US Income
Choice of Entity (700 - 2nd)
Portfolio Description
Tax Management Portfolio, Choice of Entity, No. 700-2nd, discusses federal income tax and other considerations pertinent in choosing the most advantageous legal form for conducting business and investment activities. This Portfolio provides a summary perspective on 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.
The discussion in this Portfolio has been quite significantly impacted by the choice of entity or "check-the-box" regulations which were implemented in late 1996, effective January 1, 1997. These regulations permit much greater flexibility and far fewer impediments in the choice of a business entity.
A sole proprietorship is the simplest form of doing business since no separate legal entity needs to be created and no assets are required to be separately transferred to a distinct entity. All profits are immediately taxed to the proprietor, and the proprietor directly bears all the business risks associated with the operation.
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 as co-owners for profit. The partnership is itself not subject to federal income taxation. Rather, all the income, deductions, and 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 exposure for liabilities to the extent of their respective capital contributions (and obligations for contributions) to the partnership. This limitation on liability will exist because of the application of a limited partnership law enacted by a state legislature and not because of a provision of the federal income tax laws.
A corporation is a separate legal entity that ordinarily is itself immediately subject to federal income taxation on its earnings. When these earnings are distributed to the shareholders of the corporation, those shareholders are also taxed on the receipt of those corporate profits. None of the shareholders are personally liable for corporate obligations (assuming they have not independently agreed with some creditor to be liable for those obligations and that the corporation is correctly organized). Under some circumstances, however, a corporation can elect to be an "S corporation" for federal income tax purposes. This status enables the corporate level income to flow through and be taxed immediately to the shareholders, but not be taxed to the corporation itself, the "S" corporation merely being a conduit. Further, the corporate income is not taxed to the shareholders when subsequently distributed to them (since previously taxed to them when realized by the corporation).
An increasingly important alternative in this context is the limited liability company ("LLC") which is permitted under the laws of most states. This company permits the limitation of entity level liabilities as to all owners. The LLC is ordinarily treated as a partnership for federal income tax purposes, but it does not have many of the constraints that are imposed on S corporations.
A trust can also be used as an entity for holding investment assets, but not for the operation of a business (in which event it becomes a partnership or a corporation). 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 and the ownership units regularly traded on a securities exchange.
A comparison of the attributes of various taxable entities necessitates an examination of both (i) the legal and business structure and (ii) particularly for purposes of this Portfolio, the federal income tax rules applicable throughout the entire life cycle of these entities. Consequently, this Portfolio provides an expansive discussion of the various entity characterization rules of the 1996 "check-the-box" regulations. Further, this Portfolio includes 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 related issues, including estate planning considerations, are also examined in the latter portion of this Portfolio.
This Portfolio may be cited as Streng, 700-2nd T.M., Choice of Entity.
William P. Streng, Wartburg College (B.A., 1959); Northwestern University School of Law (J.D., 1962); Law Clerk to Honorable Lester L. Cecil, Chief Judge, U.S. Court of Appeals for the Sixth Circuit, 1963-1964; associated with Taft, Stettinius & Hollister, Cincinnati, Ohio, 1964-1970; Attorney-Advisor, Office of the Assistant Secretary for Tax Policy (Office of Tax Legislative Counsel), U.S. Dept. of the Treasury, Washington, D.C., 1970-1971; Deputy General Counsel, Export-Import Bank of the United States, Washington, D.C., 1971-1973; Professor of Law, School of Law, Southern Methodist University, Dallas, Texas, 1973-1980; Visiting Professor, College of Law, The Ohio State University, 1977; Haynes & Boone, Dallas, Texas (Of Counsel, 1977-1979); Bracewell & Patterson, Houston, Texas (partner, 1980-1985; consultant, 1985-); Professor of Law, University of Houston Law Center (1985-); Visiting Professor, New York University School of Law (1990); Distinguished Lecturer at the University of Hong Kong Law Faculty (1992); Fulbright Professor at the University of Stockholm Law Faculty, Stockholm, Sweden (1993); Visiting Fellow at the Victoria University Law Faculty, Wellington, New Zealand (1996); Lecturer, U.S. International Taxation, University of Leiden, The Netherlands (1997 & 1998). Member of American Law Institute (including its Tax Advisory Group), International Fiscal Association (including its council), International Academy of Estate and Trust Law, American Bar Association's Section of Taxation, Tax Management Advisory Board, and various other professional organizations.
Author: "Tax Planning for Retirement" (Warren, Gorham & Lamont, 1989), and supplements through 1998; 800 T.M. "Estate Planning" (Tax Management, 1997), and prior portfolio versions; "U.S. International Estate Planning" (Warren, Gorham & Lamont, 1996), and supplements through 1998; "International Business Transactions -- Tax and Legal Handbook" (Prentice-Hall, 1978); "Estate Planning -- Principles, Techniques and Materials" (Tax Management, 1981).
Co-author: Bittker, Emory & Streng, "Federal Income Taxation of Corporations and Shareholders -- Forms," 4th ed. (Warren, Gorham & Lamont, 1995, with supplements through 1998); Streng & Salacuse, "International Business Planning -- Law and Taxation," six volumes (Matthew Bender, 1982, 1985, 1986, and supplements through 1998); Gifford & Streng, "International Tax Planning" (Tax Management, 1979); and, "Doing Business in China," (Matthew Bender, 1990, and subsequent supplements).
