner of a limited partnership is another business entity because a limited partnership’s general partner does not have limited liability, and individuals would not want to have personal liability for acts of the limited partnership. As a result, the formation of a limited partnership can be more costly and time-consuming because of the formation of a separate entity to act as the general partner of the limited partnership. Conversely, a limited liability company can be structured to have one individual member who has the ability to manage the limited liability company and retain the benefits of having limited liability without the necessity of forming a separate entity. Thus, forming a limited liability company is usually more cost effective and efficient than forming a limited partnership.

The abolition of the capital stock tax now effectively eliminates the necessity that real property be held in a limited partnership for the purpose of avoiding the capital stock tax. As a result, it is expected that limited liability companies will be used more than limited liability companies, because limited liability companies can be formed using a very simple structure. However, one must be cautious when deciding whether to reorganize and convert a limited partnership to a limited liability company. In addition to the standard fees and costs associated with converting a limited partnership to a limited liability company, a limited partnership that owns and operates real estate will also have to take into consideration the amount of realty transfer tax it will need to pay in order to convert. In Pennsylvania, there is a one percent tax on the value of the real estate being transferred (often along with an additional local realty transfer tax), unless an exemption to the realty tax applies. Before deciding to convert a limited partnership that holds and operates real estate to a limited liability company, it is important to analyze the relative benefits of reorganization taking into consideration the amount of realty tax liability that will be owed upon the conversion.

As a result of the phase-out of the capital stock tax, investors using business entities to own and operate real estate can now use a limited liability company without having to pay a capital stock tax. However, as noted above, for limited partnerships that already own and operate real property, it is imperative to confirm that the benefit of a simpler structure associated with converting to a limited liability company outweighs the amount of realty transfer tax liability.