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Tax Management Portfolio, Choice of Entity: Operational Issues, No. 701, discusses federal income tax and other considerations relevant to the operations of various legal forms of entities. This Portfolio, in conjunction with 700 T.M., Choice of Entity: Organizational Issues, provides a summary perspective on tax effects of the operations of 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.
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. Many sole proprietorships are now conducted through single member limited liability companies in order to provide the business owners with legal liability protection.
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 a conduit and is not subject to federal income taxation as a separate entity. Instead, the partnership's items of income and deduction as well as 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 legal exposure for liabilities to the extent of their respective capital contributions (and obligations for contributions) to the partnership. This limitation on liability exists because of the application of a limited partnership statute 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 state limited partnership law.
An increasingly important alternative in this context is the limited liability company (“LLC”), as permitted under the laws of the states. This structure limits the liability of the owners for entity level liabilities. A multiple-member LLC is treated as a partnership for federal income tax purposes unless it elects to be classified as a corporation.
A regular corporation (a “C corporation”) is subject to federal income taxation as an entity separate from its owners. When corporate earnings are distributed to the corporate shareholders, the shareholders are also taxed on those earnings. There are, therefore, two levels of tax imposed on corporate income – one at the entity level and a second at the shareholder level. None of the shareholders is 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 certain circumstances, a corporation can elect to be an “S corporation” for federal income tax purposes. This election enables the corporate level income to flow through and be taxed to the shareholders rather than the corporation itself because the “S” corporation is a conduit. Thus, S corporation income, similar to partnership income, is subject to only one level of taxation.
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 as ownership units that are regularly traded on a securities exchange.
A meaningful comparison of the attributes of these various legal entities requires an examination of their legal and business structures as well as an analysis of the federal income tax rules applicable throughout the life cycles of these entities. 700 T.M., Choice of Entity: Organizational Issues, provides a detailed examination of the various entity characterization rules of the “check-the-box” regulations. This Portfolio provides 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.
This Portfolio may be cited as Streng and Kehl, 701 T.M., Choice of Entity: Operational Issues.
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