1. Chapter 16
Partnerships, Corporations,
and S Corporations
Part I: Overview
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2. Chapter 16 Exhibits
1. What Entity Form Is Best for a New Business?
2. Selecting an Entity (Table 1)—Nontax Differences
3. Selecting an Entity (Table 2)—General Tax Differences
4. Selecting an Entity (Table 3)—Differences in Eligibility
5. Selecting an Entity (Table 4)—Differences in Tax Treatment
6. Formation of Entities—Owner Perspective
7. Effect of Operations on Owners
8. Effect of Nonstock Distributions on Owners
9. Effect of Nonstock Distributions on Entities
Chapter 16, Exhibit Contents CCH Federal Taxation Basic Principles2 of 25

3. What Entity Form Is Best for a New
Business?
General rules for small businesses:
 Taxes should not be a motivator unless there are no
nontax differences.
 If no need to incorporate, generally better to be a
limited liability company taxed as a partnership.
 If there is a need to incorporate, generally better to be
an S corporation.
 If there is a need to go public, a C corporation is
usually the only choice.
Chapter 16, Exhibit 1 CCH Federal Taxation Basic Principles3 of 25

4. Selecting an Entity (Table 1)—Nontax Differences
C Corps S Corps General Partnerships (G P/S)
Exposure Limited liability to Same as Each general partner (GP) has personal
of owners extent of investment. C corps liability for P/S debt, & a direct interest in
the P/S assets.
Owners of LLCs have limited liability;
but may not appoint 3rd parties to board
of directors.
Continuity Going concern Same as P/S dissolves after
of C corps 1. Departure of ≥ 50% GP(s); or
ownership 2. Operations cease.
Rights of Rights to investment Same as Actual rights to individual P/S assets; can
owners in stock, but not C corps bind partnership; each GP has equal right
corporate assets; to run business.
cannot bind corp.
Chapter 16, Exhibit 2a CCH Federal Taxation Basic Principles4 of 25

5. Selecting an Entity (Table 1)—Nontax Differences
C Corps S Corps General Partnerships (G P/S)
Raising Equity capital can be Cannot go Cannot trade a general partnership
equity raised through public public. interest on a public exchange, but can
capital stock offerings; however, trade a limited partnership interest
less flexible in bringing publicly; more flexible than
in different forms of corporations with forms of equity
ownership (i.e., must (e.g., can give out common or
maintain preemptive preferred P/S interest with no tax
ownership %. ⇒ the consequences.)
preemptive restrictions
are waived if employees
are offered equity
participation through
treasury stock.)
Chapter 16, Exhibit 2b CCH Federal Taxation Basic Principles5 of 25

6. Selecting an Entity (Table 1)—Nontax Differences
C Corps S Corps General Partnerships (G P/S)
Raising debt Banks may be Same as C Can more easily write custom
capital more willing to corps financing instruments (e.g., preferred
lend to debt with conversion rights).
corporations.
General Simplified with Same as C Can be too cumbersome to operate
administration centralized corps effectively without centralized
management. management like corporation, since G
P/Ss may exceed 100. G P/Ss are
subject to jurisdiction of the state. (For
LLC partners, control by states not yet
tested in the courts.)
Only if nontax differences weigh equally should one weigh the tax differences.
Chapter 16, Exhibit 2c CCH Federal Taxation Basic Principles6 of 25

7. Selecting an Entity (Table 2)—
General Tax Differences
C Corps S Corps General
Partnerships
Highest 35% if income is not distributed (but Same as 15% whether or
Marginal tax 15% accumulated earnings tax or general not income is
Rate personal holding company penalty partnership distributed.
possible);
44.75% if income is distributed. (35%
+ 15% x 65%) ⇒ possibly higher if
corporate shareholder receives
dividends, then distributes them again.
Lowest 15% on taxable income (TI) up to Same as 15% on TI up to
Marginal Tax $50,000. general $35,350 in 2012
Rate partnership for individuals;
$70,700 for joint
filers
Chapter 16, Exhibit 3a CCH Federal Taxation Basic Principles7 of 25

8. Selecting an Entity (Table 2)—
General Tax Differences
C Corps General
Partnerships
Tax accounting. Personal Service Cash, accrual or Cash, accrual or
methods Corporations (PSCs) and hybrid (all three hybrid, unless
Qualified C corporation available, partner is a “non-
(i.e., annual gross receipts ≤ regardless of qualified” C
$5mm in 3 preceding years) size). corporation. Then
may use cash, accrual or accrual method
hybrid; non-qualified C required.
corps must use accrual
only.
Chapter 16, Exhibit 3b CCH Federal Taxation Basic Principles8 of 25

9. Selecting an Entity (Table 2)—
General Tax Differences
C Corps S Corps General Partnerships
Tax Easier to administer with Complex if Very complex. With no
administration centralized management. owned by limits on # of general
(However, conflicts of many partners (GPs), large
interest may arise shareholders. partnerships (P/Ss)
between shareholders and would require very
management ⇒ e.g., complicated tax
management may prefer administration. Also,
tax methods that IRS can now audit P/Ss
maximize earnings while at P/S levels; each
shareholders may prefer partner (P) is put on
tax methods that postpone notice to toll the 3 year
earnings and taxes.) statute of limitations.
Chapter 16, Exhibit 3c CCH Federal Taxation Basic Principles9 of 25

10. Selecting an Entity (Table 2)—
General Tax Differences
C Corps S Corps General Partnerships
Subject to at-risk No, (except for personal Same as general Yes, to Ps (except
and passive holding companies or partnership PALs do not apply
activity loss personal service if the general
(PAL) rules? corporations.) partner (GP)
materially
participates and
business is a non-
rental activity).
Chapter 16, Exhibit 3d CCH Federal Taxation Basic Principles10 of 25

11. Selecting an Entity (Table 3)—
Differences in Eligibility
General
C Corps S Corps Partnerships
# Owners No limit 100 (related taxpayers can be treated as one At least 2.
taxpayer).
Owner None S corp. S/Hs NOT allowed: S corp. S/Hs None
identity 1. Nonresident aliens; allowed:
limits 2. C corporations; 1. Individuals;
3. Partnerships. 2. Estates;
4. Banks;
3. Qualified
5. Insurance cos. trusts.
Affiliate None None after 1996. Before 1997, could not None
limits own > 80% stock of another corporation.
Capital None Only one class of common stock. Code Sec. None
structure 1361(b)(1)(D). However, differences in
limits voting rights among common shares are OK.
Chapter 16, Exhibit 4a CCH Federal Taxation Basic Principles11 of 25

12. Selecting an Entity (Table 3)—
Differences in Eligibility
Treatment of Equity Owner
C Corps S Corps General Partnerships
Undistributed No tax to Current tax Current tax
income shareholder
Current losses:
General No deduction Current deduction Current deduction
Limit N/A Outside basis at risk Outside basis at risk
Character No Yes Yes
conduit (Code Sec. 1366(b))
Owner’s basis: Constant Adjusted annually Adjusted annually
General (unaffected by
corporate Outside basis AND at-
Effect of entity None (neither basis nor risk amount affected
activity)
debt AAA affected; only (Code Sec. 752)
None
“at-risk” amt)
Chapter 16, Exhibit 4b CCH Federal Taxation Basic Principles12 of 25

13. Selecting an Entity (Table 4)—
Differences in Tax Treatment
C Corps S Corps General Partnerships
Entity Any fiscal year Limited: Limited:
taxable end is OK. 1. Calendar year; or 1. Calendar year; or
year 2. Business purpose 2. Majority interest; or
satisfied if 25% gross 3. 5-Percenters’; or
rev. earned during last
4. Min. deferral rules; or
two month of adopted
FYE during past 3 years. 5. Business purpose.
Code Sec. 1378
Code Sec. 706.
Chapter 16, Exhibit 5 CCH Federal Taxation Basic Principles13 of 25

14. Formation of Entities—Owner Perspective
Formation C and S Corporations General Partnerships
Control requirement for 80% control after exchange. No control requirement
tax-free treatment:
Tax treatment for Always ordinary income. Always ordinary income.
services contributed in
exchange for ownership.
Chapter 16, Exhibit 6a CCH Federal Taxation Basic Principles14 of 25

15. Formation of Entities—Owner Perspective
Formation C and S Corporations General Partnerships
How is an Gain = Lesser of (a) or (b): Disguised sale rules:
owner’s (a) = Realized gain; Gains: Yes; Losses: Yes except losses
recognized (b) = Boot rec’d, where boot are not recognized if the disguised
gain or loss on is any property received other sale involving a 50% + partner.
“tax-free” than common stock. Debt Recognized Gain or Loss =
formation relief is also boot to the extent [(a) - (b)] x [(c) ÷ (a)], where,
determined? it exceeds the basis of all (a) = FMV of P/S interest
property contributed. received;
Realized losses are never (b) = AB of property contributed;
recognized in a Code Sec. 351 (c) = FMV of other property
exchange; realized losses are received within two years of
always recognized in a non-
Code Sec. 351 exchange.
new ownership.
[Note: (a) - (b)] = realized gain.
Chapter 16, Exhibit 6b CCH Federal Taxation Basic Principles15 of 25

16. Formation of Entities—Owner Perspective
Formation C and S Corporations General Partnerships
What is an The following formula applies Basis in partnership interest =
owner’s basis in to both tax-free and taxable (b) x {[(a) – (c)] ÷ (a)}
the ownership exchanges: AB in corp. stock =
interest? + AB in contributed prop.; (a) = FMV of P/S interest
+ Shareholder’s recog. gain; received;
– FMV of boot rec’d, including (b) = AB of property
debt relief that is boot; contributed;
– Debt relief that is not boot; (c) = FMV of other property
– Shareholder’s recog. loss. received within 2 years
of new ownership.
Chapter 16, Exhibit 6c CCH Federal Taxation Basic Principles16 of 25

17. Formation of Entities—Owner Perspective
Formation C and S Corporations General Partnerships
What is an owner’s Same as property Same as property contributed.
holding period (HP) in contributed. Split HPs may Split HPs may be necessary.
the ownership be necessary.
received?
What is an owner’s Same as the corporation’s FMV of prop. received. (Plus
basis in property adjusted basis (not FMV, as postponed loss in the rare case of a
other than equity in like-kind exchanges). 50%+ owner who postpones a
received from an realized loss on a disguised sale)
entity?
What is an owner’s HP begins on the day HP begins on the day AFTER
holding period in AFTER receipt. receipt.
property other than
equity received from
an entity?
Chapter 16, Exhibit 6d CCH Federal Taxation Basic Principles17 of 25

18. Formation of Entities—Owner Perspective
Formation C and S Corporations General Partnerships
What is an entity’s Basis in property = (a) + Basis in property = (c) + {[(a) – (c)]
adjusted basis (AB) (b), where, ÷ (a)] x (b)}, where,
in property (a) = FMV of P/S interest
contributed by a (a) = Shareholder’s AB
in contributed received;
new owner?
property; (b) = AB of property
(b) = Shareholder’s contributed;
recognized gain (if (c) = FMV other prop. received
any). w/in 2 yrs of new ownership.
Does an entity No, never. No, never.
recognize gain or
loss on the
exchange of an
ownership interest
for property in a
tax-free exchange?
Chapter 16, Exhibit 6e CCH Federal Taxation Basic Principles18 of 25

19. Formation of Entities—Owner Perspective
Formation C and S Corporations General Partnerships
Does an entity Gains: Yes; Losses: No. Gains: Yes; Losses: Yes, except
compute Gain = [greater of: (a) or (b)] – losses are not recognized if the
recognized gain (c), where: disguised sale involves a 50%+
or loss on the partner.
exchange of Gain or loss = [greater of: (a) or
property other (a) = FMV of property
(b)] - (c), where:
than equity to distributed;
(a) = FMV of property
new owners? (b) = Corporation’s debt relief
distributed;
(if any);
(b) = P/S’s debt relief
(c) = Corporation’s basis in
(if any);
property distributed.
(c) = P/S’s basis in property
distributed.
Chapter 16, Exhibit 6f CCH Federal Taxation Basic Principles19 of 25

20. Effect of Operations on Owners
General
Operating Item C Corps S Corps Partnerships
Undistributed No tax to Current tax Current tax
income: shareholder
Current losses:
General No deduction to Current deduction Current deduction
shareholder
Limit N/A Outside basis at risk Outside basis at risk
Character conduit: No Yes (Sec. 1366(b)) Yes
Owner’s basis: Constant (unaffected Adjusted annually Adjusted annually
General by corporate
activity)
Effect of entity debt None None (neither basis Outside basis AND
nor AAA affected; at-risk amount
only “at-risk” affected (Code Sec.
amount) 752)
Chapter 16, Exhibit 7 CCH Federal Taxation Basic Principles20 of 25

21. Effect of Nonstock Distributions on Owners
C and S Corporations General Partnerships
How is “amount (a) – (b), where, Cash + debt relief
distributed” to (a) = FMV of all prop. received by [i.e., for purposes of
owners computed? shareholder; determining gain, only
(b) = Corporate debt assumed by cash + debt relief are
shareholder. subject to capital gains.
Other property received by
a partner is tax-free.]
Chapter 16, Exhibit 8a CCH Federal Taxation Basic Principles21 of 25

22. Effect of Nonstock Distributions on Owners
C and S Corporations General Partnerships
What is the C Corps. S Corps. Cash + debt relief:
owners’ tax 1. Ordinary up to 1. Tax-free up to 1. Tax-free up to outside
treatment for current earnings & the lesser of: basis;
the “amount profits (E&P); • AAA Bal. 2. Capital gain to a
distributed?” 2. Ordinary up to • Stock Basis partner on the excess of
accumulated E&P; 2. Ord. up to cash or debt relief in
3. Tax-free up to accum. E&P from excess of outside basis.
outside basis prior life as a C (Loss is never
4. Capital gain on corp. (if any) recognized.)
remainder. 3. Other property: Tax-
3. Tax free up to
free.
any excess of stock
basis over AAA
balance.
4. Cap. gain on
remainder.
Chapter 16, Exhibit 8b CCH Federal Taxation Basic Principles22 of 25

23. Effect of Nonstock Distributions on Owners
C and S Corporations General Partnerships
What is the basis Always FMV, even if an owner Same as the partnership’s inside
of property assumes corporate debt. basis. [However, if a partner’s
distributed to an outside basis is less than the
owner? partnership’s inside basis in
property distributed to a partner,
then the partner’s basis of
property received is taken from
his outside basis, not from the
partnership’s inside basis. This
makes sense, given that a partner’s
outside basis must be reduced by
the “amount” of distributions and
that it cannot be negative]
Chapter 16, Exhibit 8c CCH Federal Taxation Basic Principles23 of 25

24. Effect of Nonstock Distributions on Entities
Does an entity recognize C and S Corporations General Partnerships
gain or loss on the
distribution of:
Cash or its own bonds to No. No.
owners?
Other property (other than its Gains: Yes (compute gain No gain or loss, unless it is
own stock)? in the same way as if the part of a disguised sale. In
property were sold) a disguised sale, the
partnership’s recognized
gain or loss = (a) - (b),
Losses: No (except in
where:
complete liquidation).
(a) = FMV of property
distributed.
(b) = AB of prop. dist’d.
Chapter 16, Exhibit 9a CCH Federal Taxation Basic Principles24 of 25

25. Effect of Nonstock Distributions on Entities
C and S Corporations General Partnerships
What is the character of the If owner owns ≤ 50%, then The character of the
entity’s gain or loss on the character of the entity’s partnership’s gain or loss
distribution of property to gain is the same as the on a disguised sale is the
owners? character of the property same as the character of the
distributed. property before it is
If owner owns > 50%, then distributed.
the entity’s gain is
ordinary.
Losses are not recognized.
Chapter 16, Exhibit 9b CCH Federal Taxation Basic Principles25 of 25