Choice of Entity LEARNING OBJECTIVES INTRODUCTION MODULE 1 CHAPTER 1

(1)

1.1

MODULE 1 — CHAPTER 1

Choice of Entity

This chapter examines one of the most critical decisions that a business can make: deciding on the entity classification under which it will operate as a business. Although federal taxes are a critical factor in making that decision, they are often not the only factor. How well tax advantages mesh with business law advantages, not to mention the economic realities of a particular business or industry, may all become essential considerations before an intelligent choice-of-entity decision may be made. This chapter outlines each type of business entity found under U.S. business law stat-utes: the sole proprietorship, the corporation, the partnership, the limited partnership, and the limited liability company. After this snapshot, the chapter then examines each entity in detail, with special focus on federal tax considerations. Within this examination, special emphasis is given to “cutting edge” tax developments in choice-of-entity practice, including reasons behind the tremendous surge in choosing the limited liability company (LLC) and “disregarded entities.”

LEARNING OBJECTIVES

Upon completion of this chapter, you will be able to:

Identify the different types of entities available to U.S. businesses; Understand the basic federal tax law applicable to each type of entity; Recognize the strengths and weaknesses of each type of entity; Understand the reasons behind the recent up-tick in LLC formations; Determine when “disregarded status” is effective; and

Identify recent major tax law changes that affect choice-of-entity decisions

INTRODUCTION

Starting or acquiring a new business requires deciding what business form to use. A business entity is the legal form of the business. The entity may be as simple as a sole proprietorship or as complicated as a large multina-tional corporation. The choice of entity is often primarily driven by tax considerations: the entity classification that a business venture chooses may significantly affect its tax treatment under federal, state, local, and (in some cases) foreign laws. Therefore, it is crucial to understand tax treatment before an advisor recommends a choice.

Top_Fed_07_book.indb 1.1

(2)

In the United States, a number of business entity choices are available to an entrepreneur:

Sole proprietorship;

Corporation (this may include the traditional C corporation or the S corporation, which is a passthrough entity);

General partnership; Limited partnership;

Limited liability partnership (LLP);

Limited liability limited partnership (LLLP) (not available in all states); and

Limited liability company (LLC).

No single form of business entity is ideal for all businesses in all situations. No blanket rule applies, although clearly certain industries gravitate toward certain forms (statistics are noted later in this chapter). Each of the major business entity choices available under state law (i.e., sole proprietorship, partnership, limited partnership, corporation, and LLC) has advantages and disadvantages.

Two of the most significant factors to consider when choosing the best business form are:

Liability for business obligations (how limited liability will be); and Impact of federal taxes.

Other factors, however, are also significant, such as formality, flexibility, and the cost of forming and operating the business.

To complicate consideration of the impact of federal taxes is the “check-the-box” option recently introduced into the federal tax law. Under check-the-box, within certain parameters a business may operate legally as one type of entity while being allowed to select tax treatment normally applied to another type of entity. More about this later.

SOLE PROPRIETORSHIP

Formation

A sole proprietorship is formed simply by beginning business. The sole proprietorship has no independent legal existence. A proprietor is not required to enter any agreements or file any documents in order to create the proprietorship. The sole proprietor simply starts to conduct business. However, a sole proprietorship may be required to register its name if it intends to use an assumed name.

Most small businesses operate as sole proprietorships. The sole proprietor-ship is the most basic and informal form of conducting a business. A sole proprietorship is a one-owner business. This business form cannot be used if there is more than one owner. Although a sole proprietorship may have a

(3)

1.3 M O D U L E 1 — C H A P T E R 1 — C h o i c e o f E n t i t y

number of employees, it can only have one owner. That owner is typically the driving force behind the business.

Capital Structure

The sole proprietorship does not have a capital structure independent of its owner. The sole proprietor may borrow money to fund the business venture. The proprietor may deduct the interest expense incurred if the interest expense is allocable to a trade or business. The interest expense must relate to a debt incurred by the trade or business.

The tax law recognizes this identity of the business with its owner. All profits and losses from the business, including the computations of income and expense that are relevant to profits and losses, are reflected with personal income, deductions, and credits on a single individual Form 1040 income tax return of the owner. Profits and losses from the business generally are reported on Schedule C, Form 1040.

Check-the-Box as Applied to Sole Proprietorship

The check-the-box regulations have simplified the entity classification process. They have also simplified the ability of businesses to receive the benefits of limited liability and passthrough taxation. Prior to these regula-tions, individual business owners had to incorporate and elect S corporation status to receive the benefit of limited liability and passthrough taxation.

Under the check-the-box regulations, a single-member limited liability company (LLC) may be taxed as either a corporation or a sole proprietorship, at the election of its owner. A single-member LLC is taxed as a sole propri-etorship by default if it does not elect to be taxed as a corporation. The owner will thus enjoy the benefits of limited liability, passthrough taxation, and easy filing requirements.

Treatment of Income and Losses

A sole proprietor reports income or loss on Form 1040, Individual Federal

Income Tax Return, Schedule C, Profit or Loss from Business. If the proprietor

reports a loss on Schedule C, the amount reported offsets the proprietor’s other income reported on Form 1040. If he has a business loss of $20,000 and wages of $100,000 as an employee for someone else, the loss offsets the wages or any other income reported on Form 1040. The only exception to this “all-in-one-pot” approach is the determination of employment taxes.

_EXAMPLE

Cindy Gross has a Schedule C loss of $15,000. She has wage income of $75,000. She has no other income or loss. Her adjusted gross income for income tax purposes thus is $60,000. Cindy’s share of Social Security tax, however, is based on the full $75,000 amount of her salary.

(4)

A proprietor can deduct a capital loss realized from the sale of a business asset, as well. A proprietor reports a capital loss on Form 1040 Schedule D,

Capital Gains and Losses. The proprietor offsets capital gains with capital

loss. If the capital loss exceeds the proprietor’s capital gains (whether from the business, investments or otherwise), the deduction of the capital loss is limited to $3,000 ($1,500 for those individuals filing under the married filing separately status). A loss in excess of $3,000 can be carried over to subsequent years indefinitely until it is used up.

Self-Employment Tax

A sole proprietor is subject to self-employment tax of up to 15.3 percent on the net income of the sole proprietorship reported on Schedule C. Self-employment tax comprises two components. Together they are frequently called Social Security taxes:

The first component is a 12.4 percent tax on self-employment income for old age, survivors, and disability insurance (OASDI), which is subject to a dollar cap that is adjusted each year.

The second component is a 2.9 percent tax for Medicare, which is not subject to a dollar cap.

A sole proprietor is not subject to Federal Unemployment Tax (FUTA). However, a sole proprietor is required to pay FUTA if the proprietor has employees. The FUTA tax is 6.2 percent of the first $7,000 of each employee’s salary. The proprietor is also subject to state unemployment tax but receives a credit for FUTA.

The sole proprietor reports self-employment earnings on Form 1040 Schedule SE. The proprietor must file Schedule SE, Self-Employment Tax, and pay self-employment taxes if the net earnings from self-employment were $400 or more. The sole proprietor can deduct one-half of the self-employment tax as an adjustment to income on Form 1040.

Tax Identification Numbers

A sole proprietorship must have an employer identification number (EIN) if one of the following applies:

It has employees;

It has a qualified retirement plan; or It files returns for excise taxes.

Employment of Other Individuals

The sole proprietor must collect information about employees’ entitlement to withholding exemptions by requiring an employee to complete Form W-4, Employee’s Withholding Allowance Certificate. The employer must withhold income taxes from each employee’s salary based on the

with-Top_Fed_07_book.indb 1.4

(5)

holding exemptions claimed. He must withhold the employee’s portion of FICA (Social Security) and pay the employer’s share of FICA, FUTA, state unemployment taxes, and workers’ compensation premiums. The proprietor must remit the amounts withheld at the appropriate times and file the required withholding returns.

STUDY QUESTIONS

1. The sole proprietor reports capital loss deductions using: a. Schedule C

b. Schedule D c. Schedule SE

d. Direct entries on Form 1040

2. Under what circumstance would a sole proprietor not require an EIN? a. Reporting employee wages and withholding from the

proprietor-ship

b. Making contributions to a SIMPLE plan

c. Declaring itself as a sole proprietorship on its first-year return d. Reporting excise taxes

_NOTE

Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page 10.1.

C CORPORATIONS

Corporations are creatures of the law, acquiring their status and authority solely from the government. With few exceptions, authority over corpora-tions (and other business entities) is the responsibility of the states. Thus, virtually all private corporations are organized, or chartered, pursuant to the laws of incorporation and governance of a particular state.

Most large businesses are organized for tax purposes as regular or C cor-porations. A C corporation is a corporation subject to Subchapter C of the Internal Revenue Code. A C corporation must be a separate entity created as a corporation pursuant to state law.

C corporations feature limited liability for owners, a flexible capital struc-ture, and ease of transferability. However, there is potential for double taxation at the corporation and shareholder levels: once to the corporation when the income is earned, and then again to the shareholder-owner when that income is distributed to him or her as a dividend.

(6)

Types of C Corporations

State laws generally provide for corporations in three varieties:

Publicly held and closely held corporations (in which stock is either publicly traded or privately held);

Membership corporations (in which ownership is limited to group membership); and

Professional corporations (in which membership is restricted to certain licensed professionals).

Tax Implications of Creating or Acquiring a Corporation

The initial shareholders usually contribute cash or property to the corpora-tion in exchange for shares in the corporacorpora-tion. The corporacorpora-tion does not generally recognize gain or loss upon issuance of its stock. The shareholder does not recognize gain or loss if the shareholder “purchases” the stock with cash. Although a taxpayer is generally required to recognize gain or loss upon the sale or exchange of property, there is an exception for acquiring stock. Code Sec. 351 provides an exception for transfers of property (including cash) in exchange for stock.

_COMMENT

An exchange of property for stock under Code Sec. 351 is called a Sec-tion 351 exchange.

_EXAMPLE

Victor Smith contributed land worth $500,000 in exchange for a 100 per-cent interest in Smith Inc. The land has an adjusted basis of $100,000. The exchange qualifies as a Section 351 exchange. Smith is not required to recognize any gain on the transaction. He has a basis of $100,000 in Smith Inc. stock received in the exchange.

Code Sec. 351 Requirements

Code Sec. 351 provides that the transferor (the stock purchaser) recognize no gain or loss if two factors are present:

The property must be transferred to the corporation solely in exchange for stock; and

The transferors (stock purchasers) must control the corporation im-mediately after the exchange.

For Sec. 351 to apply, the exchange also must have a valid business purpose and the corporation must not be an investment company.

(7)

Further, the transfer of services is not considered a transfer of property that will be tax free under Section 351. The prohibition applies both to services rendered in the past and those to be rendered in the future. The transferor of the services must recognize income on the receipt of stock to the extent of the fair market value of the stock received.

A C corporation is a separate legal entity that files its tax returns separate from its owners. The corporation reports its income or loss on its income tax returns. The income or loss does not pass through to the corporate shareholders. The corporation may carry over its net operating losses to offset past or future corporate income. A shareholder can only claim a loss upon the sale of his or her stock in the corporation.

_COMMENT

A client should consider starting a new business as a sole proprietorship, S corporation, or partnership. This enables use of losses generated in the early stages of the business. Once the business is profitable and perhaps looking to expand, it can be incorporated. Through incorporation, it can take advantage of benefits such as limited liability, ease of transferability, and a flexible capital structure.

Section 1244 Stock

If the corporation and shareholders qualify, the corporation may issue Section 1244 small business stock at its inception. When an individual’s investment in a corporation becomes worthless, the loss is typically treated as a capital loss. If an individual incurs a Section 1244 stock loss, however, the individual can claim an ordinary loss of up to $50,000 as a single taxpayer. A loss of up to $100,000 can be claimed by married taxpayers filing a joint return in any taxable year. If an individual’s loss exceeds the Section 1244 ceiling, the remaining loss is treated as a capital loss. Generally, an individual will have a carryover basis in the stock equal to the money and basis of the property contributed when the stock was originally acquired.

In order to qualify as Section 1244 stock, the stock must have been issued when the corporation was a small business corporation. A corporation will qualify as a small business corporation if the money and other property received for stock, contributions to capital, or paid-in surplus does not exceed $1 mil-lion. If property is contributed, its value is based on adjusted basis reduced by any liability to which it was subject at the time of contribution.

Code Sec. 1244 applies to individual taxpayers who were original investors in the corporation. If the original shareholder sells stock or gives it as a gift, the stock will not qualify as Section 1244 stock in the transferee’s hands. Nor will it

(8)

qualify as Section 1244 stock if the shareholder transfers it to a trust or estate. A corporation’s stock is not Section 1244 stock if the corporation derives more than 50 percent of its gross receipts from certain sources. It does not qualify if more than 50 percent of the gross receipts are from royalties, rents, dividends, interest, annuities, and stock or security sales. The testing period is the five taxable years immediately preceding the year in which the loss was sustained. For corporations in existence for less than five years, the testing period is the corporation’s taxable years preceding the loss year.

Employment

As an employer, a corporation must collect information about employ-ees’ entitlement to withholding exemptions by requiring an employee to complete Form W-4, Employee’s Withholding Allowance Certificate. It must withhold income taxes from each employee’s salary based on the withhold-ing exemptions claimed. It must withhold the employee’s portion of FICA (Social Security). It also must pay the employer’s share of FICA, FUTA, state unemployment taxes, and workers’ compensation premiums. The corporation must remit the amounts withheld at the appropriate times and file the required withholding returns.

Small corporations generally employ shareholder-owners. Typically, cor-porate founders are employed in newly formed corporations. The owners can decrease the effect of double taxation by payment of compensation to themselves that, if reasonable, is a deductible expense of the corporation. A corporation is allowed a deduction for ordinary and necessary salary expenses paid or in-curred during a taxable year in carrying on any trade or business. Reasonable

compensation is the amount that would ordinarily be paid for like services for

like enterprises under like circumstances.

A deduction for compensation taken by a corporation will be disallowed if the amount is unreasonable. However, that does not necessarily mean that the IRS cannot also claim that the recipient of unreasonable compensation still realizes wage income.

_COMMENT

Ever since 2006, when dividend income has been treated as capital gains for purposes of determining the rate of tax on it (generally, the 15 percent rate), an additional consideration has developed in choice-of-entity de-cision making. The “double tax” of the traditional C corporation is now reduced to a regular income bracket tax and only a 15 percent tax, which is more than half of the likely regular income tax rate of its owner. As a result, the prior incentive to remove earnings from a corporation by way of higher-than-market compensation was been significantly removed.

(9)

STUDY QUESTIONS

3. Which of the following is not an advantage of the C corporation entity choice?

a. Passthrough of losses and deductions to shareholders b. Ease of transferring property

c. Flexible capital structure d. Limited liability for its owners

4. Owners of small corporations can reduce the effect of double taxation by:

a. Starting the business immediately as a C corporation rather than using another entity type

b. Issuing additional Section 1244 stock

c. Withdrawing reserve capital regularly from corporate accounts d. Paying themselves a reasonable compensation that the

corpora-tion deducts as a corporate expense

S CORPORATIONS

Formation and Organization

S corporations have become increasingly popular both for the newly incor-porated businesses and for the existing C corporations. C corporations can elect to convert to an S corporation. In fact, statistically there have been a significantly grater number of conversions to S corporations than there have been new incorporations immediately electing S corporation status.

S corporations are small business corporations organized under Subchapter S of the Code. An S corporation combines the business and legal characteristics of a C corporation with many federal income tax characteristics of a partner-ship. The S corporation election is available only to businesses that comply with certain requirements.

Large and public corporations generally cannot elect S corporation status because of the 100-shareholder limit, as well as the single class of stock require-ment. Among other businesses, however, the S corporation is often the entity of choice.

The S corporation and the other “passthrough” entity—the partner-ship—have been running a close race in popularity. Although partnerships have had the edge in some years, Congress itself has recognized the value of the S corporation for small business. To keep the S corporation as a viable option, Congress has made the S rules more liberal, both in terms of qualification and operation. This Congressional boost principally started with the Small Business

Tax Act of 1996, but additional changes have been steadily made almost every

other year since then.

(10)

Qualification as a Small Business Corporation

An S corporation is defined as a small business corporation for which an S corporation election is in effect for the tax year. A corporation is eligible to elect and be taxed as an S corporation only if it qualifies as a small busi-ness corporation.

Checklist: Small Business Corporations

A corporation qualifies as a small business corporation only if all the fol-lowing requirements are met:

It is not an ineligible corporation (insurance companies, possessions corporations (such as those operating in Puerto Rico), IC-DISCs, and taxable mortgage pools being examples of those ineligible);

No more than 100 shareholders;

All shareholders are individuals, estates, certain trusts, or qualifying tax-exempt entities;

No shareholder is a nonresident alien shareholder; and No more than one class of stock exists.

A corporation not only must meet these requirements in order for its share-holders to elect S corporation status, but the S corporation must continue to meet the requirements thereafter. The latter principle creates a danger: If the ongoing S corporation is not constantly monitored for eligibility, it can fall into regular, C corporation status with the attendant unplanned tax results. Although organizations have a recourse—asking the IRS for a waiver and a chance to cure ineligibility—that remedial opportunity is generally only at the discretion of the IRS.

Check-the-Box and S Corporation Status

Business entities that are not automatically classified as corporations may elect to be treated as a corporation on Form 8832, Entity Classification Election. The entity electing to be treated as a corporation can then elect S corporation status by filing Form 2553, Election by a Small Business Corporation. If an eligible entity elects S corporation status on time, it will be treated as having properly elected classification as an association taxable as a corporation.

Qualified Subchapter S Subsidiary

An S corporation can own another S corporation as a subsidiary if the subsidiary otherwise qualifies as an S corporation. Although the S cor-poration is confined to “small business corcor-porations,” the “small” in the requirement speaks to the number of shareholders (a maximum of 100) and capital structure (a single class of stock) rather than to the dollar amount of assets within the corporation. Nowhere is this more apparent than in the qualified Subchapter S subsidiary (QSub) situation. The QSub rule allows

(11)

a growing business with a need for independent subsidiary operations not to be foreclosed from retaining S status.

A subsidiary qualifies as an S corporation if:

The parent corporation’s shareholders hold the subsidiary’s shares directly;

100 percent of stock is owned by the parent (to prevent circumventing the 100-shareholder rule among other goals); and

The parent elects qualified subchapter S (QSub) status for the subsidiary. The separate existence of a QSub is ignored for tax purposes. The assets, liabilities, and items of income, deduction, and credit of a QSub are treated as those of the parent corporation. A QSub election results in a deemed liquidation of the subsidiary into the parent.

An S corporation may elect to treat an eligible subsidiary as a QSub by filing Form 8869, Qualified Subchapter S Subsidiary Election. A QSub election is effective on the date specified on the election form.

Making the S Corporation Election

A small business corporation must make an election to be taxed as an S corporation. The corporation makes an election by filing Form 2553,

Election by a Small Business Corporation. The election must be signed by a

person authorized to sign the corporation’s tax return. All shareholders on the date of the election must consent to the election. The required consent may be provided on the Form 2553 or on a separate statement attached to the election. Once made, an election continues until a disqualifying act or attribute arises, or the shareholders affirmatively elect out of S status.

Treatment of Income or Losses

An S corporation is a passthrough entity (also known as a flow-through

en-tity). Any income or loss related to the operation of the corporation flows

through to the shareholders. Shareholders report their allocable share of the income or loss on their tax returns. If the S corporation has a loss, the loss is generally available to offset the shareholder’s other income. A shareholder may not be able to claim a loss in a current year if the loss is prohibited under the passive activity loss rules. Nor may the shareholder claim a loss if he or she lacks sufficient basis in the stock.

_EXAMPLE

Fred Ames owns stock in an S corporation. The S corporation reported a loss of $200,000. Ames’s pro-rata share of the loss was $25,000. Ames will claim the loss on his individual return. Ames will be allowed to claim his entire pro-rata loss provided he is not otherwise limited by basis limita-tions, at-risk rules, and passive activity loss rules.

(12)

S corporations that had been operating as C corporations for a number of years before switching also must retain certain carryover tax attributes from their C corporation days that can produce a tax liability at the corporate level before passthrough rules are triggered. This adds another layer of complexity that points to having an initial strategy under which status as a C or an S corporation is evaluated from the start, rather than after the business has been operating for several years as an incorporated entity.

If a shareholder sells S corporation shares at a loss, he or she will be able to claim a loss. An individual shareholder can claim a capital loss in any given year to the extent of any capital gains plus $3,000.

Employment

An S corporation typically must employ individuals, including active owners, to work for the corporation. It must collect information about the employees’ entitlement to withholding exemptions by requiring each employee to complete Form W-4, Employee’s Withholding Allowance

Cer-tificate. As the employer, the S corporation must withhold income taxes

from each employee’s salary based on the withholding exemptions claimed. It also must withhold and pay Social Security taxes.

Employment of Shareholder-Owners

S corporations generally employ shareholder-owners. Typically, corporate founders are employed in newly formed corporations. A corporation is allowed a deduction for ordinary and necessary expenses paid or incurred during a taxable year in carrying on any trade or business. Ordinary and necessary business expenses include a reasonable allowance for salaries or other com-pensation paid to shareholder employees for services actually rendered.

S corporation income allocated to a shareholder is not subject to self-em-ployment tax. Thus, S corporations and their shareholders often attempt to minimize wage payments in order to minimize employment tax. An S corpora-tion may be challenged if it pays a shareholder unreasonably low wages relative to the services performed.

STUDY QUESTIONS

5. Which of the following is not allowed to be a shareholder of an S corporation small business corporation?

a. Qualifying tax-exempt entities b. Nonresident aliens

c. Estates

d. All of the above are allowed as types of small business corpora-tion shareholders

(13)

6. Unlike the IRS position on reasonable compensation for shareholder-owners of C corporations, S corporations are allowed to pay S corpora-tion shareholder-owners unreasonably low wages relative to services performed because the profits and losses of the S corporation pass through to the shareholders anyway. True or False?

GENERAL PARTNERSHIPS

A partnership is an unincorporated joint undertaking by two or more per-sons to carry on a business, financial operation, or venture as co-owners for profit. For tax purposes, it is also known as a passthrough entity, which means that the entity itself is not taxed and that tax liability passes through to the individual partners, members, or shareholders of the entity. Passthrough entities are generally classified as either partnerships or S corporations for federal tax purposes, even though state law provides for other forms of entity organization, such as the limited liability company (LLC) or limited liability partnership (LLP). The other forms of entities are generally taxed as partnerships, unless the entity elects otherwise, or in the case of a single-member LLC, disregarded as an entity separate from its owner. Although an S corporation is the other passthrough entity for tax purposes, the two types have differences as well as similarities both for tax purposes and for the application of state and local law.

A business undertaken by two or more members is, by default, a partner-ship for federal income tax purposes. There are no formal legal requirements to establish such a partnership: a general partnership. Thus, individuals or entities involved in a joint business or financial undertaking may inadvertently form a partnership. They will be subject to partnership filing and other federal income tax provisions governing partnerships.

Minimum requirements to establish a partnership, under both tax and state/local law, call for a partnership to:

Engage in the active conduct of a business; Operate with a profit motive; and

Have two or more owners.

Check-the-Box Rules

Because both a corporation and a partnership share all three of the manda-tory characteristics, they must be otherwise distinguished for federal tax purposes. The check-the-box rules simplify the determination of whether an entity is a partnership or a corporation for federal tax purposes. Formerly, the courts or IRS would look at the attributes of a business association to determine whether it more closely resembled a corporation or partnership. The current check-the-box rules provide that an unincorporated business

(14)

with two or more members is taxed as a partnership automatically and by default. If the business does not want to be taxed as a partnership, it simply must elect to be taxed as a corporation.

_COMMENT

Generally, but not always, state tax laws will follow a federal tax determi-nation of tax status. However, state business law rules generally control nontax treatment of a partnership or corporation; check-the-box status will have no impact in that respect.

Partnership Agreements—Not Required, But Advisable

Although a partnership agreement is not required to create a general part-nership, a partnership agreement is advisable. Among the partners, the partnership agreement controls except under certain circumstances. The partnership agreement governs the activities of the partnership and of the partners with each other. It spells out any special allocations of income, deductions, gains, losses, and credits to the partnership for tax purposes. It governs the:

Withdrawal of a partner; Death of a partner; or

Restrictions on the sale of a partnership interest to a new partner.

Legal and Ownership Status of General Partnerships

The Uniform Partnership Act defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit.” A general partnership can be formed in writing or orally. A group of individuals or entities may form a partnership by commencing to do business consistent with a partnership model. A partnership model generally involves two or more individuals actively involved in a business for profit.

Like a corporation, a partnership is a separate legal entity. It can sue and be sued, hold real and personal property, and conduct business independently of its partners. Although each partner owns a partnership interest, no partner owns specific assets of the partnership. Unlike a corporation or limited partnership, a general partnership is not required to make any filing with the state.

The partnership as an entity. A partnership is both an entity and an ag-gregation of partners. It operates as an entity for purposes of determining amount, character, and timing of income, deductions, gains or losses, and credits generated by the partnership. Once the partnership’s gains and losses are determined, the partnership functions as a conduit (passthrough), with each partner being taxed on the partner’s share of income.

Although a partnership is not a taxable entity, it determines the amount and character of taxable items passed through to the shareholders. The

(15)

partnership makes elections about accounting methods, depreciation meth-ods, and amortization of organization and start-up costs. It also may elect optional adjustments to the basis of partnership property or treatment as an electing large partnership.

The partnership as an aggregate of individuals. A partnership is also an aggregate of individual partners. As an aggregate, the partnership is treated as a group of individuals each of whom owns an interest in the partnership. Each partner reports and pays tax on her allocable share of the partnership’s income, gain, loss, deductions, and credits. The partnership reports each of these items to each of the individual partners on Form 1065, U.S. Return

of Partnership Income, Schedule K-1.

How Partnerships Acquire and Dispose of Property

Contribution of property to a partnership. Neither the partnership nor any

partner is required to recognize a gain or loss when a partner contributes property to a partnership in exchange for an interest in the partnership. When a group of individuals or entities forms or buys a partnership, they generally contribute property (including money) in exchange for a partner-ship interest. If a partner contributes appreciated property in exchange for a partnership interest, the contributing partner is not required to recognize a gain on the transaction.

Partner’s basis in partnership interest. A partner’s basis in the partnership

is the same as the basis of the property contributed. If a partner contributes property subject to a liability in exchange for partnership interest, his or her basis is reduced to the extent the partner is relieved of the liability. If the liability exceeds the basis in the partnership interest, he or she must recognize gain to the date of the exchange.

A partnership is a passthrough entity. As is the case with the S corporation (the other passthrough entity for federal tax purposes), any income or loss related to the operation of the partnership flows through to the partners. However, there are differences in passthrough treatment between a partner-ship and an S corp, particularly the unique availability of special allocations for partnership interests.

Partners will report their allocable share of income or loss on their separate tax returns. (As in an S corp, that income or loss must be realized even though no money may actually be passed on to the partner at that time.) A loss is generally available to offset the partners’ other income. A partner may not be able to claim a loss in a current year if he or she lacks sufficient basis in the partnership. A partner may not claim a loss even if he or she has sufficient basis

(16)

if prohibited under the at-risk rules. Nor may a partner claim a loss if prohibited by the passive activity loss rules. If a partner sells a partnership interest at a loss, the partner will be able to claim a capital loss.

Partner’s Self-Employment Tax

An individual general partner is subject to self-employment tax on his or her distributive share. The general partner is subject to self-employment tax of up to 15.3 percent of his or her distributive share of partnership income. This distributive share of partnership income is reported as net earnings from self-em-ployment on Form 1065, U.S. Return of Partnership Income, Schedule K-1. STUDY QUESTIONS

7. A partnership agreement may dictate all of the following partnership governance issues except:

a. Special allocations of income and deductions

b. Procedures in case of the withdrawal or death of a partner c. Restrictions on the sale of partnership interests

d. All of the above are specified in the partnership agreement 8. A partner’s basis in property he or she contributes to the partnership

in exchange for a partnership interest:

a. Is reduced by the amount of liability for which the contributing partner is relieved, but the partner recognizes no gain by contrib-uting appreciated property

b. Does not affect basis in the partnership interest, regardless of the type of contribution; partners make equal contributions for equal portions of the partnership’s assets and liabilities separate from basis in the property

c. A partner’s contribution does not affect his or her split of the total interests in the partnership; basis in property contributed is unrelated to the partnership interest

d. Is affected only when he or she contributes noncash property

LIMITED PARTNERSHIPS

A limited partnership differs from a general partnership in that the liability of one or more of the partner’s liability for partnership obligations may be limited. Only the general partner in a limited partnership is fully liable. A limited partnership is responsible for all of its own obligations. A limited partner is not liable for the obligations of a limited partnership unless he or she is also a general partner.

Under Delaware law, a limited partnership or domestic limited partner-ship is a partnerpartner-ship formed by two or more persons. It has at least one general

(17)

partner and one or more limited partners. A limited partnership may carry on any lawful business, purpose, or activity, whether or not for profit, except for insurance and banking.

A limited partnership is governed by both state statute and the partnership agreement. Before the limited partnership can come into existence, it must file with the state in which it is to be organized. Once the limited partnership has been formed through an appropriate filing, the operative document is the limited partnership agreement. State limited partnership law merely provides fallback or default provisions in areas where the limited partnership agreement is silent. Thus, as a general matter, the provisions of the limited partnership agreement are important and the courts tend to defer to those agreements. A limited partnership does not pay tax, but it does compute income, deductions, and credits on an annual basis. Information about the business is reported to the IRS on Form 1065 and to the individual partners on separate Schedules K-1. The partners report the partnership income on their own returns and pay any taxes due based on their own tax rates.

Requirement of a General Partner

Each limited partnership must have at least one general partner. The general partner may be an individual, a corporation, or other legal entity, domestic or foreign. The general partner may also (but need not) be a limited partner. Unlike a limited partner, the general partner of a limited partnership is generally responsible for all of the partnership’s debts and obligations.

Limited Liability of Limited Partners

A limited partner is generally not liable for the obligations of a limited part-nership unless he or she is also a general partner. The limited partner may also be liable if he or she participates in the control of the business. This is a critical aspect of a limited partnership. Limited partners generally invest in the business, expecting to receive a share of the profits. They usually do not actively participate in the day-to-day operations of the limited partnership.

LIMITED LIABILITY LIMITED PARTNERSHIP

Limited liability limited partnerships (LLLPs) are similar to LLPs to the extent that states have amended their limited partnership statutes to permit limited partnerships to register as LLLPs, thereby providing the general partners a limitation on vicarious liability. About half of the states, including Delaware, allow the formation of LLLPs. In Texas and Arkansas, for example, these entities are known as “registered” limited liability partnerships. These part-nerships are a form of limited partnership that extends liability protections to general partners as well as the limited partners. In a registered or limited liability limited partnership, no general or limited partner is liable for the partnership’s obligations created solely by another partner’s malfeasance.

(18)

Creation of a limited liability limited partnership is not materially differ-ent from creation of a limited liability partnership. In Delaware, a statemdiffer-ent of qualification must be filed. An annual report must be filed and an annual fee must be paid. The partnership must have as the last words or letters of its name the words Limited Liability Limited Partnership, or the abbreviation

L.L.L.P. or LLLP.

STUDY QUESTIONS

9. Unlike a general partnership, a limited partnership is governed by both its partnership agreement and state statute. True or False?

10. The main difference between the general partner and limited partners of a limited partnership is:

a. The split in the partnership interests, which gives the general partner a greater share of pro-rata income and liabilities b. The chronological order of becoming partners; the general

partner always has the most seniority in the group

c. The embodiment of the partners: General partners are individuals, whereas limited partners are corporations or other legal entities d. Liability for debts and obligations, which rests with the general

partner

LIMITED LIABILITY COMPANIES

A limited liability company (LLC) is a business entity created under state law. Every state and the District of Columbia have LLC statutes that govern the formation and operation of LLCs, which are a hot recent favorite entity type.

An LLC has the characteristics of both a corporation and a partnership. Like a corporation, the owners (referred to as members) are usually not person-ally liable for the debts and other obligations of the LLC. Like a partnership or sole proprietorship, an LLC has great flexibility in the way it operates and does not need to follow corporate formalities, such as holding special and annual meetings with shareholders and directors.

An LLC has the flexibility to decide whether to be taxed as a partner-ship, C corporation, or—in the case of a single-member LLC—to be disregarded as an entity for federal tax purposes. If an LLC chooses to be taxed as a partnership or S corporation, or if a single-member LLC elects to be disregarded as an entity, the LLC profits and losses are reported on the member’s personal federal income tax return. Most multimember LLCs choose to be taxed as a partnership, and most single-member LLCs elect to be disregarded as an entity for federal tax purposes.

(19)

Under check-the-box, a multimember LLC usually is taxed as a partnership by default; but the entity may elect to be taxed as an association by “checking the box.” The two choices for a single-member LLC are generally disregarded entity or association.

Advantages of LLCs

The main advantage of an LLC is that its members are not personally liable for the debts of the business, vicariously or otherwise. Members of LLCs enjoy the same protections from personal liability for business obligations as shareholders in a corporation or limited partners in a limited partnership. Unlike the limited partnership form, which requires at least one general partner who is personally liable for all the debts of the business, no such requirement exists in an LLC.

A second significant advantage is the flexibility of an LLC to choose its federal tax treatment. Under the check-the-box rules, an LLC can be taxed as a partnership, C corporation, or S corporation for federal income tax purposes. A single-member LLC may elect to be disregarded for federal income tax purposes or taxed as an association (corporation).

Appeal of LLCs Versus S Corporations

In addition to liability protection and tax flexibility, LLCs may be useful in the many circumstances where S corporation status is impractical or unavailable. LLCs are not subject to restrictions on the number and types of shareholders or the one-class-of-stock limitation as are S corporations.

Another favorable characteristic of LLCs is that their members have flexibil-ity to allocate income or loss on a basis other than according to each member’s percentage interest in the LLC (using the rules for taxation of partnerships). In an S corporation, all income allocations must be based strictly on the stock ownership interest of each shareholder (the one-class-of-stock rule).

When LLCs Are Used

LLCs are typically used for entrepreneurial enterprises with small numbers of active participants, family and other closely held businesses, real estate investments, joint ventures, and investment partnerships. However, almost any business that is not contemplating an initial public offering (IPO) in the near future should consider using an LLC as its entity of choice.

Deciding to convert an LLC to a corporation later generally has no federal tax consequences. This is rarely the case when converting a corporation to an LLC. Therefore, when in doubt between forming an LLC or a corporation, for tax considerations it is usually wise to opt to form an LLC.

Characteristics Under State Statutes

Most states tax LLCs as passthrough entities the same way they are taxed under federal law. This means that in most cases, passthrough treatment is

(20)

allowed and corporate entity-level income taxes can be avoided. A state may impose other taxes on LLCs, however, such as a franchise tax, business and occupation tax, or other registration fees. The fees vary by state.

Most state statutes permit LLCs to have a perpetual life. “Modern” LLC statutes, commonly known as flexible statutes, also permit less than unanimous consent of the members to continue the business if certain events occurred and allowed members to transfer their ownership interests.

States that base their LLC statutes on earlier federal tax law may place limits on the life of an LLC. Before the check-the-box regulations, an entity could only be taxed as a partnership if it lacked continuity of life. To conform to this rule, the statues required either the articles of organization—the document filed with the respective secretary of state—or the operating agreement to provide that the LLC would have a life span limited to no more than 30 years. The LLC documents also had to provide for the unanimous consent of the members to continue the business of the LLC if certain events, such as a member’s death occurred, or to transfer an ownership interest in an LLC to a third party.

COMMENT

Early LLC statutes were designed to comply with what was known as the “Kintner regulations,” which were a response to the decision in U.S.

v. Kintner (216 F.2d 418 (9th Cir. 1954)). The four corporate

character-istics identified in the Kintner regulations were: (1) continuity of life, (2) centralization of management, (3) liability for entity debts limited to entity property, and (4) free transferability of interests (former Treas. Reg. sec. 301.7701-2). The effect of the regulations generally was to classify an unincorporated entity as a partnership if it lacked any two or more of the four corporate characteristics. Therefore, early state LLC statutes were drafted so that any LLC organized under the statute lacked two of the four characteristics. Once the check-the-box regulations were promulgated in December 1996 and the new choice of entity rules were put in place, it was no longer necessary for an LLC to lack two of the four characteristics, and, therefore, state LLC laws were made to be more flexible.

LLC Federal Tax Implications

An LLC is not a federal tax entity. LLCs are not specifically mentioned in the tax code, and there are no special IRS regulations governing the taxation of LLCs comparable to the regulations for C corporations, S corporations, and partnerships. Instead, LLCs make an election to be taxed as a particular entity (or to be disregarded for tax purposes) by following the check-the-box business entity classification regulations. The election is filed on Form 8832,

Entity Classification Election. The IRS will assign an entity classification by

default if no election is made. A taxpayer who doesn’t mind the IRS default entity classification does not necessarily need to file Form 8832.

(21)

Check-the-Box

The check-the-box regulations outline a step-by-step analysis for determin-ing the appropriate federal tax classification of an entity. A few types of entities are required to be taxed as corporations (state law corporations, certain foreign entities, and insurance companies, among others). Other entities, including LLCs, can elect one of several types of entities depending on whether the entity has only one member or more than one member.

An LLC with more than one member can elect the three entity tax treatments:

Partnership; Corporation; or

S corporation (accomplished by electing to be taxed as a corporation, then filing an S corporation election).

An LLC with only one member can elect: Disregarded entity;

Corporation (e.g., regular C corporation, personal holding company, personal services corporation, or professional corporation); or

S corporation (accomplished by electing to be taxed as a corporation, then filing an S corporation election)

Default status. The IRS will assign these classifications if no entity election

is filed for an LLC (the default rules):

Any business entity that is not a corporation is classified as a partner-ship; and

Any entity that is wholly owned by a single person will be disregarded as an entity separate from its owner (taxed as a sole proprietorship). Statistically, an LLC with more than one member will elect to be taxed as a partnership, whereas a single-member LLC will elect to be disregarded and taxed as a sole proprietorship.

General Partnership Taxation Rules

LLCs with multiple members generally elect to be taxed as partnerships. Information about the business is reported to the IRS on Form 1065 and to the individual partners on separate Schedules K-1. The partners report the partnership income on their own returns and pay any taxes due based on their own tax rates.

How Partners Report Partnership Items

Each LLC partner receives a Schedule K-1 showing the partner’s share of both “bottom line” partnership income plus a share of each item required to be separately stated (credits, capital gain, etc.). The partner reports all of these items on his or her own tax return for the tax year in which the partnership’s

(22)

tax year ends. The character of items passed through to the partners (capital vs. ordinary; long term vs. short term) is determined at the partnership level.

Self-Employment Tax

The IRS has not yet conclusively determined whether distributive shares received by LLC members are subject to self-employment tax. LLC members may be subject to self-employment tax if their interest is more analogous to a general partnership interest than to a limited partnership interest. LLC members are not subject to self-employment tax if their interests are viewed as comparable to limited partnership interests.

Net earnings from self-employment derived by an individual are generally subject to self-employment tax. General partners are subject to self-employ-ment tax on their distributive shares of income from the partnership’s trade or business. In contrast, the distributive share of a limited partner is generally excluded from the self-employment tax, except to the extent that this share is a guaranteed payment. A guaranteed payment is an amount paid to a partner for services rendered to or on behalf of the partnership, paid without regard to the income of the partnership.

Comparative Advantages and Disadvantages of LLCs

Historically, the limited partnership and the S corporation have been the entities of choice for those seeking both limited liability and passthrough taxation. Entrepreneurs and their advisors have always recognized, however, that these traditional choices were imperfect in operation. Increasingly, the relatively new LLC, providing both limited liability and passthrough taxa-tion without the operataxa-tional drawbacks has become the entity of choice for many new entrepreneurs.

LLCs versus C corporation. Corporations have vastly more legal and ac-counting rules than other entities; therefore, startup services of lawyers and accounts are expensive. Thus, the LLC, rather than the corporation, presents a better choice for the small business owner. This is mainly because the LLC is generally a lower-cost, simpler alternative to the corporation. The LLC is the fastest growing business form in the United States in large part because it offers the “best of both worlds”—limited liability, as is the case of the C corporation, but passthrough taxation, as is the case of the partnership. This avoids the double taxation problem that confronts a regular C corporation.

LLC versus S corporation. The S corporation has often been the

tradi-tional entity of choice for operating a closely held business, but the LLC possesses clear tax and nontax advantages over the S corporation, whose use is severely hampered by an assortment of restrictions. The LLC, with its offer of more complete passthrough tax treatment and its greater opera-tional flexibility, thus threatens to replace the S corporation as the entity

(23)

of choice for the closely held business. Unlike an S corp, an LLC is not restricted to a maximum number of members or a single class of stock or membership interest. Moreover, if an S corporation inadvertently breaks one of these rules, it loses its S corporation status and is then taxed as a C corporation, thus triggering double taxation.

On the other hand, the main advantage of an S corporation over an LLC is that LLCs are still relatively new creatures from the tax law standpoint. There is not a lot of case law to study regarding some of the finer points of LLC organization.

LLC versus limited partnership. Although tax considerations are not likely

to determine the choice of entity between an LLC classified as a partnership and a limited partnership—both are then subject to the federal partnership tax rules—it is important to recognize that the LLC is fundamentally a different type of entity. Most partnership tax provisions are easily applied to the LLC, but significant unresolved federal tax issues do remain, primarily arising out of two crucial differences between a partnership and an LLC.

First, there is no distinction among LLC members comparable to the distinction between general and limited partners. In a partnership, at least one member (the general partner) is always liable for the debts of the entity. In the LLC, no member is liable for the obligations of the entity.

Second, LLC members generally can participate in the management of the LLC’s business (unless such management is vested in a designated group of managers), whereas limited partners generally are prohibited from taking an active management role in the partnership.

Forming an LLC

To form an LLC, organizers must file articles of organization, or a compa-rable state document, with the appropriate state agency. (For convenience, the term articles of organization is used here to refer to the document required to be filed with the appropriate state agency.) Organizers should check their state statute to determine what has to be included in the articles of orga-nization in their state. Generally, the articles will include, at a minimum, the name of the LLC, the name and address of its registered agent and its principal place of business.

The manner in which members of LLCs contribute capital to the entity, the form that the contribution can take, the responsibility members have for their promised contributions, and the repayment of contributions are issues addressed in every state’s LLC statutes.

The LLC’s Type of Business

There are a number of factors that businesspeople should consider in choos-ing where (and whether) to form an LLC. However, the primary issue is

(24)

whether the state(s) in which the LLC will operate allows the business to organize as an LLC.

Some states do not allow certain professions to operate as an LLC. For example, California does not allow some professionals, such as financial institu-tions, insurance companies or trust companies, to operate as LLCs. Delaware, Arizona, and a few other states also prohibit banks and insurance companies from organizing as LLCs. In a few states, lawyers and law firms may not oper-ate as LLCs. Although prohibitions such as these are becoming increasingly rare, the state’s rules are something that every business should consider before finalizing the entity choice.

STUDY QUESTIONS

11. Generally, domestic business entities that are not corporations will be automatically treated as _____ for tax purposes if they have two or more owners, or will be _____ if they have only one owner.

a. C corporations; S corporations

b. Limited liability companies; S corporations c. C corporations; limited liability companies d. Partnerships; disregarded entities

12. All of the following are comparative advantages of LLCs as an entity form over S corporations for closely held businesses except: a. No restrictions on the number of members

b. More universal acceptance of the LLC entity form c. May have multiple classes of membership interests d. Does not need to elect LLC status with the IRS

LATEST DEVELOPMENTS:

OTHER “HOT TOPICS” IN CHOICE OF ENTITY

Choice of entity continues to be a developing area, not only from the per-spective of new strategies and techniques, but also in the development of new case law and IRS guidance that interpret or react to these changes. The past year has seen several important developments that should be folded into the general decision surrounding choice of entity, both selecting the entity upon the formation of the business and making an evaluation of whether an ongoing entity should change forms.

Dual-Chartered Entities

In February of 2006, the IRS issued a final regulation that clarifies classifica-tion of entities organized in more than one jurisdicclassifica-tion. The final regulaclassifica-tion

(25)

also provides transitional relief for those dual-chartered entities. The final regs provide that a dual-chartered entity will be deemed:

A corporation for all federal tax purposes if, within at least one jurisdic-tion, the entity’s organizational form would cause the entity to be classi-fied as a corporation pursuant to Treas. Reg. Sec. 301.7701-2(b); and A domestic corporation if the entity is organized as an entity under U.S. federal or state law.

The clarification allows for the elimination of definitions for resident foreign corporation, nonresident foreign corporation, and nonresident partnership.

Transition relief. The regulation provides the following transition relief:

Any dual-chartered entity organized before August 12, 2004, will be governed by the preexisting regulation;

Any business that had not been dual-chartered by August 12, 2004, is required to apply the final regulation from that date forward; and Any dual-chartered entity existing on August 12, 2004, is required to begin applying the final regulation as of May 1, 2006.

Qualified Personal Service Corporations

In March of 2006 the Tax Court allowed an accounting firm to avoid quali-fied personal service corporation (QPSC) status related to the company’s decision to create an in-house separate entity that provided financial services (Lykins, T.C. Memo 2006-35). The court determined that a corporation providing investment and accounting services was not a qualified personal service corporation and, thus, was not subject to the 35 percent flat tax.

QPSC status, and its unwanted flat 35 percent tax rate, may be imposed on any corporation involved in any one of eight service business types: ac-counting, healthcare, law, engineering, architecture, actuary, performing arts, or consulting. If the service is not on the list, it cannot put the business into QPSC stats.

A business is also only a QPSC if it is trapped under both of the following Code Sec. 448(d)(2) tests:

Ownership: Any employee performing one of the listed services must

substantially own all of the company’s stock; and

Function: A company’s function must involve “substantially all” of any

services enumerated in Code Sec. 448. The corresponding treasury regulation defines the term substantially all as meaning that at least 95 percent of employee efforts involve one of the enumerated services.

(26)

Although the corporation before the Tax Court was left with the accounting business after the split-off of its investment advisory business, it contin-ued to pay the wages, benefits and taxes of the employees of the split-off investment business. Thus, it was treated as providing both accounting and investment services. Because less than 95 percent of the time of the corporation’s employees was spent on the accounting services, substantially all of the corporation’s activities were not performed in a qualifying field and the function test of the qualified personal service corporation defini-tion was not met.

C Corporation and Sole Shareholder Are Different

In May of 2006 a taxpayer fought a losing bid to convince the Tax Court that he should be reimbursed litigation costs incurred by a C corporation of which he was part owner.

The case before the Tax Court involved an underlying matter in which a C corporation paid litigation costs incurred by the taxpayer who owned 40 percent of the corporation. The taxpayer appealed a determination that the payments were not constructive dividends as argued by the taxpayer, but instead were loans. The Tax Court rule that the C corporation’s separate entity status meant that the corporation, not the taxpayer, incurred the litigation cost.

Joint and Several Liability of Partners

In a case that spotlights a risk associated with partnership taxation, the Tax Court ordered a taxpayer to pay taxes on earnings his partner had siphoned off to surreptitiously begin a competing business (Burke, T.C. Memo. 2005-297).

The case involves a taxpayer attorney-CPA who ended a three-year partner-ship with an individual who he suspected had stolen partnerpartner-ship funds. The partnership was dissolved and all partnership receipts were placed in escrow pending a determination of proper allocation. The innocent partner-taxpayer claimed that he did not have a distributive share to report because his partner-ship income had been frozen.

The Tax Court, however, saw it differently. It held that each partner is liable for income tax on his distributive share of partnership income, regardless of whether the income is distributed; or is undistributed pursuant to a partner-ship agreement; or whether a distribution fraudulently violates a partnerpartner-ship agreement. The court ruled that the partnership had earned and realized the income, and that there was nothing conditional or contingent regarding the receipt of the partnership’s income. The occurrence of fraud by a partner does not serve to shield other partners from recognizing a proportionate share of passthrough partnership income.

(27)

Pending Legislation

Small Business Tax Flexibility Act. In the last year, representatives in

Congress have introduced House and Senate versions of a measure designed help start-up small business owners meet their tax obligation by using a taxable year most suitable to their business cycle if they earn less than $5 million during the tax year.

The Small Business Tax Flexibility Act was introduced in October of 2005

by Rep. Clay Shaw (R-FL), a senior member of the House Ways and Means Committee and Rep. John Tanner (D-TN). A Senate version (S. 2462) was introduced in March of 2006 by Sen. Olympia Snowe (R-ME). Both bills remain before legislative committees.

Until 1986, business could elect several taxable year-end dates. In 1986 Con-gress passed legislation that requires partnerships and S corporations—many of which are small business—to adopt a December 31 year-end. Supporters of the measures include the American Association of Certified Public Accoun-tants, which has argued that the current restriction unreasonably compresses workload on CPAs and other return preparers who now must squeeze all of their work for partnerships and corporations—and individuals—during the months between December and April of each year.

Small business expensing. In February of 2006 Sen. Snowe, along with five cosponsors, introduced legislation (S.2287) to amend the Tax Code to increase from $100,000 to $200,000 the dollar amount of new invest-ments a small business will be able to expense. The matter remains before the Senate Finance Committee.

STUDY QUESTION

13. The terms of the Small Business Tax Flexibility Act would benefit ac-countants by:

a. Allowing sole proprietors to elect a fiscal tax year

b. Spreading out the period during which accountants prepare partnership and S corporation returns in different seasons than individuals’ returns

c. Combining preparation and filing of several types of tax returns and payments that businesses now must file separately

d. All of the above are part of the legislation benefiting accountants

(28)

A LOOK AT THE STATS

Statistical data on choice of entity is important for two reasons. It gives a business advisor a point of reference based on what others are choosing in determining how a particular business will be taxed and, more generally, how it will fit into the business community. Second, it is what the IRS uses to help allocate its guidance, audit, and other resources.

The IRS is generally about two years behind in gathering and making public detailed statistical information for any tax year based upon the returns filed for that year. So, for example, the latest detailed data released in 2006 covers primarily the 2003 tax year, for which returns were filed in 2004. One exception is the information on sole proprietorships, for which detailed 2004 statistics recently have been released.

The IRS also issues a limited amount of “preliminary” statistical data on later tax years. Because the IRS itself needs this data to forecast and allocate its own resources, it is not surprising to find this data buried in “projection reports.” The latest of these reports is titled “Fiscal Year Return Projections for the United States: 2006–2013.” That report gives return estimates based on category of business tax return for tax year 2005 as well as projections through 2013.

2006–2013 IRS Projections

The IRS projects that the next several years should add significant increases to the numbers of tax returns filed by partnerships, S corporations, and unincorporated businesses owned by individual taxpayers.

In the Fiscal Year Return Projections report, the IRS forecasts a number of tax return statistics to provide a basis for IRS workload estimates and resource requirements. A glance at the partnership, corporation (including S corpora-tion) and individual business categories show what choice-of-entity decisions the IRS forecasts that taxpayers will make over the next seven years.

For partnership returns:

Total partnerships. A 37 percent increase from 2,863,200 in 2006 to 3,909,000 in 2013.

Partnerships; small business/self-employed. A 36 percent increase from 2,772,100 in 2006 to 3,782,400 in 2013.

Partnerships; large and mid-sized business. A 39 percent increase from 90,700 in 2006 to 126,100 in 2013.

Partnerships; tax-exempt/government entities. A 67 percent increase from 300 in 2006 to 500 in 2013.

For corporate filings, including S corporations:

Corporation income tax total. An 18 percent increase from 6,225,100 in 2006 to 7,349,300 in 2013.