Partnerships, LLCs, LLPs, and S Corporations
By Mark P. Altieri and William J. Cenker
Subtle Differences Could Trigger Big Effects
The choice of business entity has become increasingly complex because of the changes in state laws that permit additional pass-through entities for tax purposes. Although such entities are generally treated similarly, some of the subtle differences in the taxation of partnerships, LLCs, LLPs, and S corporations could have a substantial effect on the taxation of the owners in different situations. The authors identify cases where the tax effects under different flow-through entity choices could be substantially different and illustrate these differences with examples.
All states now permit the formation of limited liability companies (LLC) or limited liability partnerships (LLP), which have replaced general partnerships as the entities of choice. Many assume that the taxation of these entities, in particular LLCs electing to be taxed as partnerships, is uniformly the same as for general partnerships, although this is not always the case. There are significant differences between the taxation of the partnership entities and S corporations in several areas: entity debt and outside basis, at risk considerations, and self-employment tax issues.
LLCs generally cloak their owners in limited liability, similar to corporations. The LLP, a recently created variation of a state-law general partnership, also provides such protection. In most states, a general partnership can be seamlessly converted without tax effect into an LLP. The primary difference between an LLP and a general partnership is that the LLP partner is not personally liable for any partnership liability due to the wrongful acts or omissions (e.g., negligence) of partners or employees of the LLP. Generally, the taxation of members of an LLC, partners in a general partnership, and partners in an LLP is similar.
Many small business owners desiring limited liability will form either as an S corporation or as an LLC and elect to be taxed as a partnership. Although the taxation of S corporation and partnership operations is generally similar, that is, both are “flow-through” or “conduit” entities for federal income tax purposes, significant differences exist between the federal income taxation of S corporations and partnerships especially with regard to financing, formation, restructuring, distributions, and entity liquidation.
With the advent of LLCs, the much-maligned general partnership might appear to be a relic. Still, the use of a general partnership or an LLP might indeed be preferable to an S corporation or LLC if the at-risk issues are a primary concern.
Contributions of Property
The contribution of appreciated property and property subject to a liability may pose specific problems that would be resolved differently depending on the flow-through entity. Appreciated property (fair market value in excess of the adjusted tax basis) is often used as a capital contribution to a newly formed entity. Furthermore, such property may be encumbered by a loan that the entity assumes.
In the case of a contribution of appreciated property to an S corporation in order to obtain tax deferral, IRC section 351(a) requires that the transferor shareholder, along with all other shareholders making contemporaneous contributions of property, control the corporation immediately after such transfer, and IRC section 368(c) requires that the transferring shareholders control 80% or more of the stock. In the case of a partnership, there is no control requirement. Any contributing partner is protected from tax recognition under IRC section 721(a). What happens, however, if the entity subsequently disposes of the contributed property in a taxable transaction? Should the gain or loss attributable to the precontribution holding period be specifically allocated only to the contributing owner? In the case of an S corporation, there is no special allocation of any precontribution gain or loss. In the case of an entity taxable as a partnership, however, IRC section 704(c) requires a mandatory allocation (not a voluntary special allocation as discussed below) of pre contribution gain or loss to the contributing partner.
When encumbered property is contributed to an S corporation, and the entity assumes the underlying liability, realized gain is recognized under IRC section 357(c) by the shareholder to the extent that the assumed liability exceeds the tax basis of all her contributed property . In the case of a partnership, when such property is contributed only that portion of the liability of which the contributing owner is considered relieved creates a potential tax problem. The relieved liability constitutes a deemed cash distribution to that contributing partner. Actual or deemed cash distributions in excess of the partner’s tax basis in his interest in the entity (referred to as the outside basis) triggers a recognized taxable gain under IRC sections 752 and 731.
Receipt of Ownership Interest for Services
There are significant differences between the tax treatment of S corporations and partnerships for the contribution of services. These differences are a function of the nature of the capital interest in the partnership received.
IRC section 351(a) requires that the controlling shareholders of a newly incorporated entity receive their stock for “property” in order to obtain tax-deferral. On the other hand, IRC section 83 triggers current taxation to the recipient of property exchanged as consideration for services. Furthermore, a shareholder who receives stock solely for services is not considered a member of the requisite IRC section 368(c) controlling shareholder group necessary to effect tax-free treatment under IRC section 351. Thus, in addition to current income taxation to the service-contributing shareholder, an ancillary result would be to generally deny section 351 treatment to all contributing shareholders if the service-contributing shareholder receives more than a 20% stock interest in exchange for services. Although the service-contributing shareholder will always be taxed on the receipt of a stock interest for services, Treasury Regulations section 1.351-1(a)(1) provides that a contemporaneous transfer of a relatively significant amount of property in addition to services will allow the service-contributing shareholder’s entire stock interest to be counted for IRC section 368(c) control purposes. The IRS requires that qualifying property must have a value of at least 10% of the value of the accompanying services for this purpose (See Revenue Procedure 77-37, 1977-2 C.B. 5687). In the case of a partnership, the tax results would depend on whether the service-contributing partner received a share of current capital, or merely a right to participate in future profits. IRC section 721 and related regulations indicate that receipt of the right to participate only in future partnership profits will not trigger current income taxation to that service-contributing partner. Although the case law on this issue is still unsettles, the consensus appears to be that the receipt by a service-contributing partner of a profits interest will not trigger current income taxation, particularly if there is no long operating history to the underlying business that would allow for a reasonable valuation of such an interest. Revenue Procedure 93-27 indicates that receipt of a profits interest for providing services to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner will generally not trigger a taxable event to either the partner or the partnership.
Allocation of Tax Attributes
Partnerships clearly provide far wider flexibility with respect to allocating specific tax attributes. The owners may desire that tax attributes such as specific gain, loss, income or deductions be allocated to certain owners in a manner that is disproportionate to their general ownership interest in the entity.
Technically, such special allocations are not possible in the division of tax attributes flowing out of an S corporation. If the S corporation shareholders attempt to manipulate the normal tax allocations generated by their respective pro-rata ownership interests through employment or other side agreements, they run the risk of terminating the S election due to the creation of a second class of stock. Entities taxable as partnerships, on the other hand, are permitted to structure special tax allocations if such allocations have “substantial economic effect” under IRC section 704(b). Generally, the requisite substantial economic effect is present if the tax allocations are reflected in the partners’ capital accounts and will affect the economic distributions to and liabilities of the partners upon liquidation of the entity.
Inside and Outside Basis and the IRC Section 754 Election
The aggregate outside basis of the owners in their equity interests in the entity may vary from the entity’s inside tax basis of its assets. This phenomenon may result from the sale or purchase of individual interests in the entity or from a disproportionate distribution from the entity to an owner.
When such a disparity occurs in an S corporation, there is no entity-level mechanism for correcting the disparity. In the case of an entity taxable as a partnership, however, IRC section 754 provides an optional election that will provide a self-correcting adjustment in the event of a disparity created through the sale of a partnership interest (via IRC section 743) or in the event of a disproportionate partnership distribution (via IRC section 734).
Distribution of Appreciated Property from the Entity to the Owners
Occasionally a business will make a distribution of noncash property (typically appreciated) to some or all of its owners. This distribution may either be a liquidating distribution or a normal distribution in lieu of cash.
In an S corporation, gain is recognized as if the entity had sold the property to an unrelated party at fair market value, whether the distribution of the appreciated property is a liquidating or a nonliquidating distribution. The recognized gain is then allocated to the S corporation shareholders in proportion to their stock ownership. This applicable gain will increase the shareholder’s outside basis in their stock. Furthermore, to the extent that the fair market value of the property distributed exceeds the adjusted outside basis of the stock, gain is recognized under IRC section 1368(b)(2). In contrast, an entity taxable as a partnership generally recognizes no gain on distribution of the appreciated property. At the partner level, typically only a cash distribution in excess of the partner’s outside basis will trigger gain recognition. A distribution of appreciated property to a partner will generally not trigger partner-level gain recognition. Nevertheless, unexpected tax problems could arise in a partnership holding significant amounts of “hot assets,” that is, substantially appreciated inventory and unrealized receivables. If a distribution occurs to a partner or partners where there is not a proportionate distribution of hot assets, ordinary income recognition will occur.
Sale of Equity Interest
At some point in time, the investors will likely sell their equity interests in the business. The sale of stock in a corporation generally triggers a capital gain or loss. The tax treatment of a sale of a partnership interest, on the other hand, could depend on the underlying assets.
Absent the highly unusual application of the IRC section 341 collapsible corporation rules to an S corporation, the sale of stock in such an entity is the sale of a capital asset. An additional advantage to the sale of S corporation stock is the availability of ordinary loss treatment under IRC section 1244 if the stock is “small business stock.” Although capital gain or loss generally results on the sale of a partnership interest under IRC section 741, some of that capital gain or loss may be recharacterized under section 751 as ordinary if the entity holds meaningful amounts of hot assets.
Payments to a Retiring Owner
It is common for small businesses to redeem and purchase a retiring owner’s equity in the entity. The tax treatment of such retired owners is significantly affected by the choice of entity.
In an S corporation, if the retiring owner’s interest in the entity is redeemed, IRC section 302(b)(3) or 303 affords “sale or exchange” treatment to the transaction, characterizing the resulting gain (or loss) as capital. In the case of an entity taxable as a partnership, the intricacies of IRC section 736 must be examined. Section 736 divides payments to a retiring partner into section 736(a) ordinary income payments and section 736(b) property (capital gain) payments. Until the section 736 payments are completed, the entity continues to exist for tax purposes as a partnership even if there is only one surviving partner. Nevertheless, the implications of IRC section 736 depend upon whether hot assets are present in the partnership, whether the retirement payments are made in cash or noncash property, whether a section 754 election to adjust the inside basis of entity assets is present, and whether the partnership is primarily a service provider where capital is not a material income-producing factor.
Entity Debt and Outside Tax Basis
The effect of entity-level debt in the computation of the owner’s outside basis in the ownership interest is a major difference between the taxation of S corporations and partnerships.
There is no effect on the owner’s tax basis in S corporation stock when the entity initially incurs and pays off debt on which it is the primary obligor, even if the shareholder guarantees the S corporation debt. Thus, the outside tax basis of the owner’s interest in the S corporation is a limitation on the ability to receive a tax-free distribution from the entity as well as a general limitation on the current use of losses passing through the entity level to the owners.
The effect of entity debt in an organization taxed as a partnership is significantly different. In essence, the incurrence and retirement of partnership debt is treated as if the partners individually and proportionately borrowed the funds and then contributed those funds to the partnership. Upon retirement of the debt, there is a reciprocal deemed cash distribution to the partners. This deemed cash contribution increases the partners’ outside basis in the entity, while the deemed cash distribution reduces the partners’ outside basis (and triggers recognized gain to the extent the distribution exceeds outside basis). This “phantom income” does not occur in the S corporation context because the S corporation’s incurrence and discharge of entity-level debt has no effect on the shareholder’s outside stock basis; therefore, no deemed cash contribution or distribution occurs.
Nevertheless, there is a very technical and complex distinction between the way partners share recourse and nonrecourse debt. Generally, partners share recourse debt in accordance with their loss-sharing ratios while they share nonrecourse debt in accordance with their profit-sharing ratios. Recourse debt is partnership debt for which a partner (or a person related to a partner) bears the economic risk of loss. Conversely, nonrecourse debt is entity debt for which no partner bears an economic risk of loss (nonrecourse debt is generally secured by partnership property that serves as collateral).
Example. Mark and Bill each have a 50% interest in NewCo. Bill contributes $100,000 cash for his interest and Mark contributes property with a fair market value of $100,000 and a precontribution tax basis of $0. The entity borrows $50,000 from an unrelated party and pays interest only on the debt for the year. The entity’s the first year of operations result in a net operating loss of $20,000. Additionally, the entity makes a $5,000 cash distribution to each of the owners.
If the entity is an S corporation, neither shareholder receives outside basis credit for the entity-level debt. Mark’s basis in his ownership interest is the substituted basis of $0, while Bill’s is $100,000. Since Mark has no outside basis against which to absorb the cash distribution, it triggers a recognized capital gain of $5,000. Furthermore, Mark cannot currently use any of his $10,000 share of the corporation’s net operating loss for the year; it is suspended until he sufficiently builds up his outside basis.
Bill, on the other hand, can currently use his $10,000 share of the entity’s net operating loss. Additionally, since he has an outside basis to cover it, his cash distribution is tax-free. His outside basis in NewCo stock would be reduced by the cash distribution and loss pass-through to $85,000.
If the entity were a partnership, the partners would each get $25,000 of basis credit for the entity level debt so that both Mark and Bill could currently use their losses and receive the cash distributions tax-free.
Investors will often loan money to the entities they own. When an S corporation shareholder directly loans money to her corporation, the loan principal provides a buffer against which loss pass-throughs may be taken if the outside stock basis has been reduced to $0. The loan will not, however, directly affect the owner’s outside basis in his or her stock. It is only the outside basis in the stock interest that acts as a buffer for tax-free cash distributions.
In the case of an entity taxable as a partnership, the entity debt directly affects the partner’s outside basis in the partnership interest. When a partner loans money on a nonrecourse basis to the partnership, only that partner bears the economic risk of loss associated with default on the loan. Therefore, the lending partner gets 100% basis credit for the loan principal because it is treated as a recourse loan from that lending partner.
Example. Consider the earlier example of NewCo, except Mark now makes a $50,000 non-recourse loan to the entity with interest-only payments scheduled for the next few years.
The entity breaks even in its first year of operations, with no net income or loss. In addition, the entity distributes $5,000 of cash to Mark in addition to the interest payments on the loan.
If NewCo were an S corporation, Mark’s outside basis in his stock interest would be $0. The $5,000 cash distribution in excess of basis is a recognized taxable gain to him. If NewCo were a partnership, Mark would receive the $5,000 distribution tax-free, because his outside basis prior to the distribution was $50,000.
Members of an LLC, partners in a general partnership, and partners in a LLP are generally treated in the same manner for federal income tax purposes. The rules differ from those above on entity debt and outside tax basis analysis, however, and the choice of business entity could be a critical factor where a distinction between S corporations, general partnerships, LLCs, and LLPs becomes relevant.
Three different limitations may apply to the current deductibility of losses in a pass-through entity. The first, the overall limitation, limits the current deductibility of flowed-through losses to a partner or S corporation shareholder’s outside tax basis in the entity. Computing these deductibility limitations follows the procedures discussed above.
The second limitation that may limit the current use of losses is the at-risk rules of IRC section 465. The at-risk rules apply to individuals and closely held corporations. Business entity selection has a direct bearing on section 465.
The third limitation is the passive loss rules of IRC section 469. A business is passive with regard to a given owner unless that owner is a material participant in it under IRC section 469, which generally requires hands-on, regular and continuous services. If passive, any resulting losses are deductible by the owner only against passive income derived from other sources. With the exception of a limited partner (who, by definition, would be unable to engage in the day-to-day rendition of services to the limited partnership), business entity selection is not relevant to a determination of material participation. For this reason, this third limitation does not apply to many cases, and is less significant than the at-risk limitation.
IRC section 465 (the at-risk limitation) prohibits the current deductibility of flowed-through losses unless the partner or S corporation shareholder has a sufficient amount at-risk in the business. In the case of an S corporation or an entity taxable as a partnership, the at-risk limits apply at the owner, not the entity, level. An owner’s at-risk amount is an ever-changing number equal to: 1) cash or the adjusted basis of noncash property contributed to the business, plus 2) most recourse borrowings by the business for which the owner has personal liability, plus 3) the owner’s share of amounts borrowed for use in the business that are qualified nonrecourse financing (qualified nonrecourse financing is present if the business has recourse debt collateralized with real property it uses in its business), plus 4) the owner’s share of flowed-through income items. The owner’s at-risk amount is decreased by 1) wealth withdrawn from the business, 2) the owner’s share of flowed-through (and deducted) loss items, and 3) a reduction in recourse debt that had earlier increased the owner’s at-risk amount.
The owner will be at-risk for her share of recourse liabilities. The widespread conclusion that entities taxed as partnerships (general partnerships, LLCs and LLPs) are taxed similarly now breaks down because of the way the owners share entity liabilities under state law. A general partner will be at-risk for his share of all general partnership debt. An LLP partner will similarly be at risk for all normal debt of the LLP.
In contrast, similar liabilities in an S corporation or LLC would not increase the amount at-risk for their owners. Even though the lender would have recourse against any of the business’s assets, the personal liability shell provided by the S corporation or LLC entity would prevent the lender from satisfying the debt out of the personal wealth of the owners.\
What if the owners in the latter situation personally guaranteed the business’s debt? Under the at-risk rules, neither a member of an LLC nor an S corporation shareholder would have an increased amount at-risk by guaranteeing business debt until the owner is actually called upon to satisfy the loan. A guaranty of entity debt by a general partner or LLP partner would not disqualify that owner from an at-risk build-up since such partner would have personal liability for repayment of the debt under state law immediately upon its creation, irrespective of the guarantee. The distinction is a function of the party ultimately liable under state law. A guarantor-owner of an S corporation or LLC would have a legal right to reimbursement against the entity upon making good on the guarantee.
Example. Assume that Mark and Bill in the example above each receive Schedule K-1 losses of $20,000. Neither owner has any amount at-risk in NewCo.
During the year, NewCo borrows $30,000. Mark and Bill personally guarantee NewCo’s $30,000 bank debt. By the end of the tax year accounts and trade payables have grown by $10,000.
If the entity were an LLC or an S corporation, Mark and Bill’s at-risk amount in NewCo would be $0, despite their personal guarantees of the bank debt. Consequently, none of their losses would be currently deductible.
If the entity were a general partnership or an LLP, Mark and Bill would each have an at-risk amount at the end of the year of $20,000 and their share of NewCo losses for the year would be fully deductible (presuming no passive loss issues) on their personal returns; this would be the case even if they had not guaranteed the bank debt.
Self-Employment Tax Issues
A general partner’s earnings from self-employment would include the distributive share of partnership operating income, assuming the partnership is actively engaged in a trade or business. In contrast, distributive S corporation income (presuming payments of reasonable wages to active owners) is not subject to self-employment tax.
Example. Assume that Mark and Bill are full-time employees of NewCo. The company generates $300,000 of taxable income. If NewCo is an LLC taxed as a partnership, all $300,000 will be taxable to Mark and Bill for self-employment purposes.
Assuming that a reasonable salary for Mark and Bill is $100,000 each, and NewCo is an S corporation, the company can deduct the $200,000, with Mark and Bill each receiving a $50,000 share of the net income on their K-1s. The overall effect is to save the $2,900 Medicare portion of self-employment tax. If NewCo’s income is more than $300,000, the savings will be greater
Under the final Treasury Regulations, a limited partner’s distributive share of the income from a partnership is generally excluded from the definition of net income from self-employment. Proposed regulations provide for a partner or LLC member to be treated as a limited partner unless: 1) the partner or member has personal liability for the debts of or claims against the partnership by reason of being a partner or member; 2) the partner or member has authority to contract on behalf of the partnership; or 3) the partner or member participates in the partnership trade or business for more than 500 hours during the taxable year. Any individual providing professional services, however, will not be considered a limited partner.
An LLC member will generally not be personally liable for the debt of the corporation, whereas a partner in a LLP will bear such liability (as will a general partner in a general partnership). Accordingly, under the proposed regulations there is an advantage to a LLC over LLP, assuming the activities are nonprofessional in nature and the member meets the other specified criteria.
Example. Assume that NewCo is a nonprofessional business that generates significant operating income for tax purposes. Bill is active in the business (more than 500 hours) whereas Mark is a passive owner. In the current year, after adequate compensation has been paid to Bill, NewCo has net operating income of $500,000.
If NewCo is an S corporation, Mark and Bill’s distributive share of the operating income will not be self-employment income. However, if NewCo is a general partnership or an LLP, Mark and Bill’s distributive share of operating income will be entirely self-employment income. Even though Mark renders no services to NewCo, he bears personal liability for the general partnership or LLP debt. If NewCo is an LLC, under the proposed regulations Bill’s distributive share would be self-employment income but Mark’s would not.
The Entity of Choice
Overall, partnerships generally appear to be a more favorable tax entity than S corporations. The explosion of LLCs electing to be taxed as partnerships attests to this conclusion. The LLC is particularly suited for situations in which the entity will hold highly appreciating assets which could be refinanced by the entity and thereby build up the outside basis of the members or partners so as to absorb later tax-free cash distributions and utilize loss pass-throughs. Moreover, if it is likely that such appreciated assets will be distributed in-kind, the partnership provides distinct tax deferral advantages.
If IRC section 465 at-risk issues are a major concern, a general partnership or a LLP may provide a more viable entity for building up the owner’s at-risk amount relative to entity debt. Both an S corporation and an LLC may be inferior in terms of generating at-risk amounts to the owners.
Nonetheless, there are disadvantages to an entity taxable as a partnership. The possible negative self-employment tax implications of a partnership and the intricacies of Subchapter K over those of Subchapter S could tip the balance in certain circumstances. Moreover, before jumping to the conclusion that the S corporation is inferior to the partnership, other concerns and possibilities should be considered. If the entity anticipates going public, transitioning a privately owned S corporation to a public one is significantly easier from a tax and non-tax standpoint than the transition of a partnership.
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