1.1 MODULE 1 CHAPTER 1 Choice of Entity This chapter examines one of the most critical decisions that a business can make: deciding on the entity classification under which it will operate as a business. Although federal taxes are a critical factor in making that decision, they are often not the only factor. How well tax advantages mesh with business law advantages, not to mention the economic realities of a particular business or industry, may all become essential considerations before an intelligent choice-of-entity decision may be made. This chapter outlines each type of business entity found under U.S. business law statutes: the sole proprietorship, the corporation, the partnership, the limited partnership, and the limited liability company. After this snapshot, the chapter then examines each entity in detail, with special focus on federal tax considerations. Within this examination, special emphasis is given to cutting edge tax developments in choice-of-entity practice, including reasons behind the tremendous surge in choosing the limited liability company (LLC) and disregarded entities. LEARNING OBJECTIVES Upon completion of this chapter, you will be able to: Identify the different types of entities available to U.S. businesses; Understand the basic federal tax law applicable to each type of entity; Recognize the strengths and weaknesses of each type of entity; Understand the reasons behind the recent up-tick in LLC formations; Determine when disregarded status is effective; and Identify recent major tax law changes that affect choice-of-entity decisions INTRODUCTION Starting or acquiring a new business requires deciding what business form to use. A business entity is the legal form of the business. The entity may be as simple as a sole proprietorship or as complicated as a large multinational corporation. The choice of entity is often primarily driven by tax considerations: the entity classification that a business venture chooses may significantly affect its tax treatment under federal, state, local, and (in some cases) foreign laws. Therefore, it is crucial to understand tax treatment before an advisor recommends a choice. Top_Fed_07_book.indb 1.1 11/15/2006 2:41:08 PM
1.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE In the United States, a number of business entity choices are available to an entrepreneur: Sole proprietorship; Corporation (this may include the traditional C corporation or the S corporation, which is a passthrough entity); General partnership; Limited partnership; Limited liability partnership (LLP); Limited liability limited partnership (LLLP) (not available in all states); and Limited liability company (LLC). No single form of business entity is ideal for all businesses in all situations. No blanket rule applies, although clearly certain industries gravitate toward certain forms (statistics are noted later in this chapter). Each of the major business entity choices available under state law (i.e., sole proprietorship, partnership, limited partnership, corporation, and LLC) has advantages and disadvantages. Two of the most significant factors to consider when choosing the best business form are: Liability for business obligations (how limited liability will be); and Impact of federal taxes. Other factors, however, are also significant, such as formality, flexibility, and the cost of forming and operating the business. To complicate consideration of the impact of federal taxes is the check-thebox option recently introduced into the federal tax law. Under check-the-box, within certain parameters a business may operate legally as one type of entity while being allowed to select tax treatment normally applied to another type of entity. More about this later. SOLE PROPRIETORSHIP Formation A sole proprietorship is formed simply by beginning business. The sole proprietorship has no independent legal existence. A proprietor is not required to enter any agreements or file any documents in order to create the proprietorship. The sole proprietor simply starts to conduct business. However, a sole proprietorship may be required to register its name if it intends to use an assumed name. Most small businesses operate as sole proprietorships. The sole proprietorship is the most basic and informal form of conducting a business. A sole proprietorship is a one-owner business. This business form cannot be used if there is more than one owner. Although a sole proprietorship may have a Top_Fed_07_book.indb 1.2 11/15/2006 2:41:08 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.3 number of employees, it can only have one owner. That owner is typically the driving force behind the business. Capital Structure The sole proprietorship does not have a capital structure independent of its owner. The sole proprietor may borrow money to fund the business venture. The proprietor may deduct the interest expense incurred if the interest expense is allocable to a trade or business. The interest expense must relate to a debt incurred by the trade or business. The tax law recognizes this identity of the business with its owner. All profits and losses from the business, including the computations of income and expense that are relevant to profits and losses, are reflected with personal income, deductions, and credits on a single individual Form 1040 income tax return of the owner. Profits and losses from the business generally are reported on Schedule C, Form 1040. Check-the-Box as Applied to Sole Proprietorship The check-the-box regulations have simplified the entity classification process. They have also simplified the ability of businesses to receive the benefits of limited liability and passthrough taxation. Prior to these regulations, individual business owners had to incorporate and elect S corporation status to receive the benefit of limited liability and passthrough taxation. Under the check-the-box regulations, a single-member limited liability company (LLC) may be taxed as either a corporation or a sole proprietorship, at the election of its owner. A single-member LLC is taxed as a sole proprietorship by default if it does not elect to be taxed as a corporation. The owner will thus enjoy the benefits of limited liability, passthrough taxation, and easy filing requirements. Treatment of Income and Losses A sole proprietor reports income or loss on Form 1040, Individual Federal Income Tax Return, Schedule C, Profit or Loss from Business. If the proprietor reports a loss on Schedule C, the amount reported offsets the proprietor s other income reported on Form 1040. If he has a business loss of $20,000 and wages of $100,000 as an employee for someone else, the loss offsets the wages or any other income reported on Form 1040. The only exception to this all-in-one-pot approach is the determination of employment taxes. EXAMPLE Cindy Gross has a Schedule C loss of $15,000. She has wage income of $75,000. She has no other income or loss. Her adjusted gross income for income tax purposes thus is $60,000. Cindy s share of Social Security tax, however, is based on the full $75,000 amount of her salary. Top_Fed_07_book.indb 1.3 11/15/2006 2:41:08 PM
1.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE A proprietor can deduct a capital loss realized from the sale of a business asset, as well. A proprietor reports a capital loss on Form 1040 Schedule D, Capital Gains and Losses. The proprietor offsets capital gains with capital loss. If the capital loss exceeds the proprietor s capital gains (whether from the business, investments or otherwise), the deduction of the capital loss is limited to $3,000 ($1,500 for those individuals filing under the married filing separately status). A loss in excess of $3,000 can be carried over to subsequent years indefinitely until it is used up. Self-Employment Tax A sole proprietor is subject to self-employment tax of up to 15.3 percent on the net income of the sole proprietorship reported on Schedule C. Selfemployment tax comprises two components. Together they are frequently called Social Security taxes: The first component is a 12.4 percent tax on self-employment income for old age, survivors, and disability insurance (OASDI), which is subject to a dollar cap that is adjusted each year. The second component is a 2.9 percent tax for Medicare, which is not subject to a dollar cap. A sole proprietor is not subject to Federal Unemployment Tax (FUTA). However, a sole proprietor is required to pay FUTA if the proprietor has employees. The FUTA tax is 6.2 percent of the first $7,000 of each employee s salary. The proprietor is also subject to state unemployment tax but receives a credit for FUTA. The sole proprietor reports self-employment earnings on Form 1040 Schedule SE. The proprietor must file Schedule SE, Self-Employment Tax, and pay self-employment taxes if the net earnings from self-employment were $400 or more. The sole proprietor can deduct one-half of the self-employment tax as an adjustment to income on Form 1040. Tax Identification Numbers A sole proprietorship must have an employer identification number (EIN) if one of the following applies: It has employees; It has a qualified retirement plan; or It files returns for excise taxes. Employment of Other Individuals The sole proprietor must collect information about employees entitlement to withholding exemptions by requiring an employee to complete Form W-4, Employee s Withholding Allowance Certificate. The employer must withhold income taxes from each employee s salary based on the with- Top_Fed_07_book.indb 1.4 11/15/2006 2:41:08 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.5 holding exemptions claimed. He must withhold the employee s portion of FICA (Social Security) and pay the employer s share of FICA, FUTA, state unemployment taxes, and workers compensation premiums. The proprietor must remit the amounts withheld at the appropriate times and file the required withholding returns. STUDY QUESTIONS 1. The sole proprietor reports capital loss deductions using: a. Schedule C b. Schedule D c. Schedule SE d. Direct entries on Form 1040 2. Under what circumstance would a sole proprietor not require an EIN? a. Reporting employee wages and withholding from the proprietorship b. Making contributions to a SIMPLE plan c. Declaring itself as a sole proprietorship on its first-year return d. Reporting excise taxes NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page 10.1. C CORPORATIONS Corporations are creatures of the law, acquiring their status and authority solely from the government. With few exceptions, authority over corporations (and other business entities) is the responsibility of the states. Thus, virtually all private corporations are organized, or chartered, pursuant to the laws of incorporation and governance of a particular state. Most large businesses are organized for tax purposes as regular or C corporations. A C corporation is a corporation subject to Subchapter C of the Internal Revenue Code. A C corporation must be a separate entity created as a corporation pursuant to state law. C corporations feature limited liability for owners, a flexible capital structure, and ease of transferability. However, there is potential for double taxation at the corporation and shareholder levels: once to the corporation when the income is earned, and then again to the shareholder-owner when that income is distributed to him or her as a dividend. Top_Fed_07_book.indb 1.5 11/15/2006 2:41:09 PM
1.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Types of C Corporations State laws generally provide for corporations in three varieties: Publicly held and closely held corporations (in which stock is either publicly traded or privately held); Membership corporations (in which ownership is limited to group membership); and Professional corporations (in which membership is restricted to certain licensed professionals). Tax Implications of Creating or Acquiring a Corporation The initial shareholders usually contribute cash or property to the corporation in exchange for shares in the corporation. The corporation does not generally recognize gain or loss upon issuance of its stock. The shareholder does not recognize gain or loss if the shareholder purchases the stock with cash. Although a taxpayer is generally required to recognize gain or loss upon the sale or exchange of property, there is an exception for acquiring stock. Code Sec. 351 provides an exception for transfers of property (including cash) in exchange for stock. COMMENT An exchange of property for stock under Code Sec. 351 is called a Section 351 exchange. EXAMPLE Victor Smith contributed land worth $500,000 in exchange for a 100 percent interest in Smith Inc. The land has an adjusted basis of $100,000. The exchange qualifies as a Section 351 exchange. Smith is not required to recognize any gain on the transaction. He has a basis of $100,000 in Smith Inc. stock received in the exchange. Code Sec. 351 Requirements Code Sec. 351 provides that the transferor (the stock purchaser) recognize no gain or loss if two factors are present: The property must be transferred to the corporation solely in exchange for stock; and The transferors (stock purchasers) must control the corporation immediately after the exchange. For Sec. 351 to apply, the exchange also must have a valid business purpose and the corporation must not be an investment company. Top_Fed_07_book.indb 1.6 11/15/2006 2:41:09 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.7 Further, the transfer of services is not considered a transfer of property that will be tax free under Section 351. The prohibition applies both to services rendered in the past and those to be rendered in the future. The transferor of the services must recognize income on the receipt of stock to the extent of the fair market value of the stock received. Treatment of Income and Losses A C corporation is a separate legal entity that files its tax returns separate from its owners. The corporation reports its income or loss on its income tax returns. The income or loss does not pass through to the corporate shareholders. The corporation may carry over its net operating losses to offset past or future corporate income. A shareholder can only claim a loss upon the sale of his or her stock in the corporation. COMMENT A client should consider starting a new business as a sole proprietorship, S corporation, or partnership. This enables use of losses generated in the early stages of the business. Once the business is profitable and perhaps looking to expand, it can be incorporated. Through incorporation, it can take advantage of benefits such as limited liability, ease of transferability, and a flexible capital structure. Section 1244 Stock If the corporation and shareholders qualify, the corporation may issue Section 1244 small business stock at its inception. When an individual s investment in a corporation becomes worthless, the loss is typically treated as a capital loss. If an individual incurs a Section 1244 stock loss, however, the individual can claim an ordinary loss of up to $50,000 as a single taxpayer. A loss of up to $100,000 can be claimed by married taxpayers filing a joint return in any taxable year. If an individual s loss exceeds the Section 1244 ceiling, the remaining loss is treated as a capital loss. Generally, an individual will have a carryover basis in the stock equal to the money and basis of the property contributed when the stock was originally acquired. In order to qualify as Section 1244 stock, the stock must have been issued when the corporation was a small business corporation. A corporation will qualify as a small business corporation if the money and other property received for stock, contributions to capital, or paid-in surplus does not exceed $1 million. If property is contributed, its value is based on adjusted basis reduced by any liability to which it was subject at the time of contribution. Code Sec. 1244 applies to individual taxpayers who were original investors in the corporation. If the original shareholder sells stock or gives it as a gift, the stock will not qualify as Section 1244 stock in the transferee s hands. Nor will it Top_Fed_07_book.indb 1.7 11/15/2006 2:41:09 PM
1.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE qualify as Section 1244 stock if the shareholder transfers it to a trust or estate. A corporation s stock is not Section 1244 stock if the corporation derives more than 50 percent of its gross receipts from certain sources. It does not qualify if more than 50 percent of the gross receipts are from royalties, rents, dividends, interest, annuities, and stock or security sales. The testing period is the five taxable years immediately preceding the year in which the loss was sustained. For corporations in existence for less than five years, the testing period is the corporation s taxable years preceding the loss year. Employment As an employer, a corporation must collect information about employees entitlement to withholding exemptions by requiring an employee to complete Form W-4, Employee s Withholding Allowance Certificate. It must withhold income taxes from each employee s salary based on the withholding exemptions claimed. It must withhold the employee s portion of FICA (Social Security). It also must pay the employer s share of FICA, FUTA, state unemployment taxes, and workers compensation premiums. The corporation must remit the amounts withheld at the appropriate times and file the required withholding returns. Small corporations generally employ shareholder-owners. Typically, corporate founders are employed in newly formed corporations. The owners can decrease the effect of double taxation by payment of compensation to themselves that, if reasonable, is a deductible expense of the corporation. A corporation is allowed a deduction for ordinary and necessary salary expenses paid or incurred during a taxable year in carrying on any trade or business. Reasonable compensation is the amount that would ordinarily be paid for like services for like enterprises under like circumstances. A deduction for compensation taken by a corporation will be disallowed if the amount is unreasonable. However, that does not necessarily mean that the IRS cannot also claim that the recipient of unreasonable compensation still realizes wage income. COMMENT Ever since 2006, when dividend income has been treated as capital gains for purposes of determining the rate of tax on it (generally, the 15 percent rate), an additional consideration has developed in choice-of-entity decision making. The double tax of the traditional C corporation is now reduced to a regular income bracket tax and only a 15 percent tax, which is more than half of the likely regular income tax rate of its owner. As a result, the prior incentive to remove earnings from a corporation by way of higher-than-market compensation was been significantly removed. Top_Fed_07_book.indb 1.8 11/15/2006 2:41:09 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.9 STUDY QUESTIONS 3. Which of the following is not an advantage of the C corporation entity choice? a. Passthrough of losses and deductions to shareholders b. Ease of transferring property c. Flexible capital structure d. Limited liability for its owners 4. Owners of small corporations can reduce the effect of double taxation by: a. Starting the business immediately as a C corporation rather than using another entity type b. Issuing additional Section 1244 stock c. Withdrawing reserve capital regularly from corporate accounts d. Paying themselves a reasonable compensation that the corporation deducts as a corporate expense S CORPORATIONS Formation and Organization S corporations have become increasingly popular both for the newly incorporated businesses and for the existing C corporations. C corporations can elect to convert to an S corporation. In fact, statistically there have been a significantly grater number of conversions to S corporations than there have been new incorporations immediately electing S corporation status. S corporations are small business corporations organized under Subchapter S of the Code. An S corporation combines the business and legal characteristics of a C corporation with many federal income tax characteristics of a partnership. The S corporation election is available only to businesses that comply with certain requirements. Large and public corporations generally cannot elect S corporation status because of the 100-shareholder limit, as well as the single class of stock requirement. Among other businesses, however, the S corporation is often the entity of choice. The S corporation and the other passthrough entity the partnership have been running a close race in popularity. Although partnerships have had the edge in some years, Congress itself has recognized the value of the S corporation for small business. To keep the S corporation as a viable option, Congress has made the S rules more liberal, both in terms of qualification and operation. This Congressional boost principally started with the Small Business Tax Act of 1996, but additional changes have been steadily made almost every other year since then. Top_Fed_07_book.indb 1.9 11/15/2006 2:41:09 PM
1.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Qualification as a Small Business Corporation An S corporation is defined as a small business corporation for which an S corporation election is in effect for the tax year. A corporation is eligible to elect and be taxed as an S corporation only if it qualifies as a small business corporation. Checklist: Small Business Corporations A corporation qualifies as a small business corporation only if all the following requirements are met: It is not an ineligible corporation (insurance companies, possessions corporations (such as those operating in Puerto Rico), IC-DISCs, and taxable mortgage pools being examples of those ineligible); No more than 100 shareholders; All shareholders are individuals, estates, certain trusts, or qualifying tax-exempt entities; No shareholder is a nonresident alien shareholder; and No more than one class of stock exists. A corporation not only must meet these requirements in order for its shareholders to elect S corporation status, but the S corporation must continue to meet the requirements thereafter. The latter principle creates a danger: If the ongoing S corporation is not constantly monitored for eligibility, it can fall into regular, C corporation status with the attendant unplanned tax results. Although organizations have a recourse asking the IRS for a waiver and a chance to cure ineligibility that remedial opportunity is generally only at the discretion of the IRS. Check-the-Box and S Corporation Status Business entities that are not automatically classified as corporations may elect to be treated as a corporation on Form 8832, Entity Classification Election. The entity electing to be treated as a corporation can then elect S corporation status by filing Form 2553, Election by a Small Business Corporation. If an eligible entity elects S corporation status on time, it will be treated as having properly elected classification as an association taxable as a corporation. Qualified Subchapter S Subsidiary An S corporation can own another S corporation as a subsidiary if the subsidiary otherwise qualifies as an S corporation. Although the S corporation is confined to small business corporations, the small in the requirement speaks to the number of shareholders (a maximum of 100) and capital structure (a single class of stock) rather than to the dollar amount of assets within the corporation. Nowhere is this more apparent than in the qualified Subchapter S subsidiary (QSub) situation. The QSub rule allows Top_Fed_07_book.indb 1.10 11/15/2006 2:41:10 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.11 a growing business with a need for independent subsidiary operations not to be foreclosed from retaining S status. A subsidiary qualifies as an S corporation if: The parent corporation s shareholders hold the subsidiary s shares directly; 100 percent of stock is owned by the parent (to prevent circumventing the 100-shareholder rule among other goals); and The parent elects qualified subchapter S (QSub) status for the subsidiary. The separate existence of a QSub is ignored for tax purposes. The assets, liabilities, and items of income, deduction, and credit of a QSub are treated as those of the parent corporation. A QSub election results in a deemed liquidation of the subsidiary into the parent. An S corporation may elect to treat an eligible subsidiary as a QSub by filing Form 8869, Qualified Subchapter S Subsidiary Election. A QSub election is effective on the date specified on the election form. Making the S Corporation Election A small business corporation must make an election to be taxed as an S corporation. The corporation makes an election by filing Form 2553, Election by a Small Business Corporation. The election must be signed by a person authorized to sign the corporation s tax return. All shareholders on the date of the election must consent to the election. The required consent may be provided on the Form 2553 or on a separate statement attached to the election. Once made, an election continues until a disqualifying act or attribute arises, or the shareholders affirmatively elect out of S status. Treatment of Income or Losses An S corporation is a passthrough entity (also known as a flow-through entity). Any income or loss related to the operation of the corporation flows through to the shareholders. Shareholders report their allocable share of the income or loss on their tax returns. If the S corporation has a loss, the loss is generally available to offset the shareholder s other income. A shareholder may not be able to claim a loss in a current year if the loss is prohibited under the passive activity loss rules. Nor may the shareholder claim a loss if he or she lacks sufficient basis in the stock. EXAMPLE Fred Ames owns stock in an S corporation. The S corporation reported a loss of $200,000. Ames s pro-rata share of the loss was $25,000. Ames will claim the loss on his individual return. Ames will be allowed to claim his entire pro-rata loss provided he is not otherwise limited by basis limitations, at-risk rules, and passive activity loss rules. Top_Fed_07_book.indb 1.11 11/15/2006 2:41:10 PM
1.12 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE S corporations that had been operating as C corporations for a number of years before switching also must retain certain carryover tax attributes from their C corporation days that can produce a tax liability at the corporate level before passthrough rules are triggered. This adds another layer of complexity that points to having an initial strategy under which status as a C or an S corporation is evaluated from the start, rather than after the business has been operating for several years as an incorporated entity. If a shareholder sells S corporation shares at a loss, he or she will be able to claim a loss. An individual shareholder can claim a capital loss in any given year to the extent of any capital gains plus $3,000. Employment An S corporation typically must employ individuals, including active owners, to work for the corporation. It must collect information about the employees entitlement to withholding exemptions by requiring each employee to complete Form W-4, Employee s Withholding Allowance Certificate. As the employer, the S corporation must withhold income taxes from each employee s salary based on the withholding exemptions claimed. It also must withhold and pay Social Security taxes. Employment of Shareholder-Owners S corporations generally employ shareholder-owners. Typically, corporate founders are employed in newly formed corporations. A corporation is allowed a deduction for ordinary and necessary expenses paid or incurred during a taxable year in carrying on any trade or business. Ordinary and necessary business expenses include a reasonable allowance for salaries or other compensation paid to shareholder employees for services actually rendered. S corporation income allocated to a shareholder is not subject to self-employment tax. Thus, S corporations and their shareholders often attempt to minimize wage payments in order to minimize employment tax. An S corporation may be challenged if it pays a shareholder unreasonably low wages relative to the services performed. STUDY QUESTIONS 5. Which of the following is not allowed to be a shareholder of an S corporation small business corporation? a. Qualifying tax-exempt entities b. Nonresident aliens c. Estates d. All of the above are allowed as types of small business corporation shareholders Top_Fed_07_book.indb 1.12 11/15/2006 2:41:10 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.13 6. Unlike the IRS position on reasonable compensation for shareholderowners of C corporations, S corporations are allowed to pay S corporation shareholder-owners unreasonably low wages relative to services performed because the profits and losses of the S corporation pass through to the shareholders anyway. True or False? GENERAL PARTNERSHIPS A partnership is an unincorporated joint undertaking by two or more persons to carry on a business, financial operation, or venture as co-owners for profit. For tax purposes, it is also known as a passthrough entity, which means that the entity itself is not taxed and that tax liability passes through to the individual partners, members, or shareholders of the entity. Passthrough entities are generally classified as either partnerships or S corporations for federal tax purposes, even though state law provides for other forms of entity organization, such as the limited liability company (LLC) or limited liability partnership (LLP). The other forms of entities are generally taxed as partnerships, unless the entity elects otherwise, or in the case of a singlemember LLC, disregarded as an entity separate from its owner. Although an S corporation is the other passthrough entity for tax purposes, the two types have differences as well as similarities both for tax purposes and for the application of state and local law. A business undertaken by two or more members is, by default, a partnership for federal income tax purposes. There are no formal legal requirements to establish such a partnership: a general partnership. Thus, individuals or entities involved in a joint business or financial undertaking may inadvertently form a partnership. They will be subject to partnership filing and other federal income tax provisions governing partnerships. Minimum requirements to establish a partnership, under both tax and state/local law, call for a partnership to: Engage in the active conduct of a business; Operate with a profit motive; and Have two or more owners. Check-the-Box Rules Because both a corporation and a partnership share all three of the mandatory characteristics, they must be otherwise distinguished for federal tax purposes. The check-the-box rules simplify the determination of whether an entity is a partnership or a corporation for federal tax purposes. Formerly, the courts or IRS would look at the attributes of a business association to determine whether it more closely resembled a corporation or partnership. The current check-the-box rules provide that an unincorporated business Top_Fed_07_book.indb 1.13 11/15/2006 2:41:10 PM
1.14 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE with two or more members is taxed as a partnership automatically and by default. If the business does not want to be taxed as a partnership, it simply must elect to be taxed as a corporation. COMMENT Generally, but not always, state tax laws will follow a federal tax determination of tax status. However, state business law rules generally control nontax treatment of a partnership or corporation; check-the-box status will have no impact in that respect. Partnership Agreements Not Required, But Advisable Although a partnership agreement is not required to create a general partnership, a partnership agreement is advisable. Among the partners, the partnership agreement controls except under certain circumstances. The partnership agreement governs the activities of the partnership and of the partners with each other. It spells out any special allocations of income, deductions, gains, losses, and credits to the partnership for tax purposes. It governs the: Withdrawal of a partner; Death of a partner; or Restrictions on the sale of a partnership interest to a new partner. Legal and Ownership Status of General Partnerships The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on as co-owners a business for profit. A general partnership can be formed in writing or orally. A group of individuals or entities may form a partnership by commencing to do business consistent with a partnership model. A partnership model generally involves two or more individuals actively involved in a business for profit. Like a corporation, a partnership is a separate legal entity. It can sue and be sued, hold real and personal property, and conduct business independently of its partners. Although each partner owns a partnership interest, no partner owns specific assets of the partnership. Unlike a corporation or limited partnership, a general partnership is not required to make any filing with the state. The partnership as an entity. A partnership is both an entity and an aggregation of partners. It operates as an entity for purposes of determining amount, character, and timing of income, deductions, gains or losses, and credits generated by the partnership. Once the partnership s gains and losses are determined, the partnership functions as a conduit (passthrough), with each partner being taxed on the partner s share of income. Although a partnership is not a taxable entity, it determines the amount and character of taxable items passed through to the shareholders. The Top_Fed_07_book.indb 1.14 11/15/2006 2:41:10 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.15 partnership makes elections about accounting methods, depreciation methods, and amortization of organization and start-up costs. It also may elect optional adjustments to the basis of partnership property or treatment as an electing large partnership. The partnership as an aggregate of individuals. A partnership is also an aggregate of individual partners. As an aggregate, the partnership is treated as a group of individuals each of whom owns an interest in the partnership. Each partner reports and pays tax on her allocable share of the partnership s income, gain, loss, deductions, and credits. The partnership reports each of these items to each of the individual partners on Form 1065, U.S. Return of Partnership Income, Schedule K-1. How Partnerships Acquire and Dispose of Property Contribution of property to a partnership. Neither the partnership nor any partner is required to recognize a gain or loss when a partner contributes property to a partnership in exchange for an interest in the partnership. When a group of individuals or entities forms or buys a partnership, they generally contribute property (including money) in exchange for a partnership interest. If a partner contributes appreciated property in exchange for a partnership interest, the contributing partner is not required to recognize a gain on the transaction. Partner s basis in partnership interest. A partner s basis in the partnership is the same as the basis of the property contributed. If a partner contributes property subject to a liability in exchange for partnership interest, his or her basis is reduced to the extent the partner is relieved of the liability. If the liability exceeds the basis in the partnership interest, he or she must recognize gain to the date of the exchange. Treatment of Income and Losses A partnership is a passthrough entity. As is the case with the S corporation (the other passthrough entity for federal tax purposes), any income or loss related to the operation of the partnership flows through to the partners. However, there are differences in passthrough treatment between a partnership and an S corp, particularly the unique availability of special allocations for partnership interests. Partners will report their allocable share of income or loss on their separate tax returns. (As in an S corp, that income or loss must be realized even though no money may actually be passed on to the partner at that time.) A loss is generally available to offset the partners other income. A partner may not be able to claim a loss in a current year if he or she lacks sufficient basis in the partnership. A partner may not claim a loss even if he or she has sufficient basis Top_Fed_07_book.indb 1.15 11/15/2006 2:41:11 PM
1.16 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE if prohibited under the at-risk rules. Nor may a partner claim a loss if prohibited by the passive activity loss rules. If a partner sells a partnership interest at a loss, the partner will be able to claim a capital loss. Partner s Self-Employment Tax An individual general partner is subject to self-employment tax on his or her distributive share. The general partner is subject to self-employment tax of up to 15.3 percent of his or her distributive share of partnership income. This distributive share of partnership income is reported as net earnings from self-employment on Form 1065, U.S. Return of Partnership Income, Schedule K-1. STUDY QUESTIONS 7. A partnership agreement may dictate all of the following partnership governance issues except: a. Special allocations of income and deductions b. Procedures in case of the withdrawal or death of a partner c. Restrictions on the sale of partnership interests d. All of the above are specified in the partnership agreement 8. A partner s basis in property he or she contributes to the partnership in exchange for a partnership interest: a. Is reduced by the amount of liability for which the contributing partner is relieved, but the partner recognizes no gain by contributing appreciated property b. Does not affect basis in the partnership interest, regardless of the type of contribution; partners make equal contributions for equal portions of the partnership s assets and liabilities separate from basis in the property c. A partner s contribution does not affect his or her split of the total interests in the partnership; basis in property contributed is unrelated to the partnership interest d. Is affected only when he or she contributes noncash property LIMITED PARTNERSHIPS A limited partnership differs from a general partnership in that the liability of one or more of the partner s liability for partnership obligations may be limited. Only the general partner in a limited partnership is fully liable. A limited partnership is responsible for all of its own obligations. A limited partner is not liable for the obligations of a limited partnership unless he or she is also a general partner. Under Delaware law, a limited partnership or domestic limited partnership is a partnership formed by two or more persons. It has at least one general Top_Fed_07_book.indb 1.16 11/15/2006 2:41:11 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.17 partner and one or more limited partners. A limited partnership may carry on any lawful business, purpose, or activity, whether or not for profit, except for insurance and banking. A limited partnership is governed by both state statute and the partnership agreement. Before the limited partnership can come into existence, it must file with the state in which it is to be organized. Once the limited partnership has been formed through an appropriate filing, the operative document is the limited partnership agreement. State limited partnership law merely provides fallback or default provisions in areas where the limited partnership agreement is silent. Thus, as a general matter, the provisions of the limited partnership agreement are important and the courts tend to defer to those agreements. A limited partnership does not pay tax, but it does compute income, deductions, and credits on an annual basis. Information about the business is reported to the IRS on Form 1065 and to the individual partners on separate Schedules K-1. The partners report the partnership income on their own returns and pay any taxes due based on their own tax rates. Requirement of a General Partner Each limited partnership must have at least one general partner. The general partner may be an individual, a corporation, or other legal entity, domestic or foreign. The general partner may also (but need not) be a limited partner. Unlike a limited partner, the general partner of a limited partnership is generally responsible for all of the partnership s debts and obligations. Limited Liability of Limited Partners A limited partner is generally not liable for the obligations of a limited partnership unless he or she is also a general partner. The limited partner may also be liable if he or she participates in the control of the business. This is a critical aspect of a limited partnership. Limited partners generally invest in the business, expecting to receive a share of the profits. They usually do not actively participate in the day-to-day operations of the limited partnership. LIMITED LIABILITY LIMITED PARTNERSHIP Limited liability limited partnerships (LLLPs) are similar to LLPs to the extent that states have amended their limited partnership statutes to permit limited partnerships to register as LLLPs, thereby providing the general partners a limitation on vicarious liability. About half of the states, including Delaware, allow the formation of LLLPs. In Texas and Arkansas, for example, these entities are known as registered limited liability partnerships. These partnerships are a form of limited partnership that extends liability protections to general partners as well as the limited partners. In a registered or limited liability limited partnership, no general or limited partner is liable for the partnership s obligations created solely by another partner s malfeasance. Top_Fed_07_book.indb 1.17 11/15/2006 2:41:11 PM
1.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Creation of a limited liability limited partnership is not materially different from creation of a limited liability partnership. In Delaware, a statement of qualification must be filed. An annual report must be filed and an annual fee must be paid. The partnership must have as the last words or letters of its name the words Limited Liability Limited Partnership, or the abbreviation L.L.L.P. or LLLP. STUDY QUESTIONS 9. Unlike a general partnership, a limited partnership is governed by both its partnership agreement and state statute. True or False? 10. The main difference between the general partner and limited partners of a limited partnership is: a. The split in the partnership interests, which gives the general partner a greater share of pro-rata income and liabilities b. The chronological order of becoming partners; the general partner always has the most seniority in the group c. The embodiment of the partners: General partners are individuals, whereas limited partners are corporations or other legal entities d. Liability for debts and obligations, which rests with the general partner LIMITED LIABILITY COMPANIES A limited liability company (LLC) is a business entity created under state law. Every state and the District of Columbia have LLC statutes that govern the formation and operation of LLCs, which are a hot recent favorite entity type. An LLC has the characteristics of both a corporation and a partnership. Like a corporation, the owners (referred to as members) are usually not personally liable for the debts and other obligations of the LLC. Like a partnership or sole proprietorship, an LLC has great flexibility in the way it operates and does not need to follow corporate formalities, such as holding special and annual meetings with shareholders and directors. An LLC has the flexibility to decide whether to be taxed as a partnership, C corporation, or in the case of a single-member LLC to be disregarded as an entity for federal tax purposes. If an LLC chooses to be taxed as a partnership or S corporation, or if a single-member LLC elects to be disregarded as an entity, the LLC profits and losses are reported on the member s personal federal income tax return. Most multimember LLCs choose to be taxed as a partnership, and most single-member LLCs elect to be disregarded as an entity for federal tax purposes. Top_Fed_07_book.indb 1.18 11/15/2006 2:41:11 PM
MODULE 1 CHAPTER 1 Choice of Entity 1.19 Under check-the-box, a multimember LLC usually is taxed as a partnership by default; but the entity may elect to be taxed as an association by checking the box. The two choices for a single-member LLC are generally disregarded entity or association. Advantages of LLCs The main advantage of an LLC is that its members are not personally liable for the debts of the business, vicariously or otherwise. Members of LLCs enjoy the same protections from personal liability for business obligations as shareholders in a corporation or limited partners in a limited partnership. Unlike the limited partnership form, which requires at least one general partner who is personally liable for all the debts of the business, no such requirement exists in an LLC. A second significant advantage is the flexibility of an LLC to choose its federal tax treatment. Under the check-the-box rules, an LLC can be taxed as a partnership, C corporation, or S corporation for federal income tax purposes. A single-member LLC may elect to be disregarded for federal income tax purposes or taxed as an association (corporation). Appeal of LLCs Versus S Corporations In addition to liability protection and tax flexibility, LLCs may be useful in the many circumstances where S corporation status is impractical or unavailable. LLCs are not subject to restrictions on the number and types of shareholders or the one-class-of-stock limitation as are S corporations. Another favorable characteristic of LLCs is that their members have flexibility to allocate income or loss on a basis other than according to each member s percentage interest in the LLC (using the rules for taxation of partnerships). In an S corporation, all income allocations must be based strictly on the stock ownership interest of each shareholder (the one-class-of-stock rule). When LLCs Are Used LLCs are typically used for entrepreneurial enterprises with small numbers of active participants, family and other closely held businesses, real estate investments, joint ventures, and investment partnerships. However, almost any business that is not contemplating an initial public offering (IPO) in the near future should consider using an LLC as its entity of choice. Deciding to convert an LLC to a corporation later generally has no federal tax consequences. This is rarely the case when converting a corporation to an LLC. Therefore, when in doubt between forming an LLC or a corporation, for tax considerations it is usually wise to opt to form an LLC. Characteristics Under State Statutes Most states tax LLCs as passthrough entities the same way they are taxed under federal law. This means that in most cases, passthrough treatment is Top_Fed_07_book.indb 1.19 11/15/2006 2:41:11 PM
1.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE allowed and corporate entity-level income taxes can be avoided. A state may impose other taxes on LLCs, however, such as a franchise tax, business and occupation tax, or other registration fees. The fees vary by state. Most state statutes permit LLCs to have a perpetual life. Modern LLC statutes, commonly known as flexible statutes, also permit less than unanimous consent of the members to continue the business if certain events occurred and allowed members to transfer their ownership interests. States that base their LLC statutes on earlier federal tax law may place limits on the life of an LLC. Before the check-the-box regulations, an entity could only be taxed as a partnership if it lacked continuity of life. To conform to this rule, the statues required either the articles of organization the document filed with the respective secretary of state or the operating agreement to provide that the LLC would have a life span limited to no more than 30 years. The LLC documents also had to provide for the unanimous consent of the members to continue the business of the LLC if certain events, such as a member s death occurred, or to transfer an ownership interest in an LLC to a third party. COMMENT Early LLC statutes were designed to comply with what was known as the Kintner regulations, which were a response to the decision in U.S. v. Kintner (216 F.2d 418 (9th Cir. 1954)). The four corporate characteristics identified in the Kintner regulations were: (1) continuity of life, (2) centralization of management, (3) liability for entity debts limited to entity property, and (4) free transferability of interests (former Treas. Reg. sec. 301.7701-2). The effect of the regulations generally was to classify an unincorporated entity as a partnership if it lacked any two or more of the four corporate characteristics. Therefore, early state LLC statutes were drafted so that any LLC organized under the statute lacked two of the four characteristics. Once the check-the-box regulations were promulgated in December 1996 and the new choice of entity rules were put in place, it was no longer necessary for an LLC to lack two of the four characteristics, and, therefore, state LLC laws were made to be more flexible. LLC Federal Tax Implications An LLC is not a federal tax entity. LLCs are not specifically mentioned in the tax code, and there are no special IRS regulations governing the taxation of LLCs comparable to the regulations for C corporations, S corporations, and partnerships. Instead, LLCs make an election to be taxed as a particular entity (or to be disregarded for tax purposes) by following the check-the-box business entity classification regulations. The election is filed on Form 8832, Entity Classification Election. The IRS will assign an entity classification by default if no election is made. A taxpayer who doesn t mind the IRS default entity classification does not necessarily need to file Form 8832. Top_Fed_07_book.indb 1.20 11/15/2006 2:41:12 PM