Taxation of LLCs and Partnerships
Under state law, a partnership is generally defined as “an association of two or more persons to carry on as co-owners a business for profit.”1 But for Federal tax purposes, the definition of a partnership is much broader and includes any “syndicate, group, pool, joint venture, or other unincorporated organization through, or by means of which any business, financial operation, or venture is carried on and which is not … a corporation or trust or estate.”2
Any business entity3 with more than one owner that is not classified as a corporation is, by default, characterized as a partnership.4 This default characterization applies to limited liability companies. In other words, unless a limited liability company elects to be classified for tax purposes as a corporation, it is treated as a partnership for Federal tax purposes.
An entity classified as a partnership becomes disregarded as separate from its owner for Federal tax purposes if ownership is reduced to a single person or entity, in which case it is treated as a sole proprietorship.5 This would include a single-member limited liability company that does not elect to be treated as a corporation. Because single-member limited liability companies offer creditor protection without requiring a separate tax return, they are often the preferred form for single-owner small businesses.
Like S corporations (and unlike C corporations), partnerships and limited liability companies are “pass through entities,” meaning that the entity does not pay tax on its income. Instead, each owner must report his share of the entity’s items of income and loss on his own tax return. This ensures that business income is taxed only once, at the owner level.
Double Taxation: Separate vs. Pass-Through Treatment
Unlike C corporations, the income of partnerships is subject to a single level of tax at the partner level. The partnership functions as a conduit to pass income and deductions through to the partners. The partnership is required to file Form 1065 to report income and deductions.8 This return shows each partner’s distributive share of the partnership’s income and deductions. Each partner must include that partner’s share of the partnership income and deductions on his personal tax return.9
Restrictions on Ownership
Unlike S corporations, ownership of partnerships and limited liability companies is generally unlimited. There are no restrictions on who may be a partner or on how many persons or entities can be members of a single partnership.
Restrictions on Capital Structure
Compared to S corporations, partnerships have more flexibility to allocate a profits, losses, and credits among the owners. Because of the “one class of stock” requirement, all S corporation distributions must be pro rata among the shareholders. Partnerships may make unequal distributions and allocations (as long as the allocations have substantial economic effect under Treas. Reg. § 1.704-1(b)(2)(i)).
Adjustments to Basis
Under the default rules, a partnership’s basis in partnership assets is not affected by distributions to the partners or transfers of partnership interests. But unlike corporate tax law, the Internal Revenue Code allows the partnership to adjust the tax basis of partnership assets if the partnership makes an election under Code § 754 (754 election). A partnership can make a 754 election when there is a “substantial basis reduction” resulting from a distribution10 or if there is a transfer of partnership interest by reason of sale or exchange or death of a partner.11 Once the election is in place, it applies to all applicable transfers and can be revoked only with the consent of the district director for the district where the partnership’s tax returns are filed.
A 754 election will allow the partnership to adjust a partner’s share of the basis of the partnership assets (inside basis) to equal the partner’s basis in his partnership interest (outside basis). It does so by triggering two provisions: Code § 734(b) and Code § 743(b).
Code § 734(b) applies to distributions that result in gain or loss recognition under Code § 731(a) or distributions that change the tax basis of an asset under Code § 732. Code § 743(b) applies on to the sale or exchange of a partnership interest or the death of a partner. It makes an adjustment equal to the difference between the recipient partner’s basis (cost basis if acquired by sale or exchange, stepped-up basis if inherited) and the recipient partner’s share of the partnership’s adjusted basis of partnership property.12 This adjustment is prorated across the partnership assets.13
Partners are subject to self-employment tax on their distributive shares of the ordinary income of the partnership (unless they come within the limited partner exemption in Code § 1402(a)(13)). Limited liabilities that are taxed as partnerships can avoid this treatment by electing to be treated as a corporation, then electing to be treated as a subchapter S corporation for tax purposes. But, as with corporate forms, the limited liability company would be required to pay an appropriate salary that would be subject to FICA and FUTA withholding. Electing subchapter S treatment may also be impractical due to the loss of flexibility required by the rules governing S corporations.
An alternative strategy is to form a C corporation or S corporation to hold the general partnership interest in a limited partnership. The owners that provide services would do so as employees of the corporate general partner. Compensation for services rendered to the corporate general partner would be subject to self-employment tax; distributions from the partnership to them as limited partners would not. But, as always, the compensation paid to the owner-employees must be reasonable in light of the services provided.
Partners of partnerships (and members of limited liability companies) can take advantage of fewer tax-favored fringe benefits than they could as employees of C corporations. Fringe benefits available to partners include:
- Working condition fringe benefits. A working condition fringe benefit is any property or service provided to an employee to the extent that, if the employee had paid for the property or service, the payment would have been deductible under Code §§ 162 or 167 as a business expense. Tax-free working condition fringe benefits include business-related use of an automobile, business-related use of country club dues paid by the partnership, job-related education expenses, and job placement assistance.
- De minimus fringe benefits. Partners may receive de minimus fringe benefits, such as tax-free meals (supper money) and local transportation fair for overtime work, traditional birthday/holiday gifts with low value, occasional tickets to recreational events, and traditional gifts for length of service.
- Dependent care assistance. A partner may receive tax-free any amounts provided under a written plan of the partnership-employer, up to $2,500 annually ($5,000 for a married person).
- Educational assistance programs. Partners may take advantage of employer-provided educational assistance up to the applicable limits, regardless of whether it is job related.
- Use of on-premises athletic facilities. Partners and their spouses and children may use on-premises athletic facilities.
State-Level Franchise Tax Issues
Although a full discussion of state law tax consequences of choice of entity is beyond the scope of this guide, capital-based franchise taxes should be given careful consideration when choosing a corporate entity. In many states, corporations are subject to franchise tax, making the corporate form more costly than other alternatives, such as limited liability companies. This makes partnerships or limited liability companies more desirable from a franchise tax perspective. Consideration of this issue at the time of formation can prevent detrimental tax consequences that could arise if the organization later decides to convert to limited liability company status.
- Uniform Partnership Act § 6
- I.R.C. § 761(a)
- A “business entity” is joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation or venture and divide the profits therefrom. Treas. Reg. § 301.7701-1(a)(2).
- Treas. Reg. § 301.7701-2(c); Treas. Reg. § 301.7701-3(b)(1)(i)
- Treas. Reg. § 301.7701-3(f)(2).
- I.R.C. § 761(f)(1).
- See Rev. Proc. 2002-69, 2002-2 C.B. 831, for special rules applicable to state law entities owned by husband and wife in community property states.
- I.R.C. § 6031(a), (e); Treas. Reg. § 1.6031-1(a)-(1)(a)
- I.R.C. § 702.
- I.R.C. § 734(a).
- Treas. Reg. § 1.754-1(b).
- Treas. Reg. § 1.743-1
- See I.R.C. § 755.
- I.R.C. § 743(d)