L. Andrew Immerman

Alston & Bird LLP

404-881-7532

andy.immerman@alston.com

Mastering Corporations, Partnerships, & LLC's:

Tax Issues

Different Kinds of Taxes

This presentation deals with U.S. federal income tax.

There are many other tax jurisdictions in the world.

State and local tax.

Foreign tax.

There are many other kinds of taxes, such as:

Employment tax.

Excise tax.

Sales tax.

Property tax.

Don’t neglect other taxes.

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Business Law vs. Tax Law

Tax law has its own jargon, such as "disregarded entity," "C corporation" (C Corp), or "S corporation" (S Corp).

Even more confusing, tax law and business law may use the same terms for different concepts. For example, to a tax advisor "corporation" means an

entity that is taxed as a corporation.

That entity might have been formed under state law as a corporation, LLC, partnership, business trust, or almost anything else.

Overview: The Main Choices

Although the rules are confusing, it helps to keep in mind that we are talking almost exclusively about just four alternatives:

1. C Corps.

2. S Corps.

3. Partnerships.

4. "Nothings."

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The Main Choices: Corporations

If an entity is formed under a statute that calls it a "corporation" or "incorporated," it is almost always classified by the IRS as corporation.

However, unincorporated entities (such as partnerships and LLCs) can almost always elect with the IRS to be classified as corporations if they want to be.

In a few special cases unincorporated entities are required to be classified as corporations, for example:

Regulated Investment Companies ("RICs") (mutual funds).

Real Estate Investment Trusts ("REITs").

Publicly traded partnerships or LLCs (unless income is passive).

Banks or insurance companies. 5

C Corporations and S Corporations

Most corporations are either C Corps or S Corps.

C Corps pay tax on their own income, and the shareholders pay tax on dividends (two levels of tax).

"C Corp" is a tax concept and not a business law concept, named after a group of provisions in the Internal Revenue Code known as "Subchapter C."

In general, a corporation formed under state law is automatically classified as a C Corp.

A corporation is never an S Corp unless it meets the qualifications and makes an election.

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C Corporations and S Corporations

In general S Corps pay no tax on their own income, but file tax returns; the shareholders pay tax on their shares of corporation’s income, whether or not the corporation pays dividends (one level of tax).

"S Corp" is a tax concept and not a business law concept, named after a group of provisions in the Internal Revenue Code known as "Subchapter S."

If it meets the criteria, an unincorporated entity (such as a partnership or LLC) may elect to be an S Corp.

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S Corporation Requirements

Initial election must be approved by 100% of shareholders.

One class of stock (but differences in voting rights are permitted).

Maximum of 100 shareholders.

No nonresident alien shareholders.

All shareholders must be individuals (not entities), except for certain trusts, estates, and tax-exempts.

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The Main Entity Choices: Partnerships

Partnerships (as defined under the tax rules) pay no tax on their own income, but file tax returns; the partners pay tax on their shares of the income whether or not the partnership makes distributions (one level of tax).

"Partnership" is both a tax concept and a business law concept, but the two are not the same.

A multi-member business formed as a partnership or LLC under state law is usually, but not always, classified as a partnership under the tax rules.

A business formed as a corporation under state law is not eligible to be treated as partnership.

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The Main Entity Choices: Limited Liability Companies (LLCs)?

LLCs are sometimes partnerships, sometimes C Corps, sometimes S Corp, and sometimes – as explained below – "nothings."

LLC is not a tax concept; one thing that an LLC can never be for tax purposes is an LLC.

Most LLCs wind up being treated as partnerships, and tax advisors often use "LLC" and "partnership" interchangeably, but watch out for exceptions.

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The Main Entity Choices: "Nothings" ("disregarded entities")

"Nothing" or "disregarded entity" is a tax concept; a "nothing" is a perfectly ordinary business entity formed under state law.

"Nothing" means essentially what it sounds like: the IRS just ignores it, as if it didn’t exist (although there are some exceptions).

"Nothings" pay no tax on their own income, and file no tax returns; the single owner of the nothing pays tax on 100% whether or not the nothing makes distributions (one level of tax).

A business formed as a single-member LLC is usually, but not always, classified as a "nothing."

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The Main Entity Choices: "Nothings" ("disregarded entities")

A "nothing" can only have one owner at a time (although owners for tax purposes are not always the same as owners under business law).

"Nothings" pay no tax on their own income, and file no tax returns; the single owner of the nothing pays tax on 100% whether or not the nothing makes distributions (one level of tax).

A "nothing" owned by an individual can be thought of as a sole proprietorship; a "nothing" owned by a corporation or partnership can be thought of as a branch or division.

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What should you choose?

There is no single right answer.

However, in a majority of cases, a partnership (that is, an entity taxed as a partnership, generally including a multi-member LLC) has the most favorable consequences.

Although accountants often recommend S Corps because of potential employment tax savings, S Corps have many disadvantages compared to partnerships.

C Corps are the least desirable, but publicly traded entities generally have to be C Corps.

A "nothing" often is desirable, but it is only a possibility if the entity has one owner.

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Partnership vs. S Corporation

Contrary to popular belief, "S Corps" are not taxed as partnerships.

S Corps are subject to many of the same "Subchapter C" tax rules that apply to C Corps.

Example: S Corps are subject to the rule that the contributors of property in a tax-free contribution must have 80% control of the corporation. Code § 351.

Entities taxed as partnerships are subject to Subchapter K and not to Subchapter C.

Example: The contributors of property to a partnership do not need to meet the 80% control requirement in order to get tax-free treatment. Code § 721.

An LLC is Very Often the Best Choice

From a tax viewpoint, all entities taxed as partnerships are very similar, whether formed as partnerships or LLCs.

Largely for nontax reasons, it is much more common to form a business as an LLC than as a partnership.

An LLC should be the first form to consider for a new business, although it is not always the right choice.

Unless otherwise noted, we will treat "LLC" and "partnership" as synonymous.

However, keep in mind that LLCs may be C Corps, S Corps, or "nothings."

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Overview: The Principal Tax Benefits of LLCs

You can pay one tax instead of two.

LLC income is subject to only one level of tax.

You can easily change your mind later.

Converting from LLC to Corp tends to be tax-free (but not vice versa).

You can capitalize it any way you want.

LLCs can issue an infinite variety of equity and debt.

You can pass through losses most effectively.

Losses incurred by an LLC may be deductible by the members, including debt-financed losses.

Anyone can own an LLC.

There are no limits on the types of owners or number of owners an LLC may have.

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You can easily make tax-free contributions.

Contributions of appreciated property to LLCs are generally tax-free.

You can get tax-free equity for services.

Issuing a "profits interest" in an LLC to a service provider is rarely a taxable event.

You can easily take tax-free distributions.

LLC distributions, even of appreciated property, are normally tax-free.

Of the eight tax benefits of LLCs listed above, seven – all except a single level of tax – are advantages that LLCs have over S Corps.

Overview: The Principal Tax Benefits of LLCs

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One Tax vs. Two Taxes

Income of C Corps, is subject to both corporate level tax and shareholder level tax.

S Corps generally do not pay corporate-level tax. Exception: Some instances where the S

Corp was formerly a C Corp, or acquired a C Corp in a tax-free transaction. See §§ 1374, 1375.

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C Corps sometimes attempt to "zero out" income by deducting salary, rent, interest and other expenses.

Depending on the circumstances, however, it can be difficult or impossible to "zero out" a C Corp's income.

"Zeroing out" a C Corp's income is an especially risky plan if the C Corp has assets – including goodwill – that appreciate in value.

One Tax vs. Two Taxes

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Under current law, most C Corp dividends to shareholders who are individuals are taxable at long-term capital gain rates (normally a maximum of 15%).

The special tax rate reduces, but does not eliminate, the disadvantages of double tax.

For very small C corporations, lower tax rates on income up to $75,000 may be helpful.

One Tax vs. Two Taxes

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Converting from Corp to LLC: Usually Taxable

Converting from corporation to LLC tends to be a tax catastrophe.

Converting from C Corp to LLC is normally taxable to both the C Corp and its shareholders.

Exception: Corporate subsidiaries (80% or more owned by other corporations). §§ 332, 337.

Even converting from S Corp to LLC normally triggers at least one level of tax. § 336.

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Converting from LLC to Corp is usually not taxable. See Rev. Rul. 84-111, 1984-2 CB 88.

However, conversions from LLC to Corp require careful thought.

The most common tax trap when converting from LLC to Corp is making sure that the former LLC owners have 80% control of the Corp "immediately after" the conversion. § 351(a).

Converting from LLC to Corp: Usually Tax-Free

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Corporate Capitalization Decisions Are Constrained

An S Corp can have only one class of equity, although differences in voting rights are allowed. § 1361(b)(1)(D).

A C Corp can have multiple classes of equity. However, the deduction for interest but not dividends tends to

favor debt capital over equity capital for C Corps, which can distort capitalization decisions.

LLCs can have an unlimited variety of capital structures. Debt vs. equity decisions are less influenced by tax considerations,

and can more easily be made for nontax reasons.

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Pass-Through of Losses

Losses do not pass through from a C Corp. Shareholders do not get to deduct a C Corp's losses.

Losses pass through from an S Corp, but generally not debt-financed losses.

LLCs generally pass through even debt-financed losses. Nevertheless, even for LLCs, there are important restrictions

on the deduction of losses that are passed through. See, e.g., §§ 465, 469, 704(d).

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S Corp Ownership Is Limited

Ownership of S Corp stock is very limited:

All holders generally must be US individuals, although certain trusts, estates, and tax-exempt entities also can hold S Corp stock.

Issuing one share to an investor that happens to be a corporation or partnership terminates S Corp status.

Maximum 100 shareholders.

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Practical Limitations on LLC Ownership

Although anyone can own LLC interests, there are some practical limitations:

Publicly-traded LLCs are generally taxed as C Corps (unless their income is passive).

Pass-through of the LLC’s operating income may be problematic for some investors, such as certain foreign persons or tax-exempt entities.

Most individuals (other than professionals in fields such as law and accounting) prefer to be treated as employees rather than as "partners," and an LLC "partner" cannot be an employee.

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The Code provides for tax-free contributions of appreciated property to Corps as well as LLCs. § 351.

However, the rules for LLCs are more favorable than for Corps. § 721.

C Corps and S Corps are treated alike for this purpose.

You Can Easily Make Tax-Free Contributions

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Example: Property Contribution A and B are equal owners of an existing

entity, X.

C contributes appreciated property (basis of zero and fair market value of $100) to X in exchange for 20% of the equity in X.

X

A B C

FMV = $100

Basis = 0

X

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Property Contribution: If X is a Corp

C has $100 of taxable gain because he is not in control of X immediately after the exchange. See §§ 351, 368(c).

X

Taxable Gain = $100

C B A

X

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Property Contribution: If X is an LLC

If X is an LLC, C has no taxable gain. See § 721(a).

There is no 80% control requirement for LLCs.

Taxable Gain = 0

B A C

X X

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Example: Encumbered Property Contribution

A and B form X. Each has an equal interest.

In exchange for his interest, A contributes property with: fair market value of

$1,000, basis of $500, and subject to a liability of

$800 incurred long ago. B contributes $200 in cash. X assumes the liability; A and

B guarantee the liability.

A B

X

X

Cash =

$200

FMV = $1,000

Basis = $500

Debt = $800

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Encumbered Property Contribution: If X is a Corp

A B

X

A recognizes gain of

$300 (excess of liability

over basis). § 357(c)).

Taxable Gain =

$300

X

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Encumbered Property Contribution: If X is an LLC

A B A generally recognizes no taxable gain.

However, because he is relieved of half the $800 liability, A is treated as receiving a $400 cash distribution from X, reducing his basis from $500 to $100. See §§ 705(a), 707, 722, 752.

Taxable Gain =

0

X

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An employee or other service provider is taxable on the fair market value of C Corp or S Corp stock received as compensation for services, although the tax can be deferred until the stock is vested. § 83.

Equity for Services: Corporations

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A service provider is generally not taxable on receipt of a vested or unvested "profits interest" in an LLC as compensation for services to or for the LLC. See Rev. Proc. 93-27, 1993-2 CB 343; Rev. Proc. 2001-43, 2001-2 CB 191.

Equity for Services: LLCs

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Equity for Services

"Capital Interest" = • Any interest that would give the holder a share

of the proceeds if the partnership's assets were sold at fair market value, and the proceeds distributed in a complete liquidation of the partnership.

"Profits Interest" = • Any partnership interest other than a capital

interest.

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Example: Equity for Services

A and B form X. Each has an equal interest.

A contributes property with a fair market value of $1,000 and a basis of zero.

B contributes future services that he will perform for X, and receives an unrestricted interest in X.

A B

X

FMV = $1,000

Basis = 0

Services

X X

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Equity for Services: If X is a Corporation

A and B both have taxable gain.

A has gain, equal to $1,000, because he is not in control of X immediately after the exchange (and is not part of a control group).

B has taxable ordinary income equal to $500 (assumed to be the value of his interest in X).

However, X may have a $500 deduction for the compensation to B.

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Equity for Services: If X is an LLC

A has no taxable gain (no control

group requirement).

In general, B also will have no

taxable gain, provided he receives

only a profits interest in X.

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Distributions are never taxable to the LLC. § 731(b).

Distributions are usually not taxable to the members. §§ 731(a), 704(c)(1)(B), 707(a)(2)(B), 737.

Of course, the fundamental reason why distributions themselves are tax-free is that the LLC members are taxable as the LLC earns income, whether or not the income is distributed. § 702.

Distribution of Property

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Unlike an LLC, a corporation generally recognizes taxable gain when its appreciated assets are distributed to the shareholders. §§ 311(b), 336(a). With a C Corp, the corporation itself is taxable on the

gain.

With an S Corp, the gain generally passes through to the shareholders and is taxable to them.

In addition, at least with a C Corp, the shareholders generally recognize taxable income when they receive a distribution. §§ 301, 302, 331(a).

Distribution of Property

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Example: Distribution of Property

A and B are equal owners of X.

X owns real property with a fair market value of $1,000 and a zero basis.

X also has $1,000 cash.

Each of A and B has a basis of $100 in his interest in X.

X distributes the cash to A and the asset to B.

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Distribution of Property

X

A B

X

Property:

FMV = $1,000

Basis = 0

Cash:

$1,000

Basis = $100

Receives $1,000 Cash

Basis = $100

Receives $1,000 in

Property

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Distribution of Property: If X is an S Corp

Each of A and B has $900 of taxable gain.

This $900 consists of:

$500 share of the $1,000 gain recognized by X when X disposes of the property. See § 336 (or § 311 for no liquidating distributions). This $500 gain increases each of their bases from $100 to $600.

Additional $400 of gain ($1,000 less $600 basis) on the $1,000 distribution (whether in cash or in property) to each. See § 1367.

B has gain although he receives no cash.

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Distribution of Property: If X is a C Corp

Each of A and B has $900 of taxable gain.

Plus:

X itself has $1,000 of taxable gain.

X presumably would have to reduce the distributions to A and B so that X has money to pay its tax with.

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Distribution of Property: If X is an LLC

B has no taxable gain because he receives no cash or marketable securities.

A still has $900 of taxable gain, but A has gotten $1,000 cash. See § 731(a).

There is no gain to X. See § 731(b).

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Example: Debt Financed Distribution

A and B form X; each has an equal interest.

A contributes property with a fair market value of $1,000 and a zero basis.

B contributes $1,000 cash.

X borrows $500.

X has zero net income, but makes a distribution of $100 to each of A and B.

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Debt Financed Distribution

A B

X

X

Cash contribution = $1,000

Distribution = $100 Property contribution:

FMV = $1,000

Basis = 0

Distribution = $100

X Borrows $500;

distributes $100 each to

A and B

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Debt Financed Distribution: If X is a Corp

A has taxable gain on the $100 distribution, because he has a zero basis in his interest in X.

B, however, can receive the distribution tax-free although the distribution reduces his basis in X from $1,000 to $900.

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Debt Financed Distribution: If X is an LLC

In general, neither A nor B is taxable on the distribution

A's basis would decrease from $250 (i.e., A's share of the $500 debt) to $150.

B's basis would decrease from $1,250 (i.e., B's $1,000 basis from the cash contribution, plus B's share of the $500 debt) to $1,150.

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LLC/Partnership

S Corporation

C Corporation

Limited

Liability

Generally yes for

all members (with

LLCs, LLPs, and

LLLPs).

Yes for all

shareholders.

Yes for all shareholders.

Levels of

Federal Income

Tax

One.

Generally one, unless

it was formerly a C

corporation.

Two.

Number of

Owners

At least two. May

be taxable as a

corporation if

publicly traded, or

treated as a tax

nothing if only one

member.

One to 100.

No restrictions.

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Types of

Owner

No restrictions.

Generally limited to

U.S. individuals,

certain U.S. trusts,

and tax-exempt

entities.

No restrictions.

Classes of

Ownership

Multiple classes

permitted.

One (but differences

in voting rights are

permitted).

Multiple classes

permitted.

LLC/Partnership

S Corporation

C Corporation

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LLC/Partnership

S Corporation

C Corporation

Tax-Related

Transfer

Restrictions

Generally no.

May be taxable

as a corporation if

publicly traded.

Technical

"termination" on

certain transfers.

Yes. Transfer to an

ineligible

shareholder

terminates S status.

Cannot exceed 100

shareholders.

No.

Tax

Restrictions

on Converting

to Other Form

Generally can

convert tax free.

Generally can

convert tax free only

to C corporation.

Generally can convert

tax free only to S

corporation (if eligible).

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Participation in

Tax-Free

Corporate

Mergers/

Acquisitions

No.

Yes.

Yes.

Employment

Tax on

Owner/

Employee

Self-employment

tax on full share of

business income

to general

partners, and to

limited partners on

guaranteed pay for

services. Unclear

treatment of LLC

members.

Owner-employees

are subject to

FICA/FUTA on salary

but not on other

income.

Owner-employees

are subject to

FICA/FUTA on salary

but not on other

income.

LLC/Partnership

S Corporation

C Corporation

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Tax on

Distributions

Nontaxable to the

extent of a

member's tax

basis (with some

exceptions).

Cash distribution:

Generally nontaxable

to the extent of the

shareholder's basis.

Property distribution:

Generally one level

of tax.

Cash distribution:

Generally taxable to the

shareholder.

Property distribution:

Generally taxable to both

corporation and

shareholder (two levels

of tax).

LLC/Partnership

S Corporation

C Corporation