Choice of Entity: Operational Issues (Portfolio 701)

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. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

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.

Authors

James M. Kehl, MST

James M. Kehl, CPA, M.S. Taxation, is currently with the accounting firm of Weil, Akman, Baylin & Coleman, P. A. (WABC), which is located in Timonium, Maryland. He graduated with an accounting degree from Loyola University of Baltimore and received a Master of Science in taxation from the University of Baltimore. Mr. Kehl has over forty-one (41) years of experience with national, regional and local CPA firms where he has focused primarily on taxation. Mr. Kehl also has extensive experience with financial statements, audits, review and compilations. At WABC, Mr. Kehl is in charge of accounts that consist of high net-worth individuals, low-income housing partnerships, investment advisory partnerships, and clients in a variety of other industries.

Mr. Kehl is the author of The Practical Guide to Code Sec. 199 and the Code Sec. 199 Tax Planning & Compliance Manual. He has also authored articles on partnership income tax topics that have appeared in The Journal of Passthrough Entities, Taxes-The Tax Magazine, Tax Strategies, BNA's Daily Tax Report, BNA's Insights and Commentary and BNA's Real Estate Taxation. The author has served as a discussion leader for seminars on a variety of topics for the Maryland Association of CPAs, AICPA and other professional organizations. Mr. Kehl has also edited and updated several BNA Tax Practice Series chapters on the passive loss rules and a variety of tax topics concerning S corporations.

Table of Contents

Detailed Analysis
I. Operational Tax Considerations
A. Tax Planning Issues Summarized
B. Taxation of Income
1. Who Is Taxed/Applicable Rates
a. Sole Proprietorship
b. Partnership
c. C Corporation
d. S Corporation
e. Trusts and Estates
f. Other Entities
g. Comparisons
2. Deduction for Qualified Business Income of Pass-Through Entities and Sole Proprietorships
a. Combined Qualified Business Income Amount
(1) Deductible Qualified Business Income for Qualified Trade or Business
(a) Qualified Business Income
(b) W-2 Wage Limitation
(i) W-2 Wages
(ii) Qualified Property
(iii) Taxable Income Exception to Limitation
(c) Specified Service Trade or Business Exclusion
(i) Specified Service Trade or Business
(ii) Taxable Income Exception to Exclusion
(d) Carryover of Losses
(2) Qualified REIT Dividends
(3) Qualified Publicly Traded Partnership Income
b. Special Rules for Trusts and Estates
c. Special Rules for Specified Agricultural or Horticultural Cooperatives
(1) Qualified Production Activities Income
(2) Rules for Patrons of Specified Agricultural and Horticultural Cooperatives
(a) Deduction Allowed to Patrons
(b) Reduction of Qualified Business Income with Respect to Income Received from Cooperatives
3. Special Allocations of Income and Deductions
a. Objective of “Special Allocations”
b. Sole Proprietorship
c. Partnership
(1) Special Allocations of Income
(2) Family Partnerships
(3) Contributed Property
(4) Late-Entry Partners
d. C Corporation
e. S Corporation
f. Trust
g. Other Entities
h. Comparisons
4. Tax Accounting Concepts
a. Potential Benefit of Tax Accounting Variances
b. Sole Proprietorship
c. Partnership
d. C Corporation
e. S Corporation
f. Trusts and Estates
g. Other Entities
h. Comparisons
5. Assignment of Income and Deductions
a. Potential Benefit of Income Assignments
b. Sole Proprietorship
c. Partnership
d. C Corporation
e. S Corporation
f. Trust
g. Other Entities
h. Comparisons
6. Choice of Taxable Year — Adoption and Change
a. Importance of Tax Year Choice
b. Sole Proprietorship
c. Partnership
d. C Corporation
e. S Corporation
f. Trusts & Estates
g. Other Entities
h. Comparisons
7. Choice of Accounting Method
a. In General
(1) Cash Method
(2) Accrual Method
(3) Other Permissible Methods
(4) Hybrid Methods
b. Sole Proprietorship
c. Partnership
d. C Corporation
e. S Corporation
f. Trusts and Estates
g. Comparisons
8. Applicability of Tax Loss Limitation Rules
a. Identification of Tax Loss Limitation Rules
b. Sole Proprietorship
c. Partnership
d. C Corporation
e. S Corporation
f. Trust
C. Alternative Minimum Tax
1. Structure of Alternative Minimum Tax
2. Sole Proprietorship
3. Partnership
4. C Corporation
5. S Corporation
6. Trust
7. Comparisons
D. Estimated Tax Payments
1. Sole Proprietorship
2. Partnership
3. C Corporation
4. S Corporation
5. Trust
a. Payment Requirement
b. Allocation to Beneficiaries
6. Comparisons
E. Tax Return Filing Requirements
1. Sole Proprietorship
a. Return Filing Requirement
b. Filing Date for Return
2. Partnership
a. Return Filing Requirement
b. Filing Date for Return
3. C Corporation
a. Return Filing Requirement
b. Filing Date for Return
4. S Corporation
a. Return Filing Requirement
b. Filing Date for Return
5. Trust or Estate
a. Return Filing Requirement
b. Filing Date for Return
II. Distributions of Cash, Property and Entity Ownership Units
A. Cash Distributions
1. Options for Income Tax Treatment
2. Sole Proprietorship
3. C Corporation
a. Shareholder/Recipient Treatment
b. Treatment of the Distributing Corporation
4. S Corporation
a. Shareholder/Recipient Treatment
b. Treatment of S Corporation Making Distribution
5. Partnership
a. Distributee Partner Treatment
b. Distributor Partnership Treatment
6. Trust
a. Distributee Beneficiary Treatment
b. Distributor Trust Treatment
7. Other Entities
8. Comparisons
B. Distributions of Property Other than Cash
1. Alternative Tax Choices for Property Distributions
2. C Corporation
a. Treatment of a C Corporation Making a Distribution
b. Shareholder/Recipient Treatment
3. S Corporation
a. Treatment of Corporation Making Distribution
b. Shareholder/Recipient Treatment
4. Partnership
a. Distributor Partnership Treatment
b. Distributee Partner Treatment
5. Trust
a. Distributor Trust Treatment
b. Distributee Beneficiary Treatment
6. Other Entities
a. Distributor Treatment
b. Distributee Treatment
7. Comparisons
C. Disguised or Constructive Distributions
1. Income Tax Treatment Choices
2. C Corporation
3. S Corporation
4. Partnership
5. Trust
6. Other Entities
7. Comparisons
D. Distributions of Entity Ownership Units
1. Alternative Distribution Techniques
2. Corporate Stock Distributions
a. Corporate Stock and Stock Rights/Section 305
(1) Distribution May Be Ordinary Dividend
(2) Distributions in Lieu of Money
(3) Disproportionate Distributions
(4) Distributions of Common and Preferred Stock
(5) Distributions on Preferred Stock
(6) Distributions of Convertible Preferred Stock
(7) Transactions Treated as Distributions
(8) Stock Rights
b. Section 306 Stock
(1) Definition
(2) Dispositions Other than Redemptions
(3) Redemptions
(4) Exceptions
3. S Corporation Stock Distributions
4. Partnership Unit Distributions
a. Options
b. Changes in Income Interests
c. Changes in Capital Interests
d. Closing of Partnership Year
5. Trust Unit Distributions
6. Other Entity Distributions
7. Comparisons
III. Termination/Partial Termination of an Entity Ownership Interest
A. Options for Terminating Entity Ownership Interest
B. Terminating the Sole Proprietorship Interest
C. Corporate Share Sales/Redemptions/Partial Liquidations
1. Share Sale to Third Party
a. Sale by Shareholder
b. Corporate Level Impact
c. Sale of S Corporation Stock
2. Stock Redemption Transactions
a. Definition of Corporate Redemption Transaction
b. Complete Terminations
c. Substantially Disproportionate Redemptions
d. Redemptions Not Essentially Equivalent to a Dividend
e. Partial Liquidations
f. Corporate Level Impact of Redemption Transaction
D. Partnership Interest Transfers
1. Partnership Interest Sale to Third Party
a. Effect to Selling Partner
b. Partnership Level Impact
2. Liquidation of Entire Partnership Interest — Sale to Partnership
a. Impact to Selling Partner
b. Sale of Partial Interest
c. Determining Partner's Distributive Share When Interest Terminated
d. Partnership Level Impact
E. Trust Interest Transfers
1. Types of Trust Interest Transfers
2. Trust Interest Sale to Third Party
a. Sale of Grantor Trust Interest
b. Sale by Beneficiary of Nongrantor Trust Interest
c. Impact at the Trust Level
d. Sale of Unit Trust Interest
3. Transfer of Ownership Interest to the Trust
a. Grantor Trust
b. Non-Grantor Trust
F. Comparisons
IV. Taxable Disposition/Liquidation of the Entire Enterprise
A. Tax Issues and Planning Concerning the Termination of the Entire Enterprise
B. Terminating the Sole Proprietorship
C. Corporate Sales/Liquidations
1. Mechanics of Termination of Corporate Entity
2. Federal Income Tax Effects
a. Shareholder-Level Results
(1) Stock Transfers
(2) Liquidation/Cash Distributions
(3) Liquidation/Property Distributions
(4) Liquidation/Reincorporation Risk
b. Corporate-Level Effects
(1) Stock Purchase
(2) Complete Liquidation/Cash Distributions
(3) Liquidating Distributions of Installment Obligations
(4) Complete Liquidation/Property Distributions
(5) Liquidating Distribution/Loss Recognition Limitation
(6) Liquidation of a Controlled Corporate Subsidiary
D. Partnership Interest Sales/Complete Liquidations
1. Mechanics of Partnership Termination
a. Transferring All Partnership Interests
b. Complete Liquidation of the Partnership
2. Federal Income Tax Effects
a. Identifying a Partnership Termination
b. Sale of All Partnership Interests
c. Liquidating Distribution/Partner-Level Tax Effects
d. Liquidating Distribution/Tax Effects to Partnership
E. Trust Interest Sales/Liquidations
1. Mechanics of Trust Termination
2. Federal Income Tax Effects
F. Comparisons
V. Tax-Free Disposition of a Business Enterprise Interest
A. Mechanics/Tax Effects of Disposition
1. Types of Tax-Free and Tax-Deferred Dispositions
2. Sole Proprietorship
a. Like-Kind Exchanges
b. Transfer to Controlled Corporation
3. Corporate Spin-Offs/Reorganizations
a. Available Choices
b. Spin-Offs
(1) Tax-Free Corporate Division
(2) Shareholder Treatment upon Spin-Off Completion
c. Reorganizations
(1) Options for Tax-Free Acquisitions and Dispositions
(2) Basic Tax Consequences
4. Partnership
a. Availability of Tax-Free Exchange Mechanisms
b. Tax-Free Division of Partnership
c. Tax-Free Disposition of Entire Partnership
d. Conversion of Partnership to an LLC
e. Conversion into Single Member LLC
f. Single Member Entity Acquires New Member
5. Trusts
a. Alternative Disposition Techniques
b. Grantor Trusts
c. Nongrantor Trusts
6. Other Entities
7. Comparisons
B. Income Tax Attribute Carryovers
1. Identifying Important Tax Attributes
2. Sole Proprietorship
3. Corporate Spin-Offs/Reorganizations
4. Partnership
VI. Multiple and Related Entities
A. Issues Concerning Multiple and Related Entities
B. Combined Income Tax Reporting
1. Sole Proprietorship
2. C Corporations
a. Identifying Multiple Corporation Relationships
b. Limitations on Multiple Tax Benefits
c. Allocation of Income and Deductions
d. Consolidated Tax Returns
(1) Eligibility to File Consolidated Return
(2) Election to File Consolidated Return
(3) Computation of Consolidated Taxable Income
(4) Liability for Consolidated Return Tax
(5) Benefits of Consolidated Return Tax Status
3. S Corporations
a. Affiliated Group Status
b. Ownership of Other Entities
4. Partnerships
a. Tiered Partnerships
(1) Description of Arrangement
(2) Allocation of Liabilities
(3) Fiscal Year Elections
(4) Transfer of Tiered Partnership Interests
b. Allocation of Income and Deductions
c. Share Ownership Arrangements
d. Trust Beneficiary Status
e. Corporate Holdings of Partnership Interests
5. Trusts
a. Multiple Trusts
b. Trusts and Beneficiaries
c. Trust as Partner
d. Trust as Corporate Shareholder
C. Transfer Pricing
1. Basic Rules
2. Regulations Under §482
a. Best Method Rule
b. Pricing for Tangible Property Transfers
c. Pricing for Intangible Property
3. Applicability to Different Types of Entities
D. Special Rules for Transactions Between Owners and Entity
1. Types of Rules
2. Sales of Capital Assets
3. Sales of Depreciable Assets
4. Losses Arising from Sales of Property
VII. Compensation Issues
A. Reasonable Compensation Issues
1. In General
2. Effect to Employee
B. Fringe Benefits
1. General Nondiscrimination Rules
2. Group Term Life Insurance
3. Meals and Lodging
4. Accident and Health Plans
C. Qualified Retirement Plans
D. Payroll Withholding Considerations
E. Social Security Tax Considerations
1. Employer's Social Security Tax Responsibility
2. Self-Employment Tax
F. Unemployment Compensation Tax
VIII. Estate Planning Considerations
A. Types of Planning Issues
1. Alternative Estate Planning Situations
2. Valuation Situations
B. Pre-Death Ownership Restructurings
1. Objective of Enterprise Ownership Restructurings
2. Gift Tax Valuation in Ownership Restructurings
3. Corporate Restructurings
a. Income Tax Planning
b. Tax-Free Reorganization Treatment
c. Possible Dividend Treatment
d. Possible Preferred Stock Bailout Treatment
e. Transfer Tax Planning
4. Partnership Restructurings
C. Buy-Sell Agreements
1. Framework for Buy-Sell Agreements
a. Objective of Agreement
b. Alternative Structures for Buy-Sell Agreements
c. Fixing the Price to Be Paid
2. Payment Methods
D. Property Owned at Death
E. Valuation of Family Farms and Real Property
1. Special Valuation Procedure
2. Types of Qualified Property Ownership
3. Trade or Business Concept
F. Post-Death Special Tax Rules
1. Corporate Stock Redemption/§303
a. Availability of Exchange Treatment for Corporate Shareholder
b. Section 303 Requirements
c. Limitation of Redemption Amount
d. Parties Eligible to Use §303
e. Time Limitations
2. Delayed Tax Payment Opportunities
a. Deferral Availability for Business Interests
b. Amount of Estate Tax that May Be Deferred
c. Qualifying Interest in Closely Held Businesses
d. Identifying the Qualifying “Closely Held Business”
e. Termination of Installment Privilege
f. Election Procedure
g. Similar Deferral for Trust Reversions and Remainders
G. Family Partnerships or Family LLCs
1. In General
2. IRS Attacks on Family Limited Partnerships
IX. Special Transnational Considerations
A. Scope of Choice of Entity Issues
B. Foreign Taxing Regimes
C. U.S. Taxation of Inbound Foreign Enterprise Activities
1. U.S. Tax Characterization of Foreign Entity
2. Income Taxation on Profits
3. Branch Profits Tax
4. Earnings Stripping Rules Before 2018
D. Outbound Investment
E. U.S. Income Tax Treaties
F. Hybrid Entities
G. Dually Chartered Entities
X. State Tax Implications

Working Papers

Table of Worksheets
Worksheet 1 Comparison of Business Entity Requirements
Worksheet 2 Comparison of Subchapter C with S Corporation/Shareholder Tax Considerations — Section 1202 Calculation with $11 Million Sale Price
Worksheet 3 Comparison of Subchapter C with S Corporation/Shareholder Tax Considerations — Section 1202 Computation Assuming a $2 Million Sale Price
Worksheet 4 Summary of Federal Income Tax Forms Relevant to Various Types of Business and Investment Entities