Considerations in determining whether to elect S corporation or LLC status.

The last few years have produced all explosion of legislation permitting the formation of limited liability companies (LLCs). Most states now permit the formation of LLCs and/or limited liability partnerships (LLPs).(1)

LLCs are generally taxed under subchapter K (governing the Federal income taxation of partnerships). The Federal income tax classification of an LLC as a partnership, as opposed to an entity taxable as a corporation, hinges on Regs. Sec. 301.7701-2, which provides that all unincorporated entity will be classified as a corporation if it possesses more corporate than noncorporate characteristics. For an entity to be taxed as a partnership, it must possess less than three of the following corporate characteristics"(1) continuity, of life, (2) centralized management, (3) limited liability and (4) free transferability of interests.

Limited liability, is inherent in an LLC; thus, the analysis turns on which, if any, of the additional three attributes the LLC has. Generally, LLC members will desire (or actually have) centralized (i.e., representative) management (2); thus, the LLC will have limited liability. and centralized management and, therefore, must ensure that continuity of life and free transfer ability of interests are lacking. Rev. Proc. 95-10(3) provides guidance on this issue and has applied to LLCS the ruling criteria used for state law partnerships.(4)

Many a small business desiring limited liability will be able to elect to be either an S corporation or an LLC taxable as a partnership, if it is owned by at least two and fewer than 36 individuals.(5) Which form of entity should be chosen? Although the taxation of S corporation and partnership operations is generally similar (i.e., both are "flowthrough" or "conduit" entities for Federal income tax purposes), significant differences exist between the Federal income taxation of S corporations and partnerships, especially in the areas of financing, formation, restructuring, distributions and entity liquidation,(6) and are the subject of this article.

Entity Formation

Contributions of Appreciated Property

Often, appreciated property is transferred to a newly formed entity as a capital contribution. In the case of such a contribution to an S corporation, to obtain tax deferral, Sec. 351(a) requires that the transferor shareholder, along with all other shareholders making contemporaneous property contributions, must "control" the corporation immediately after the transfer. Under Sec. 368(c), "control" is defined as 80% or more of all classes of stock, including voting stock.(7)

In the case of an LLC taxable as a partnership, there is no control requirement, the contributing partner (whether a 1% or a 99% owner) recognizes no gain, under Sec. 721 (a).

Example 1: K and J are equal owners of ABC Co., which they formed several ears ago. K contributes currently a significant amount of highly appreciated property to ABC for an additional 10% of the issued and outstanding equity interest. If ABC is an S corporation, K will recognize the appreciation on the contributed property, because he is not in Sec. 368(c) control of the entity immediately after the contribution. If ABC is an LLC taxable as a partnership, the contribution is tax free under Sec. 721(a).

Contributions of Liability Property

When encumbered property is contributed to an S corporation and the transferee assumes the underlying liability, the contributing shareholder recognizes gain under Sec. 357(c) to the extent the liability assumed exceeds the tax basis of all property contributed by that shareholder.

In the case of an LLC taxable as a partnership, the contributing owner recognizes gain to the extent his liability is relieved. The relieved liability constitutes a deemed cash distribution to that owner under Sec. 752(b); actual or deemed cash distributions in excess of the owners outside basis in his interest trigger gain recognition under Sec. 731(a)(1).

Example 2: K and J are equal owners of NEWCO. In exchange for his interest, K contributed encumbered property with a fair market value (FMV) of $100,000 and basis of $25,000 and subject to a $40,000 liability that NEWCO assumed and K and J secondarily guaranteed.

If NEWCO is an S corporation, K would recognize a $15,000 gain ($40,000 - $25,000); NEWCO is an LLC taxable as a partnership, at the time of contribution, K establishes a 25,000 tax basis in his NEWCO interest against which he is deemed to have received a$20,000 cash distribution ($40,000 X 50%, the amount of the liability he is deemed relieved of@. Because K's basis in NEWCO exceeds the deemed cash distribution, the $20,000 triggers no gain recognition. Ks outside basis is reduced from $25,000 to $5,000 by absorbing the distribution.

Receipt of Ownership Interest for Services

Sec. 83 triggers gain recognition to a service provider (SP) who receives an equity interest. in the case of a newly incorporated entity, this result may cause more problems than mere taxation to the SP-shareholder.

Sec. l351(a) requires that the controlling shareholders of a newly incorporated entity must have received their stock for "property" for the exchange to be tax-deferred. Services are not property for this purpose, a shareholder who receives stock solely for services is not a member of the controlling shareholder group necessary to effect tax-free treatment under Sec. 351 Apart from current income taxation to the SP-shareholder, an ancillary result would be to generally deny Sec. 351 treatment to all shareholders if the SP-shareholder receives more than a 20% stock interest in exchange for services.

In the case of an LLC taxable as a partnership, the tax results depend on whether the SP-partner received a share of current capital(9) or merely a right to participate in future profits. Sec. 721 and Pegs. Sec. 1.721-1(b)(1) indicate that an SP-partner's receipt of the right to participate only in future partnership profits does not trigger current income taxation. The consensus appears to be that the receipt by an SP-partner of a profits interest will not trigger current income taxation, particularly if there is no long operating history of the underlying business that would allow for a reasonable valuation of such an interest.(10) The IRS has provided significant guidance in this area in Rev. Proc. 93-27,(11) in which an individuals receipt of a profits interest in exchange for services to or for the benefit of a partnership (as a partner or in anticipation of becoming one) generally does not trigger gain recognition to either the partner or the partnership.

Example 3: J and K form NEWCO as equal owners. J contributes equipment with an FMV of $100,000 and a zero basis. K receives his interest in return for professional services rendered in the formation of NEWCO and to be rendered in its new business.

If NEWCO is an S corporation, K receives stock with an FMV (under a hypothetical liquidation@ of at least $50,000 that win be currently taxable to him if the stock is unrestricted. The value of the stock taxed to K will be ordinary income, although NEWCO will have an offsetting deduction for the compensatory payment.(12) In J's case, because he is not in control of NEWCO immediately after the transfer, Sec. 351 does not apply; J will recognize $100,000 gain.

If NEWCO is an LLC taxable as a partnership, Sec. 721(a) protects J from income recognition. Additionally, if K receives a right only to share in 50% of NEWCO's future profits, and has no right to share in J's $100,000 capital contribution in the event of a liquidation, he will not recognize gain currently.

Operational Tax issues

Entity Debt and Outside Tax Basis

The effect of entity-level debt in the computation of an owner's outside basis in his interest is another major difference between the taxation of S corporations and partnerships. Under Sec. 1367, there is no effect on a shareholder's basis in S stock when the corporation initially incurs and pays off debt on which it is the primary obligor, even if the sharehoder(s) guarantee(s) the debt. This is important because the outside tax basis of the shareholders interest limits his ability to receive a tax-free distribution from the corporation, and generally limits the current use of losses passing through from the corporation to the shareholders.

The incurrence and retirement of partnership-level debt is treated as if the partners individually and proportionately borrowed rowed the funds and then contributed them to the partnership. On the partnership's retirement of the debt, a deemed cash contribution increases the partners, outside bases, a deemed cash distribution reduces such bases (and triggers gain recognition to the extent it exceeds outside basis).(13) This possibility of "phantom income" does not occur in the S corporation context because (as was discussed) the corporations incurrence and discharge of debt has no effect on the shareholders outside stock basis, there is no deemed cash contribution or distribution. Caution: There is a very technical and complex distinction between the way partners share recourse and nonrecourse debt. Basically, partners share recourse debt in accordance with their loss-sharing ratios, while they share nonrecourse debt in accordance with their profit-sharing ratios. In this article, for simplicity's sake, it is assumed that all partnership debt is shared in accordance with general profit- and loss-sharing ratios.

Example 4: J and K form NEWCO, in which each has a 50% interest. J contributes $100,000 cash for his interest and K contributes property with an FMV of $100,000 and a zero basis for his interest. NEWCO borrows $50,000 from an unrelated party and pays interest only on the debt for a year. After the first year of operations, NEWCO has a $20,000 net operating loss (NOL) and makes a $5,000 cash distribution to each J and K.

If NEWCO is an S corporation, neither shareholder gets an increase in outside basis for NEWCO's debt. K's basis in his NEWCO interest is the substituted basis of zero, and J's is $100,000. Because K has no outside basis against which to absorb the cash distribution, he recognizes a $5,000 capital gain. Further, K cannot use currently any of his $10,000 share of NEWCO's NOL for the year; it is suspended until he sufficiently builds up his outside basis.

On the other hand, J can use currently his $10,000 share of NEWCO,s NOL (presuming no passive loss or at-risk problems). Further, the cash distribution is tax free to him, because he has outside basis to cover it. His outside basis in NEWCO stock would be reduced to $85,000 by the $5,000 cash distribution and the $10,000 loss passthrough.

If NEWCO is an LLC taxable as a partnership, J's and K's basis would increase by $25,000 each for NEWCO's debt; thus, both could currently use their losses and receive the cash distributions tax free.

Effect on Basis of Owner-to-entity Loans

When a shareholder loans money to an S corporation, the principal amount provides a buffer against which loss passthroughs may be taken if the outside stock basis has been reduced to zero. However, the loan will not directly affect the shareholder's outside stock basis, which alone acts as a buffer for tax-free cash distributions.

As previously noted, in the case of an LLC taxable as a partnership, the debt directly affects the owner's outside basis in his interest. Further, under Regs. Sec. 1.752-2(c)(1). unless there is a guarantee of the obligation by the other owners, when an owner lends money to the LLC, he alone bears the ultimate economic risk of loss associated with default, thus, the lending partners basis will increase by the loans principal amount.

Example 5: J and K form NEWCO as equal owners. J contributes cash for his interest@ K contributes property with an FMV of $100,000 and a zero basis for Ids interest. K also lends NEWCO $50,000 with interest-only payments scheduled for the next few years.

NEWCO breaks even in its first year of operations, with no net income or loss, and distributes $5,000 to K in addition to the interest payments on the loan.

If NEWCO is an S corporation, Ks outside basis in his stock interest is zero and the $5,000 distribution in excess of basis must be recognized. If NEWCO is an LLC taxable as a partnership, K receives the $5,000 distribution tax free, because his outside basis prior to the distribution is 50,000.

Allocation of Tax Attributes

An entity's owners may desire that tax attributes (e.g., specific gains, losses, income or deductions) be allocated in a manner disproportionate to their general ownership interests. Technically, such special allocations are not possible in S corporations; if the S shareholders attempt to manipulate the normal tax allocations (e.g., through employment or other side agreements), they run the risk of terminating the S election due to the creation of a second class of stock under Regs. Sec. 1.1361-1.

An LLC taxable as a partnership, on the other hand, can structure special tax allocations if they have "substantial economic effect" as defined in Sec. 704(b) and Regs. Sec. 1.704-1(b). Although recent changes(14) to the Sec. 704(b) regulations have restricted flexibility in this area, very generally, the requisite substantial economic effect is present if the tax allocations are reflected in the partners, capital accounts and will affect the economic distributions to and liabilities of the partners on entity liquidation. Caution: Infusing substantial economic effect into an agreement requires precise, lengthy (and thus, costly) drafting.

Example 6: J and K contribute $50,000 each to NEWCO in return for their equal interests. NEWCO uses the funds to acquire depreciable property. The parties decide that 90% of the tax depreciation nd be allocated to J and 10% to K, while other tax attributes will be shared equally.

Although j and K may not implement the desired allocation of the tax depreciation through an S corporation, they may be able to do so through all LLC taxable as a partnership (the special allocation must have a purpose other than just reducing the partners, overall tax liability). For the special allocation to the respected, it must also be reflected in the partners, respective capital accounts and affect actual economic distributions in the event of NEWCO's liquidation (i.e., distributions must be made in accordance with the adjusted capital accounts).

Precontribution Gain or Loss on Contributed

Property

As was discussed, when shareholders controlling 80% or more of an S corporation or any partner contributes appreciated property to an entity, there is generally no tax on the difference between the FMV of the property and the basis on the date of contribution; the entity takes a carryover basis. What happens if the entity subsequently disposes of the contributed property in a taxable transaction? Should gain or loss attributable to the precontribution holding period be specially allocated only to the contributing owner?

In the case of an S corporation, there is no special allocation precontribution gain or loss. For an LLC taxable as a partnership, there is a mandatory allocation under Sec. 704(c)(1) of precontribution gain or loss to the contributing partner.

Example 7: J and K form NEWCO as equal owners. J contributes $100,000 cash for his interest; K contributes property with an FMV of $100,000 and a zero basis for his interest. NEWCO's basis in the property is K's zero carryover basis. Several years later, NEWCO sells the property to an unrelated party for $120,000.

If NEWCO is an S corporation, the $120,000 gain is allocated $60,000 each to J and K.(15) If NEWCO is an LLC taxable as a partnership, the first $100,000 of gain must be allocated to K;J and K are then allocated $10,000 each of the remaining $20,000 gain.

Caution: The implications of Sec. 704(c) go far beyond those just illustrated (e.g., tax depreciation attributable to contributed property typically requires a special allocation).

Inside and Outside Basis and the Sec. 754 Election

The owners, aggregate outside bases in their equity interests may vary from the entity's inside tax basis of its assets, this phenomenon may occur on the sale and purchase of interests in the entity or from a disproportionate distribution from the entity to an owner. When such a disparity occurs in an S corporation, there is no corporate-level mechanism for correcting it. In the case of an LLC taxable as a partnership, however, Sec. 754 provides an election to adjust the basis of entity property in the event of a disparity created through the sale of a partnership interest (via Sec. 743) or a disproportionate distribution (via Sec.734).

Example 8: B and J own 50% each of ABC Co., which was formed several years ago. ABC owns one asset, the FMV of which is $200,000; ABC's inside tax basis is zero. B sells her 50% interest in ABC to K for $100,000. Shortly thereafter, ABC sells its sole asset to an unrelated party for $200,000.

If ABC is an S corporation, the resulting $200,000 gain is allocated $100,000 each to J and K. If ABC is an LLC taxable as a partnership, and has made a Sec. 754 election, K win be provided a special inside basis step-up in the underlying asset of $100,000. On the sale of the asset, the gain allocable to K will be offset by the special basis step-up, K will recognize no gain.

Distribution and Liquidation Issues

Distributions of Appreciated Property

Occasionally, an entity will distribute noncash property (typically, appreciated property) to some or all of its owners in lieu of cash. In an S corporation, whether the distribution is liquidating or nonliquidating, gain is recognized in accordance with Sec. 336 or 311(a) as if the entity had sold the property to an unrelated party at FMV. This gain is then allocated to the share-holders in proportion to their stock ownership and increases each's outside stock basis. Further, gain is recognized under Sec. 1368(b)(a) to the extent the FMV of the property distributed exceeds the adjusted outside stock basis.

Under Sec. 731(b), an LLC taxable as a partnership generally recognizes no gain on a distribution of the appreciated property. Typically, at the partner level, gain is recognized under Sec. 731(a)(1) only to the extent a cash distribution exceeds a partners outside basis, a distribution of appreciated property to a partner generally does not trigger partner-level gain recognition.

Example 9: J and K are equal owners of ABC Co., which owns property with an FMV of $100,000 and a zero basis. ABC distributes cash to J and the property to K. Ks outside basis in his ABC interest is $30,000 before the distribution.

If ABC is an S corporation, the distribution will cause $50,000 to be recognized by each shareholder, such gain will increase J's and K's outside stock bases. Ks outside basis increases from $30,000 to $80,000; K then accounts for the property distribution, which results in a $20,000 gain ($100,000 - $80,000). In addition to his share of the $100,000 gain, J would recognize gain to the extent the cash distributed to him exceeds his adjusted outside stock basis.

If ABC is an LLC taxable as a partnership, it recognizes no gain on its distribution of appreciated property to K. K recognizes no gain, because there is no cash distribution to him. K will take a zero carryover adjusted basis in the property distributed; his basis in ABC remains at $30,000 Although no entity-level gain will flow through to J, he will recognize gain to the extent the cash distributed to him exceeds his outside basis.

Caution: Unexpected tax problems arise in a partnership holding meaningful amounts of "hot, assets" (i.e., substantially appreciated inventory and unrealized receivables, as defined in Sec. 751(d) and (c)). If a distribution is made to one or more partners without a proportionate distribution of hot assets, ordinary income recognition occurs.

Sale of Equity Interest

The hot asset issue can reappear on the sale of a partnership interest. Although capital gain or loss generally results on such a sale under Sec. 741, some of it may be recharacterized as ordinary under Sec. 751 if the entity holds meaningful amounts of hot assets. Absent the (highly unusual) application of the Sec. 341 collapsible corporation rules to an S corporation, a sale of S stock is the sale of a capital asset.

For a sale of S stock at a loss, ordinary loss treatment may be available for "small business stock," as defined in Sec. 1244.(16) Generally, a loss on the sale of a partnership interest will generate hard-to-use capital losses via Sec. 741.(17)

Payments to a Retiring Owner

Commonly, on the retirement or death of a small business owner, the entity redeems and purchases his equity interest. In an S corporation, Sec. 302(b)(3) or 303 affords sale or exchange treatment to the transaction, resulting in capital gain or loss. In the case of an LLC taxable as a partnership, Sec. 736 bifurcates payments to a retiring partner into Sec. 736(a) ordinary income payments and Sec. 736(b) property (capital) payments. According to Regs. Sec. 1.736-1(a)(6), until these payments are completed, the entity continues to exist as a partnership for tax purposes even if there is only one surviving partner. Caution.. The results under Sec. 736 depend on whether (1) the partnership has "hot assets," (2) the retirement payments are made in cash or noncash property, (3) a Sec. 754 election has been made and (4) the partnership is primarily an SP in which capital is not a material income-producing factor.

Example 10: J and K, unrelated, are equal owners of ABC Co., which has $200,000 cash, land with an FMV of $150,000 and $50,000 of unstated goodwill. K retires and ABC purchases his equity interest for $200,000 cash.

If ABC is an S corporation, K recognizes capital gain or loss under Sec. 302(b)(3) on the deemed sale of his S stock.

If ABC is an LLC taxable as a partnership and is a service business, the retirement payments to K would be Sec. 736(b) payments giving rise to capital gain (or loss); however, the $25,000 paid for Ks share of the unstated goodwill is a Sec. 736(a) payment (triggering ordinary income to K and a deduction to ABC).(18)

If capital is a material income-producing factor in ABC's business, the $200,000 retirement payment would give rise to capital gain or loss under Sec. 736(b). (Whether or not ABC is a service business, its ownership of hot assets would complicate the calculation and cause K to recognize ordinary income.)

Which Entity Should be Chosen?

As the examples illustrate, an LLC generally appears to be more favorable for tax purposes than an S corporation, particularly if the entity will hold highly appreciating assets that could be refinanced to build up the members, outside bases to absorb later tax-free cash distributions and use any loss passthroughs. If there is a likelihood that such appreciated assets will be distributed in kind, an LLC provides distinct tax deferral advantages.(19)

Corporations in insolvency or bankruptcy generally follow the same rules for cancellation of debt (COD) income and reduction of tax attributes as do individuals, because the Sec. 108(e) stock-for-debt exception to COD income was repealed by the Revenue Reconciliation Act of 1993; however, some notable differences remain. For S corporations, the Sec. 108 rules apply at the corporate level. In the case of a bankrupt or insolvent partnership, the Sec. 108 rules apply at the partner level, each partner reports his share of COD income unless he meets the bankruptcy or insolvency exclusions. Despite these differences, it would be rare for a tax adviser to be able to conclude at the inception of the entity which type of entity would provide more benefits in the event of future bankruptcy or insolvency.

Generally, an S corporation is the superior entity for maintaining a qualified retirement plan. For example, the Sec. 401(d)(1)(B) controlled group rules require more than 50% common ownership to aggregate commonly owned partnerships, as opposed to Sec. 414(b) and (c), which impose an 80% or more requirement for commonly owned corporations. Additionally, plan contribution and allocation rules, generally contained in Secs. 415 and 401(1), are significantly more complex for unincorporated entities. Under Regs. Sec. 1.401(k)-1, both elective contributions and the company match for an unincorporated entity count toward the general $9,500 contribution limitation for Sec. 401(k) plans, but only elective contributions by key S corporation employees are subject to the limitation. Finally, more restrictions are imposed on partnership plans that own life insurance than on comparable S corporation plans.

Further, there are disadvantages to an LLC taxable as a partnership in terms of complexity. As noted in this article (under the "Caution[s]") the intricacies of subchapter K outweigh those of subchapter S. As discussed in Federal Taxation of Partnerships and Partners:(20)

The distressingly complex and confusing nature of the provisions of subchapter K present a formidable obstacle to the comprehension of these provisions without the expenditure of a disproportionate amount of time and effort even by one who is sophisticated in tax matters with many years of experience in the tax field....surely, a statute has not achieved 'simplicity' when its complex provisions may confidently be dealt with by at most only a comparatively small number of specialists who have been initiated into its mysteries.

This degree of mastery separates tax professionals from others and may be welcome, as it will largely survive the general tax simplification that may result from flat tax reform. Hopefully, this article has allowed the reader to take a constructive step toward understanding some of these intricacies and to suggest the proper business entity for clients.(21)

EXECUTIVE SUMMARY

* Subchapter K is technically more sophisticated than subchapter S; thus, it may be easier to work with an S corporation on a daily basis. * An LLC generally appears to be more favorable for tax purposes than an S corporation, particularly if the entity will hold highly appreciating assests that could be refinanced to build up the members' outside bases to absorb later tax-free cash distributors and use any loss passthroughs. * In addition to the issues addressed here, other questions must also be resolved before making the election decision.

(1) In this article, LLCs and LLPs are collectively referred to as "LLCs." In most states. LLPs are preexisting state law general partnerships that have converted Federal tax free; see note 6. Generally, the state law and taxation pertaining to LLPs parallels that of LLCs. In Ohio, for example, state franchise taxation is based on the entity's status for Federal tax purposes; see Ohio PC Section5733.01(F). Additionally, the tax adviser should ensure that a given business or profession may be conducted through either an LLC or an LLP. Physicians in Ohio, for example, due to medical board restrictions, may not be able to practice through either entiry; see Ohio PC Sections 1705.03 and 4733. (2) Even if the LLC's managers are members, the entiry may still be deemed to have centralized management if managers are subject to periodic elections by the members or if the nonmanaging members have a substantially nonrestricted power to remove them; see Rev. Proc. 95-10, 1995-1 CB 501, Section 5.03. Member-managers will be subject to self-employment (SE) tax under Prop. Regs. Sec. 1.1402(a)-18 on their distributive shares of LLC net operating income. A member who is not a manager will be deemed a limited partner for purposes of the SE tax exemption under Sec. 1402(a)(13) on his distributive share of LLC operating income. (3) Rev. Proc. 95-10, id. The analysis of corporate versus noncorporate attributes contained in Rev. Proc. 95-10 will become moot if the "check the box" approach originally promulgated in Notice 95-14, 1995-1 CB 297, and extended in proposed regulations recently issued under Sec. 7701 (PS-43-95, 5/9/96), is adopted. The proposed rules would generally classify, an entity with two or more owners that is not a state law corporation as a partnership for tax purposes. regardless of the constraints imposed under the current regulations, unless the owners elected to be taxed as a corporation. (4) According to Rev. Proc. 95-10, note 2, Section 5.01, the IRS will generally rule that an LLC lacks continuity of life if the death, insanity, bankruptcy, retirement, resignation or expulsion of a member-manager fin the case of an LLC with centralized management@ or of any member (if there is no centralized management) will dissolve the LLC, unless the entity is continued by the consent of not less than a majority in interest of the remaining members. Further, under Section O5.02, the IRS will generally rule that there is no free transferability of interests if a member owning more than a 20% interest in the LLC cannot assign to nonmembers all the attributes of the members interests without the consent of at least a majority of nontransferring member-managers (when managers have been designated), or at least a majority of the nontransferring members (when managers have not been designated). (5) If the business is owned by a single individual, S corporation versus LLC analysis ends; most states allow single@shareholder corporations, but not single-member LLCs. Further, Rev. Proc. 95-10, note 2, and Prop. Pegs. Sec. 301.7701-3(a) prohibit partnership treatment for single-member LLCs. (6) Rev. Rul. 95-37, 1995-1 CB 130 J, provides that partnership-to-LLC conversions are treated as tax-free partnership-to-partnership conversions under Rev. Rul. 84-52, 1984-1 CB 157. See Cochran, Blazek and Elliott, "the Costs of Converting a Partnership to an LLC," 26 The Tax Adviser 455 (Aug. 1995). However, conversions of corporations to LLCs are deemed liquidations resulting in double @if a C corporation) or single (if an S corporation) levels of tax@ see IRS Letter Rulings 9404021 (11/1/93) and 9404014 (11/29/93). (7) (Rev. Rul. 59-259, 1959-2 CB 115. provides additional direction in the case of an issuance of nonvoting common stock. (8) Although the SP-shareholder will always be taxed on the receipt of stock for services, Regs. Sec. 1.351-1(a)(1)(ii) provides that a contemporaneous transfer of a relatively significant amount of property in addition to services will allow the SP-shareholders entire stock interest to be counted for Sec. 368(c) control purposes. The Service requires that the qualifying property be valued at at least 10% of the value of the accompanying services; see Rev. Proc. 77-37, 1977-2 CB 568, Section 3.07. (9) This occurs via a hypothetical liquidation of the partnership immediately following the SP-partners receipt of an interest; see Rev. Proc. 93-27, 1993-2 CB 343. (10) See William G. Campbell, 943 F2d 815 (8th Cir. 1991) (68 AFTR2d 91-5425, 91-2 USTC [paragraph] 50,420), rev'g TC Memo 1990-236; Ronald H. Pacheco, 912 F2d 297 (9th Cir. 1990)(66 AFTR2d 90-5429, 90-2 USTC [paragraph] and Sol Diamond, 492 F2d 286 (7th Cir. 1974) (33 AFTR2D 74-852, 74-1 USTC [paragraph] 9306), aff'g 56 TC 530 (1971). Although most practitioners discount the possibility, if the SP-partners receipt of a future profits interests is taxable, a myriad of further complicating tax issues can arise, including the partnership's recognition of income under general anticipatory assignment of income law. In contrast. an S corporation, protected under Sec. 1032 and Regs. Sec. 1.1032-1(a), would not recognize gain on an issuance of shares as compensation for services. (11) Rev. Proc. 93-27, note 9. (12) If the services provided by the SP-shareholder are in the nature of start-up or organizational expenditures, Secs. 195(a)(1) and 248(a), respectively, would require the deduction to be amortized over at least al months. (13) Sec. 752 and Regs. Sec. 1.752-1. For example, if a partnership repaid a $50,000 debt, a 50% partner with a $20,000 outside basis in his partnership interest would recognize a $5,000 gain ($25,000 - $20.000). (14) See TDs 8385 (12/26/91) and 8500 (12/27/94). (15) Although such a possibility most likely would not direct the initial formation of NEWCO as an S corporation rather than as an LLC, if J had significant capital losses and/or carryovers, any resulting gain applicable to him that was nonrecaptured Sec. 1231 gain would increase his outside stock basis without a tax cost. 16 Generally, Sec. 1244(c)(1) and (3) define a "small business corporation" as a corporation engaged in the active conduct of a trade or business with aggregate contributions to capital and paid-in surplus of not more than $ million. The maximum amount deductible as an ordinary loss in any one year is $50,000 ($100@,000 on a joint return). (17) Sec. 1244 applies to a worthlessness loss on small business stock (as opposed to a sale at a loss); however. more favorable results may be obtained if the worthless loss is significant and the entity is an LLC taxable as a partnership, because the interest owner is not encumbered by Sec. 165(g), as is the owner of stock. Generally, this would result in an ordinary loss to the extent of the owners outside basis, because there is no "sale or exchange" generating a capital loss. (18) If ABC's operating agreement provided that retirement payments include a payment for entity goodwill, they could be characterized as Sec. 736(b) payments for property. (19) Before concluding that an S corporation is inferior to an LLC, the tax adviser should consider further issues. If it is anticipated that the entity will go public, transitioning a privately owned S corporation to a public company is significantly easier (from a tax and nontax standpoint) than is the transition of an LLC. The LLC will have to incorporate prior to the initial public offering; the transfer of heavily encumbered properties from the LLC to the new corporation could trigger significant gain recognition under Sec. 357(c), among other problems. Similarly, if there is a desire to terminate the tax conduit (i.e., single level of taxation) aspect of the business for income-splitting or other purposes, an S corporation is preferable. As opposed to simply revoking an S election, the LLC would have to convert to a C corporation to effect such a result, with the same potential Sec. 357(c) problems. An S corporation is also preferable if the business win have target possibilities; while an S corporation can participate in a Sec. 368 tax-free reorganization, an LLC may do so only after incorporating and hurdling Sec. The SE tax distinction between S corporations and state law partnerships is relatively well-known. The extension of limited partner treatment to LLC members who are not managers was discussed in note 2. Generally, general partners in a state law partnership or member-managers of an LLC engaged in an active trade or business must report their entire distributive shares of net income as SE income; an S shareholder does not pay SE tax on such income, provided he has been adequately compensated for any services rendered to the corporation. See IRS Pub. 533, Self-Employment Tax, for helpful illustrations and narratives. Another potential consideration is an S corporation's ability to provide relatively easy-to-implement equity-based compensation devices (e.g., incentive and nonqualified stock options). Although quasi-equity-based compensatory devices are available through a partnership (e.g., modifications in future profits interests), they are not as well defined as the stock option approaches. This could be an important factor to consider at the inception" of the entity if the use of such compensatory tools for key workers is a strong possibility. (20) McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners (Warren, Gorham K Lamont, 2d ed., 1990), preface, p. v, citing David A. Foxman, 41 TC 535, n. 9 (1964), aff'd, 352 F2d 466 (3d Cir. 1965)(16 AFTR2d, 5931, 65-2 USTC [paragraph] 9737). (21) For a basic but thorough comparison of the taxation of S corporations, partnerships and C corporations, see Eustice and Kuntz, Federal Income Taxation of S Corporations (Warred, Gorham K, Lamont, 3d ed., 1993), Section 2.03. For a superb work comparing all significant tax add nontax features of an S corporation and an LLC, see Darrow," Limited Liability Companies and S Corporations: Deciding Which is Optimal and Whether to Convert to LLC Status" 48 The Tax Lawyer 1 (Fall 1994). For another monumental work comparing all meaningful distinctions between an entity taxed under subchapter K versus subchapter S, see ABA Section of taxation, Committee on S Corporations, Subcommittee on the Comparison of S Corporations and Partnerships, Report on the Comparison of S Corporations and Partnerships (Parts I and II)," 44 The Tax Lawyer 483 (Winter 1991) and 813 (Spring 1991).