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Federal Taxation of Business Entities
Santa Clara University School of Law
Morse, Susan C.

Forms of Business Organizations
 
Sole proprietorship: A sole proprietor is personally liable for debts and claims against the business. Additionally, all income and other expenses should be reported on his or her individual tax returns
               
Partnership: The UPA defines a partnership as an association of two or more persons to carry on as co-owners a business for profit. There are several types of partnerships forms
First, a general partnership is one that each partner has the right to share in profit of the partnership and an undivided interest in the partnership property. General partners ordinarily are also jointly and severally liable for all debts and obligations of the partnership.
 
A limited partnership has both a general partner (or partners) and limited partners. Limited partners generally do not participate in management and are not personally liable for debts and obligations of the partnership.
 
An LLP basically operates as a GP, but all the partners obtain full or partial ,limited liability. Generally speaking, an LLP is protects from vicarious liability for acts of other partners.
 
An LLLP is a traditionally limited partnership in form but extend limited liability to the general partners much like an LLP.
 
Limited Liability Company: A LLC is an unincorporated entity in which the owners, called members, have limited liability for the enterprise’s debt and claims even if they participate in management. A GP may benefit from limited liability if the partners form an LLC and the LLC acts as a partner in the partnership.
 
Corporation: A corporation permits limited liability to its shareholders. The owners of the corporation generally do not participate in the company management. However, shareholders are also subject to double taxation. The corporation is subject to 35% tax under § 11. The shareholders, who receive the dividends, are subject to a 15% tax under the new qualify dividend rule.
 
Aggregate v. Entity
Under a pure aggregate concept, the business organization itself is not treated as a separate taxable entity. A GP, LP, LLP, LLLP or a S corp. employs an aggregate approach for some tax purposes. However, it is important to note that partnerships are treated as entities for purposes of selecting a taxable year, computing and characterizing partnership income, making elections, etc. Therefore, partnerships are usually a hybrid between aggregate and entity.
 
On the other hand, under an entity concept, a business organization is a separate taxable person that must determine and pay tax on its annual taxable income. Transactions between the entity and its owners generally are treated as if they were between unrelated entities.  
S corporations are generally subject to a single, shareholder-level tax (similar to that of partnerships). However, S corporations remain corporation for purposes of Subchapter C. Thus, the two corporate subchapters often operate in tandem when an S corporation engages in transactions, such as distribution of appreciated property, stock redemptions and liquidations, that are subject to Subchapter C, or when an S corp. formerly was a C corp.
 
Relevant Statutes
 
C Corporation
§ 11: The corporate tax will be the sum of (1) 15% of amount not exceeding $50,000 plus (2) 25% of amount exceeding $50,000 and not exceeding $75,000 plus (3) 34% of amount exceeding $75,000 and not exceeding $10,000,000. Where the corporation has taxable income in excess of $100,000, the amount of tax determined under the preceding sentence for such taxable year shall be increased by the lesser of (i) 5% of such excess, or (ii)$11,750. Where the corporation has taxable income in excess of $15,000,000, the amount of tax should be increased by an additional amount equal to the lesser of (i) 3 percent of such excess, or (ii) $100,000.
However, for the purpose of this class, we can assume that the corporate tax rate is at 35%.
 
Partnership:
§ 702(a): Partnership, unlike C corporation, is not itself a taxpaying entity, but instead passes items of income, loss, deduction, and credit through to its shareholders for reporting on their individual returns. Subchapter K takes an aggregate approach.
 
S Corp:
§ 1366(a): Like partnership, items of income, loss, deduction, or credit passes through to shareholders of a S corp.
 
Initial Formation Issues:
Partnership or Corporation:
Generally speaking, a business decided to carry out its business as any business form must make proper election under relevant state or federal law. However, the following are the relevant code provisions governing the election of business form.
 
§ 7701(a)(2) states that a partnership is any group, JV or other unincorporated organization that carries on a business, but not a trust or estate or a corporation.
 
§ 7701(a)(3) states that corporation includes association, joint-stock companies, and insurance companies.
 
Reg. 301-7701-2(b) defines a corporation as a business entity organized under a state or similar statute that refers to the entity as incorporated.
Reg. 301-7701-3 further provides the check-the-box regulation. Generally speaking, an eligible entity with at least 2 member is permitted to elect to be classified as an association (and thus a corporation under § 301-7701-2(b)(2)). Without such election, however, the default is partnership.
 
Additional Info:
Reg. 301-7701(a)(2) provides some background whether an a joint undertaking give rise to entities for federal tax purposes. In general, entities established for the purpose of carry on a trade, business, financial operation or venture and divide the profits is an entities for federal tax purposes, whereas a joint undertaking to share expenses is not a separate entity for federal tax purposes, nor is mere co-ownership of property that is maintained, kept in repair, and rented or leased (for example, tenants in common lends a farm for cash rental). 
 
Reg. 301-7701-2(a) states a business entity is any entity recognized for federal tax purposes and that is not a trust. Generally speaking, a business entity with 2 or more members is classified for

1361(d) also permits a qualified subchapter S trust. The main difference here is that a QQST permits only a single beneficiary, while a small business trust permits multiple beneficiaries, under the condition that each beneficiary is treated as a shareholder.  
 
Last, § 1361(c)(4) states that a corporation is not treated as having more than 1 class of stock solely because there are differences in voting rights. However, preferred stocks may be treated as a different class. In this situation, the issue is whether the corporation issues any of the preferred stock, if not, then the S corp. still qualifies for the 1 class of stock rule. 1361(b)(1)(D).
§ 1361(c)(2)(A)(6) permits 501 entities to be qualified as a S corp.
 
Timing Issue:
§ 1361(b)(1)(B) allows an election to be made at anytime during the taxable year and on or before 15th day of the 3rd month of the taxable year (that means, if you want to effective day to be on Jan 1. 2008, the last day to file is March 15). However, for example, if the corporation files the election after 75 days after Jan.1 2005, the election window for 2005 is expired. Under § 1362(b)(1)(A), any election made after 75 days (March 15) of 2005 will be considered an election for the next taxable year, which is Jan 1, 2006.
 
Termination:
Termination of a S election is described by § 1362(d). There are two main ways. First, a revocation is permitted under 1362(d)(1). Second, cessation is permitted under 1362(d)(2).
 
Revocation means that the company chooses to revoke the election through a simple shareholder majority. Cessation means that the S corp. no longer meets the criteria for being an S corp such as exceeding the permissible number of shareholders. In the case of revocation, termination is valid for the first day of the current taxable year if made before the 15th day of the 3rd month (approximately 75 days) under 1362(d)(1)(C)(i). For example, if the taxable year begins Jan. 1, 2005, the corporation may revoke the S election up until Mar. 15, 2005 and termination will be effective Jan. 1, 2005. If the election is made after the 15th day of the 3rd month, it is effective for the first day of the following taxable year according to 1362(d)(1)(C)(ii). Keeping with the same example, any revocation after Mar. 15, 2005 will be valid for Jan. 1, 2006. Under 1362(d)(1)(D), if a prospective date is specified in the revocation, the revocation will be effective from that prospective date.