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Reviewing Partnerships, and Corporations

A. Johnson

Reyte On Publishing
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The choice of business entity is one of the many difficult tasks facing a business owner. This is

so because the appropriate choice depends on many factors which can change as the business

progresses through its life cycle. Changes to the tax and legal environment may also

significantly affect the most desirable form of doing business.

Perhaps the most frequently mentioned factors in the choice-of-entity game are liability

protection for the owners and tax minimization. These factors have led to the explosion in the

use of limited liability companies (LLCs) and limited liability partnerships (LLPs).

Partnership

Partnership tax law allows for certain flexibility not available in an S corporation. For example,

the result effect on appreciated property may generally be distributed free of tax. From this S

corporations recognize there is a gain this type of distributions, partners can then increase the tax

basis of their interests. This increase is used for determining whether distributions are taxable,

for third-party borrowings. With S corporation, this in not allowed by owners. Partnerships have

the added advantage of allocating items of taxable gain and lose disproportionately. They can, if

a complicated test is satisfied, allocate items of taxable gain and loss disproportionate to

ownership interests. Again S corporations are allowed this taxable ability.

Partnerships may also offer certain estate tax benefits. For example, it is arguable that greater

valuation discounts may be obtained when a limited partnership interest, rather than corporate

stock, is transferred to children. Also, when an interest in a partnerships is obtained by

inheritance, it is possible to adjust the basis of assets of the partnership to the date-of-death value

of the partnership interest. Although stock in a corporation will obtain a basis adjustment if

received by reason of death, it is not possible to also pass that adjustment through to the basis of

the assets held by the corporation.

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LLC, LLP, and Partnership

LLC statutes shield the owners or members from any liability by reason of being a member of

the entity. However, each member may incur liability by other means such as a loan surety. LLP

statutes offer similar protection, although the partners may not be shielded from contract claims

against the entity. Because LLCs and LLPs are relatively new, it is not clear how state laws will

deal with conflicts between owners, and conflicts between owners and third parties (Andersen,

2004).

Both LLCs and LLPs will be taxed as partnerships provided there are at least two owners. New

Mexico has informally announced that it will follow the federal income tax classification of these

entities. Some states such as New Mexico allows for a one-member LLC, and the tax law

generally treats a one member LLC as a proprietorship or individual owner or a corporate owner

so that there is no separate income tax filing required for such an entity, though separate gross

receipts filings may be necessary (Andersen, 2004).

One-owner LLCs may be used to offer added protection from liability while maintaining a

simple tax structure. For example, a corporation could use a one- member LLC to segregate a

risky, activity from other corporate assets while maintaining single-entity tax treatment. This

result is similar to that which would be obtained with a subsidiary corporation without the need

to be concerned with consolidated tax regulations or the need to make a special election for a

wholly owned S corporation subsidiary.

FLP Family Limited Partnership

It has bee noted over the last few years that a new business structure namely a Family Limited

Partnership or (FLP) that has been growing among small businesses. This formation reduces
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estate tax and allows some control over partnership assets. The definition of partnership is "a

syndicate, group, pool, joint venture, or other unincorporated organization through or by means

of which any business, financial operation, or venture is carried on, and which is not, within the

meaning of this title, a trust, estate, or corporation and the term partner includes a member of

such a syndicate, group, pool, joint venture, or organization” according to the Internal Revenue

Code, Section 7701(a)(2).

Family members can make financial contributions and/or offer services that can be construed as

partnership standing. In the case of a FLP, the participant has to pass the “assignment-of-income

principle" requirement in order to be viewed as a partner according to the IRS code (MacCrate &

McEvoy, 2000).

C Corporation

Corporations also offer a liability shield for the owners, although regular ("C") corporations may

expose corporate earnings to two levels of tax - one at the corporate level and another when the

earnings are distributed to the shareholders. Two levels of tax can be avoided by making an

election to treat the corporation as a S corporation. This choice can now more simply be made

following changes to tax law since the 1996 Tax Act. Which changed the along with several

other things, to expand the type of shareholders that the entity may have and also allow for

ownership of subsidiaries. S corporations may now have an employee stock ownership plan as a

shareholder without the plan being subject to a tax on unrelated business taxable income

(Andersen, 2004).

S Corporation

The ability to own subsidiaries makes it easier to structure a tax-free acquisition involving an S

corporation and to isolate risky activities in a separate entity. If the subsidiary is also an S
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corporation, a special election must be made that has the effect of disregarding the entity for tax

purposes. The entity still exists for state law purposes but its income is reported as a division of

the parent S corporation (Andersen, 2004). An S corporation could own a one-member LLC as

an alternative to the S subsidiary. The IRS has issued helpful administrative guidance regarding

how to implement recent S corporation changes.

By limiting the amount of compensation paid to shareholder-employees, S corporations may,

within limits, reduce payroll tax liabilities. In contrast, a general partner is subject to self-

employment tax on all trade or business earnings of the partnerships. Limited partners pay SE tax

only on guaranteed payments for services. In theory, non-managing members of an LLC should

be subject to the SE tax rules applicable to limited partners. In practice, it is not clear how

members of an LLC will determine their SE tax liabilities. Committee reports accompanying the

1997 Tax Act suggest that the Senate will clarify the SE tax treatment of LLC income

(Andersen, 2004).

The myriad of factors affecting choice of entity and the dynamic nature of that choice during the

life cycle of a business suggest the need to regularly consult with your tax advisor to ensure that

the appropriate choice is made and that, once made, the maximum benefits arc realized.
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References

Andersen, B. L. (2004). Benefit Issues Regarding Partnerships, S Corporations, and Sole

Proprietorships. Journal of Pension Benefits.

MacCrate, J. R. & McEvoy, J. (2000). Family Limited Partnerships, Corporations, and Valuation

Issues. Retrieved October 13, 2009 from http://www.accessmylibrary.com/coms2/summary_0286-

28180511_ITM
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References

Hamill, J.R. (1998). "The ABCs of LLCs, LLPs, Ss and Cs.(limited liability companies; limited
liability partnerships; S corporations; corporations)." New Mexico Business Journal. 1998.