165 ALI-ABA Course of Study Representing the Growing Business: Tax, Corporate, Securities, and Accounting Issues February 21-23, 2008 Pasadena, California Federal Income Tax Considerations in the Choice of Business Entity By Roger M. Ritt Wilmer Cutler Pickering Hale and Dorr LLP Boston, Massachusetts 2008 WilmerHale. All rights reserved.
166 FEDERAL INCOME TAX CONSIDERATIONS IN THE CHOICE OF BUSINESS ENTITY Table of Contents Page I. Choices of Business Entity....1 A. Sole proprietorship...1 B. C corporation...1 C. S corporation...2 D. General partnership...3 E. Limited partnership...3 F. Limited liability company...4 G. Business trusts...4 H. Other organizational forms...4 II. Federal Income Tax Considerations in the Choice of Business Entity...5 A. Formation of the enterprise...5 B. Taxation of operating income...7 C. Deductibility of operating losses...13 D. Special allocations...15 E. Choice of taxable year...17 F. Choice of accounting method...18 G. Taxable sale of the assets of, or an interest in, the business organization...19 H. Tax-free sale of assets of, or interests in, the business organization to an acquiring corporation...21 I. Liquidation or dissolution of the business...21 J. Retirement or death...22 K. Employee benefits...24 2008 WilmerHale. All rights reserved.
167 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). Under the Code, the term corporation generally is defined to include an association, a joint-stock company, and an insurance company. See I.R.C. 7701(a)(3). 1/ 1. 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). 1/ Unless otherwise noted, references to statutory sections are references to sections of the Code. 1
168 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). 2. 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); 2
169 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). 2/ 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, partnerships are by default classified as such for federal income tax purposes, but can elect (by filing Form 8832 Entity Classification Election) to be taxable as a corporation. See Treas. Reg. 301.7701-1, 301.7701-2, and 301.7701-3. See also Section I.B.1, 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 2/ 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. 3