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SUBCHAPTER S CORPS. & PARTNERSHIPS.
Term Paper ID:22556
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Essay Subject:
Definies businesses & compares purposes, formation, federal income tax issues, pension plans & benefits, shareholder liability.... More...
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11 Pages / 2475 Words
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Paper Abstract:
Definies businesses & compares purposes, formation, federal income tax issues, pension plans & benefits, shareholder liability.
Paper Introduction:
S CORPORATIONS AND PARTNERSHIPS
This research paper describes the essential similarities and differences between a Subchapter S corporation (an "S corporation") and a partnership with the emphasis on the difference in their treatment for federal income tax purposes. It also includes a discussion of the tax treatment of pension plans and pension benefits. The principal advantage of an S corporation over a partnership is that shareholders of-an S corporation can obtain limited liability and the flow-through tax advantages of a partnership. An S corporation is, however, not the only way owners can obtain those goals. To some degree, a limited partnership can achieve them. Professional corporations can be formed by the owners of certain types of professional firms such as attorneys. And, since 1990, limited liability
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87(1958). 12IRS Regulation 1.7 1.2(a). In tax-free reorganizations and acquisitions, S corporationsgenerally are treated more favorably than partnerships. Endnotes 1United States Senate, S. Rep. Spudis. 28Edward J. The corporation must not have more than 35 shareholders. New York: Practising Law Institute, 1988.Continuing Education of the Bar. To some degree, a limited partnershipcan achieve them. Background S corporations were first proposed to Congress by PresidentEisenhower in 1954 and became part of the Internal Revenue Code in 1958 asSections 1361-1379. McNulty, Federal Income Taxation of S Corporations(Westbury, CT: Foundation Press, 1992, 172. Lib.) (Chicago: Commerce Clearing House, 1993), 2 2. Bahls. Recently, the IRS has been cracking down on many transactionsinvolving partnerships which previously were ignored. Bahls. If it fails to meet this test, the partnership will be taxed asthough it were a C corporation. Keatinge, and Barbara C. Votingrights can be staggered or varied, but all shares must have the same rightsto distributions and in liquidation.4 Once S status is elected, it remains in effect unless it is voluntaryrevoked, with the consent of more than 5 percent of the shareholders, oris otherwise terminated by a "disqualifying event." Once revoked orterminated, S status can not be re-elected for five years, except with theconsent of the IRS. The IRS definition of a partnershipis "the relationship existing between two or more persons who join togetherto carry on a trade or business with each person contributing money,property, labor or skill, and each expecting to share in the profits andlosses of the business."5 The key feature of a partnership is theproprietary interest of all the partners, Wheeler v. 24Manning, 1351-1352. Klein and David S. Forty-Seventh Annual Institute on Federal Taxation. L. Purpose, Definition and Formation Subchapter S was enacted to allow the owners of closely heldbusinesses "to select the form of business organization desired, withoutthe necessity of taking into account major differences in taxconsequences."1 An S corporation is a creation of the Internal RevenueCode and has no legal standing as such. 2d Sess. A shareholder of a corporation may be required by its creditorsto guarantee personally the debts of the corporation. Conclusion The foregoing summarizes the state of the tax law as it exists todaywith respect to S corporations and partnerships, each of which serves validpurposes in the appropriate situation. The 35 shareholder maximum can limit the S corporation's abilityto raise equity capital. It may have"straight debt" but not debt which is convertible into equity. Spitz, "S Corporations, CurrentIssues and Planning Opportunities." In USC Tax Institute, Forty-SeventhAnnual Institute on Federal Taxation (New York: Matthew Bender, 1995), 1-1. . 443 (1985.)Roche, Edward J., Jr., Robert R. At present, new S corporations areless in vogue than the new limited liability companies. 25Manning, 2 3. There are few significant differences in the federal taxationof qualified pension plans and pension benefits established by Scorporations or partnerships. Non-qualified, unfunded deferredcompensation plans in an S corporation are treated the same as in a Ccorporation, payments becoming deductible only when benefits are paid.McNulty says that, "unlike a partnership, an S corporation cannot structurepayments to a retiring shareholder or the estate of a deceased shareholderso as to make them deductible."33 Recent Developments The 1993-1995 proposals to Congress would have raised the minimumnumber of shareholders to 5 , removed the restriction on alien ownership,permitted S corporations to own more than 8 percent of another corporationand allowed two classes of stock.34 Schaaf said that, if these proposalswere adopted, "S corporations will obtain significant additionalflexibility in their capital and operational structure."35 one reason that Congress may not be in any hurry to act is that mostnew companies being formed to gain the benefits of limited liability andflow-through tax advantages are limited liability companies. 21McNulty, 174. Different rules relating to the pass-through of losses apply to Scorporations and partnerships. When services orproperty are transferred to a partnership, there generally is no tax, but,under Section 351 of the IRC, there is a special rule, applicable to Scorporations but not to partnerships, that the transferor must control 8 percent of the stock.26 When S corporations are merged, acquired or sold,they can take advantage of the tax-free reorganization sections of the IRC,which are available only to corporations and their shareholders.Generally, partnerships must recognize gain or loss on such transactions.27 9. Start Your Subchapter 'S' Corporation (New York:John Wiley & Sons, 1988), 65. and Richard A. 1983, 85th Cong. IRSRegulation 1.7 1.2(a) states that "subchapter K is intended to permittaxpayers to conduct joint business (including investment) activitiesthrough a flexible economic arrangement without incurring an entity leveltax."12 Under Subchapter K, "each partner reports only his share of [thenet income of the partnership]. 29William P. For example, profits may be allocated in adifferent ratio than losses or liquidating distributions may differ fromcurrent distributions."17 McNulty says that "the inability to makepartnership-type special allocations may make the S corporation far lesssuitable for real estate investments."18 He says that "a partnershipagreement can rather flexibly allocate income, losses and futureappreciation among various partners or classes of partners," includingdepreciation.19 5. Westbury, Connecticut: Foundation Press, 1992.Mesler V. 18McNulty, 189. Keatinge, and Barbara C. 11. 5Internal Revenue Service, Publication 5411, December, 1987. Spitz. Roche, Jr., Robert R. . These newentities have been provided for in the laws of more than 35 states,including California, and are more attractive than either S corporations orpartnerships for many investors because "the LLC is not subject to thecumbersome and often confusing rules relating to the election of Scorporation status, basis, distributions, built-in-gains, and passiveincome."36 LLCs are not of-much use, however, to most current Scorporations because, if the owners of those corporations tried to convertthem into limited liability companies, they would trigger a very large taxattributable to the gains inherent in their assets. McNulty says that, in some circumstances,the tax benefit of the losses can be higher in an S corporation than in apartnership, but, when gains are involved, he says the taxes on owners willgenerally be lower in partnerships than S corporations.21 Anotherdifference is that entity-level borrowing in a partnership adds to the taxbasis of a partner, thus increasing the size of any loss or decreasing anytaxable gain, but such debt does not increase the basis of a shareholder inan S corporation.22 7. It also includes a discussion of the taxtreatment of pension plans and pension benefits. (C.C.H. To qualify as a partnership for tax purposes, a partnership mustunder Revenue Ruling 88-73 and Regulation 3 1.77 1-2 lack at least two ofthe following four characteristics: continuity of life, centralization ofmanagement, limited liability, and free transferability of partnershipinterests. 27McNulty, 174-175. Berkeley: Continuing Education of the Bar, January/ February, 1993, 1-55.Internal Revenue Code, Sections 1361-1379 and Regulations thereunder and Subchapter K and Regulations thereunder.Internal Revenue Service. one special rule applies to s corporations. 1 . Bragg Management Co., 39 Cal. Wiley. House of Representatives. Federal Tax Treatment of S Corporations and Partnerships S corporations are governed by Subchapter S of the Internal RevenueCode and partnerships by Subchapter K. 4Lipon, Richard. Choosing the Business Entity. 9Ibid., 9. 19McNulty, 176. The Final Section7 1 Regulations were issued in early 1995, which Wasserman and Cuff call "amajor frontal assault by the Treasury on abusive partnershiptransactions."29 A partnership will not be eligible to be taxed as apartnership under those proposed regulations unless its transactions meetthe following criteria: (1) all transactions must be entered into by a"bona fide" partnership and for "a substantial business purpose;" (2) theform of the transaction must pass muster under a substance over formprinciple; and (3) they must "accurately reflect the partners' economicagreement and clearly reflect [their] income."3 Partners have become moreinterested in finding ways to limit their liabilities through professionalcorporations or limited liability companies, because of the expandedliabilities of professionals to third parties for negligence andmalpractice.31 Pension Plans and Benefits Since 1982, S corporations and partnerships have been treated in thesame manner as C corporations with respect to pension or retirement planswhich are qualified under IRC Sections 4 1-415.32 Klein and Bahls saythat, "in the case of qualified retirement plans, the benefits available toS corporations are essentially identical to those available to C corporateshareholders."33 The same is true for partnerships. The code sections dealing with S corporations havebeen amended several times, most significantly by the Subchapter S RevisionAct of 1982 (Pub. None of the shareholders can be non-resident aliens. the items of corporate income, loss,deductions, and credits are passed through to the shareholders in a mannersimilar to that of partners in a partnership."1 Forty percent of allcorporations in the United States, 1.6 million, are S corporations.11 Thetreatment of partnerships under Subchapter K is similarly motivated. 7Mesler v. Different Features of S Corporations and Partnerships In an S corporation, just like any other corporation, a shareholder'sliabilities are limited to the amount of his investment. Finally, S corporations are subject to a special rule that theymay not own more than 8 percent of the stock of another corporation.28 For a more complete treatment of this subject, the chart on pp. . In his testimony before a House subcommittee in 1994, RobertBlair, the Chairman of the S Corporation-Reform Project, said that "becauseof these limitations, S corporations are unable to access capital from manytypes of lenders."15 Manning says that "participants in a venture who makecapital contributions disproportionate to their share in profits may insistupon a fixed priority return on their investment . 11See Reform Proposals for Subchapter S Corporations, Hearing Before,the Subcommittee on Procurement, Taxation. 12-27to 12-33 of Bravenec's text is useful. They find the restriction on nonresidentaliens holding ownership a handicap. Federal Taxation of S Corporations (2nd Ed.). priority returns aremore difficult to arrange in S corporations."16 3. Start Your Own Subchapter "S" Corporation. Professional corporations can be formed by the owners ofcertain types of professional firms such as attorneys. 36Roche, 248. An increasing number of S corporations are becoming involved ininternational transactions. . New York: John Wiley & Sons, 1988.----------------------- 6 3d 29 , 7 2 P. "The Single-Class of Stock Regulations." Journalof Taxation, November 1994, 278. An S corporation is, however, not the onlyway owners can obtain those goals. are held jointly and severally liable for the debts andobligations of the partnership."6 This distinction between an Scorporation and a partnership may, however, become blurred for severalreasons. . If acorporation makes an S election while such a loan is outstanding, the planis disqualified. 14John K. In S corporations, contributions are based on employeecompensation; in partnerships, they are based on the general partner'sshare of business income, whether distributed or not. In a general partnership, "allpartners . 13Manolakas, 57. No. Bravenecsays that, "although an S corporation cannot have a partnership as ashareholder, it may be a partner in a partnership."3 3. IRC Section 4975(c) (1) (1) (B) (d) prohibits any loans from a qualified plan to ashareholder-employee who owns more than 5 percent of the stock. 15Reform Proposals supra., 48. Government Printing Office, 1994), 48. Every corporation has centralized management and control. June 23, 1994(Washington, DC: U.S. Section 47: 287.732) and some others,including California, impose small income taxes on the corporate entity.In California, income of S corporations is subject to an annual 2.5 percenttax at the corporate level under Cal. New York: Matthew Bender, 1995.Wasserman, William P. 22McNulty, 173. . 4. Rptr. S CORPORATIONS AND PARTNERSHIPS This research paper describes the essential similarities anddifferences between a Subchapter S corporation (an "S corporation") and apartnership with the emphasis on the difference in their treatment forfederal income tax purposes. Avoiding taxation on the distribution of assets which haveappreciated in value in s corporations-is more difficult than withinpartnerships. Rev. Stat. and Tourism of the Committee onSmall Business. "Seeing Shelter, Partnership Structure Is Called in Question as Liability Risk Rises." Wall Street Journal, 1 June 1992, Al.Lipon, Richard W. Partnerships can be formed by a simple agreement among the partners.Any natural person, including corporations and aliens, can be a partner.No government filings are necessary. and Terence F. Publication 5411. Spudis,"Limited Liability Companies Offer Pass-Through Benefits Without S Corp.Restrictions." Journal of Taxation, April, 1991, 248. Death orwithdrawal of any general partner, however, causes the dissolution of alimited partnership. C. For federal income taxpurposes, the Subchapter S election must be filed under IRC Section 1362(a) on or before the 15th day of the third month of the corporation'scurrent taxable year or, if it is newly formed, the earliest of the datesthe corporation has shareholders, starts in business or acquires assets.All shareholders must consent to the election. 2d Sess. Death and buy-out arrangements can be more flexible in thepartnership than in the S corporation. New York: Matthew Bender, 1995, 1-1 to 1-45.United States Senate. "The Single Class of Stock Regulations." Journal of Taxation, November 1991, 278-282.Manning, Elliott. 23Bravenec, 12-35. Anyone who selects thepartnership form by mistake is stuck. Bragg Management Co., 39 Cal. Bravenec says that"Subchapter S applies only to a 'small business corporation' that files aproposed election under [IRC] Section 1372."2 Any corporation which doesnot qualify as an S corporation or which loses that qualification is taxedas a C corporation. A partnership can be recast by the IRS as an employment relationship-and lose its flow-through tax benefits if one partner, usually the providerof capital, has the power to terminate the arrangement and keep thebusiness, Pounds v. One state, Louisiana, does not recognize Scorporations (LA. 8Manolakas, 4. United States, 372 F. Apartnership will be terminated on the death, withdrawal or bankruptcy of apartner, but this can be avoided by agreement among the partners. Fringe benefits, such as premiums paid for medical and disabilityplans and for group life insurance and meals and lodging provided by an Scorporation to an employee, are taxable as income to any employee who owns2 percent or more of the stock. . "Limited Liability Companies offer Pass-Through Benefits Without S. They share a common feature, namelythat the income of the business is taxed once, to the owner, thus avoidingdouble taxation. Taxation of Pass-Through Entities Part I: S Corporations Program Handbook. Senate Rep. and David G. This involves some highly technical rules which weredeveloped under the Tax Reform Act of 1986 to block C corporations frommaking S elections and then distributing appreciated property free of tax.In general, partnerships "can distribute appreciated assets in kind withoutrecognition of gain at the entity level under IRC Section 731, except forcertain 'hot assets' such as receivables."2 6. 2d 6 1, 216Cal. and Richard A. 2. Partnerships have been partof the common law for centuries and are governed by the laws of the 5 states which have passed, with some variations, their versions of theUniform Partnership Act and the Uniform Limited Partnership Act. Comr., T. The first requirement is that acorporation be formed under the laws of some state. The principal advantageof an S corporation over a partnership is that shareholders of-an Scorporation can obtain limited liability and the flow-through taxadvantages of a partnership. No. "IRS Attempts to 'Demonize' the Partnership: The Final Section 7 1 Regulations-Antiabuse Regulations Or Simply Abusive Regulations." In USC Tax Institute, Forty-Seventh Annual Institute on Federal Taxation. 2d 342 (5th Cir. Manolakas, "Taxation of S Corporations." In ContinuingEducation of the Bar, Taxation of Pass-Through Entities Part I: SCorporations Program Handbook (Berkeley: Continuing Education of the Bar,January/February, 1993), 3. afford significant flexibility in establishingfinancial relationships. A court may decideto prevent fraud or for other public policy reasons to pierce the corporateveil or hold a shareholder liable on the theory that he is the alter ego ofthe corporation.7 A limited partner in a limited partnership is also ableto limit his liability to the amount of his investment, but only if he"refrains from participating in.the actual control of the partnership," andprovided that there is at least one general partner who is liable for theobligations of the partnership.8 An S corporation, like any corporation, has perpetual existence. Ann. S Corporations and Life Insurance. In a generalpartnership, "all partners investment. Restrictions." Journal of Taxation, April 1991, 248-253.Schaaf, Donald A. New York: Matthew Bender, 1995, 21.1 to 21.95.Wiley, Arnold S. Wasserman and Terence F. 3d 29 , 7 2 P. 4. 87 (1958).USC Tax Institute. Manning says that afford significant flexibility in"partnerships . Lib.), Chicago: Commerce Clearing House, 1993.Manolakas, Thomas G. Various disqualifying transactions, applicable only to Scorporations, can result in a loss of S corporation status. Bravenec, Federal Taxation of S Corporations andShareholders (2nd Ed.) (New York: Practising Law Institute, 1988), 3-1. The contributions aredeductible against the entity's income, there is no tax on the earnings ofthe assets in the pension fund until distributions are made, and thedistributions are taxable to owners when they are paid out in a lump sum orover time. 34McNulty, 61. Manolakas says that "the ability to avoid the incidenceof double taxation, coupled with the fact that the maximum income tax iscurrently less than the maximum corporate rate, has led to the increasedpopularity of S corporations in the post-Tax Reform Act of 1986 era."9 Hesays that "S corporations are treated, the items of corporate income, aspass-through entities . . The one class of stock rule has been a major topic ofcontroversy. 1 3-9 , Washington, D. Tax Trans. BibliographyBravenect Lorence L. 97-354) and by the Tax Reform Act of 1986.Various proposed revisions in the code were presented to Congress in 1993-199 but they have not been enacted into law. And, since 199 ,limited liability companies can be formed which offer almost all theadvantages of an S corporation without its disadvantages. S Corporations and LifeInsurance (Chicago: American Bar Association, 1993), 25. One Hundred Third Congress,Second Session, Serial No. Under Section 1377 (a), distributions of profits or losses froman S corporation must be made strictly in accordance with a shareholder'sequity interest. 2Lorence L. 35Schaaf, Donald A. Thomas G. Bravenec says that a recipient of afinal payout from a partnership can obtain a stepped-up basis to currentfair market value without incurring a tax at the partnership level, butaccomplishing this in an s corporation may be impossible.23 Manning saysthat "distributions upon death, retirement or other withdrawal may be madewith minimal adverse tax effects" in a partnership.24 He says that "apartnership presents the best opportunity to pay a retiring or withdrawingpartners with pre-tax dollars."25 8. The taxation ofS corporations and partnerships is similar, but there are some importantdifferences. December 1987.Klein, William D. 31Bertrand Lablis, "Seeing Shelter, Partnership Structure Is Calledin Question as Liability Risk Rises." Wall Street Journal, 1 June 1992,Al. In fact,,many partnership agreements so provide. Avoiding taxation on the movement from a corporation to apartnership is much easier than vice versa. Chicago: American Bar Association, 1992.Lablis, Bertrand. Memo 1978-2 8. And, finally, corporate shareownership is freely transferable, whereas partnership interests are not,but in fact shareholder agreements in corporations often restricttransferability. 32Arnold S. 2d 6 1, 216 Cal. 26McNulty, 174. 2 McNulty, 189 and Bravenec, 12-35. Corp. This amount is combined with [his] incomefrom other sources and each partner then pays tax on his net income."13 There are, however, certain differences in the federal tax treatmentof S corporations and partnerships which may make one form of organizationor the other more attractive, depending on specific factual circumstances.McNulty summarizes those differences as follows: The rules of Subchapter K offer a greater degree of flexibility to participants than do the Subchapter S rules, and eligibility for S status is much more restricted than is eligibility for partnership membership. 1967) . Berkeley: Continuing Education of the Bar, 1993, 1- 55.McNulty, John K. 3Bravenec, 12-41. An ESOP, Employee Stock Ownership Plan, is not available to an Scorporation because the stock in an ESOP is owned by a trust. On the other hand, the rules applicable to S corporations are much less ambiguous than their Subchapter K counterparts, offering a great degree of certainty to the participants in a venture.14 Some important areas of difference are as follows: 1. 16Elliott Manning, Choosing the Business Entity (C.C.H.Tax Trans. C. To qualify as a S corporation, the following requirements must bemet: 1. "S Corporations: Current Issues and Planning Opportunities." In USC Tax Institute, Forty-Seventh Anniial Institute on Federal Taxation. Rptr. 2. 33William D. 3 Wasserman, 21-3. The corporation must have only one class of stock. "Taxation of S Corporations." In Continuing Education of the Bar, Taxation of Pass-Through Entities Part I: S Corporations Program Handbook. 17Manning, 313. 1 Ibid., 8. Cuff, "IRS Attempts to'Demonize' the Partnership: The Final Section 7 1 Regulations-AntiabuseRegulations Or Simply Abusive Regulations." In USC Tax Institute, Forty-Seventh Annual Institute on Federal Taxation (New York: Matthew Bender,1995), 21-2. 443 (1985). Federal Income Taxation of S Corporations. Qualification as an S corporation for federal incometax purposes qualifies a corporation for similar tax treatment at the statelevel in all but seven states. Rev. and Tax Code Section 238 2.Separate elections must be filed in most states. All shareholders must be individual persons (and not an estate ortrust). Cuff. No, 1983, 85th Cong.
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