A business entity is generally taxed as a C corporation if it is considered a corporation as a matter of law, if it is an association that has elected to be taxed as a C corporation, or if it is a publicly traded partnership. One of the most significant questions facing the owners of a new business is what form in which to operate. Operating a business as a C corporation can be very costly from a tax standpoint because C corporations, unlike pass-through entities, are treated as separate taxable entities and, as such, are subject to double taxation.
A C corporation computes its taxable income differently from an individual. It has available a dividends-received deduction that does not apply to individuals, and special rules may apply to its charitable contributions deduction, organizational expenditures, capital losses, passive activity losses, and amount at risk in an activity. In addition, certain deductions are unavailable to corporations.
Owners of a closely held corporation have a unique tax planning opportunity available to them that is not available to shareholders in a publicly held corporation — the option of having the corporation elect to be taxed as an “S corporation.” If a corporation elects S status, the shareholders not only continue to have the legal benefits of operating in the corporate form (e.g., limited personal liability) but also enjoy many of the federal (and possibly state) income tax advantages accorded an owner of a proprietorship or partners in a partnership (e.g., a single level of tax and the availability of losses of the business entity to offset other income of the entity’s owner(s)). [Note, however, that members of firms structured as limited liability companies (LLCs) generally enjoy the same limited liability exposure as S corporation shareholders do while having the additional benefit of being able to elect to be taxed, under subchapter K, as if they were partners in a partnership.
A partnership is a joint undertaking, other than a corporation or a trust, by two or more taxpayers to conduct a business or investment activity for a profit. Frequently, a business relationship between two or more taxpayers is something other than a partnership.
The rules governing the taxation of a partnership combine both an aggregate and an entity approach. That is, some of the provisions ignore the existence of the partnership as a separate entity and treat it, instead, as an aggregate of individual owners. Other provisions treat the partnership as an entity separate from its owners. The most significant of the provisions reflecting the aggregate approach is the rule providing that a partnership is not, itself, subject to tax. Each partner reports the partner’s share of each partnership tax item on the partner’s own 1040 individual income tax return via a Schedule K-1 kicked out by the partnership return, Form 1065.. However, reflecting an entity approach, the amount, character, and timing of income, deductions, gains, losses, and credits of the partnership are determined at the partnership level.
The partners pay the income taxes on the partnership’s profits, even if they do not receive a distribution of those profits.
If a partnership produces a loss for the taxable year, the conduit principle permits the partnership’s losses to be passed on to the partners. The losses are available to offset income from other sources that the partner has reported.
Although the tax consequences of a particular partnership transaction are governed by general income tax principles, the Internal Revenue Code grants the partners a certain amount of flexibility in determining when the results of the transaction are reported and a great deal of flexibility in determining how the results of a transaction are allocated among the partners. Each partner’s share of the partnership’s income, deductions, gains, losses, and tax credits is generally determined by the partnership agreement under state partnership law. This flexibility carries over to the tax treatment of partnerships, which gives partners a variety of choices, such as special allocations, optional basis adjustments, and whether to structure a buy-out agreement as a sale or liquidation.
These choices are permitted even if their only purpose is to achieve an overall reduction in taxes. However, the law of partnership taxation does not permit taxpayers to disguise a transaction as something else. In addition, partners cannot disregard basic income tax principles, such as the assignment of income doctrine. Partnership losses cannot be assigned to a taxpayer who was not a partner at the time the partnership incurred those losses, and taxpayers may not use contributions of property to a partnership, transfers of partnership interests, and distributions of partnership property to shift losses built in to the property from one partner to another.
Limited liability companies (“LLCs”) became popular in the early 1990s as an alternative to the corporate or partnership form of operating a business. LLCs are hybrid entities that combine the pass-through tax attributes of partnerships with the corporate characteristic of limited liability. That is, an LLC taxed as a partnership for federal tax purposes is subject to only one level of taxation and yet its owners are protected from liability for LLC debt under state law. In contrast, partners in a state law general partnership are jointly and severally liable for partnership debt. Only limited partners in a state law limited partnership enjoy limited liability and this applies only if the limited partner does not participate in management. In an LLC, the members may actively participate in the management of the business without losing the protection of limited liability under state law. As a result of this, LLCs have been viewed as combining the “best of both worlds.”