Choice of Entity (Portfolio 700)
The Portfolio, Choice of Entity, discusses federal income tax and other considerations pertinent in choosing the most advantageous legal form for conducting business and investment activities.
Bloomberg Tax Portfolio, Choice of Entity, No. 700, discusses federal income tax and other considerations pertinent in choosing the most advantageous legal form for conducting business and investment activities. This Portfolio provides a summary perspective on the various legal forms of business enterprises and their relative advantages and disadvantages. These forms primarily include the sole proprietorship, a general partnership, a limited partnership, a regular corporation, an S corporation, a limited liability company, and a trust. A variety of other specialized entities have unique treatment as specified under the Internal Revenue Code, however, and those entities are also examined in this Portfolio.
The discussion in this Portfolio has been quite significantly impacted by the choice of entity or “check-the-box” regulations which were effective January 1, 1997. These regulations permit much greater flexibility and far fewer impediments in the choice of a business entity.
A sole proprietorship is the simplest form of doing business since no separate legal entity needs to be created for state law purposes and no assets are required to be separately transferred to a distinct legal entity. All profits are immediately taxed directly to the proprietor, and the proprietor directly bears all the business risks associated with the operation.
A partnership can be either a general or limited partnership. In either situation, the partnership is an alliance of two or more persons who intend to carry on a business (or investment activity) as co-owners for profit. The partnership is itself not subject to federal income taxation. Rather, all the income, deductions, and other tax attributes are allocated to the partners in accordance with the partnership agreement. In a general partnership all the partners have unlimited personal liability for the debts of the partnership. In a limited partnership, however, those partners designated as limited partners only have exposure for liabilities to the extent of their respective capital contributions (and obligations for contributions) to the partnership. This limitation on liability will exist because of the application of a limited partnership law enacted by a state legislature, and not because of a provision of the federal income tax laws, assuming the parties comply with the requirements of the limited partnership statute.
A corporation is a separate legal entity that ordinarily is itself immediately subject to federal income taxation on its taxable income. When these earnings are distributed (as dividends) to the shareholders of the corporation, those shareholders are also taxed on the receipt of those corporate profits. None of the shareholders are personally liable for corporate obligations (assuming they have not independently agreed with some creditor to be liable for those obligations and the corporation is correctly organized). Under some circumstances, however, a corporation can elect to be an “S corporation” for federal income tax purposes. This status enables the corporate level income to flow through and be taxed immediately to the shareholders (but not be taxed to the corporation itself), the “S” corporation merely being a conduit. Thereafter, the S corporation income is not taxed to the shareholders when subsequently distributed to them (since previously taxed to them when realized by the corporation).
An increasingly important alternative in this context is the limited liability company (“LLC”), as permitted under the laws of the states. This structure permits the limitation of entity level liabilities as to all owners. The LLC is ordinarily treated as a partnership for federal income tax purposes, but it does not have many of the constraints that are imposed on S corporations.
A trust can also be used as an entity for holding investment assets, but not for the operation of a business (in which event the trust becomes a partnership or a corporation for federal tax purposes). A trust can be a grantor trust or a regular trust (i.e., a “true trust”). In some situations, ownership interests in a trust may be widely distributed and the ownership units regularly traded on a securities exchange.
A comparison of the attributes of these various entities necessitates an examination of both (i) the legal and business structure and (ii) particularly for purposes of this Portfolio, the federal income tax rules applicable throughout the entire life cycles of these entities. Consequently, this Portfolio provides an expansive discussion of the various entity characterization rules of the “check-the-box” regulations. Further, this Portfolio includes a comparison of the income tax rules applicable to entities (i) when being organized, (ii) when operating and receiving profits or incurring losses, (iii) when making distributions of profits in cash, property, or entity ownership units, (iv) when terminating an ownership interest, (v) when the entire enterprise terminates, and (vi) when the enterprise engages in a tax-free restructuring. Various additional issues relevant to entity choice, including estate planning considerations, are examined in the latter portion of this Portfolio.
Table of Contents
I. The Framework for Choosing a Business Entity
II. Alternative Business Organization Forms
III. Federal Tax Classification of Entities
IV. Business/Local Law Considerations in Choosing an Entity
V. Organizational Considerations
VI. Operational Tax Considerations
VII. Distributions of Cash, Property and Entity Ownership Units
VIII. Termination/Partial Termination of an Entity Ownership Interest
IX. Taxable Disposition/Liquidation of the Entire Enterprise
X. Tax-free Disposition of a Business Enterprise Interest
XI. Multiple and Related Entities
XII. Compensation Issues
XIII. Estate Planning Considerations
XIV. Special Transnational Considerations
XV. State Tax Implications
Professor of Law
University of Houston, Law Center