Electronic copy available at: http://ssrn.com/abstract=1361915 PARTNERSHIPS , S CORPORATIONS, & LLCs EDITED BY SAMUE L P STARR, CPA, LL . M.

ORGANIZING A PROFESSIONAL PRACTICE: AN AFTER-TAX CHOICE-OF-ENTITY CALCULUS

BY THOMAS E. RUTLEDGE, MARKS. FRANKLIN, AND STEPHEN M. LUKINOVICH

A crucial decision made in any sional practices, we consider, on a pro for­ The tax tail should by no means wag the business venture is the choice ma basis, the after-tax benefit realized by choice-of-entity dog, but practitioners agree of entity, a complex calculus the professional owner of the venture un­ that weighs and balances competing in­ der various classification scenarios. While that the overall tax liability projected to terests and objectives against the "stan­ this analysis is of necessity limited to its result from any particular form chosen for a dard models" that are available under assumed facts, we conclude that assuming the various business organization professional practice is a serious considera­ such is otherwise defendable. It is from statutes. The standard model ultimately the tax perspective most efficient to use tion. The key to any comparison wi ll be the selected is then customized to the ven­ an S corporation in which 25% of earn­ assumptions made, including those re lating ture by private agreement. Or at least ings are distributed as salary with the bal­ that is what should happen. ance distributed in the form of dividends. to the client's income and the stabi lity of the In most organizations, the client, the The next most efficient approach is to or­ practice. accountant, or the attorney makes a ganize an LLC taxed as a partnership in quick decision, informed by the advisor's which 50% of the funds available to our prior practice and an up-to-date appreci­ owner are distributed as a guaranteed ation of recent changes in the law (both payment with the balance as a distribu­ organization and tax). There are many tion, where this member is not a manager. discussions that compare, on a character­ istic-by-characteristic basis, the various means of organizing a business struc­ ture. 1 Here, we attempt to quantify the STATE LAW ORGANIZATION OPTIONS impact of those various factors. Almost every state now allows a profes­ THOMAS E. RUTLEDGE is a member sional practice to be organized as a sole of, and MARKS. FRANKLIN is an asso­ ciate with, th e law firm of Stoll Keenan Basic facts. We assume our facts as fol­ proprietorship, as a general partnership, Ogden PLLC, both resident in the firm's lows: A veterinary practice owned as a professional service corporation Louisville, Kentucky, office. Mr. Rutledge equally by three licensed professionals, (PSC), as an LLC, or as a limited liability has previously written for The journal, and chairs th e Subcommittee on Limited with four additional employees. In the partnership (LLP) .2 Liability Companies of the Committee on practice, one owner has "all ocable" Traditionally, a professional practice LLCs, Partnerships and Uninco rp orated gross income of $500,000 and de­ Entities of the ABA Section of Business had to be organized either as a sole pro­ Law. Mr. Franklin is a member of th e ductible expenses (before determina­ prietorship or as a general partnership. Kentucky Society of CPAs. STEPHEN M. tion of owner contributions to retire­ Due to certain tax pressures, however, LUKINOVlCH, CPA, is a member of th e accou nting firm of Chilton & Medley ment savings accounts) of $150,000, efforts were made to develop forms of PLC in Louisville, and is a board mem­ resulting in $350,000 that is to be dis­ business organization that, while not ber of th e Kentucky Society of CPAs. tributed in some manner to this owner. "incorporated;' would have the tax ben­ Copyright © 2009, Thomas E. Rutledge, After reviewing our facts and the state efits of corporate tax classification un­ MarkS. Franklin, and Stephen M. Luki­ nm,ich. law governing the organization of profes- der the Code.

JOURNAL OF TAXATION I MARCH 2009 • 135

Electronic copy available at: http://ssrn.com/abstract=1361915 PARTNERSHI PS, S CORPORATIONS, & LLCs

This course of action culminated for purposes of the Code, be classi­ closest analog, S corporation status, in Kintner, 216 F.2d 418, 46 AFTR fied as a corporation. 4 As a general imposed significant limitations and, 995 (CA-9, 1954). In response to the rule, these various PSC acts imposed because of the maximum number of government's loss in that case, the structural limitations, such as who shareholders at times permissible, Kintner classification Regulations may serve as members of the board was not available to larger firms.s were adopted by Treasury with the of directors, who may qualify as purpose and effect of making it shareholders, requirements as to of­ more difficult for professional firms ficers other than the treasurer and Early in the 1990s, the LLC was to achieve the benefits of corporate the secretary, the voting of shares, identified by several professions classification even as state law incor­ and mandatory buyout require­ as a viable mechanism for the poration was denied them. Proving ments on death or disability.s organization of professional Ludwig Borne's adage that "nothing Early in the 1990s, as the "LLC ex­ is lasting but change;' professionals plosion" was taking place, this form firms. in the various states turned to their of business organization was identi­ respective state legislatures and lob­ fied by several professions (most no­ bied for the adoption of professional tably the accounting industry as rep­ service corporation statutes pur­ resented by the AI CPA) as a viable States have taken a variety of ap­ suant to which they could formally mechanism for the organization of proaches to structural limitations on professional LLCs. For example, in incorporate their practices.3 professional firms. This categoriza­ Kentucky the only requirements ap­ Eventually, every state adopted a tion of the LLC was based on the plicable to a professional LLC that PSC act, and with great reluctance availability of partnership taxation, differ from a nonprofessional LLC in­ the Service agreed that a PSC would, not usually an option in the PSC. The volve name identifiers and a recitation

NOTES in the articles of organization as to 1 See, e.g., McNulty and Kwon. "Tax Con­ sional services to be rendered by LLC) and what profession or professions are be­ siderations in Choice of Entity Decision;· 8 275 100(1) (name requirements). ing practiced through the LLC.7 By Bus. Entities 28 (May/June 2006); Keatinge 8 See Tenn. Code sections 48-249-1106 (pro­ and Conaway, Keatinge and Conaway on fessional services to be rendered only by contrast, the Tennessee LLC Act im­ Choice of Business Entity (Thomson Reuters/ individuals so licensed by the state), 48-249- poses on professional LLCs structural West, 2007), Appendix A. 1108 (name requirements). 48-249- 11 09 (eli­ limitations roughly equivalent to those 2 The Ca lifornia LLC act precludes the use of gible members). 48-249-1100 (transfers only to eligible persons) and 48-249-1111 (manda­ the professional LLC in California by licensed imposed on PSCs organized in that tory redemption) . professionals. California Corp. Code section state. a The 2006 Revised Uniform Lim­ 17375. See also Calif. AG Opn. 04-103 9 68 U.L. A. 407 (2008). ited Liability Company Act (RULL­ (7/23/04) 10 See generally Rutledge and Hester, "Practical 3 See generally Rutledge, "The Place (If Any) Guide to Limited Liability Partnerships," 5 CA)9 contains no provisions specific to of the Professional Structure in Entity Ration­ State Limited Uability Company and Partner­ the regulation of professional firms, ship Laws (Jacobson. Ludwig, Miller. and alization;· 58 Bus. Law. 1413 (2003), pages leaving such matters exclusively to the 1415-16. Rutledge, eds.; Aspen, 2008) See RUPA section 306(c). See also Bishop, 4 See, e.g., Bittker and Eustice, Federal In­ 11 rules and regulations adopted by pro­ "The Limited Liability Partnership Amend­ come Taxation of Corporations and Share­ fessional regulatory boards. ments to the Uniform Partnership Act holders, Seventh Edition (Thomson Reuters/ (1994);' 53 Bus. Law. 101 (1997). But see Even as the availability of LLCs WG&L, 2006). ~ 2.06. See also Rev. Rul. 70- Ederer v. Gursky, 881 N.E.2d 204, 9 N Y3d 101 , 1970-1 CB 278. moved across the country, there rose 514 (N.Y., 2007). wherein the New York Court 5 See Model Professional Corporation Supple­ of Appeals held that section 26(b) of the New the effort, initially in Texas, to permit ment (1984), § 20 (permissible shareholders), York Partnership Act applies, inter alia, only to the formation of the LLP. A subspecies § 23 (mandatory redemption of shares of claims of third parties against the partnership deceased or unlicensed shareholder or transfer­ but does not apply to claims among the part­ of the general partnership, as con­ ee), § 30 (requirements as to directors and offi­ ners. In this instance, the court held that the trasted with a new form of business cers). § 31 (proxies and voting tnusts) partners in an LLP were personally liable on organization, the LLP modifies-to a 6 Starting in 1958, an S corporation was limited claims asserted by a former partner against to ten shareholders under Section 1371 the partnership. Based on Ederer. a similar greater or lesser degree, depending lall1 ). The threshold increased to 15 w ith con­ holding was rendered in Kuslansky v. Kus­ on the state statute at issue-the tra­ ditions in 1976 and 15 generally in 1978. In lansky, Robbins. Stechel and Cunning­ ham, LLP, 50 App Div. 3d 1101, 858 N YS 2d 198 1, the limit was raised to 25, and in 1982 ditional rule that all partners are ei­ 212 (N.Y. App. Div., 2d Dept., 2008). to 35 under Section 1361(b)(1)(A). In 1996, ther jointly or severally liable for debts 12 While all states authorize the formation of an that limit was increased to 75, and was raised and obligations of the partnership.1o again to 100 (and the method of counting the LLP, four states restrict the LLP form to pro­ number of shareholders liberalized) by the fessional practices. See N.Y Partnership Law As now embodied in the Revised Uni­ American Jobs Creation Act of 2004. The section 121-1500 ILLP status available only to professional service partnerships without form Partnership Act (RUPA), an LLP 1996 legislation also provided for the electing limited partners); Nev. Stat. section 87.020(5) small business trust and allowed charitable affords all partners limited liability (LLP status available only to partnerships organizations as permissible shareholders of formed to render professional services); Or. from the debts and obligations of the an S corporation. Other limitations on S cor­ Rev. Stat. section 67.500 (LLP status avail­ partnership, the same rule of limited poration status include the requirement of a able only to partnerships that render or are single class of stock, a prohibition of nonresi­ liability that applies in the corpora­ affiliated with an LLP that renders profes­ dent alien shareholders, and limits on trusts sional services); Cal. Corp. Code sections tion and the LLC.1 1 All states now and estates as shareholders. 16951 and 16101 (8)(A) (LLP status available permit the organization of a profes­ 7 See Ky. Rev. Stat. Ann. sections 275.025(3) only to partnerships of architects. accoun­ (articles of organization to set forth profes- tants, or attorneys) . sional practice as an LLP.12

136 • JOURNA L OF TAXATION I MARCH 2009 PARTNERSHIPS, S CORPORATIONS, & LLCs

This is not to suggest that there are not substantive distinctions be­ Assumptions tween these various forms of organi­ zation and that for state law purpos­ For all of the spreadsheets used herein, we made certain assumptions es they are fungible. For example, and determinations as to presentation. PSC acts typically restrict the firm to a single profession.13 State taxes. We have not included any state tax liability in our model. Such taxes should be included, however, especially in jurisdictions that impose entity-level income or franchise taxes on structures that are, for federal tax purposes, pass-through entities. For example, Alabama AFTER-TAX COMPARISON imposes a Business Privilege Tax on taxable net worth on entities We compare the after-tax benefits re­ structured as either S corporations or partnerships. New Mexico im­ alized by a hypothetical owner-pro­ poses no entity-level income tax on partnerships whileS corporations fessional in a professional practice in New Mexico must pay franchise tax at the entity level. organized as a PS C, an LLC, or an LLP. Our analysis is limited to a hy­ Federal tax rate. We have assumed, in all of our models, a federal tax pothetical year of ordinary opera­ rate of 35% for all C corporations' current-year earnings retained; tions; we ignore the tax implications graduated tax rates are not appropriate in a professional context by to a continuing owner of a new own­ reason of Section 11 (b)(2). Conversely, in our Subchapter K models, er joining the venture and the impli­ we have presumed an individual federal income tax bracket allocation cations to each of a continuing and a of 35%. Any applicable alternative minimum tax (AMT) has not been departing owner on a voluntary or included in these models. involuntary termination for the rela­ tionship.14 Most professional firms in Section 448(d)(2). As defined in Section 448(d)(2), a "qualified per­ most years are not going to have per­ sonal service corporation" is a corporation for which substantially all sons joining or leaving the firm, so of the activities involve the performance of services in the fields of this analysis we submit is "typical:' health, law, engineering, architecture, accounting, actuarial science, Our hypothetical owner is allo­ performing arts, or consulting, and substantially all of the stock is held directly or indirectly by employees performing services for the corpo­ cated $500,000 of company income ration in connection with the professional services being rendered, re­ and $150,000 of deductible expenses, tirees who perform said services for the corporation, the estate of an yielding $350,000 of income to be, in individual who performed those services, and persons who acquired some manner, transferred to her.15 the stock by reason of the death of persons who performed said ser­ Our question: Is it most tax-efficient vices. Our model assumes that the business in question falls within to pay those funds to her in a combi­ this definition. nation of salary and dividends from a C corporation, salary and divi­ Section 482. We assume, for purposes of this analysis, that Section dends from an S corporation, or dis­ 482, permitting the reallocation of gross income among related orga­ tributions (or even distributions and nizations where "necessary in order to prevent the evasion of taxes or guaranteed payments) from an LLC/ clearly to reflect the income of any such organizations, trades, or busi­ LLP subject to Subchapter K?16 For nesses" is not applicable to any scenario presented. See also Section purposes of simplicity, we assume 1366(e). Nonetheless, we do not mean to suggest that any division be­ that the PSC is used for either of the tween salary and dividends is, in any particular factual situation, ap­ propriate or defendable. NOTES 13 See, e.g., Maryland Code Ann. Corps. & Allocations of funds within our models. Our models begin with as­ Assns. section 5-102(a)(1 ). Other states are more flexible, permitting " related profession­ sumed divisions of the possible distributions between salary/ al services" in the same PSC. See, e.g., Ky. dividends or, in the case of the LLC, distributions that are or are not Rev. Stat. Ann. section 274.01511) . subject to self-employment tax. These assumed divisions were chosen 14 For a listing of some of those tax issues, see, e.g., Committee on Partnerships and Un­ for purposes of illustration. The determination of a "sweet spot" divi­ incorporated Business Organizations, ABA sion between various categories of earnings is a step that should be Section of Business Law, "Model Limit­ ed Liabi lity Company Membership Interest undertaken as the next step in the analysis. Redemption Agreement:• 61 Bus. Law. 1197 !May 2006), page 1198. "Taxable income." With respect to this item, we have included for 15 This being a professional practice in which federal tax purposes the tax treatment of salary vs. dividends asap­ capital is not a material income-producing item, we assume no retained earnings. plicable plus self-employment taxable income vs. non-self-employ­ 16 It is of course possible for an LLC or an LLP to ment taxable income along with the effect of the deductibility of cer­ elect classification as an association taxable as tain fringe benefits. a corporation !Reg. 301.7701-31a)). in which instance it will be subject to Subchapter C, or to elect S corporation status. See also Temp. Reg . 301.7701-3Tic)(1 )(v)(C)

JOURNAL OF TAXATION I MARCH 2009 • 137 PARTNERSHIPS, S CORPORATIONS, & LLCs possible corporate sub chapters of the ing 2% or more of an S corporation's use those funds to purchase eye­ Code, while the LLC is the model for stock may not, on a tax-advantaged glasses for her son, those $100 glass­ Subchapter KY basis, participate in an employer­ es have been purchased with pre-tax We here compare the after-tax maintained cafeteria plan.23 dollars. Conversely, absent an FSA, dollars retained by a professional ser­ Another issue that arises is the our owner will need to earn approx­ vice-provider/owner across the three degree to which, by characterization imately $166 to generate, on an af­ predominant tax systems, namely of the mechanism by which they are ter-tax basis, the $100 necessary for Subchapter C, Subchapter S, and transferred to the owner, particular the purchase of those glasses.28 In Subchapter K. While our ultimate dollars are or are not subject to ei­ that latter instance, the $66 that has concern is with a "macro" analysis on ther FICA or self-employment taxes. been diverted to satisfaction of a tax an operating basis, 18 such analysis In a C or S corporation, funds dis­ liability is not available to be dis­ must, of course, first take account of tributed as "salary" are subject to posed of by the owner for other per­ the "micro" issues to be considered. FICA24 while distributions made in sonal benefit. Initially, under both Subchapter the form of "dividends" are not.2s K and Subchapter S, absent circum­ Conversely, except for those made to stances not considered here, earn­ "limited partners;'2s normally all Even as the availab ility of LLCs ings are not taxable to the business "distributions" made from a trade or moved across the country, there organization.19 Conversely, in a C business LLC to a member are sub­ rose the effort, initially in Texas, corporation, current-year earnings ject to self-employment taxes.27 to permit the formation of the LLP. retained are taxable to the entity.2o See also the basic assumptions set Further, in the context of a PSC,21 all forth in the sidebar on page 137. earnings are taxed at a flat rate of 35%.22 In the C corporation, there After- Tax Benefits to We will assume on deferrals that exists the greatest flexibility for the Professional Owners an owner is making maximum annu­ organization of benefit plans, the It is always, at best, difficult to com­ al contributions to a Section 401 (k) cost of which is not treated as tax­ pare apples with oranges. Neverthe­ plan with a 50% match of up to 3% able income to the shareholder. less, that is one of the tasks that of income, as well as a profit sharing For example, a shareholder in a C needs to be undertaken in this ven­ contribution. Of the income other­ corporation may, on a tax-advan­ ture. To the extent that benefits can wise distributable to an owner, up to taged basis, participate in an em­ be acquired on a pre-tax, as con­ a total of $46,000 has been placed in ployer-maintained Section 125 cafe­ trasted with an after-tax, basis, our a profit sharing plan.29 In addition, teria plan. Conversely, partners in a owner has benefited. in the context of the C corporation, partnership (which would include By way of a simple example, if our we assume that $4,00030 is deferred the members of an LLC taxed under owner can divert $100 to a flexible into the FSA part of the cafeteria Subchapter K) or shareholders hold- spending account (FSA) and then plan on behalf of our shareholder.31

NOTES In addition, the company is paying her insurance premiums on a pre-tax 17 The LLC analysis set forth he rein should be 26 Section 1402 (a)( 13). equally applicable to an LLP taxed under 27 Under the self-employment tax regime, a tax basis through the cafeteria plan. Subchapter K. of 12.4% is imposed on distributions, one-halt Consequently, in certain circum­ 18 Our analysis does not consider the tax of w hich is deductible by the member/partner. stances the nominal $350,000 avail­ results to an owner on either the redemption A M edicare-equivalent tax of 2.9% is likewise of her interest in the business or on the sale imposed, of w hich one-half is deductible. Reg. able for distribution to our owner of that interest to a third party. 1. 1401-1 (b) . For purposes of the statement will be reduced by deductible plan 19 See Sections 701 and 1363(a) made in the text. we assume that. at least in contributions. 20 See Section 11 (a). the context here being discussed, it is not possible, with respect to a professional 21 Defined in Section 448(d)(2) as any corpora­ The nondiscrimination rules ap­ owner/service provider, to characterize her as tion whose owners provide se rvices in the plicable to plans subject to ERISA a "limited partner" and thereby take advan­ fields of health, law, engineering, architec­ will affect the net earnings of the ven­ ture, accounting, actuarial science, perform­ tage of Section 1402 and Reg. 1.1402(a)-1, ing arts, or consulting. Pursuant to Rev. Rul. pursuant to which she cou ld receive a guaran­ ture to a degree greater than just the 91-30, 1991-1 CB 61, veterinary practices ta ll teed payment that is subject to self-employ­ funds diverted for the benefit of the within the scope of Section 448(d)(2). ment tax and an additional distribution that is itself not subject to such tax. Nevertheless, in professional owners. These differenti­ 22 See Section 11(b)(2) certain of the examples discussed in the text, ations must be taken into account in 23 Section 125(d)(1)(A); Reg. 1.125-1(g)(2) below, with respect to our models under 24 The FI CA tax has two components. Old Age, Subchapter K, that we do make exactly that any choice-of-entity analysis. Survivors, and Disability Insurance (OASDII is assumption. assessed at the ra te of 6. 2% on the employ­ 28 Assuming an effective tax rate of 40%. ee and 6.2% on the employer, both subject Different Scenario s Under Subchapter C 29 Sections 415(a)(1)( 8) and (c)(1) to an annually adjusted cap ($ 106,800 tor With respect to each of our scenarios 20091. The M edicare component is· 1.45% 30 This amount will be covered by the limits set imposed on the employer and 1.45% imposed out in the plan document. under Subchapter C, we assume that on the employee, with no wage cap applicable 31 A cafeteria plan also can include other pre-tax the company, on a pre-tax basis, has to either. benefits such as dependent care (up to $350,000 that is ultimately avail­ 25 Section 1402(a)(2). See also Reg. 1. 1402(a)- $5,000), dental insurance premiums, or cer­ 5(a) tai n li te insurance premiums. able/transferable to our shareholder-

138 • JOURNA L OF TAXATION I MARCH 2009 PARTNERSHIPS, S CORPORATIONS, & LLCs

EXHIBIT 1 •Subchapter C Scenarios

Scenario I Scenario 2 Scenario 3 Scenario 4 Scenario 5 Assumptions: Sa lary I Guaranteed Payment & Other Emp loyment Benefits 0% 25% 50% 75% 100% Dividend or Distribution 100% 75% 50% 25% 0%

Entity Level: Gross Revenue $ 500,000 $ 500,000 $ 500,000 $ 500,000 $ 500,000 Non Salary Operating Expenses (150,000) (150,000) ( 150,000) ( 150,000) (150,000) Net Earnings before Sa lary Related Expenses $ 350,000 $ 350,000 $ 350,000 $ 350,000 $ 350,000

Salary I Guaranteed Payment & Other Employment Benefits: "Net taxable salary" (41,596) (I 10,093) (I 96,343) (282,592) 40 I (k) Deferrals (15,500) (15,500) (15,500) (I 5,500) Cafeteria Plan (FSA) (4,000) (4,000) (4,000) (4,000) Total Gross Salary I Guaranteed Payment $ $ (61,096) $ (129,593) $ (2 I 5,843) $ (302,092)

Other Employment Benefits: FICA Tax Deduction - Soc. Sec. (3,540) (6,324) (6,324) (6,324) FICA Tax Deduction - Medicare (828) {1 ,821) (3 ,072) (4,322) Health Insurance Premiums (6,762) (6,762) (6,762) (6,762) (6,762) 401(k) Match (3%)1Profit Sharing Contribution (22% C corp) (15,274) (30,500) (30,500) (30,500) Total Other Employment Benefits (6,762) (26,404) (45,407) (46,657) (47,908)

Total Salary I Guaranteed Payment & (6,762) (87,500) ( 175,000) (262,500) (350,000) Other Employment Benefits Entity Level Distributable Federal Taxable Income 343,238 262,500 175,000 87,500 0 X Highest Entity Level Federal Income Tax Rate 35% 35% 35% 35% 35% Entity Level Federal Income Tax Liability $ 120,133 $ 91 ,875 $ 6 1,250 $ 30,625 $ 0

Indivi dual Level: Tux Liability 0 11 Salary I Guarameed Payme11ts + Net Taxable Salary I Guaranteed Payment $ $ 4 1,596 $ I 10,093 $ 196,343 $ 282,592 I 00% Health Insurance Premiums 50% of Self Employment Tax- Soc. Sec. 50% of Se lf Employment Tax- Medicare Taxable Income From Salary I Guaranteed Payment 41 ,596 110,093 196,343 282,592 X Highest Individual Income Tax Rate 35% 35% 35% 35% 35% Individual Federal Income Tax Liability On Salary I Gua ranteed $ $ 14,559 $ 38,533 $ 68,720 $ 98,907 Payment

Al/ocatio11 I Distribution of Entity's brcome: Profit Allocation I Distribution Received From Entity $ 343 ,238 $ 262 ,500 $ 175,000 $ 87,500 $ X Qualified Dividend Distribution Tax Rate 15% 15% 15% 15% 15% Individual Federal Income Tax Liability From Profit Allocation I $ 51,486 $ 39,375 $ 26,250 $ 13, 125 $ Distribution

Emp/oym e11t Tuxes: + Self Employment Tax- Soc. Sec (Employer & Employee portions $ $ $ $ $ x 0.9235 per limitation) + Self Employment Tax - Medicare (Employer & Employee portions x 0.9235 per limitation)) + Employment Tax - Soc. Sec. (Employer & Employee portions) 7,080 12,648 12,648 12,648

+ Employment Tax - Medicare (Employer & Employee portions) 1,656 3,642 6,143 8,645

Total Employment Tax Liability $ $ 8,736 $ 16,290 $ 18,79 1 $ 21 ,293

Total Entity Federal, Individual Federal, and Employ ment Tax $ 171,6 19 $ 154,544 $ 142,323 $ 131 ,261 $ 120,200 Liability

J O U RN A L O F T AXAT I O N I M A R C H 2 0 0 9 • 139 PARTNERSHIPS, S CORPORATIONS, & LLCs employee. We consider in Exhibit 1 a payments to the shareholder-owner In contrast with the situation un­ variety of scenarios in which those in favor of dividend characteriza­ der the C corporation, of all the S funds will be distributed to the own­ tion, not only has the ability to make corporation examples we have ana­ er as salary, giving rise to a deduction contributions to a Section 401 (k) lyzed, it is most efficient (albeit mar­ by the company and a reduction in plan or to receive benefits from a ginally), due to the retirement plan its taxable income,32 those amounts Section 125 cafeteria plan been di­ contribution/deduction, to weight being subject to FICA,33 or as divi­ minished by reason of the "earned the available funds toward dividend dends, which amounts will not give income" limitations,37 but we have distributions and away from salary. rise to a deduction by the company also radically increased the corpora­ As is true with the C corporation ex­ (i.e., those amounts will constitute tion's taxable income, all out of a de­ amples, it is possible to take the net income taxable to the corporation) sire to avoid the FICA tax regime. benefits of the allocation of funds but which will be exempt from FICA. Reviewing the possible scenarios too far in shifting them to distribu­ under Subchapter C, we see that, tions rather than salary; the ability notwithstanding the preferential to place funds in a Section 401 (k) Another issue is the degree to 15 % rate applied to dividends re­ plan has been diminished, as the which, by characterization of the ceived, subjecting those dollars first contribution limits are determined to a 35% corporate tax rate signifi­ in accordance with earned income.39 mechanism by which they are cantly increases the overall tax expo­ Furthermore, the long-term via­ transferred to the owner. sure. Therefore, on our pro forma bility of the preferential treatment of particular dollars are subject to analysis, it generally is most tax effi­ distributions vis-a-vis salary in S cient for our C corporation employ­ corporations, particularly those ren­ FICA or self-employment tax. ee-stockholder to take the entirety of dering professional services, is open the income allocable to her in the to question. Several proposals in form of salary (and bonus) pay­ Congress have sought to limit that ments as contrasted with dividends, preferential treatment.4o As such, it is Here we must account as well for even though the latter would be ex­ incumbent upon practitioners to the different rates that are applicable empt from self-employment tax. continue to track these issues. to salary/ordinary income34 and div­ idends.3s While we do consider here Different Scenarios Under Subchapter S a scenario in which 1 OOo/o of the In the context of an S corporation, The nondiscrimination rules available funds will be distributed in we must account for the rules of the applicable to ERISA plans will the form of salary, with no amounts partial pass-through regime that is affect net earnings to a degree distributed in the form of a dividend, Subchapter S. Our professional own­ we by no means suggest that it satis­ er will have ordinary income to the greater than just the funds fies the "adequate compensation" re­ extent of her allocable share of the diverted for the benefit of the quirements under the Code.3s corporation's earnings. S corpora­ professional owners. In this example, the lowest com­ tions do not benefit from the prefer­ bined tax liability results when all of ential rate applied to dividend distri­ the available funds are distributed to butions from a C corporation, so the the employer in the form of either effective income tax rates on salary That said, the maximum differen­ salary or tax-favored benefit plans. and dividends are the same. But while tial of $4,629 between the S corpora­ The corporation's tax liability is re­ salary is subject to self-employment tion scenarios considered, amount­ duced to zero, there having been no tax, distributions are not.38 As such, ing to less than 1.5% of net earnings, funds retained as earnings. Con­ the total tax on distributions is lower is not significant when compared to versely, where we grossly weight the than that on salary. See Exhibit 2. the far greater differentials that exist in the C corporation scenarios. 32 Section 162(a)( 1) Yearout, "Self-Employment Taxes and Pass­ 33 See notes 24 through 27. supra, and the through Entities : Where Are We Now?;' 109 Different Scenarios Under Subchapte r K accompanying text. Tax Notes 211 (10/1 0/05); 2005 TN T 196-23. A partnership, as such, is not a tax­ 34 Sections 1(a)-(d). 41 Section 701. 35 Section 1(h); 15% for 2008. 42 As noted in the "Assumptions" sidebar, this payer; rather, tax liability with re­ ana lysis does not take account of state 36 See generally Moran, 390-4th T.M. (BNA). spect to the operations of the part­ taxes. Attention is required, however. to such Reasonable Compensation. issue, especially in those jurisdictions that nership is borne by the partners.41 37 See, e.g., Section 415(c)(3)( 8). impose an entity-level tax on business orga­ Consequently, for federal tax purpos­ 38 Section 1402(a)( 2). nizations that, for federal purposes, are taxed es42 no tax liability is generated at the 39 See note 37. supra. as partnerships. For a review of state-level 40 See, e.g ., Keatinge, "Self-Employment Tax taxes imposed on LLCs and LLPs. see Ely, entity level, and all taxes are paid on Issues in LLCs Ta xed as Partnershi ps," Grissom, and Thistle, "State Tax Treatment of the allocable share by the individual LLCs and LL Ps: Update for 2009;' 19 J. Suffolk University Law School Legal Studies partners. This approach applies the Research Paper 07-33 (9/18/07); Culpepper, Multistate Tax 'n 20 (Ma rch/Apri l 2009). Holo, Keatinge, Lenz, Schippel, Sha pack, and 43 Section 701; Re g. 1.701-1 . aggregate concept of partnerships.43

140 • JOURNAL OF TAXATION I MARCH 2009 PARTNERSH IPS, S CORPORA TION S , & LLCs

EXHIBIT 2 •Subchapter S Scenarios

Scenario I Scenario 2 Scenario 3 Scenario 4 Scenario 5 Assumptions: Salary I Guaranteed Payment & Other Employment Benefit s 0% 25% 50% 75% 100% Dividend or Distri bution 100% 75% 50% 25% 0%

E ntity Level: Gross Revenue $ 500,000 $ 500,000 $ 500,000 $ 500,000 $ 500,000 Non Salary Operating Expenses ( 150,000) ( 150,000) ( 150,000) ( 150,000) ( 150,000) Net Earn ings before Salary Rel ated Ex penses $ 350,000 $ 350,000 $ 350,000 $ 350,000 $ 350,000

Salary I Guaranteed Payment & Other Employment Benefits: "Net taxable salary" (45,365) ( 114,036) (200,285) (286,534) 40 I (k) Deferrals (15,500) ( 15,500) ( 15,500) ( 15,500) Cafe teria Plan (FSA) Total Gross Salary I Guaranteed Payment $ $ (60,865) $ (129,536) $ (2 15.785) $ (302.034)

Other Em ployment Benefits: FICA Tax Deducti on - Soc. Sec. (3,774) (6,324) (6,324) (6,324) FICA Tax Deduct ion - Medicare (883) (l ,878) (3 ,129) (4,380) Health Insurance Premiums (S-Carp W -2) (6,762) (6,762) (6,762) (6,762) (6,762)

40l (k) Match (3%)1Pro fit Sharing Contribution (22% S-Carp) (1 5,2 16) (30,500) (30,500) (30,500) Total Other Employment Benefits (6,762) (26,635) (45,464) (46,7 15) (47,966)

Total Salary I Guaranteed Payment & Other Employment Benefits (6,762) (87,500) (175,000) (262,500) (350,000) Entity Level Distri butable Federal Taxable Income 343,238 262,500 175,000 87,500 X Hi ghest Entity Level Federal Income Tax Rate 0% 0% 0% 0% 0% Entity Level Federal Income Tax Liability $ $ $ $ $

Individ ual Level: Tax Liability on Salary + Net Taxable Salary $ 6,762 $ 52,127 $ 120,798 $ 207,047 $ 293 ,296 100% Health Insurance Premiums (6,762) (6,762) (6,762) (6,762) (6,762) 50% of Self Employment Tax -Soc. Sec. 50% of Self Empl oyment Tax - Medicare Taxable Income From Salary 45,365 114,036 200,285 286,534 X Highest Individ ual Income Tax Rate 35% 35% 35% 35% 35% Individual Federal Income Tax Liabi lity On Salary $ $ 15 ,8 78 $ 39,913 $ 70,100 $ I 00,287

Allocation I Distribution of Entity's Income: Profit Allocation I Di stribution Received From Entity $ 343,238 $ 262,500 $ 175,000 $ 87,500 $ X Qualified Dividend Distributi on Tax Rate 35% 35% 35% 35% 35% Indi vidual Federa l Income Tax Liability From Profit Allocation I Distribution $ 120,133 $ 9 1,875 $ 6 1,250 $ 30,625 $

Employment Taxes: + Self Employment Tax - Soc. Sec (Employer & Employee portions x 0.9235 per limitation) $ $ $ $ $ + Self Empl oyment Tax - Medi care (Employer & Employee portions x 0.9235 per limitation)) + Employment Tax - Soc. Sec. (Employer & Employee porti ons) 7,547 12,648 12,648 12,648 + Employment Tax -Medicare (Employer & Employee porti ons) 1,765 3,757 6,258 8,759 Total Employment Tax Liability $ $ 9,312 $ 16,405 $ 18,906 $ 2 1,407

Total E ntity Federal, Individual Federal, and Employment Tax $ 120,133 $ 11 7,065 $ 11 7,567 $ 119,63 1 $ 121,694 Liability

142 • JOU RN A L OF T AXA T I O N I M ARC H 2 0 0 9 PARTNERSH IP S, S CORPORATIONS, & LLCs

Generally speaking, with the ex­ long as they are determined with re­ ception of distributions to "limited gard to the earnings of the partner­ Practice Notes partners;' and assuming the alloca­ ship ("scheduled payments").49 ble item is not generated from an ex­ Accordingly, in our scenarios un­ Among the many subjective empt category such as real estate der Subchapter K, we provide an ex­ and objective factors that go leasing activities,44 all distributions ample in which, with respect to a into a choice-of-entity analy­ from a partnership are subject to presumed non-manager member in sis, federal income taxation self-employment tax. There arises, a professional LLC, a portion of the may be the least subjective then, the question of who constitutes distributions made are in the form of and most quantifiable. Practi­ a "limited partner" in structures that payments that are not guaranteed5 0 tioners must be careful, how­ are governed by Subchapter K but and therefore do not fall within the ever, to ensure that tax model­ which are not organized in the tradi­ scope of Section 1402(a)(l3).51 See ing employs the appropriate tional form of a limited partnership. Exhibits 3 (member as manager) and assumptions, that possible 4 (non-manager member). changes in the law are taken In prior years, issues also arose in into account where appropri­ Despite the preferential15% rate using partnerships for professional ate, and that the unique char­ on dividends, subjecting those practices by reason of limitations on acteristics of any particular retirement savings plans and the de­ type of venture are reflected. dollars first to a 35% corporate ductibility of premiums paid for tax rate significantly increases health insurance. Fortunately, as of today, these distinctions have been the overall tax exposure. and need to be weighed against oth­ substantially eliminated. For exam­ er factors such as the certainty asso­ ple, health insurance premiums are fully deductible by either a corporate ciated with a PS C compared to the flexibility of an LLC. For example, in a manager-man­ payor52 or by an individual part­ ner.53 Nevertheless, distinctions re­ In reviewing the optimal outcome aged LLC in which the members, qua of our three models of Subchapter C, members, do not have agency author­ main under cafeteria plans. 54 Subchapter S, and Subchapter K, we ity on behalf of the LLC, and in which see that the comparison among them the members who are themselves not The question is who is a 'limited does not yield a material distinction as managers may not owe fiduciary to ultimate tax liability and, converse­ obligations to either their co-owners partner' in structures governed ly, funds available to our professional or the venture,45 their position is by Subchapter K but not owner. The maximum differential of nearly indistinguishable from that of organized in the traditional form $3,135 (the difference between the a limited partner in a traditional lim­ ited partnership structure. This leads of a limited partnership. Subchapter C total of $120,200 and to the question whether distributions the Subchapter S total of $117,065) is made to those persons (other than less than 1o/o of the $350,000 with guaranteed payments) are subject to which our analysis began. self-employment tax. Under Subchapter K, of the ten The marginal tax rate under our Guaranteed payments (i.e., those scenarios we have modeled, the low­ highest tax C corporation scenario determined without regard to part­ est net tax liability arises from a bal­ was 34.34%, while that for our low- nership income46) made to a limited anced allocation of available funds partner for services rendered are sub­ to guaranteed payments and distrib­ ject to self-employment tax.47 Con­ utions. 44 Section 1402(a)(1 ); Reg . 1.1402(a)-4. 45 See. e.g., Ky. Rev. Stat. Ann. section 275. 170(4). versely, distributions to limited part­ 46 See Section 707(c) ners made with respect to partnership 47 Section 1402(a)( 13); Reg 1402(a)-1(b). income are not necessarily subject to COMPARISON OF VARIOUS SCENARIOS 48 Note that " limited partner" is not defined in self-employment tax.48 While there is Once we appreciate that the treat­ the Code. See also Ltr. Rul. 911 0003. 49 Reg. 1. 1402(a)-2(b). no binding authority with respect to ment of the net $350,000 to be dis­ 50 As such, the payments are with regard to when and how such arrangements are tributed to our professional owner partnership income. Contrast Section 707(c) . appropriate, in certain LLCs-even in differs under the various Code sub­ 51 This position. while supportable under cu rrent the professional context-one mem­ law, is under review by the Service and likely chapters, we can compare the most would fail upon an implementation of the 1997 ber may be designated the "manager" efficient form of organization from proposed amendments to the Section 1402 whose distributions will be subject to each of those subchapters. This Regulations (REG-209824-96, 1/10/97). See Levine and Paul, "IRS Shifts Focus With self-employment tax, while the others comparison is presented in Exhibit Controversial New SE Tax Proposed Reg­ will be non-managerial members 5. The entity's initial owners must ulations." 86 JTAX 325 (June 1997). whose distributions are, arguably, not determine the degree to which the 52 Section 162. 53 Section 162(1) subject to self-employment tax so resulting differences are material 54 Section 125(d)(1)(A).

JOURNAL OF TAXATION I MARCH 2009 • 143 PARTNERSHIPS. S CORPORATIONS, & LLCs

• EXHIBIT 3 Subchapter K-Member as Manager

Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Assumptions: Salary I Guaranteed Pay ment & Other Employment Benefits 0% 25% 50% 75% 100% Div idend or Distribution 100% 75% 50% 25% 0%

Entity Level: Gross Revenue $ 500,000 $ 500,000 $ 500,000 $ 500,000 $ 500,000 Non Salary Operating Expenses {150,000) (150,000) {150,000) ( 150,000) ( 150,000) Net Earnings before Salary Related Expenses $ 350,000 $ 350,000 $ 350,000 $ 350,000 $ 350,000

Salary I Guaranteed Payment & Other Employment Benefits : "Net taxable sa lary" (34,738) ( 122,238) (209,738) (297,238) 40 I (k) Deferrals (15,500) ( 15,500) (15,500) (15,500) Cafeteria Plan (FSA) Total Gross Salary I Guaranteed Payment $ (50,238) $ ( 13 7,738) $ (225,238) $ (312,738)

Other Employment Benefits: FICA Tax Deduction - Soc. Sec. FICA Tax Deduction - Medicare Hea lth Insurance Premiums (G uaranteed Payments) (6,762) (6,762) (6,762) (6,762) (6,762)

40 I (k) Match (3%)1Profit Sharing Contribution ( 17% Partnership) (30,500) (30,500) (30,500) (30,500) Total Other Employment Benefits (6 ,762) (37,262) (37,262) (37,262) (37,262)

Guaranteed Pay ment & Other Employment Benefits (6,762) (87,500) (175,000) (262,500) (350,000) Entity Level Di stributable Federal Taxable Income 343,238 262,500 175 ,000 87 ,500 X Highest Entity Level Federal income Tax Rate 0% 0% 0% 0% 0% Entity Level Federal income Tax Liability $ $ $ $ $

Individual Level: Ta.r; Liability on Guaranteed Payments + Guaranteed Payment $ 6,762 $ 41 ,500 $ 129,000 $ 216,500 $ 304,000 I 00% Health Insurance Premiums (6,762) (6,762) (6,762) (6,762) (6,762) 50% ofSelfEmployment Tax - Soc. Sec. (6,324) (6,324) (6,324) (6,324) (6,324) 50% of Self Empl oyment Tax- Medicare (5,075) (5,075) (5 ,075) (5 ,075) (5 ,075) Taxable Income From Guaranteed Payment (11 ,399) 23 ,339 110,839 198 ,339 285,839 X Highest Individual Income Tax Rate 35% 35% 35% 35% 35% Individual Federal Income Tax Li ability On Salary I Guaranteed $ (3 ,990) $ 8,169 $ 38 ,794 $ 69,419 $ 100,044 Payment

Allocation I Distribution of Entity's ltrcome: Profit All ocation I Distribution Received From Entity $ 343,238 $ 262,500 $ 175,000 $ 87.500 $ X Qualified Dividend Distribution Tax Rate 35% 35% 35% 35% 35% Individual Federal Income Tax Liabi li ty From Profit Allocation I Di stribution $ 120, 133 $ 9 1,875 $ 61 ,250 $ 30,625 $

Employment Taxes: Self Employment Tax - Soc. Sec (Employer & Employee portions + x 0.9235 per limitati on) $ 12 ,648 $ 12,648 $ 12,648 $ 12,648 $ 12 ,648 Self Employment Tax -Med icare (Employer & Employee + portions x 0.9235 per limitation)) 9,374 9,374 9,374 9,374 9,374 + Employment Tax - Soc. Sec. (Employer & Employee portions) + Employment Tax - Med icare (Employer & Employee portions) Total Employment Tax Liability $ 22 ,022 $ 22,022 $ 22 ,022 $ 22,022 $ 22,022

Total Entity Federal , Individual Federal, and Employment Tax Liability $ 138,165 $ 122,065 $ 122,065 $ 122,065 $ 122,065

144 • J OUR N AL OF TAXATIO N I M A R C H 20 0 9 PARTN ERSH IPS, S CORPORATIONS, & LLCs

EXHIBIT 4 •Subchapter K-Non-Manager Member

Scenario I Scenario 2 Scenario 3 Scenario 4 Scenario 5 Assumptions: Salary I Guaranteed Payment & Other Employment Benefits 0% 25% 50% 75% 100% Di vidend or Distribution 100% 75% 50% 25% 0%

Entity Level: Gross Revenue $ 500,000 $ 500,000 $ 500,000 $ 500,000 $ 500,000 Non Salary Operating Expenses (150,000) (150,000) (150,000) (150,000) (150,000) Net Earnings before Salary Re lated Expenses $ 350,000 $ 350,000 $ 350,000 $ 350,000 $ 350,000

Salary I Guaranteed Payment & Other Employment Benefits: "Net taxable salary" (50,655) (123,571) (209,738) (297,238) 40 I (k) Deferrals (15,500) (15,500) (15,500) (15 ,5 00) Cafeteria Plan (FSA) Total Gross Salary I Guaranteed Payment $ $ (66,155) $ (139,071) $ (225,238) $ (312,738)

Other Employment Benefits: FICA Tax Deduction- Soc. Sec. FICA Tax Deduction -Medicare Health Insurance Premiums (Guaranteed Payments) (6,762) (6,762) (6,762) (6,762) (6,762) 401(k) Match (3%)/Profit Sharing Contribution (17% Partnership) (14,583) (29,167) (30,5 00) (30,500) Total Other Employment Benefits (6,762) (2 1,345) (35,929) (37,262) (37,262)

Guaranteed Payment & Other Employment Benefits (6,762) (87,500) (175,000) (262,500) (350,000) Entity Level Distributable Federal Taxable Income 343,238 262,500 175,000 87,500 X Highest Entity Level Federal Income Tax Rate 0% 0% 0% 0% 0% Entity Level Federal Income Tax Liability $ $ $ $ $

Individual Level: Ta.v: Liability 011 Guara11teed Payme11ts + Guaranteed Payment $ 6,762 $ 57,417 130,333 $ 216,500 $ 304,000 100% Health Insurance Premiums (6,762) (6,762) (6,762) (6,762) (6,762) 50% of Self Employment Tax - Soc. Sec. (419) (5,425) (6,324) (6,324) (6,324) 50% of Self Employment Tax- Medicare (98) (1,269) (2,537) (3 ,806) (5 ,075) Taxable Income From Guaranteed Payment (517) 43 ,961 114,710 199,608 285,839 Highest Individual income Tax Rate 35% 35% 35% 35% 35% Individual Federal income Tax Liability On Salary I Guaranteed Payment $ (18 1) $ 15,386 40,148 $ 69,863 $ 100,044

Al/ocatio11 I Distributio11 of Entity's llrcome: Profit Allocation I Distribution Received From Entity $ 343 ,238 $ 262 ,500 $ 175,000 $ 87,500 $ X Qualified Dividend Distribution Tax Rate 35% 35% 35% 35% 35% Individual Federal income Tax Liability From Profit Allocation I Distribution $ 120, 133 $ 91,875 61,250 $ 30,625 $

Employment T(L'(es: Self Employment Tax - Soc. Sec (Employer & Employee portions + x 0.9235 per limitation) $ 774 $ 10,020 $ 12,648 $ 12,648 $ 12,648 Self Employment Tax - Medicare (Employer & Employee + portions x 0.9235 per limitation)) 181 2,343 4,687 7,030 9,374

+ Employment Tax- Soc. Sec. (Employer & Employee portions)

+ Employment Tax - Medicare (Employer & Employee portions) Total Employment Tax Liability $ 955 $ 12,363 $ 17,335 $ 19,678 $ 22 ,022

Total Entity Federal, Individual Federal, and Employment Tax Liability $ 120,908 $ 11 9,625 $ 11 8,733 $ 120,166 $ 122,065

JOURNAL OF TAXATION I MARCH 2009 • 145 PARTNERSHIPS, S CORPORATIONS, & LLCs

• EXHIBIT 5 Comparison of Results

Non -Manager Member CCore sCore PartnershiE Assumptions: Sala ry I Guaranteed Pay ment & Oth er Employment Benefi ts 100% 25% 50% Di vidend or Di stributi on 0% 75% 50%

Entity Level: Gross Revenue $ 500,000 $ 500,000 $ 500,000 No n Sa lary Operating Expenses (150,000) (150,000) ( 150,000) Net Ea rnings before Salary Related Ex penses $ 350,000 $ 350,000 $ 350,000

Salary I Guaranteed Pay ment & Other Employment Benefits: "Net taxa bl e salary" (282,592) (45,365) (123,57 1) 40 1(k) Deferrals (15,500) ( 15,500) ( 15,500)

Cafeteria PJ ~ n (FSA) (4,000) Total Gross Sa la ry I Guaranteed Payment $ (3 02,092 ) (60,865) $ (139,07 1)

Oth er Employment Benefit s: FI CA Tax Ded uct ion ·Soc. Sec. (6,324) (3 ,774) FI CA'Tax Deduction - Medicare (4,322) (883) Hea lth In surance Premium s (6,762) (6,762) (6,762) 40 I (k) Match (3%)1Pro fi t Sharing Contribution (22% C corpiS corp ; (30,500) (15,216) (29,167) 17% Partnership) Total Oth er Empl oyment Benefi ts (47,908) (26,635) (35,929)

Total Sa lary I Guaranteed Payment & Oth er Empl oyment Benefit s (350,000) (87,500) ( 175,000) Entity Level Distributabl e Federal Taxable Income 262.500 175,000 Highest Entity Level Federal Income Tax Rate 35% 0% 0% Entity Level Fede ral In come Tax Li abil ity

Individual Level:

Tax Liability 011 Salary I Guaranteed Payments + Net Taxa bl e Sa lary I Guaranteed Payment 282,592 52,127 130,333 100% Health Insurance Premiums (6,762) (6,762) 50% of Self Employment Tax -Soc. Sec. (6,324) 50% of Self Empl oyment Tax -Medi care 2,537 Taxable Income From Salary I Guaranteed Payment 282,592 45,365 11 4,7 10 Hi ghest Individual Income Tax Rate 35% 35% 35% Indi vidual Federal Income Tax Liability On Salary I Guaranteed Payment 98,907 15,878 $ 40, 148

Allocation I Distribution of £miry's Income: Profit All ocati on I Distributi on Received From Enti ty 262,500 175.000 Qualified Di vidend Di stribution Tax Rate 15% 35% 35% Individual Federal In come Tax Li ability From Profit All ocati on / Distributi on $ 9 1,875 6 1,250

Employment Taxes: + Se lf Employment Tax -Soc. Sec (Empl oyer & Empl oyee porti ons x 0.9235 per limitati on) 12,648 + Self Empl oyment Tax -Medi care (E mployer & Employee porti ons x 0.9235 per limitati on)) 4,687 + Employment Tax - Soc . Sec. (Employer & Empl oyee porti ons) 12,648 7,547 + Employment Tax -Medi care (Employer & Employee portions) 8,645 I ,765 Total Empl oyment Tax Li abili ty 21,293 9.3 12 17,335

Total Entity Federal, Individual Federal, and Employment Tax Liability 120,200 s 11 7,065 118,733

146 • JOURNAL OF TAXATION I MARCH 2009 PARTNERSHIPS, S CORPORATIONS, & LLCs est S corporation scenario was ceiving an incentive interest in return ,. J 33.44%-a nine-tenths of one per­ for the provision of development ser­ centage point differential. On a pro vices. Further, our fact situation is forma basis, that is a slim reason to rather static; we assume a stable, pro­ make a choice-of-entity determina­ fessional practice that is profitable tion. Rather, taking account of the without alterations in ownership. different options available between the various subchapters and using the opportunities each presents, for The relative certainty of the rules all intents and purposes the ultimate governing a PSC will have to be tax burden under Subchapters C, S, and K can be leveled, leaving the weighed against the flexibility choice-of-entity calculus to focus on available in the LLC form. distinctions between organizational forms under state law.

Many start-up ventures incur loss­ CONCLUSION es that are supported by debt financ­ Choice of entity is a complicated ing. In the context of an S corpora­ question that requires the assessment tion, failing to properly structure that and weighting of a wide variety of debt as a personal obligation of the factors including, but in no manner shareholder, rather than initially an limited to, tax treatment. Others of obligation of the business organiza­ those factors include the mecha­ tion that is in turn guaranteed by the nisms desired for decision-making shareholder, limits the deductibility and desired apparent agency struc­ of losses as the latter structure does ture, 55 capital lock-in or a desire for not create at-risk basis. Conversely, in liquidity in the venture,5s and the an LLC taxed as a partnership, a free transferability of interests in the guarantee of the debt undertaken by venture or, by contrast, a rule of"pick the business organization is sufficient your partner."57 Those other factors, to create at-risk basis against which as between forms of organization, are losses may be taken.5a Additionally, relative to one another, providing in the context of an organization more or less of a particular charac­ teristic. By contrast, tax treatment taxed under Subchapter K, Section is-at least pro forma-subject to 754 presents planning opportunities quantification and comparison on an with respect to basis step-ups on absolute basis. Likely such quantifi­ transfers of ownership interests, an cation is too seldom done. opportunity that does not exist with We have here limited our analysis either the C or the S corporation. to a hypothetical fact situation. The These and many other considera­ conclusions reached herein cannot tions of this nature need to be taken be applied to a different fact situation into account in the choice-of-entity such as a real estate development calculus. Still, the type of pro forma venture involving, by way of exam­ modeling done here may and should ple, a finance provider, a realty be employed irrespective of the na­ provider, and a developer who is re- ture of the venture. •

NOTES

55 See, e.g., Rutledge, "The Lost Distinction Be­ different between various states. For example, tween Agency and Decisional Authority: in the LLC, capital lock-in exists in LLCs orga­ Unfortunate Consequences of the Member­ nized in Virginia (Va. Code Ann. section 13.1- Managed versus Manager-Managed Distinc­ 1040.2) but not those organized in Delaware tion in the Limited Liability Company:· 93 Ky. (Del Code Ann. tit 6, section 18-604). L. J. 737 (2004-05); Rutledge and Frost, 57 See, e.g., RUPA section 401 (i) (a person may "RULLCA Section 301-The Fortunate Conse­ become a partner only with the consent of all quences (and Continuing Questions) of Distinguishing Apparent Agency and Decisional incumbent partners); Ky. Rev. Stat. Ann. sec­ AuthoritV:' 64 Bus. Law. 37 (2008) tion 275.275(1 )(a) (a person acquiring an inter­ est from an LLC is admitted as a member on 56 See. e.g., Stout. "On the Nature of Corpora­ tions:· 2005 U. Ill. L. Rev. 253. Practitioners the consent of all incumbent members). need to recognize that individual characteris­ 58 See Melvin, 88 TC 63 (1987) But see Prop. tics may, in the same form of organization, be Reg. 1.465-16.

JOURNAL OF TAXATION I MARCH 2009 • 147