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Tax Considerations in Choice of Entity, and Working with LLCs, Part 1

George R. Goodman of Foley & Lardner LLP


This article first appeared in the May 2007 issue of Taxes - The Tax Magazine

Introduction

A variety of business entities can be availed of to conduct a business. Choosing the best generally entails a two-tier analysis. First, the type of state law format or entity must be selected, from among a proprietorship or division, partnership, limited liability company, corporation, or trust. Both income and non-income tax considerations play a role in that choice. Second, assuming a particular state law format or entity, then its income tax classification must be determined. Obviously, that determination is based solely or almost entirely on income tax considerations.

LLCs are the most versatile entity from an income tax standpoint. LLCs can generally elect between being classified as a disregarded entity or partnership on the one hand, or a corporation on the other. If corporate classification is chosen or otherwise applies, then it may be possible to further elect between an S or C corporation. It often makes sense to set up a new business or venture as an LLC, or to convert an existing entity into an LLC, to minimize both income and non-income taxes. LLCs open up new possibilities in structuring mergers and acquisitions. LLCs can also be used to further estate planning goals. A business owner, accountant, or business law practitioner thus needs to have a good understanding of the many roles that can be played by LLCs and the potential tax savings they offer.

This article begins with a discussion of the non-income tax considerations in making the initial choice between an LLC and a state law corporation. Then, given the ability of LLCs to be classified as any time of business entity for income tax purposes, it discusses the income taxation of an LLC under each classification and the considerations relevant to a U.S. person in choosing among the income tax classifications. The drafting of LLC agreements for LCCs is addressed, focusing on the tax-related provisions one would expect for an LLC classified under each income tax category. The participation of LLCs in M&A transactions is analyzed based on each type of income tax classification. Finally, self-employment tax compliance is analyzed for the different classifications of LLCs. At the state tax level, the primary focus is on Illinois taxes; however, the state tax analysis for LLCs organized or operating in other states would proceed along similar lines.

Basic Filing Fees

Formation of limited liability business entities typically requires filings with the State along with payment of various fees. Such fees will have a bearing on which type of state law entity to use. In forming a business entity to operate in a state, there are two basic approaches. One can organize the entity under that state's own laws. Or, the entity could be organized under the laws of another state ( Delaware being perhaps the most popular), and then qualified to do business in the state of operation.

For entities organized under Illinois law, the following table compares the Illinois Secretary of State filing fees for various types of entities:

Illinois Secretary of State Filing Fees

Domestic

LLC

Corporation

Ltd Partnership

LLP

Articles of Organization

$500

$150

$1

$100 per partner, to $5,000

Annual Reports

$250

$75

$100

$100 per partner,
to $5,000

As one can see, the filing fees for an LLC are more than for a corporation, and for a tiny operation, might dictate use of a corporation.

As noted, another popular strategy is to organize the entity in Delaware, and then qualify it to do business in the states where it operates. In that case, filings and filing fees would have to be made and paid in both Delaware and the states of operation. For Delaware entities operating in Illinois, the basic filing fees are as follows:

Delaware Division of Corporations Filing Fees

Domestic

LLC

Corporation

Ltd Partnership

LLP

Articles of Organization

$90

$89

$200

$200 per partner

Annual Reports

$200

$25

$200

$200 per partner

Illinois Secretary of State Filing Fees

Foreign

LLC

Corporation

Ltd Partnership

LLP

Application to Transact Business in Illinois

$500

$150

$150

$500

Annual Reports

$250

$75

$100

$300

Again, the basic filing fees tend to be a couple hundred dollars more per year for an LLC than a corporation.

Corporate Franchise Taxes

In addition to the various filing fees, consideration should be given to applicable capital-based franchise taxes. In Illinois, corporations, both foreign and domestic, are subject to an initial franchise tax of 0.15% and an annual franchise tax of 0.10% of paid-in capital apportioned to Illinois (based on assets and income), in each case subject to a $25 minimum and $2 million cap, and an additional franchise tax of 0.15% of increases in paid-in capital. Delaware imposes an annual corporate franchise tax equal to the lesser of the amounts computed under the "authorized shares method" ($35 for 3,000 or less shares; $62.50 for between 3,001 and 5,000 shares; $112.50 for 5,001 to 10,000 shares, plus $62.50 for each additional 10,000 shares or portion thereof), or the "assumed par value method" ($250 per million of assumed par value), with a $35 minimum and $165,000 cap.

The Illinois franchise tax applies only to corporations. For entities with more than about $200,000 paid-in capital allocable to Illinois, the corporate franchise tax will more than offset the filing fee differences and make the corporate form more costly.

Conversion to LLC to Eliminate Corporate Franchise Tax

Where an existing corporation is incurring substantial franchise tax, consideration should be given to converting it to an LLC to eliminate the franchise tax. The conversion could be effected by forming a new LLC and merging the corporation into it. A check-the-box election to treat the new LLC as a corporation for income tax purposes (described further below) is generally advisable to make the conversion tax-free for income tax purposes (as a reorganization under IRC õ368(a)(1)(F)). Absent the election, the LLC would likely be disregarded or classified as a partnership, causing the conversion to be viewed as a taxable liquidation of the corporation, with the tax on the gains at the corporate and stockholder levels being potentially catastrophic. However, if the corporation is a wholly-owned subsidiary of a parent corporation, conversion to a disregarded LLC could generally be accomplished as a tax-free liquidation under IRC õ332.

Franchise Tax on Foreign Corporate Members of LLC

Where a foreign corporation is a member of an LLC doing business in a state, consideration should be given to whether the foreign corporation is considered to be transacting business in the state through the LLC and thereby brought within the state's corporate franchise tax. In illinois a foreign corporate member an llc operating in illinois does not appear automatically deemed to be doing business in illinois through the LLC However, the corporation could be considered doing business in Illinois as a result of its own activities on behalf of the LLC, such as if it opens an office in illinois to manage the business.

Texas Franchise Tax

Previously, Texas imposed a franchise tax on both corporations and LLCs (but not partnerships) that were doing business in texas The tax was the larger of two components: a tax on net taxable capital similar to a traditional capital-based franchise tax, and an earned surplus tax similar to an income tax. Since the tax did not apply to partnerships, it was common to conduct operations in texas through a limited partnership

Effective for reports due on or after January 1, 2008, this tax has been replaced by a "franchise margin tax." See Tex. Tax Code Ann. õõ171.001 et seq. (eff. 2008). The base has been broadened to generally include partnerships, as well as LLCs and corporations (with exemptions for passive entities and general partnerships among individuals). The new tax is imposed on the lesser of (i) 70% of total revenue and (ii) a marginal income figure. In general, given the broader applicability of the new franchise margin tax to all types of entities, such tax should become less of a factor in choosing the type of entity to use in Texas, making LLCs more popular there.

Income Tax Classification and Compliance

In General

For federal income tax purposes, business entities, including LLCs, are classified under the check-the-box regulations, Treas. Reg. õõ301.7701-1, -2 and -3. See Littriello v. U.S. , 95 AFTR2d 2005-2581 [1], rehearing denied, 96 AFTR2d 2005-5764 (D.C.Ky. 2005) (regulations upheld as valid, although taxpayer has appealed to 6th Circuit). Certain entities, such as corporations organized under the corporate statutes and insurance companies, are per se classified as corporations. All other entities, including LLCs, are eligible to elect their classification, and are thus referred to as "eligible entities."

Under the check-the-box regulations, a domestic LLC with a single owner member ("SMLLC") is disregarded as separate from its owner as the "default" classification, unless the owner files IRS Form 8832 with the Internal Revenue Service to affirmatively elect to classify it as a corporation. A disregarded LLC owned by an individual is classified as a sole proprietorship of the individual, reportable on Schedule C of the individual's Form 1040 (if it operates a business). A disregarded LLC owned by a corporation is treated as a direct operating division of the corporation, and rolled up into the corporation's Form 1120 or 1120S tax return. A disregarded LLC owned by a partnership is treated as a direct operating division of the partnership, and rolled up into the partnership's Form 1065 tax return. It should be noted, however, that for collection, employment tax, and excise tax purposes, an otherwise disregarded SMLLC may be respected and treated as a separate entity.

If a domestic LLC has more than one owner, then it is classified as a partnership for federal income tax purposes as the "default" classification, unless corporate classification applies as discussed in the next paragraph. An LLC classified as a partnership does not pay federal income tax but files a Form 1065 tax return to report its income, and reports its member partners' shares of its items of income, gain, loss, deduction, and credit to them on Form 1065 K-1s.

A domestic LLC can be classified as a corporation as a result of (i) an affirmative election to treat it as such on IRS Form 8832, or (ii) public trading of membership interests in the LLC under IRC õ7704. Further, an LLC classified as a corporation can elect to be taxed as an S corporation under Subchapter S of the Internal Revenue Code if it meets the definition of a "small business corporation," and it and all the members elect S status on IRS Form 2553. In that case, it would generally not pay federal income tax but would file a Form 1120S tax return to record its income, and provide each member stockholder with a Form 1120S K-1 showing his or her share of its items of income, gain, loss, deduction, and credit.

Absent an S election, an LLC classified as a corporation is generally taxed under Subchapter C of the Internal Revenue Code as a regular C corporation, and files a Form 1120 tax return and pays the tax due thereon. It would generally report dividends paid to individual stockholders on IRS Form 1099.

Foreign Eligible Entities

In general, the classification of foreign eligible entities is determined at the time its classification becomes relevant for federal tax purposes. Certain foreign corporate-type entities are classified as per se corporations. For a foreign eligible entity, default classification turns on whether the members have limited liability. If all members have limited liability, then corporate classification is the default classification. If at least one member has unlimited liability, the default classification is a partnership if the LLC has at least two members, or a disregarded entity if it has only one member. Like domestic eligible entities, foreign eligible entities can file Form 8832 to adopt a classification other than their default classification.

A foreign entity may be classified one way under U.S. tax laws and a different way under the foreign country's tax laws. These are known as "hybrid" entities, and a substantial amount of tax planning revolves around hybrid entities. One example of a hybrid entity is a Nova Scotia Unlimited Liability Company, which is treated as a corporation under Canada tax laws but is a disregarded entity or partnership under U.S. tax laws (absent a corporate election). Another example of a hybrid entity is a foreign partnership which is treated as such under the tax laws of the foreign country, but for which a check-the-box election is made to treat it as a corporation for u.s tax purposes.

Pre-existing Eligible Entities

The default classification for eligible entities in existence prior to the November 29, 1999, effective date of the check-the-box regulations is the classification that they claimed immediately prior thereto (except that any single member LLC previously treated as a partnership is treated as a disregarded entity).

Husband-Wife Ownership

In the case of an LLC (for which a check-the-box election has not been made to treat it as a corporation) owned by a husband and wife as community property under the marriage laws of a state, foreign country, or U.S. possession, the spouses can choose to treat the LLC as either a disregarded entity or as a partnership, and the IRS will accept either position. Rev. Proc. 2002-69, 2002 C.B. 831.

Tiered Structures

Despite the seeming simplicity of the check-the-box scheme, some tiered ownership structures can raise difficult questions. In Rev. Rul. 2004-77, 2004-31 I.R.B. 119, the Service ruled that an eligible entity that has two members under local law, one of which is a disregarded entity for federal tax purposes that is owned by the other member, is considered to have a single owner, and is therefore disregarded unless an election is made to treat it as a corporation.

Example (1). X, a corporation, is the sole member of M LLC, and N is a partnership or LLC owned by X and M. Assuming M is disregarded, X is treated as the sole member and owner of N. Accordingly, both M and N are disregarded as separate from X under the default treatment.

Example (2). Suppose T is a grantor trust owned by two grantor/beneficiaries, A and B, and T is the sole member of M LLC under state law, and M owns property P.


This could be analyzed in either of two ways. Under a top down approach, A and B could be treated as owners of the trust corpus, which is the M membership interest, causing M to have two owners, A and B. In that case, M cannot be disregarded, and is a partnership between A and B unless an election is made to treat it as a corporation.

Under a bottom up approach, M could be viewed as owned solely by T, therefore causing M to be viewed as a disregarded SMLLC and effectively rolled up into T. T would be treated as owning the property P as the trust corpus. A and B would in turn be treated as owning the underlying property P as co-owners or tenants in common. Such co-ownership could be treated as mere co-ownership, or perhaps classified as a partnership depending how active A and B are in the ownership and management of property P. It is not entirely clear which approach applies.

Illinois Classification

Illinois generally follows the federal classification of an llc for illinois income tax purposes 35 ILCS õõ5/102, and 5/1501(a)(4) and (16); Ill. Dep. Rev. Reg. õõ100.4500(a)(3)(A) and 100.9750.

Election out of Subchapter K

Under IRC õ761(a) and Treas. Reg. õ1.761-2, an unincorporated organization may elect to be excluded from Subchapter K if it is availed of for investment purposes only and not for the active conduct of a business ("investment partnership"), or for the joint production, extraction or use of property, but not for the purpose of selling services or property produced or extracted ("joint operating agreement"), and certain other conditions are met. Under the election, Subchapter K does not apply, and the members compute and reflect their items of income individually as co-owners. Moreover, although partnership interests generally cannot be exchanged tax-free under IRC õ1031, if a valid election is made under Treas. Reg. õ1.761-2, the members may treat their interests as interests in each of the underlying assets and thus as eligible for IRC õ1031 exchange rollover. However, for other purposes outside of Subchapter K and IRC õ1031, such as for self-employment tax purposes, the electing partnership remains a partnership.

One of the conditions for making the Treas. Reg. õ1.761-2 election is that the participants own the underlying property as coowners. Because of this requirement, it is doubtful whether an LLC can make the election. See Rev. Rul. 2004-86, 2004-33 I.R.B. 99 ("because the assets of Delaware Statutory Trust will not be owned by the beneficiaries as coowners under state law, DST will not be able to elect to be excluded from the application of subchapter K"); Notice 2004-53, 2004 I.R.B. 209 (Service soliciting comments on circumstances under which participants should be treated as owning the property as coowners in order to be able to elect out of Subchapter K).

Income Tax Rates for Different Classifications

Disregarded Entity versus S or C Corporation

A single member LLC can be classified as either a disregarded entity or a corporation. If it is a disregarded entity, its items of income, gain, loss, deduction, or credit are reflected on the owner's tax return. If it is a corporation, then its items of income, loss, deduction or credit are reflected on its corporate tax return (Form 1120 or 1120S). If the corporation is a C corporation, then the income is taxed at the entity level. However, if the corporation is an S corporation, the income flows through and is taxed to the owner stockholder.

Example (3). Individual A is the sole member of LLC M. M has $100 of ordinary income during the year, which is distributed to A (net of any taxes on M). Tax is determined at highest federal and state rates on ordinary income.


Disregarded Entity

S Corporation

C Corporation

Pre-Tax Operating

Income

$100

$100

$100

Entity Level Taxes

IL PPR Income Tax

IL Reg Inc Tax (4.8%)

Fed Inc Tax (35%)

Total

$1.5

$1.5

$2.5

$4.8

$32.45

$39.75

Distribution to A

$100

$98.5

$60.25

Taxes on A

On Operating Income

IL (3%)

Federal (35%)

On Distribution

IL (3%)

Federal (15%)

Total

$3

$33.95

$36.95

$3

$33.95

$36.95

$1.81

$8.77

$10.58

Net to A after Taxes

$63.05

$61.55

$49.67

As can be seen from this table, the disregarded format is the best. It is a little better than the S corporation since Illinois imposes a 1.5% income tax at the corporate level on S corporations. The C corporation format is by far the worst, and note that the results would be even worse if the current 15% rate on dividends in increased.

Partnership or S Corporation versus C Corporation

An LLC with two or more members can be classified as a partnership or C or S corporation. Income taxation as a partnership or S corporation is similar (aside from differences relating to allocations, liabilities, and distributions), and less burdensome than taxation as a C corporation.

Example (4). Individuals B and C are members of LLC N. N has $100 of ordinary income during the year, which is distributed to B and C (net of any taxes on N). Tax is determined at highest federal and state rates on ordinary income.

Partnership

S Corporation

C Corporation

Pre-Tax Operating

Income

$100

$100

$100

Entity Level Taxes

IL PPR Income Tax

IL Reg Inc Tax (4.8%)

Fed Inc Tax (35%)

Total

$1.5

$1.5

$1.5

$1.5

$2.5

$4.8

$32.45

$39.75

Distribution to B and C

$98.5

$98.5

$60.25

Taxes on B and C

On Operating Income

IL (3%)

Federal (35%)

On Distribution

IL (3%)

Federal (15%)

Total

$3

$33.95

$36.95

$3

$33.95

$36.95

$1.81

$8.77

$10.58

Net to B and C after Taxes

$61.55

$61.55

$49.67

Here, partnership and S corporation classification come out the same because Again, both are far better than C corporation classification.

Low-Bracket Income Spreading Strategies

An individual already in a high tax bracket due to income from existing sources might consider setting up a new income-generating business as a C corporation so that the income from that business can be taxed in the C corporation's lower rate brackets. The current rate brackets for C corporations is as follows:

Marginal Tax Rate

Income Bracket

15%

$0-$50,000

25%

$50,000-$75,000

34%

$75,000-$100,000

39%

$100,000-$335,000

34%

$335,000-$10,000,000

35%

$10,000,000-$15,000,000

38%

$15,000,000-$18,333,333

35%

$18,333,333 and up

However, a number of factors make this strategy difficult to profit from in practice. First, the C corporation rates quickly approach the 35% maximum federal rate for individuals, so the lower C corporation rates could cover only small amounts of income. Second, most states tax C corporations at higher rates than individuals (in Illinois, 7.3% versus 3%). Third, the individual must pay a second tax on realizing the earnings personally through a dividend or stock sale or redemption (unless the stock is held until death and a tax-free basis step-up is achieved, or the stock is donated to charity), so the strategy really only works if income is retained. Fourth, retention of the earnings to defer the double tax means that even a corporation that was small originally will eventually push into the higher brackets. Fifth, special rates or taxes apply to personal service corporations, IRC õ11(b)(2), and personal holding companies, IRC õ541. Finally, there are the filing fees, franchise taxes, and other costs associated with setting up the entity (although these costs (other than franchise taxes) would be incurred in setting up an LLC to achieve limited liability anyway).

Another strategy that is more promising is to spread the income among other family members in lower rate brackets, by setting up the business in an LLC in which they have interests. The benefit is that their shares of the income would be taxed in their lower brackets. If the LLC is supposed to be classified as a partnership for tax purposes, the family partnership limitation in IRC õ761(e) and related principles must be considered. Since the applicability of those doctrines to family S corporation stockholders is less apparent, it might be advantageous to implement this strategy by electing S corporation status. The so-called "kiddie tax," under which a child under age 14 is taxed at his or her parents' marginal rate on his or her unearned income in excess of a threshold amount (generally, $1,700 in 2006, increased by inflation), may limit this strategy. This strategy could also be coupled with estate planning strategies to minimize estate and gift taxes and provide for succession.

The same analysis applies where there are multiple unrelated owners participating in the business. Spreading the income among all their separate tax brackets may result in lower tax rates than if it were taxed in a single C corporation return. See generally, Goodman, Employing a Corporation and Other Strategies to Reduce Taxes, 72 TAXES 174 (April 1994).

Differing Tax Treatments of Partnership and S Corporation Transactions

The common law and early partnership laws viewed partnerships as an aggregate of the partners with no separate legal existence, much like co-owners of property. This aggregate view informed the income tax treatment of partnership. Partners were not regarded as separate taxable entities and the partners were taxed on their share of the income as if earned directly. Although the Code now treats partnerships as separate entities in many respects, the aggregate theory continues to have considerable force. As a result, to a large extent partners are treated much as though they engaged in the partnership's activities directly and incurred and realized the underlying tax items directly. See Goodman, Corporate and Partnership M&A Tax Laws: Is it time to Merge Subchapters C and K?, 95 Tax Notes 1497 (June 3, 2002).

By contrast, in keeping with the state corporation laws, the tax law treats corporations as separate and distinct from their shareholders. Although items of S corporations pass through to their stockholders, this occurs more as a result of statutory assignment of the items to them than any fundamental theory that they incur or realize the items in any direct sense.

The aggregate approach to partnerships leads to different tax results in a number of areas than the separate entity approach to S corporations. Similarly, for a SMLLC, disregarded classification results in direct ownership, versus separate entity treatment if S corporation status is elected. Direct ownership or aggregate treatment produces more favorable tax consequences than S corporation classification in some contexts, less favorable in others, as seen below.

Treatment of Indebtedness

One area where direct ownership or aggregate treatment under partnership or disregarded LLC classification produces more favorable tax results than S corporation status is where there is outside financing of the business. In the case of an entrepreneur, including one operating through a disregarded SMLLC, loan proceeds are not includible in income, and to the extent invested in property, create tax basis and generate direct deductions. In the case of a partnership, borrowings by the partnership are in effect treated as borrowings by the partners, by being included in their outside basis in their partnership interests. This both allows deductions from the debt to pass through to the partners, and for loan proceeds to be distributed tax-free, as if the partners incurred the debt directly themselves.

By contrast, in the case of an S corporation, borrowings by the corporation are not treated as borrowings by the stockholders and do not increase the stockholders' outside tax basis in their stock. As a result, S corporation losses financed by such debt cannot pass through to the S corporation stockholders. Moreover, a distribution of loan proceeds may generate capital gain to the stockholders. Thus, the likely use of debt financing, at the outset or in the future, may point towards disregarded entity or partnership classification rather than election to be an S corporation.

Debt-Financed Name Loss Type Pass Through. Example (5). Individual A forms a new SMLLC M with a capital contribution of $100. M borrows $1,000 from independent Bank and generates a loss of $250 in the first year. The following table shows the extent to which M's $250 loss will flow through to A and be deductible on A's personal return (subject to at-risk, passive loss, and other possible limitations), depending on the classification of M:

A's Deduction if M classified as

Disregarded

S Corp

C Corp

$(250)

$(100)

$0

In the S corporation case, A could increase the loss pass through by borrowing the $1,000 from Bank him or herself, and then contributing or loaning the money to M. In that case, the full $250 loss will pass through to A.

Example (6). The facts are the same as in Example (5), except that B joins A and they together form new LLC M with a capital contribution of $50 each. M borrows $1,000 from independent Bank and generates a loss of $250 in the first year. The following table shows the extent to which M's $250 loss will flow through to A and B and be deductible on their personal return (subject to at-risk, passive loss, and other possible limitations), depending on the classification of M:

A's and B's Total Deduction if M classified as

Partnership

S Corp

C Corp

$(250)

$(100)

$0

In the S corporation case, again, A and B could increase the loss pass through by borrowing the $1,000 from Bank themselves, and then contributing or loaning the money to M. In that case, the full $250 loss would pass through to them.

Debt-Financed Distributions. Example (7). Years ago, individual A contributed $100 to then newly-formed LLC N which purchased some vacant land. The land has appreciated in value to $1,000. A would like to get some cash out and to that end, has N borrow $500 against the land and distribute to A. If N is a disregarded entity, then A is treated as receiving the loan proceeds directly, which are tax-free. If N is an S or C corporation, the $500 distribution would return A's $100 basis in the stock tax-free, and the $400 balance of the distribution would be capital gain. The taxation of A's receipt of the $500 loan proceeds are summarized as follows:

A's Taxable Income if N classified as

Disregarded

S Corp

C Corp

Tax-Free

$400

$400

In the corporation cases, A might be able to avoid the tax by borrowing him or herself against the stock, but that may be problematic.

Example (8). The facts are the same as in Example (7), except that A and B take the place of just A and together contributed a combined $100 to M. In that case, if M is a partnership, the $1,000 borrowing is allocated to A and B and increases their outside bases in their M partnership interests by $1,000, allowing them to receive the entire $500 distribution as a tax-free return of capital. The corporate results are the same as above.

A's and B's Total Taxable Income if M classified as

Partnership

S Corp

C Corp

Tax-Free

$400

$400

Debt Assumptions. The direct ownership and aggregate approaches under disregarded SMLLC and partnership classification produce more favorable tax results than separate entity S corporation treatment on an assumption of debt by the LLC as well. Assumptions of debt are common in the context of transferring an existing business to a new LLC. A disregarded SMLLC's assumption of a debt of its owner is a nonevent for tax purposes. An LLC partnership's assumption of debt of a partner is a nonevent to the extent the debt remains allocated to that partner, although it is treated as a distribution to the extent the debt is allocated to other partners. But an S corporation's assumption of a stockholder's debt in excess of the basis of the property contributed is generally treated as a taxable boot distribution. Thus, the extent of gain recognition upon transferring a business to an LLC may depend on the classification of the LLC.

Example (9). A incurs $100 debt to purchase depreciable property. After the tax basis has been depreciated to $20, A contributes the property subject to the $100 debt to SMLLC M. If M is disregarded, the transaction has no income tax consequences. However, if M is a C or S corporation, A must recognize $80 gain under IRC õ357(c), being the excess of the $100 debt assumed by M over A's $20 basis in the contributed property.

A's Taxable Income if M classified as

Disregarded

S Corp

C Corp

Tax-Free

$80

$80

Example (10). The facts are the same as in Example (9) except that A contributes the property to new LLC M in exchange for M's assumption of the $100 nonrecourse liability and a 50% interest in M, while B contributes $50 cash in exchange for the other 50% interest. Implicitly, the property is valued at $150 on a gross basis. The debt assumption is assumed not to be a tax avoidance or deemed sale transaction under IRC õõ357(b) or 707(a)(2)(B). $80 of the debt (equal to the built-in gain that would be allocated to A under IRC õ704(c) if the property were disposed of solely in satisfaction of the debt) would be allocated to A, and it is assumed the remaining $20 of debt would be allocated 50/50 between A and B. A is thus allocated $90 of the debt, and is considered relieved of only $10 of debt. Since A had a $20 basis in P, A can absorb the $10 debt relief and recognizes no gain on the transaction.

If M is an S or C corporation, A has the same $80 taxable gain under IRC õ357(c) as in Example (9). The results are as follows:

A's Taxable Income if M classified as

Partnership

S Corp

C Corp

Tax-Free

$80

$80

Transfers of Interests

Another area where the direct ownership and aggregate approaches for disregarded and partnership LLCs produce different tax results than separate entity corporate status is on transfers of interests. Here, disregarded or partnership classification may or may not produce the most favorable tax consequences, depending on the circumstances.

Under the separate entity approach to corporations, a sale of stock (membership interest in electing LLC) does not affect a C or S corporation's inside basis in its assets (unless the purchaser is another corporation and a IRC õõ338(g) or 338(h)(10) election is made). Nor can a sale of corporation stock cause a C or S corporation to terminate as an entity (although a sale to a nonqualified S corporation shareholder would terminate the S election). The stock buyer simply takes a tax basis in the shares equal to the purchase price.

The stock seller generally realizes capital gain or loss. Under the only look-through rule currently in effect for stock sales, gain on a sale of S corporation stock is, to the extent attributable to collectibles held by the S corporation, treated as 28% collectibles gain. See IRC õ1(h)(5); Treas. Reg. 1.1(h)-1. Under IRC õ341 (currently repealed, but set to become effective again with the sunsetting of the repeal after 2008), gain on C or S corporation stock is recharacterized as ordinary income if the corporation is a collapsible corporation, meaning it is availed of to avoid ordinary income on certain types of underlying constructed ordinary assets.

The aggregate approach to partnerships in this area leads to much different, and in many cases less favorable, results. On the seller's side, although the seller's gain or loss on a sale of a partnership interest is generally characterized as capital gain or loss, broad look-through rules apply, as discussed below. To the extent there is capital gain, unfavorable holding period rules can cause a disproportionately large percentage of the capital gain to be treated as short-term capital gain if the seller has made any contributions to the partnership within one year of the sale. See Treas. Reg. õ1.1223-3.

Under broad look-through rules, amounts realized from the sale of a partnership interest that are attributable to unrealized receivables and inventory items of the partnership are treated as an amount realized from the sale of a noncapital, ordinary asset. IRC õ751. In addition, capital gain on a sale of an interest which is attributable to collectibles or real estate depreciation recapture is subject to the 28% and 25% rates applicable to such types of gain, respectively. IRC õ1(h)(5). This aggregate approach applies only to hit the seller with ordinary income.

By contrast, on a sale of a partnership interest at a loss, the sale produces an unfavorable capital loss, even if the partnership has underlying ordinary loss property - the aggregate approach is not applied in the taxpayer's favor to characterize the loss as ordinary in part based on the partnership's underlying assets. Ordinary loss is obtainable only by having the partnership sell the underlying ordinary loss assets.

On the purchase of a partnership interest, the partnership can elect under IRC õ754 to adjust the buyer's share of the inside asset basis to reflect the amount paid for the interest. The effect is much as though the buyer purchased a direct share in the underlying assets. If the buyer purchases at a gain to the seller, the buyer will benefit from a step-up in his or her share of underlying asset basis. However, if the 754 election is in effect, a buyer who purchases at a loss to the seller will suffer a step-down in basis. In addition, to prevent duplication of loss on a sale of an interest in a partnership having a substantial built-in loss (tax basis exceeding value of assets by more than $250,000), a step-down in the buyer's share of inside basis in underlying assets is now required even if a 754 election is not in effect. See IRC õ741(b).

Finally, a sale or exchange of more than 50% of the capital and profits interests in a partnership within a 12-month period will terminate its existence for income tax purposes, and assuming it continues to exist with at least two partners, cause it to be considered a new partnership. This is to some extent an aggregate concept. Although the termination and new formation is generally not a taxable transaction, it would close the partnership's tax year, potentially restart depreciation over longer recovery periods, and have other adverse consequences under certain circumstances.

Other Income Tax Differences

A number of other differences exist in the tax treatment of entrepreneurships, partnerships, S corporations, and C corporations as well. In some cases, the differences could be partially explained as resulting from an aggregate approach to partnership and entity approach to corporations. Very briefly, some other commonly encountered differences are as follows:

  • On formation, a contribution of appreciated property to a corporation (whether S or C) in exchange for stock is tax-free only if the property transferors as a group are in "control" of the transferee corporation immediately afterwards, meaning they own 80% of the voting stock and 80% of each class of nonvoting stock. IRC õ351. By contrast, any contribution of property to a partnership for an interest therein is generally tax-free under IRC õ721, even if the property transferor(s) have only a small interest in the partnership afterwards - there is no "control immediately after" requirement. This makes it easier to use partnership interests as a tax-free acquisition currency.
  • Partnerships can generally be liquidated on a tax-free basis, while liquidation of a corporation triggers gain or loss recognition at the corporate level on all its assets as well as at the stockholder level on all their stock. This is true of an S corporation as well, although there would be only one level of tax.
  • A business can be acquired on a tax-free basis by an unrelated corporation much more easily if it is classified as a corporation than if it is a partnership. The tax-free reorganization rules under IRC õ368 apply only to combinations of corporations. IRC õ368 does not require that the acquired target corporation's stockholders own "control" of the acquiring corporation afterwards. Thus, a large corporation can acquire a much smaller corporation on a tax-free basis under those rules. If the acquired entity is a partnership, IRC õ368 does not apply. The transaction is viewed as a contribution of the LLC's business to the acquiring corporation, which can only be done tax-free under IRC õ351, which requires the LLC owners to own "control" of the acquiring corporation afterwards. Thus, if the exit strategy for a business is a tax-free acquisition by a large corporation, at some earlier time the business would need to be set up as a corporation to enable that to happen.
  • Only a corporate purchaser can make an IRC õõ338(g) or 338(h)(10) election on the purchase of the stock of another corporation. Thus, if corporation is to be acquired with a 338(g) or 338(h)(10) election, the acquiring entity must be classified as a corporation, including an LLC for which a check-the-box election is made.
  • The rules governing equity-based compensation (options, restricted stock, etc.) are more highly developed and certain for corporations than they are for partnerships. See Rev. Procs. 93-27 and 2001-43; Prop. Reg. õõ1.83-3(e) and (l); õ1.721-1(b). Thus, if equity compensation is to be used, partnership classification may entail more complexity and uncertainty.
  • There may be differences available with regard to availability of pension plans, fringe benefits, etc.

George R. Goodman, grgoodman@foley.com, is of counsel in Foley's Tax & Employee Benefits Practice. He is also a member of the firm's Tax, Valuation & Fiduciary Litigation and Insurance Practices, as well as the Life Sciences and International Business Industry Teams. He principally advises clients on the structure and tax aspects of transactions, investments, and business organizations. His broad experience includes mergers and acquisitions, consolidated returns, tax-free spin-offs and other tax-efficient asset dispositions, partnerships, real estate, international transactions, financial products, venture capital investments, tax-sharing arrangements, and insolvency work-outs. His clients include business enterprises, investment funds, exempt organizations, and individuals. Mr. Goodman is vice-chair of the Corporate Taxation Division of the Chicago Bar Association and is a member of the American Bar Association. He speaks and writes frequently on tax-related topics, and has served as an editorial advisor to the AICPA's The Tax Advisor magazine.

Foley & Lardner LLP is a highly regarded, national law firm providing client-focused, interdisciplinary services that result in high-value legal counsel for their clients. Their practice areas encompass the full range of corporate legal services, including corporate governance and compliance, securities, mergers and acquisitions, litigation, labor and employment, intellectual property and IP litigation, and tax. Their attorneys are recognized as insightful thought leaders on these and many other of today's most complex business issues.Through their innovative industry team approach, they strategically blend relevant services with first-hand industry experience. Their unique approach enables them to provide comprehensive, tailored solutions to their clients based upon the needs of their respective industry.

[1] The Littriello District Court decision was affirmed in April 2007 by the Sixth Circuit