Choice of Entity and What Is a "Partnership" for Tax Purposes?

• Pages: 1-24
• Author: James R. Repetti,William H. Lyons,Charlene D. Luke

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Chapter One

CHOICE OF ENTITY AND WHAT IS A

“PARTNERSHIP” FOR TAX PURPOSES?

A. Introduction

Partnerships can be very useful vehicles for engaging in various

profit seeking ac tivities. They often provide more tax advantages

than a C corporation and gre ater flexibility than an S corporation.

These adv antages, how ever, come at a price. Partnership tax laws

represent some of the most complex tax s tatutes and re gulations in

the United States. This complexity has arisen because of competing

philosophies about how partnerships should be taxed and because of

the need to prevent taxpayers from abusing the flexibility th at

partnership taxation provides.

This chapter introduces two important concepts: (1) the federal

income tax factors rele vant to choosing the type of entity to conduct

a business and (2) the factors affecting classification as a partnership

or corporation for federal income tax purposes. Section B discusses

some of the key factors that taxpayers and their advisors should

consider when selecting the type of entity to use to conduct a business

or investment activity. Section C addresses when federal income tax

law will treat two or more persons as having formed a new tax entity

that exists separate from themselves and when such entity will be

taxed as a partnership or corporation.

B. Choice of Entity: An Overview of Taxation of

Partnerships, C Corporations, and S Corporations

1. Introduction

Tax planners will usually consider three types of entities for

their clients to conduct a business or investment activity: a

partnership (or limited liability company (“LLC”) taxable a s a

partnership

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), a corporation that has elected to be govern ed by the

rules contained in Subchapter S of the Internal Revenue Code

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(an S

corporation), or a corporation that is governed by Subchapter C of the

Code

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(a C corporation).

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As discussed in § C, below, an LLC with more than one owner is taxable as a

partnership unless it elects to be taxable as a corporation.

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An S corporation is a corporation that has elected to be governed by

Subchapter S of the Internal Revenue Code, §§ 1361 through 1379.

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A C corporation is a corporation that is governed by Subchapter C of the

Internal Revenue Code, §§ 301 through 385.

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Choice of Entity and What Is a

“Partnership” for Tax Purposes?

Ch. 1

The central principle underlying the federal income taxation

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of

partners i s that the existence of the partnership should matter as

little as possible. As an American Law Institute (“ALI”) study put it,

“the ideal mode for taxing partnership earnings is to tax each partner

as though he were directly conducting his proportionate sh are of the

partnership business.”

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This mo de of taxation is usu ally referred to

as the “aggregate” approach because it treats the partnership as an

aggregate of individuals, each conducting her share of the

partnership’s business. The ALI emphasized, ho wever, that this

principle controls only in the absence of countervailing factors.

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A

“countervailing factor” that often makes it undesirable to try to tax

partners as if they were conducting their shares of the business as

sole proprietors is administrative convenience. Administrative

convenience normally suggests that the partnership be treated as an

entity separate from the partners—i.e., that the “entity” approach be

used.

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To illustrate the considerations raised above, think about a

laundry business co nducted by Emi ly and Frank as equal partners.

Each contributed equal amounts of cash, each does identical work,

and each takes the same amount of money out of the business. In this

very simple example, it is easy to apply the aggre gate approach and

tax Emily and Frank as if each were conducting half of the business:

each can include in income half of the income of the laundry.

Treating the partnership as an “aggregate,” as in the example

above, is not always practical; sometimes an “entity” approach must

be used. Suppose that the laundry building burns down, and that

Emily wants to reinvest the insurance proceeds in a new bui lding,

electing nonrecognition of gain under § 1033. Frank (who has a large,

deductible loss from another activity) would prefer that the gain be

recognized. Can both partners get the tax treatment they want? No:

§ 703(b) adopts the entity approach and allows nonrecognition only

if the partnership itself makes the election and replaces the building.

Section 703(b), with three exceptions, provides that elections

affecting the computation of partnership income must be made by the

partnership, and § 1033(a)(2)(A) allows nonrecognition only if “the

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This discussion focuses on federal income taxation of partnerships, S

corporations, and C corporations. State tax rules applicable to such entities and their

owners may differ from the federal income tax rules.

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American Law Institute, Federal Income Tax Project, Subchapter K, 5 (1984).

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Id. (emphasis omitted).

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Indeed, concerns about administrative convenience prompted the drafters of

the Revised Uniform Partnership Act (1997) to recommend that states use the entity

approach in formulating laws that govern the conduct of partnerships so that

partnerships can own property as an entity, contract as an entity, and be sued as an

entity.