COMPARING FORMS OF BUSINESS:
AN INTRODUCTION TO "CHOICE OF ENTITY"

L. Andrew Immerman
Alston & Bird LLP (Atlanta, GA)

12.2001

I. COMPARISON OF ENTITIES

A. The Principal Choices

1. C Corporation

• Generally formed as a corporation under state law

Two levels of tax

2. S Corporation

• Generally formed as a corporation under state law

• Elects to pay only one level of tax

3. Partnership

Generally formed as a partnership (limited or general) under state law

• Pays only one level of tax (unless it elects otherwise)

4. Limited Liability Company

• Formed as a limited liability company under state law

• Pays only one level of tax (unless it elects otherwise)

5. Proprietorship/Branch

•Not formed as an entity at all under state law

•Pays only one level of tax

6."Tax Nothing" (one-member LLC)

Generally formed as a limited liability company under state law

•Pays only one level of tax (but may elect otherwise)

B. C Corporation - Selected Advantages and Disadvantages

1. Advantages:

Interests can be publicly traded

Can participate in tax-free "reorganizations"

Most easily offers tax-free fringe benefits to employees

Top corporate-level tax rate on ordinary income is lower than top ordinary income rate on individuals

_ No tax to owners on "phantom" income; no need to

distribute cash for owners to pay tax on the entity's

income

Disadvantages:

Two levels of tax: corporate and shareholder

Additional taxes on some accumulations of income (accumulated earnings tax; personal holding company tax)

Self-help methods of avoiding corporate-level tax (e.g., high leverage or high compensation to shareholder/employees) may be challenged

_ Liquidation or conversion to pass-through often has

heavy tax cost

C. S Corporation - Selected Advantages and Disadvantages

1. Advantages:

2. Disadvantages:

Generally one level of tax

Easy to convert to C corporation, if, for example, entity wants to go public

Conversion from C corporation to S corporation is generally tax free (except for LIFO recapture)

Can participate in tax-free "reorganizations"

Possible employment tax benefit

• Restrictions on eligible owners

Total of at most 75 owners

•Generally only U.S. individuals, plus some trusts, estates and exempt organizations

Only one class of interests allowed

Violations of restrictions can cause loss of S corporation status

• S corporations do not pass tax items through to

owners as effectively as partnerships/LLCs

D. Partnership - Selected Advantages and Disadvantages

1. Advantages:

One level of tax

Transfers of appreciated property to and from the partnership are generally tax-free

No restrictions on eligible owners

Special allocations and multiple classes of interests possible

2. Disadvantages:

• Publicly traded partnership may be taxed as a

corporation

• At least one partner must have unlimited liability (but

LLP or LLLP election can eliminate the problem)

• Sometimes difficult to convert to C corporation, if, for

example, entity wants to go public

• Cannot participate in tax-free "reorganizations" with

corporations, unless it converts to a corporation

• Complexity of partnership tax rules

E. Limited Liability Company (LLC) - Selected Advantages and

Disadvantages

1. Advantages:

• Generally the same advantages as a partnership

• In addition, in an LLC no member need have unlimited liability

2. Disadvantages:

• Publicly traded LLC may be taxed as a corporation

• Uncertainties exist on some issues because LLCs are relatively new

F. Proprietorship/Branch - Selected Advantages and Disadvantages

1. Advantages:

• One level of tax

• Simplest form of entity

2. Disadvantages:

• No limited liability

• Only one owner possible

G.

2.

II.

A. Introduction

Tax Nothing - Selected Advantages and Disadvantages

Effective January 1 , 1997, a "Tax Nothing" is generally a one-member LLC that is disregarded under the Check the Box Regulations.

1. Advantages:

Disadvantages:

• Limited liability with pure pass-through taxation

Tax Nothings may be preferable to consolidated subsidiaries:

Simpler

Avoid occasional substantive disadvantages of the consolidated return rules

Tax Nothings may give corporation the effect of "selective consolidation"

Tax Nothings may offer the effect of consolidated returns in states where consolidation is not permitted.

Tax Nothings may be preferable to S corporations

Tax Nothings may be useful internationally

Only one owner possible

May be taxed as corporations in a few states

THE CHECK THE BOX REGULATIONS

IRS Regulations effective 1/1/97

The IRS gave up trying to find any substance to the distinction between corporations and partnerships. Local law labels and taxpayer choice now control.

B. Eligible Entities

Default Rules

Old four-factor test is gone. Four factors were continuity of life, limited liability, centralized management, and free transferability of interests.

Public trading -- not limited liability -- has become a "super factor." The most important substantive restriction on an entity's ability to be treated as a partnership for tax purposes is that a publicly traded entity generally cannot be taxed as a partnership. See Code § 7704.

Tax Nothing (also known as a "single member entity" or "SME") is authorized

In general, an unincorporated multi-member entity can choose to be taxed as a partnership or as a corporation. An eligible entity may include:

Partnership (general, limited, LLP, LLLP)

LLC

Anything else states come up with

In general, an unincorporated one-member entity can choose to be taxed as a "nothing" or as a corporation

Some entities must be taxed as corporations:

Incorporated entities

Publicly traded partnerships

Insurance companies

State-chartered banks with federally, insured deposits

Foreign entities specifically listed in the regulations ("per se" corporations)

New entities (i.e., formed on or after January 1, 1997):

A new domestic entity that doesn't expressly elect otherwise, and is eligible to "check the box," is classified as:

A partnership if it has more than one member

• A "nothing" if it has only one member

A new foreign entity that doesn't elect otherwise, and is eligible to "check the box," is classified as:

A corporation, if all members have limited liability (regardless of the number of members)

• A partnership, if it has more than one member, and at

least one member lacks limited liability

• A "nothing" if it has only one member, and that

member lacks limited liability

Existing entities:

An existing entity (foreign or domestic) that doesn't elect otherwise, and is eligible to "check the box," has whatever classification the entity itself claimed before January 1, 1997

• Exception: A one-member entity that claimed

partnership classification will be classified as a

"nothing"

D. Grandfather Rules

For periods before January 1, 1997, IRS won't challenge the classification an entity claimed if:

The entity had a "reasonable basis" for the classification

If the entity's tax classification changed within 60 months before January 1, 1997, the entity and its members recognized the tax consequences of the change

The entity and its members hadn't been notified on or before May 8, 1996, that the classification was under IRS audit

• A foreign "per se" corporation that meets the above requirements,

and certain others, may be eligible for classification as a

partnership even for periods on or after January 1, 1997

E. Mechanics

• Making the election:

• Form 8832 (enclosed)

• Made by authorized person (unanimous consent not

required)

• Effective up to 75 days before form is filed, or up to 12

months after

• Changing an election

• Changes are only permitted once every 60 months

• 60-month limitation seems easily avoided (e.g., by an LLC contributing its assets to a corporation)

• Protective elections

• IRS discourages filing a Form 8832 to "elect" the status an

entity would have anyway under the default rules

• Domestic entities rarely file a Form 8832 because they want

the default classification, and are sure of getting it

• Foreign entities often file protective elections, because of

uncertainty in applying the foreign default rules

F. Conversions

• Converting from one tax classification to another by "checking the box" is

no more tax-free than converting by some other method -- it can be an

incredibly taxable event

Partnership (or tax nothing) to corporation

• These conversions are often tax-free but there can be traps

-- for example, tax on liabilities in excess of tax basis

There are various ways to accomplish these conversions, and tax consequences can be different

Corporation to partnership (or to tax nothing)

• These conversions often generate two full levels of tax -

approach these with caution

• The corporation is generally taxed on the excess of the fair

market value of its assets over its basis in the assets

• The shareholders are generally taxed on the fair market

value of the same assets over the shareholders' basis in the stock

IRS issued regulations in 1999 clarifying the effect of conversions. See enclosed article "New Tax Regulations Reveal the Consequences of 'Checking the Box."'

Converting from partnership to LLC (or LLC to partnership) typically does not involve a change in tax classification, although tax issues should be considered

End