Federal Income Tax Considerations in the Choice of Business Entity

Copyright (c) 2005 Wilmer Cutler Pickering Hale and Dorr LLP. All rights reserved.

By Roger M. Ritt

I. Choices of Business Entity.

A. Sole proprietorship. In conducting a business as a "sole proprietorship", an individual (the "sole proprietor") typically segregates a portion of his or her assets and dedicates them to a specific business purpose. A sole proprietorship involves neither the creation of a new, separate entity nor the shifting of assets from one individual to another individual or entity.
 
B. C corporation. A "C corporation" is a separate legal entity, generally created pursuant to state or federal law, that is treated as a "corporation" for purposes of Subtitle A, Chapter 1, Subchapter C of the Internal Revenue Code of 1986, as amended (the "Code" or "I.R.C."), and that is not an "S corporation" (as defined below).
 
1. Under the Code, the term "corporation" generally is defined as including an association, a joint-stock company, and an insurance company. See I.R.C. § 7701(a)(3). n1
 
2. Under applicable Treasury Regulations (the "Regulations"), certain unincorporated business entities can elect to be classified as corporations for tax purposes. See Treas. Reg. §§ 301.7701-1, 301.7701-2, and 301.7701-3.
 
a. An eligible entity with at least two owners can elect to be classified as either a corporation or a partnership. See Treas. Reg. § 301.7701-3(a).
 
b. An eligible entity with a single owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner. See Treas. Reg. § 301.7701-3(a).
 
c. In the absence of an election, an eligible entity is classified under certain "default rules". See Treas. Reg. § 301.7701-3(b).
 
(1) A domestic eligible entity is a partnership if it has two or more members; or it is disregarded as an entity separate from its owner if it has a single owner. See Treas. Reg. § 301.7701-3(b)(1).
 
(2) A foreign eligible entity is a partnership if it has two or more members and at least one member does not have limited liability; a corporation if all members have limited liability; or disregarded as an entity separate from its owner if it has a single owner that does not have limited liability. See Treas. Reg. § 301.7701-3(b)(2).
 
d. Entities that are not eligible to elect their classification and that must be classified as corporations include:
 
(1) Any business entity organized under a federal or state statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic;
 
(2) Any business entity organized under a state statute, if the statute describes or refers to the entity as a joint-stock company or joint-stock association;
 
(3) Any insurance company;
 
(4) Any state-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act or a similar federal statute;
 
(5) Any business entity wholly owned by a state or any political subdivision thereof;
 
(6) Any business entity that is specifically taxable as a corporation under other provisions of the Code (e.g., a publicly traded partnership); and
 
(7) Certain foreign entities. See Treas. Reg. §§ 301.7701-2(b).
 
e. Certain entities are treated as having made an election (a "deemed election") to be classified as a corporation, including real estate investment trusts (REITs) and organizations exempt under § 501(a). See Treas. Reg. § 301.7701-3(c)(v).
 
3. Section 1361(a)(2) of the Code states that the term "C corporation" means, with respect to any taxable year, a corporation which is not an "S corporation" for such year.
 
C. S corporation. An "S corporation" is a "small business corporation" for which a valid election under Section 1362(a) of the Code is in effect for the taxable year. I.R.C. § 1361(a)(1).
 
1. In general, a "small business corporation" is a domestic corporation that does not:
 
a. Have more than 100 shareholders (with members of a family considered as a single shareholder);
 
b. Have as a shareholder a person (other than certain estates, trusts, or tax-exempt entities or, under certain circumstances, an S corporation) who is not an individual;
 
c. Have as a shareholder a nonresident alien; or
 
d. Have more than 1 class of stock (except as to differences in voting rights among shares of common stock). See I.R.C. § 1361(b)(1) and (c).
 
2. Certain corporations, however, are ineligible for treatment as S corporations. Such corporations include:
 
a. Certain banks and other financial institutions;
 
b. Certain insurance companies;
 
c. Corporations to which an election under Section 936 of the Code (relating to the Puerto Rico and possessions tax credit) applies; and
 
d. Domestic international sales corporations ("DISCs") or former DISCs. See I.R.C. § 1361(b)(2).
 
D. General partnership. A "partnership" is generally an association of two or more persons to carry on as co-owners a business for profit. See Uniform Partnership Act ("UPA") § 101(6). n2
 
1. Under the Code, the term "partnership" generally is defined as including 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 a corporation, trust, or estate. See I.R.C. § 761(a). See also I.R.C. § 7701(a)(2).
 
2. Under the Regulations, certain unincorporated business entities can elect to be classified as partnerships for tax purposes. See Treas. Reg. §§ 301.7701-1, 301.7701-2, and 301.7701-3. See also Section I.B.2, above.
 
E. Limited partnership. In general, a "limited partnership" is a partnership formed by two or more persons under state law and having one or more general partners and one or more limited partners. See Uniform Limited Partnership Act ("ULPA") § 1. See also Revised Uniform Limited Partnership Act ("RULPA") § 101(7).
 
F. Limited liability company. In general, a "limited liability company" is an unincorporated association, without perpetual duration, usually having two or more members, and having been organized under state law, where permitted.
 
1. Limited liability companies are hybrid entities that combine certain attributes of the corporate form with certain attributes of the partnership form.
 
2. Under the Regulations, limited liability companies generally can elect to be classified as either corporations or partnerships for tax purposes. See Treas. Reg. §§ 301.7701-1, 301.7701-2, and 301.7701-3. See also Section I.B.2, above.
 
3. If a limited liability company has only one member, it is generally disregarded for federal (and often state) tax purposes. For federal tax purposes, this is equivalent to being a sole proprietorship.
 
G. Business trusts. Massachusetts or Maryland business trusts are created by the execution of a declaration of trust whereby property is transferred to trustees who manage and control the property for the benefit of certain designated beneficiaries. These entities are typically used by REITs.
 
1. Such a trust can elect to be taxed either as a corporation or partnership for federal income tax purposes, although typically, most such trusts elect to be taxed as a corporation. See Treas. Reg. §§ 301.7701-1, 301.7701-2, and 301.7701-3. The federal income tax treatment of a business trust will follow the choice made in such an election.
 
2. For Massachusetts income tax purposes, Massachusetts business trusts are taxed only at the trust level as if they are individuals, and the beneficiaries are not taxed upon receipt of dividends of income taxed to the trust. See M.G.L. c. 62, § 8. This form of entity was sometimes used as an alternative to an S corporation to avoid the Massachusetts excise tax imposed on an S corporation with annual total receipts of $ 6 million or more, but under recently enacted legislation S corporations generally cannot avoid such tax by using a Massachusetts business trust. There are many pitfalls in the Massachusetts taxation of such trusts which should be evaluated prior to choosing this form of entity.
 
H. Other organizational forms. Other forms in which a business may be organized and conducted, but which, in light of their limited current usage, will not be analyzed herein, include the following:
 
1. Limited liability partnership. A "limited liability partnership" is a partnership in which the individual partners generally remain personally liable for their own acts but not the acts of other partners. This form of business may be useful for partnerships that seek some limitation on the personal liability of their individual partners but that, for some reason, cannot operate as limited partnerships.
 
2. Joint-stock company. A "joint-stock company" is an unincorporated, profit-seeking association of individuals that is considered a distinct legal entity for certain limited purposes. The members of a joint-stock company generally transfer full control of their business affairs to a group of managers and retain only limited control over such managers.
 
3. Publicly traded partnership. A "publicly traded partnership" is a vehicle for holding assets in limited partnership form while permitting the holders of limited partnership interests greater liquidity of interests through listing their interests on a stock exchange or other comparable market.
 
4. Nominee trust. A "nominee trust" is a non-taxable entity, which generally is used to hold bare legal title to real estate. Essentially, the nominee trust acts as an agent for individual or entity beneficial owners. The beneficial owner(s) are the owners for income tax purposes and are subject to all income tax consequences arising from the actions of the trustees.

n1 Unless otherwise noted, references herein to statutory sections shall be references to sections of the Code.
n2 Unless otherwise noted, the term "partnership" shall be used herein to refer to any entity that is treated as a partnership for federal income tax purposes (e.g., certain general partnerships, limited partnerships, limited liability companies, or limited liability partnerships). In general, any such entity (i.e., a general partnership, limited partnership, limited liability company, or limited liability partnership) that is not treated as a partnership for federal income tax purposes will be treated as a C corporation for such purposes.

II. Federal Income Tax Considerations in the Choice of Business Entity.
 
A. Organization of the enterprise. In selecting the form in which a business will be operated, the federal income tax consequences that will be incurred with respect to the organization of the business must be considered.
 
1. Sole proprietorship. There are typically no federal income tax consequences to the organization of a business as a sole proprietorship.
 
2. C corporation. A corporation may be organized in either a nontaxable transaction or a taxable transaction.
 
a. In general, under Section 351 of the Code, no gain or loss is recognized on the transfer by one or more persons of property to a corporation (other than an investment company) solely in exchange for stock in such corporation if, immediately after the transfer, the corporation is controlled by the transferors of the property. See I.R.C. § 351(a).
 
(1) For purposes of Section 351 of the Code, "control" is defined as the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of each other class of stock of the corporation. See I.R.C. §§ 351(a) and 368(c). See also Rev. Rul. 59-259, 1959-2 C.B. 115.
 
(2) If, in addition to the stock permitted to be received under Section 351(a) of the Code, the transferors of property receive other property or money, then the transferors may be required to recognize a gain, but not a loss. See I.R.C. § 351(b). A transfer of liabilities in excess of tax basis will also trigger gain recognition.
 
(3) No gain or loss will be recognized to the corporation itself on the receipt of money or other property in exchange for stock of the corporation. See I.R.C. § 1032(a).
 
b. Gain or loss may otherwise be recognized if Section 351 of the Code does not apply or if, for example, the transaction is structured as a sale of assets to the corporation.
 
c. In general, a corporation must amortize its "organizational expenditures" over a period of 180 months (15 years). See I.R.C. § 248(a). The term "organizational expenditures" includes any expenditure which:
 
(1) Is incident to the creation of the corporation;
 
(2) Is chargeable to capital account; and
 
(3) Is of a character which, if expended incident to the creation of a corporation having a limited life, would be amortizable over such life. I.R.C. § 248(b).
 
3. S corporation. As in the case of a C corporation, an S corporation generally may be formed in either a nontaxable transaction, under Section 351 of the Code, or a taxable transaction, structured as a sale of assets.
 
4. Partnership. Like a corporation, a partnership may be formed in either a nontaxable or taxable transaction.
 
a. In the case of a partnership (other than an investment company), no gain or loss is recognized upon the contribution of property to the partnership in exchange for an interest in such partnership unless built-in loss property is contributed. Unlike the treatment afforded in the case of a corporation, the transferors of property to a partnership need not "control" the partnership. See I.R.C. § 721. A partner that contributes appreciated property to a partnership, however, may be required to recognize gain upon the distribution of such property to another partner (see I.R.C. § 704(c)(1)(B)), or upon a subsequent partnership distribution of other property to the contributing partner (see I.R.C. § 737).
 
b. The transfer of a partnership interest in return for services performed by a new partner may be a taxable event. See Treas. Reg. § 1.721-1(b)(2); U.S. v. Frazell, 335 F.2d 487 (5th Cir. 1964), cert. denied, 380 U.S. 961 (1965); and Diamond v. Commissioner, 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974). But see also Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991). See also Notice 2005-43, I.R.B. 2005-24, and related Proposed Regulations under § 83 and Subchapter K relating to the transfer of a partnership interest in connection with the performance of services.
 
c. Section 721 of the Code will not apply if the transaction is otherwise structured as a sale.
 
d. Like a corporation, a partnership must amortize its "organizational expenses" over a period of 180 months (15 years). See I.R.C. § 709(b)(1). The term "organizational expenses" includes expenditures which:
 
(1) Are incident to the creation of the partnership;
 
(2) Are chargeable to capital account; and
 
(3) Are of a character which, if expended incident to the creation of a partnership having an ascertainable life, would be amortized over such life. I.R.C. § 709(b)(2).
 
B. Taxation of income. A central issue in choosing the particular business form in which to operate is the manner and extent to which income will be taxed.
 
1. Sole proprietorship. Because a sole proprietorship is not a separate entity, all of the tax consequences arising from the operation of such a business will be borne by the sole proprietor. Unlike the case of a C corporation, there is no problem of double taxation (as discussed below).
 
a. Individual income is subject to tax at a maximum rate of 35%. See I.R.C. § 1. Phaseout of personal exemptions and reductions of allowable itemized deductions at higher income levels may produce a slightly higher marginal tax rate.
 
b. Individual net capital gains generally are taxable at a maximum rate of 15% if attributable to property held for more than one year. See I.R.C. § 1(h). This rate is lower than the maximum rate of tax (35%) on corporate net capital gains. See I.R.C. §§ 11 and 1201.
 
c. Finally, individuals generally are subject to an alternative minimum tax of 26% with respect to the first $ 175,000 of alternative minimum taxable income in excess of the exemption amount and 28% with respect to amounts in excess of such $ 175,000. See I.R.C. § 55(b).
 
(1) For 2005, the exemption amounts are: $ 45,000 for joint filers; $ 33,750 for unmarried individuals; and $ 22,500 for married individuals filing separately. See I.R.C. § 55(d)(1).
 
(2) Such exemption amounts are subject to a phaseout. See I.R.C. § 55(d)(3).
 
2. C corporation. In general, the use of a C corporation will result in double taxation -- a tax at the corporate level on the corporation's earnings, plus a tax at the shareholder level on the corporation's after-tax income that is actually distributed to shareholders as dividends.
 
a. C corporations are taxed at the following rates:
 
(1) 15% of taxable income that does not exceed $ 50,000;
 
(2) 25% of taxable income that exceeds $ 50,000 but does not exceed $ 75,000;
 
(3) 34% of taxable income that exceeds $ 75,000 but does not exceed $ 10 million; and
 
(4) 35% of taxable income that exceeds $ 10 million. See I.R.C. § 11(b).
 
b. In the case of C corporations with taxable income in excess of $ 100,000, the amount of tax is increased by the lesser of 5% of the excess or $ 11,750. In the case of corporations with taxable income in excess of $ 15 million, the amount of tax is increased by the lesser of 3% of the excess or $ 100,000. See I.R.C. § 11(b) (flush language). The effect of these surtaxes is to recapture the benefits of the lower 15%, 25%, and, in the case of corporations having taxable income over $ 10 million, 34% tax rates.
 
c. When previously taxed corporate income is then distributed to shareholders as dividends, such income is again taxed, this time at the shareholder level (generally at a maximum rate of 15% under legislation enacted in 2003).
 
d. The maximum effective rate of taxation for distributed corporate earnings generally is therefore 44.75% (35% + (15% x 65%)).
 
e. There are methods, however, for avoiding double taxation in the C corporation context:
 
(1) The payment of reasonable compensation to shareholder-employees will be deductible by the corporation under Section 162(a) of the Code. Such deductions will lower the amount of corporate earnings subject to tax.
 
(a) In the case of publicly-held corporations, no deduction is allowed for remuneration to certain employees to the extent that the amount of such remuneration exceeds $ 1 million. See I.R.C. § 162(m)(1). An exception is provided where the remuneration is payable solely on account of certain performance goals. See I.R.C. § 162(m)(4)(C).
 
(b) All wages are subject to a 2.9% Medicare payroll tax, and all wages within the applicable Social Security wage base ($ 90,000 for 2005) are subject to a 12.4% Social Security payroll tax.
 
(2) The corporation may be able to structure payments to shareholders so that the payments qualify for another type of deduction, including:
 
(a) Interest,
 
(b) Rent, or
 
(c) Royalties.
 
(3) The corporation may retain its earnings, rather than distribute them to its shareholders. This method of avoiding double taxation, however, may be checked by:
 
(a) The accumulated earnings tax of 15% on improper accumulations of earnings; or
 
(b) The personal holding company tax of 15%, if 5 or fewer individuals own more than 50% of the corporation's outstanding stock and at least 60% of the corporation's adjusted ordinary gross income is personal holding company income. See I.R.C. §§ 531-547.
 
f. The maximum rate of tax on corporate net capital gains is 35%. See I.R.C. §§ 11 and 1201. This rate is higher than the maximum rate of tax (15%) on individual adjusted net capital gains. See I.R.C. § 1(h).
 
g. Certain personal service corporations are subject to a tax rate of 35% on all of their taxable income; they are ineligible for use of the graduated corporate income tax rates. See I.R.C. § 11(b)(2).
 
(1) A personal service corporation is a corporation the principal activity of which is the performance of personal services, where such services are substantially performed by employee-owners. I.R.C. § 269A(b)(1).
 
(2) An employee-owner is any employee who owns, on any day during the taxable year, more than 10% of the outstanding stock of the personal service corporation. I.R.C. § 269A(b)(2).
 
h. Corporations are subject to an alternative minimum tax of 20% of their alternative minimum taxable income for the taxable year as exceeds the exemption amount, reduced by the alternative minimum tax foreign tax credit. I.R.C. § 55(b)(1)(B).
 
(1) The exemption amount for corporations is presently $ 40,000, subject to a phaseout. See I.R.C. § 55(d)(2).
 
(2) The corporate alternative minimum tax rate is significantly lower than the non-corporate alternative minimum tax rate.
 
(3) Effective for taxable years beginning after 1997, the corporate alternative minimum tax is repealed for certain corporations' first year of existence, and thereafter for certain corporations having average annual gross receipts of $ 7.5 million or less. See I.R.C. § 55(e).
 
i. To the extent that a C corporation receives dividend income from a domestic corporation and such income is subject to taxation, the C corporation generally will be eligible for a "dividends received deduction" of:
 
(1) 100% in the case of dividends received by a small business investment company operating under the Small Business Investment Act of 1958 (applying to certain corporations investing solely in small business concerns that facilitate ownership in such concerns by persons whose participation in the free enterprise system is hampered because of social or economic disadvantages);
 
(2) 100% in the case of certain dividends distributed between members of the same affiliated group;
 
(3) 80% in the case of dividends received from a 20%-owned corporation; and
 
(4) 70% in the case of all other dividends. See I.R.C. §§ 243-246A.
 
3. S corporation. In the case of an S corporation, profits and losses generally are passed through to the shareholders of the S corporation. Unlike a C corporation, an S corporation generally is not subject to a corporate income tax, an accumulated earnings tax, or a personal holding company tax.
 
a. Because an S corporation is a pass-through entity, its shareholders will be subject to a maximum tax rate of 35% on corporate earnings.
 
b. The S corporation is itself taxable on income in only limited circumstances. See, e.g., Section 1374 of the Code (tax imposed on certain built-in gains) and Section 1375 of the Code (tax imposed when passive investment income of corporation having Subchapter C earnings and profits exceeds 25% of gross receipts).
 
c. Unlike C corporations, S corporations are ineligible for the 100% "dividends received deduction". See I.R.C. § 243(b)(1).
 
d. If an S corporation revokes its S election, the corporation will be taxed at corporate rates, and any later dividends or liquidating distributions will trigger an additional tax at the shareholder level. In deciding whether to use a C corporation or an S corporation, the following factors, in addition to the present rate structure, must be considered:
 
(1) The shareholders' need for cash;
 
(2) The corporation's need for cash; and
 
(3) The desire of the owners of the corporation to sell or retain the business.
 
4. Partnership. In general, a partnership, as such, is not subject to federal income taxation. Rather, the persons carrying on business as partners are subject to income taxation in their individual capacities. See I.R.C. § 701. A partnership, then, like an S corporation, is a pass-through entity.
 
a. Income earned by a partnership and thus, its individual partners, is subject to taxation at a maximum rate of 35%.
 
b. In addition to avoiding the problem of double taxation present in the C corporation context, the pass-through nature of a partnership may be otherwise favorable. For example, under Section 705(a)(1)(B) of the Code, a partner's basis in his or her partnership interest is increased by his distributive share of partnership tax-exempt income. This increase is necessary to prevent taxation of such tax-exempt income upon the distribution of such income or upon the sale of the partner's interest in the partnership. In the case of a C corporation, however, although tax-exempt income is not taxed at the corporate level, it will result in an increase in the corporation's earnings and profits, and, consequently, distribution of such tax-exempt income may result in ordinary dividend income to individual shareholders.
 
C. Deductibility of losses. Also critical to the selection of a business entity is the extent to which losses generated by the entity may be utilized.
 
1. Sole proprietorship. In the case of a sole proprietorship, the sole proprietor generally may offset his or her other income with losses from the sole proprietorship. The sole proprietor will be subject to all loss limitations otherwise applicable to individual taxpayers.
 
a. Under the "at-risk" limitations of Section 465 of the Code, an individual will (subject to an exception for the holding of real property) be entitled to a deduction only to the extent of the aggregate amount with respect to which the individual is at risk. See I.R.C. § 465.
 
b. Under the "passive loss" limitations of Section 469 of the Code, an individual engaged in a trade or business in which he or she does not materially participate will not be entitled to certain deductions or credits arising out of such activity. See I.R.C. § 469.
 
2. C corporation. In general, the shareholders of a C corporation may not offset the losses of the corporation against their other sources of income. To the extent that a corporation is unable to use its losses during any taxable year, the corporation generally retains such losses in the form of net operating losses, which may be carried back 2 years (under recent legislation losses incurred in 2001 and 2002 can be carried back 5 years) or forward 20 years to reduce corporate income in other years. See I.R.C. § 172.
 
a. A shareholder generally will realize a capital loss upon the sale (for consideration less than basis) or worthlessness of his or her stock. See I.R.C. §§ 1001(a) and 165(g).
 
b. A shareholder may be able to obtain favorable ordinary loss treatment upon the sale (for consideration less than basis) or worthlessness of Section 1244 small business stock.
 
(1) For any taxable year, the aggregate amount that may be treated by the shareholder as an ordinary loss under Section 1244 of the Code may not exceed:
 
(a) $ 50,000, or
 
(b) $ 100,000, in the case of joint filers. See I.R.C. § 1244(b).
 
(2) The aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus, may not exceed $ 1 million. See I.R.C. § 1244(c)(3)(A).
 
(3) The stock in issue must have been issued by the corporation for money or other property (other than stock or securities). See I.R.C. § 1244(c)(1)(B).
 
(4) The corporation, during the period of its 5 most recent taxable years ending before the date the loss on the stock was sustained, must have derived more than 50% of its aggregate gross receipts from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities. See I.R.C. § 1244(c)(1)(C).
 
c. A shareholder, under certain circumstances, may be able to generate a loss deduction with respect to certain "bad debts" arising from loans by the shareholder to the corporation. See I.R.C. § 166.
 
d. With respect to the utilization of losses by the corporation itself, the "at-risk" limitations of Section 465 of the Code -- which limitations are applicable to individuals -- generally are not applicable to widely-held C corporations. See I.R.C. § 465(a)(1).
 
(1) Such limitations will, however, be applicable to C corporations in which, at any time during the last half of the taxable year, more than 50% in value of the stock is owned, directly or indirectly, by or for not more than 5 individuals. See I.R.C. §§ 465(a)(1)(B) and 542(a)(2).
 
(2) Businesses that anticipate facing substantial limitations under the "at-risk" rules of Section 465 of the Code should consider forming a C corporation, provided that they would not be subject to the exception set forth in the preceding paragraph.
 
e. Similarly, the "passive loss" limitations of Section 469 of the Code -- which limitations are applicable to individuals -- are not applicable to widely-held C corporations. See I.R.C. § 469(a)(2).
 
3. S corporation. The shareholders of an S corporation generally may deduct their share of the corporation's losses against other sources of income. See I.R.C. § 1366.
 
a. A shareholder's ability to deduct corporate losses, however, is limited to the shareholder's basis in his or her corporate stock or debt. I.R.C. § 1366(d)(1).
 
b. An S corporation shareholder will be subject to the "at-risk" and "passive loss" limitations. See I.R.C. §§ 465 and 469.
 
c. The inability of S corporations to utilize certain net operating losses may also be significant. No carryforward and no carryback of losses arising in a taxable year during which a corporation was a C corporation may be carried to a taxable year during which the corporation is an S corporation. See I.R.C. § 1371(b)(1).
 
d. Moreover, no carryforward and no carryback of losses may arise at the corporate level for a taxable year during which the corporation is an S corporation. See I.R.C. § 1371(b)(2).
 
e. Section 1244 stock may be utilized in conjunction with an S election.
 
4. Partnership. Partners in a partnership generally may utilize their partnership losses against other sources of income. See I.R.C. §§ 701 and 702(a)(8).
 
a. A partner, however, may deduct his share of losses only to the extent of his adjusted basis in his partnership interest (taking into account his share of the partnership's debt) at the end of the partnership year in which the losses occurred. I.R.C. § 704(d).
 
b. Any excess of such losses over such basis is allowed as a deduction at the end of the partnership year in which such excess is repaid to the partnership. I.R.C. § 704(d).
 
c. A partner in a partnership will also be subject to the "at-risk" and "passive loss" limitations. See I.R.C. §§ 465 and 469.

D. Special allocations. Another tax consideration in choosing a business entity will be whether losses or other items of deduction may be specially allocated among the individuals involved.
 
1. Sole proprietorship. In a sole proprietorship, all items will be allocated to the sole proprietor.
 
2. C corporation. Although a C corporation may have multiple classes of stock with varying preferences, special allocations are otherwise not available in the case of C corporations.
 
3. S corporation. An S corporation can have only one class of stock (except that there may be differences in voting rights among shares of common stock), and thus, special allocations are not available in the case of S corporations. See I.R.C. § 1361(b)(1)(D).
 
4. Partnership. In the case of a partnership, however, losses and other deductions may be specially allocated among the partners.
 
a. A partner's distributive share of income, gain, loss, deduction, or credit generally is determined by the partnership agreement. See I.R.C. § 704(a).
 
b. Nevertheless, a partner's distributive share of income, gain, loss, deduction, or credit is determined in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances) if:
 
(1) The partnership agreement does not provide as to the partner's distributive share of income, gain, loss, deduction, or credit; or
 
(2) The allocation to a partner under the agreement of income, gain, loss, deduction, or credit does not have substantial economic effect. See I.R.C. § 704(b).
 
E. Choice of taxable year. In selecting a business entity, individuals will also want to consider their options with respect to the taxable year of the business.
 
1. Sole proprietorship. The taxable year of a sole proprietorship will be the same as the taxable year of the sole proprietor. The sole proprietorship's taxable year generally is required to be the same as its annual accounting period (the annual period on the basis of which the sole proprietor regularly computes his or her income in keeping his or her books). See I.R.C. § 441(a)-(c).
 
2. C corporation. A C corporation's taxable year generally is required to be the same as its annual accounting period (the annual period on the basis of which the taxpayer regularly computes its income in keeping its books). See I.R.C. § 441(a)-(c). A C corporation may choose a fiscal taxable year, unless it is a personal service corporation and then it is subject to certain limitations. See I.R.C. § 441(i); Treas. Reg. § 1.444-2T.
 
3. S corporation. In the case of an S corporation, the taxable year generally must be either:
 
a. A calendar year; or
 
b. Any other accounting period for which the corporation establishes a business purpose to the satisfaction of the Secretary. See I.R.C. § 1378.
 
4. Partnership. Unless it can establish that it has a valid business purpose otherwise, a partnership must not have a taxable year other than:
 
a. The taxable year which constitutes the taxable year of 1 or more partners having an aggregate interest in partnership profits and capital of more than 50%;
 
b. If there is no such taxable year, the taxable year of all of the partners having an interest of 5% or more in partnership profits or capital; or
 
c. If there is no such year, the partnership must adopt a tax year that results in the least aggregate deferral of income to the partners. See I.R.C. § 706(b).
 
F. Choice of accounting method. The owners of a business should also consider that their choice of a particular business entity may affect their ability to utilize certain accounting methods (e.g., the cash method of accounting).
 
1. Sole proprietorship. Generally, there are no restrictions on the method of accounting that may be used by a sole proprietorship, provided that the method used clearly reflects income and is consistent with the method used by the sole proprietorship in keeping its books. See I.R.C. § 446(a)-(c).
 
2. C corporation. Generally, C corporations may not use the cash method of accounting (and must instead use the accrual method or some other approved method of accounting). See I.R.C. § 448(a)(1). The following types of C corporations, however, may use the cash method of accounting:
 
a. Certain farming businesses;
 
b. Qualified personal service corporations; and
 
c. Certain corporations with gross receipts of not more than $ 5 million. See I.R.C. § 448(b).
 
3. S corporation. Unlike C corporations, S corporations generally may use either the cash method or accrual method of accounting. See I.R.C. § 448(a). S corporations that are treated as "tax shelters", however, are precluded from using the cash method of accounting. See I.R.C. § 448(a)(3) and (d)(3).
 
4. Partnership. In general, partnerships may also use either the cash method or accrual method of accounting. See I.R.C. § 448(a). The following types of partnerships, however, may not use the cash method of accounting:
 
a. Partnerships that have a C corporation as a partner; and
 
b. Partnerships that are treated as "tax shelters". See I.R.C. § 448(a)(2)-(3).
 
G. Sale of the assets of, or an interest in, the business organization. A critical consideration in choosing a form of entity for doing business is the tax consequences upon exit. When the business is sold, the seller will seek a single level of taxation, and the buyer will seek a fair-market-value tax basis for the assets purchased. Also of importance will be whether the gains from such a sale will result in ordinary income or capital gains, which can be taxable to an individual at a more favorable rate (approximately 20% lower).
 
1. Sole proprietorship. The assets of a sole proprietorship may be sold with only a single level of tax. When the sole proprietor sells his or her business, each asset is considered as being sold separately by the sole proprietor. See Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945). Thus, the nature of the assets comprising the business will be determinative of whether the sole proprietor realizes ordinary income or capital gain.
 
2. C corporation. Since the repeal of the General Utilities doctrine as part of the Tax Reform Act of 1986, the seller of a C corporation can achieve a single level of tax only if he or she sells the stock of the C corporation. A sale of assets will cause realization of gain at the corporate level to the extent of the appreciation in value of the assets, and a second level of tax at the shareholder level when the proceeds of the sale are distributed. See I.R.C. §§ 311, 302, and 301. A stock sale, however, does not afford the buyer a basis step-up in the assets, unless the buyer makes a Section 338 election, which generally is disadvantageous.
 
a. In general, a shareholder of a C corporation recognizes capital gain or loss on the sale of his or her stock in the corporation. Exceptions to this general rule of capital gain or loss treatment are that:
 
(1) The realization and recognition of long-term capital gain requires that the shareholder meet the "more than 1 year" holding period requirement of Section 1222(3) of the Code.
 
(2) If the shareholder is a dealer in securities, then any gain he or she realizes generally will be treated as ordinary income. See I.R.C. § 1221(a)(1).
 
b. Section 1202 of the Code permits a non-corporate taxpayer to exclude from gross income up to 50% of any gain realized on the sale or exchange of qualified small business stock issued after August 10, 1993, and held by the taxpayer for more than 5 years. See I.R.C. § 1202(a).
 
(1) The 50% exclusion generally is available to taxpayers who own stock in a qualified C corporation that actively conducts a qualified trade or business and that satisfies a maximum gross assets test (generally, $ 50 million). See I.R.C. § 1202(d).
 
(2) To the extent that this 50% exclusion is available, it may provide shareholders of C corporations (and not S corporations) with the opportunity to cash out their positions at a lower capital gains rate, thus providing a significant advantage over the other choices of business organization.
 
(3) A non-corporate taxpayer may defer recognition of gain on the sale of qualified small business stock by reinvesting the sale proceeds in another qualified small business within 60 days of the sale. However, additional ownership requirements apply if the non-corporate taxpayer is either a partner in a partnership or an S corporation shareholder. See I.R.C. § 1045.
 
3. S corporation. Subject to the "sting tax" imposed under Section 1374 of the Code, the assets of an S corporation can be sold, and the corporation liquidated, with only a single level of tax at the shareholder level. Section 1374 of the Code generally imposes a corporate level tax upon the sale or exchange by an S corporation that has converted from a C corporation of assets that were held by the corporation when it was still a C corporation. See I.R.C. § 1374(d).
 
4. Partnership. The assets of a partnership can be sold with only a single level of tax at the partner level. Indeed, a partner can sell his partnership interest with only a single level of tax at the partner level, and the purchaser of the partnership interest can get a stepped-up basis in his "share" of the assets of the partnership if the partnership makes an election under Section 754 of the Code. In the case of a sale or exchange of a partnership interest, gain or loss generally is recognized to the transferor partner, and such gain or loss is considered as resulting from the sale or exchange of a capital asset. See I.R.C. § 741.
 
a. An exception to this rule is provided in the case of a partnership that has unrealized receivables or inventory items. See I.R.C. §§ 741 and 751.
 
b. The amount received by the partner in exchange for his or her partnership interest which is attributable to unrealized receivables or inventory items of the partnership generally will result in the realization of ordinary income. See I.R.C. § 751(a).
 
H. Liquidation or dissolution of the business. The tax consequences of liquidating or dissolving the business are another major consideration in selecting a business entity.
 
1. Sole proprietorship. The distribution of assets from a sole proprietorship to the sole proprietor is not a taxable event. See I.R.C. § 331(b).
 
2. C corporation. In the case of a C corporation, amounts received by a shareholder in a distribution in complete liquidation of the corporation are treated as being made in full payment in exchange for the shareholder's stock, thus leading to full capital gain or loss recognition by the shareholder. See I.R.C. § 331. Gain or loss is also recognized by the liquidating corporation. See I.R.C. § 336.
 
a. The effect of these provisions is that distributions of appreciated property by C corporations will be subject to double taxation.
 
b. An exception to the foregoing provisions is provided in Sections 332 and 337 of the Code for complete liquidations of subsidiaries by their parents.
 
3. S corporation. In contrast to the treatment afforded C corporations, liquidating distributions by S corporations will, in effect, be taxed only once because any gain recognized by the corporation on such distributions will be passed through to the shareholders, whose stock bases will be increased by the amount of gain recognized. See I.R.C. §§ 1366 and 1367(a)(1). (But state tax laws may not have such an efficient result.)
 
4. Partnership. In a partnership liquidation, a partner generally will recognize gain only to the extent that any money distributed exceeds the adjusted basis of the partner's interest in the partnership immediately before the distribution. See I.R.C. § 731(a)(1). (For these purposes, relief from liability is treated as a distribution of money.) In a partnership liquidation, a partner may recognize a loss to the extent that only money, unrealized receivables, and inventory are distributed. See I.R.C. § 731(a)(2).
 
a. Any gain or loss recognized under these rules generally will be considered to be capital in nature, unless it is attributable to unrealized receivables or substantially appreciated inventory. See I.R.C. §§ 731, 741, and 751.
 
b. Generally, no gain or loss is recognized by the partnership on a distribution to a partner of property, including money. See I.R.C. § 731(b).
 
c. For purposes of these rules, the term "money" includes certain marketable securities, which must be taken into account at their fair market value as of the date of their distribution. See I.R.C. § 731(c)(1).
 
I. Retirement or death. The organizers of a business will also need to know the tax consequences of the retirement or death of one or all of the organizers.
 
1. Sole proprietorship. There are no immediate business-related income tax consequences upon the death or retirement of a sole proprietor.
 
2. C corporation. Upon the death or retirement of a corporate shareholder, the corporation may want to be able to redeem the shareholder's stock. Moreover, the estate of a deceased shareholder may want the corporation to redeem the shareholder's stock to provide funds for payment of death taxes and other expenses.
 
a. If such a redemption qualifies under Section 302 of the Code, then the redeemed shareholder or his estate generally will realize a capital gain or loss. See I.R.C. § 302(a). Section 302 will apply to a redemption of stock under any of the following circumstances:
 
(1) The redemption is not essentially equivalent to a dividend. See I.R.C. § 302(b)(1).
 
(2) The redemption is substantially disproportionate with respect to the shareholder. See I.R.C. § 302(b)(2).
 
(3) The redemption is in complete redemption of all of the stock of the corporation owned by the shareholder. See I.R.C. § 302(b)(3).
 
(4) The redemption is in partial liquidation of the distributing corporation. See I.R.C. § 302(b)(4).
 
(5) An elaborate network of constructive ownership rules applies in determining whether the requirements of §§ 302(b)(1), (2), or (3) are met. See I.R.C. § 318.
 
b. If the redemption does not qualify under Section 302 of the Code, then the redeemed shareholder will be treated as:
 
(1) To the extent of the corporation's earnings and profits, receiving a dividend, resulting in income (generally taxed at a maximum rate of 15% under recently enacted legislation) with no basis offset; and
 
(2) Otherwise, as receiving a distribution in offset of his or her stock basis, with any amount in excess of such basis being treated as capital gain. See I.R.C. §§ 302(d) and 301(a) and (c).
 
c. Section 303 of the Code provides that a redemption of stock after the death of a shareholder to pay the shareholder's funeral and administrative expenses, as well as death taxes, will qualify for capital gains treatment, even if it might otherwise be taxable as a dividend.
 
3. S corporation. See the above discussion of C corporations.
 
4. Partnership. A partnership has considerable flexibility in planning for the death or retirement of a partner. It can: treat the death or retirement as a complete liquidation of the partnership (as discussed above); have another partner or a third party purchase the partnership interest; or liquidate the partnership interest.
 
a. If the partnership interest of a retired or deceased partner is sold to another partner or a third party, then gain or loss is recognized to the outgoing partner, and such gain or loss will be considered as resulting from the sale or exchange of a capital asset. See I.R.C. § 741.
 
(1) An exception to this rule is provided in the case of a partnership that has unrealized receivables or inventory items. See I.R.C. §§ 741 and 751.
 
(2) The amount received by the partner in exchange for his partnership interest that is attributable to unrealized receivables or inventory items of the partnership generally will result in the realization of ordinary income. See I.R.C. § 751(a).
 
b. Where the death or retirement of a partner is treated as a liquidation of the partnership interest, payments made in liquidation of such interest are treated as either:
 
(1) Payments made in exchange for the partner's interest in partnership property. See I.R.C. § 736(b); or
 
(2) Payments made as a distributive share of partnership income or as guaranteed payments. See I.R.C. § 736(a).
 
c. Payments made in exchange for the partner's interest in partnership property generally result in capital gain or loss to the outgoing partner. See I.R.C. §§ 731, 732, and 751.
 
d. Payments made as a distributive share of partnership income or as guaranteed payments generally result in ordinary income to the outgoing partner. See Treas. Reg. § 1.736-1(a)(4).
 
J. Inadvertent termination of business organization. Persons who are organizing a business as an S corporation, a partnership, a limited partnership, a limited liability company, or a limited liability partnership, must also consider the fact that any such entity is subject to inadvertent termination.
 
1. S corporation. Certain events will subject an S corporation to termination of its status as such.
 
a. An S election will be terminated if:
 
(1) The corporation's S election is revoked;
 
(2) The corporation has more than 100 shareholders;
 
(3) Stock is transferred to an ineligible shareholder;
 
(4) A second class of stock is established; or
 
(5) The corporation has subchapter C earnings and profits at the close of each of 3 consecutive taxable years and has gross receipts for each of such taxable years more than 25% of which are passive investment income. See I.R.C. § 1362(d).
 
b. If a corporation's S election has been terminated, such corporation may be ineligible to make another S election for 5 years. See I.R.C. § 1362(g).
 
c. If, however, an S election is inadvertently terminated, and if certain conditions are otherwise satisfied, then the Secretary may treat the corporation as continuing to be an S corporation during the period specified by the Secretary. See I.R.C. § 1362(f).
 
2. Partnership. Partnerships may also be subject to inadvertent termination.
 
a. A partnership will be terminated if:
 
(1) No part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners; or
 
(2) Within a 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital or profits. See I.R.C. § 708(b)(1).
 
b. The consequences of a partnership being terminated could include the closing of the partnership's taxable year.
 
K. Employee benefits. The ability of businesses to make certain employee benefits available to their shareholders, partners, or members might also depend on the organizational form in which they conduct business.
 
1. General rules. Under the Code, employee benefits that are accorded favorable tax treatment are typically available to "employees" only. See, e.g., I.R.C. § 79 (group-term life insurance purchased for employees) and § 105 (certain amounts received under accident and health plans excluded from gross income of employees). Moreover, many such provisions, by their own terms, exclude from the definition of the term "employee" persons who are "self-employed individuals". See, e.g., I.R.C. § 105(g).
 
2. Characterization of business owners working for such business. In general, business owners who perform services for the business will be characterized as follows:
 
a. A sole proprietor generally is treated as a "self-employed individual". See I.R.C. § 401(c).
 
b. Shareholders working for their own C corporation may be considered "employees" who are not "self-employed individuals".
 
c. Shareholders in an S corporation, to the extent that they own more than 2% of the S corporation's stock, are, for purposes of the provisions of the Code relating to employee fringe benefits, generally treated as partners in a partnership. See I.R.C. § 1372.
 
d. Partners in a partnership generally will be considered "self-employed individuals" and not "employees". See I.R.C. § 1402(a); and Rev. Rul. 69-184, 1969-1 C.B. 256.
 
3. Health and accident benefits. Under Sections 105 and 106 of the Code, tax-favored health and accident benefits generally are available to "employees" but are not available to "self-employed individuals". See I.R.C. § 105(g).
 
a. Shareholder-employees of a C corporation may generally avail themselves of the full benefits of Sections 105 and 106 of the Code, while similar benefits are not necessarily available for owner-employees of other business organizations.
 
b. In general, a self-employed individual will be entitled to a deduction for amounts paid to provide insurance for employees, but he or she will be able to deduct the cost of providing insurance to himself or herself only to the extent that the cost of such insurance, together with other unreimbursed medical expenses, exceeds 7.5% of his or her adjusted gross income. See I.R.C. §§ 162 and 213(a).
 
c. Self-employed individuals generally are allowed a deduction equal to 100% of the amount paid during the taxable year for health insurance coverage for the individual and the individual's spouse and dependents. See I.R.C. § 162(1).
 
4. Cafeteria plans. The benefits provided under a Section 125 cafeteria plan generally are not available to self-employed individuals. See Prop. Treas. Reg. § 1.125-2T. Accordingly, such benefits will be available to shareholder-employees of C corporations but may not be available for owner-employees of other business organizations.
 
5. Employer-provided meals and lodging. The exclusion under Section 119 of the Code of the value of meals or lodging furnished to an employee for the convenience of the employer is also available to employees only. See I.R.C. § 119(a). Accordingly, C corporations may be able to provide their shareholder-employees with excludable meals and lodging, while other business organizations are denied this benefit.
 
6. Group-term life insurance purchased for employees. Similarly, the $ 50,000 exclusion of group-term life insurance provided to employees by employers, as provided under Section 79 of the Code, is applicable to employees only. Accordingly, C corporations are able to provide their shareholder-employees a limited exclusion for such benefits, while other business organizations are denied this benefit.
 
7. Borrowing from a qualified pension plan. Under Section 4975 of the Code, a shareholder-employee of a C corporation may borrow money from a qualified plan without incurring a penalty, provided that certain nondiscrimination and other requirements are otherwise satisfied. See I.R.C. § 4975(d)(1). This same benefit is unavailable to most S corporation shareholders. See I.R.C. § 4975(f)(6)(C).

Selecting a Business Entity:  United States Tax Considerations	
	 	 	 	 	 	
Applicable Consideration	C Corporation	S Corporation	
I.	Organizational	 	 	
	Considerations	 	 	
	 	 	 	 	 	
	A.	Ownership restrictions	 	 	
		1.	Number of owners	No restrictions	No more than 100	
					owners	
		2.	Type of owners	No restrictions	Restricted to U.S.	
					individuals, certain	
					trusts and estates,	
					certain tax-exempt	
					entities	
		3.	Affiliations	No restrictions	Cannot be owned by	
					another corporation	
					other than a single S	
					corporation parent	
	 	 	 	 	 	
	B.	Capital structure	No restrictions	Generally restricted	
					to one class of stock	
	 	 	 	 	 	
II.	Operational Considerations	 	 	
	 	 	 	 	 	
	A.	Taxation of income,	Not passed through	Generally passed	
		deduction of losses	to owners	through to owners	
	B.	Taxation of	 	 	
		distributions	 	 	
		1.	Cash distributions	Generally taxable to	Generally not taxable	
				owner as dividends;	to owner if previously	
				otherwise taxable as	taxed and if not in	
				capital gain if in	excess of basis	
				excess of basis	 	
		2.	Property	Appreciation taxable	Appreciation taxable	
			distributions	to entity; value	to owner; generally	
				taxable to owner as	not ultimately taxable	
				if cash	to entity	
	 	 	 	 	 	
	C.	Loss limitations	 	 	
		1.	Quantitative	No restrictions	Limited to basis of	
			restrictions		stockholders (capital	
					plus loans)	
		2.	Passive-loss	Generally no	Restrictions	
			restrictions	restrictions unless	applicable at owner	
				closely held	level	
		3.	At-risk restrictions	Generally no	Restrictions	
				restrictions unless	applicable at owner	
				closely held	level	
	D.	Income/loss	Characterization at	Characterization at	
		characterization	entity level	entity level	
	E.	Income/loss allocation	N.A.	Generally pro rata in	
					accordance with stock	
					ownership	
	F.	Taxable year	No restrictions	Generally restricted	
					to calendar year	
	G.	Accounting method	Accrual, but cash	Accrual or cash, but	
				available to certain	cash unavailable to	
				farming businesses,	corporations with	
				personal service	tax-shelter attributes	
				corporations, and	 	
				corporations with	 	
				receipts of $ 5	 	
				million or less	 	
	 	 	 	 	 	
III.	Tax Rates	 	 	
	 	 	 	 	 	
	A.	Maximum federal tax	 	 	
		rates	 	 	
		1.	Entity level	35%/35%	Generally N/A	
			(o.i./c.g.)	 	 	
		2.	Individual level	35%/15%	35%/15%	
			(o.i./l.t.c.g.)	 	 	
	B.	Maximum federal AMT	20% (on larger	28% (on smaller base)	
		rates on income received	base); for tax years	 	
		by entity	after December 31,	 	
				1997, may not apply	 	
				for certain small	 	
				corporations	 	
	C.	Accumulated earnings tax	15%	Not subject to	
		rate		accumulated earnings	
					tax	
	 	 	 	 	 	
IV.	Compensatory Considerations	 	 	
	 	 	 	 	 	
	A.	Deductibility of	Reasonable	Reasonable	
		compensation paid	compensation	compensation	
				deductible; amounts	deductible	
				in excess of $ 1	 	
				million may not be	 	
				deductible if entity	 	
				publicly held	 	
	B.	Fringe benefits	No restrictions	Restrictions	
					applicable to >2%	
					owners	
	C.	ESOPs	No restrictions	Available in taxable	
					years beginning after	
					December 31, 1997	
	D.	Social security taxes on	Owner pays 1/2 of	Owner pays 1/2 of	
		compensation paid to	OASDI tax (12.4%) +	OASDI tax (12.4%) +	
		owners	1/2 of HI tax	1/2 of HI tax (2.9%);	
				(2.9%); entity pays	entity pays rest	
				rest	 	
	E.	Unemployment taxes on	Entity pays FUTA tax	Entity pays FUTA tax	
		compensation paid to	 	 	
		owners	 	 	
	 	 	 	 	 	
V.	Disposition and Exit	 	 	
	Considerations	 	 	
	 	 	 	 	 	
	A.	Sale of ownership	 	 	
		interests	 	 	
		1.	Gain	Generally treated as	Generally treated as	
				capital gain;	capital gain	
				deferral of gain or	 	
				reduced tax rate may	 	
				be available for	 	
				smaller entities	 	
		2.	Loss	Generally treated as	Generally treated as	
				capital loss;	capital loss; ordinary	
				ordinary loss may be	loss may be available	
				available for	for smaller entities	
				smaller entities	 	
	B.	Sale of assets by entity	Gain taxable to	Gain recognized by	
				entity; proceeds of	entity but generally	
				sale taxable to	passed through to	
				owner upon	owner	
				distribution	 	
	C.	Liquidation of entity	Gain taxable to	Gain recognized by	
				entity; proceeds of	entity but generally	
				liquidation taxable	passed through to	
				to owner upon	owner	
				distribution	 	
						
Selecting a Busines Entity:  United States Tax Considerations	
	 	 	 	 	
Applicable Consideration	LLC/LLP/Partnership	
I.	Organizational	 	
	Considerations	 	
	 	 	 	 	
	A.	Ownership restrictions	 	
		1.	Number of owners	Partnerships require at least	
				2 owners	
		2.	Type of owners	No restrictions	
		3.	Affiliations	No restrictions	
	 	 	 	 	
	B.	Capital structure	No restrictions	
	 	 	 	 	
II.	Operational Considerations	 	
	 	 	 	 	
	A.	Taxation of income,	Passed through to owners	
		deduction of losses	 	
	B.	Taxation of	 	
		distributions	 	
		1.	Cash distributions	Generally not taxable to	
				owners if not in excess of	
				basis	
		2.	Property	Generally not taxable to	
			distributions	owners and not ultimately	
				taxable to entity	
	 	 	 	 	
	C.	Loss limitations	 	
		1.	Quantitative	Limited to basis (including	
			restrictions	share of entity's debt)	
		2.	Passive-loss	Restrictions applicable at	
			restrictions	owner level	
		3.	At-risk restrictions	Restrictions applicable at	
				owner level	
	D.	Income/loss	Characterization at entity	
		characterization	level	
	E.	Income/loss allocation	By agreement of owners if	
				substantial economic effect	
	F.	Taxable year	May be restricted to calendar	
				year	
	G.	Accounting method	Accrual or cash, but cash	
				unavailable to certain	
				partnerships with	
				C-corporation partners or	
				tax-shelter attributes	
	 	 	 	 	
III.	Tax Rates	 	
	 	 	 	 	
	A.	Maximum federal tax	 	
		rates	 	
		1.	Entity level	N/A	
			(o.i./c.g.)	 	
		2.	Individual level	35%/15%	
			(o.i./l.t.c.g.)	 	
	B.	Maximum federal AMT	28% (on smaller base)	
		rates on income received	 	
		by entity	 	
	C.	Accumulated earnings tax	Not subject to accumulated	
		rate	earnings tax	
	 	 	 	 	
IV.	Compensatory Considerations	 	
	 	 	 	 	
	A.	Deductibility of	Reasonable compensation	
		compensation paid	deductible	
	B.	Fringe benefits	Restrictions applicable to	
				owners	
	C.	ESOPs	Unavailable	
	D.	Social security taxes on	Owners pay self-employment	
		compensation paid to	tax (15.3%), 1/2 deductible,	
		owners	possibly on larger base	
	E.	Unemployment taxes on	Compensation paid to owners	
		compensation paid to	not subject to FUTA tax	
		owners	 	
	 	 	 	 	
V.	Disposition and Exit	 	
	Considerations	 	
	 	 	 	 	
	A.	Sale of ownership	 	
		interests	 	
		1.	Gain	Generally treated as capital	
				gain	
		2.	Loss	Generally treated as capital	
				loss	
	B.	Sale of assets by entity	Gain recognized by entity but	
				passed through to owners	
	C.	Liquidation of entity	Gain recognized by entity but	
				passed through to owners