Limiting Your Liability with LLCs and S Corporations

Congress enacted the first Subchapter S legislation in 1958, providing an alternative organization to select when establishing a business. More recently, an increasing number of states have enacted limited liability company (LLC) statutes. Neither S corporations nor LLCs are subject to tax at the entity level. They are similar to partnerships because all items of income and deduction retain their character and flow-through directly to shareholders. Additionally, both provide limited liability to the owners.

Taxpayers should examine the current tax issues affecting both of these types of organizations. First, a 1994 revenue ruling affects planning opportunities for the use of S corporations as members in partnerships. Next, we must deal with the still-unclear area of the passive-activity loss limitations' applicability to LLCs.

Expanded Opportunities for Partnerships with S Corporations
The Internal Revenue Service (IRS) eliminated a lingering uncertainty by declaring in revenue ruling 94-43 that it will respect the organization of separate corporations that form a partnership even if the structure allows the parties to plan around §1361(b)(1)(A), which limits an S corporation to 35 shareholders. The IRS revoked revenue ruling 77-220, which did not respect the formation of an S corporation by three separate corporations attempting to conduct a business in partnership form.

The parties involved in the 77-220 ruling included 30 individuals who entered into the joint operation of a business. They began by dividing into three groups of 10 members each to avoid §1371, which imposed a 10-shareholder limitation on S corporations. The three separate corporations then organized a partnership for the operation of the enterprise.

The IRS concluded that the three corporations should be treated as a single corporation for purposes of making the election to be taxed as a small business corporation. Accordingly, the corporation would have 30 shareholders and the S corporation election would not be valid.

In revoking revenue ruling 77-220, the IRS observed that the point of the restriction on the number of S-corporation shareholders is to obtain simplicity in the administration of a corporation's tax affairs. The fact that several S corporations are partners in a single partnership, the IRS reasoned, does not increase the administrative complexity at the S corporation level.

The logical conclusion of the ruling suggests that an S corporation can enter into a partnership with any other person-including a person ineligible to own S corporation stock-as long as the structure does not increase the administrative complexity at the S-corporation level. If the §1361(b) requirements for a small business corporation are met, then an S corporation should be able to form a partnership even with persons who could not themselves own stock in the corporation. Requirements include having no more than 35 shareholders; no shareholders who are not individuals; no shareholders who are nonresident aliens; and there must be only one class of stock. For example, an S corporation should be allowed to join in a partnership with C corporations, foreign corporations, or nonresident aliens.

Similarly, entering into a partnership should not jeopardize an S corporation's ability to satisfy the single-class-of-stock requirement in §1361(b)(1)(D). Depending on how a partnership allocates its income, losses, deductions, and credits, the shareholders of an S-corporation partner may receive significantly different shares of those items than they would receive if the S corporation were to conduct the partnership's business directly. However, the IRS should respect the partnership allocations if they satisfy §704(b) and other applicable Subchapter K rules. Partnership special allocations do not necessarily mean an S corporation has more than one class of stock as long as the S corporation's distributions to its shareholders satisfy the "identical rights" requirement in regulation §1.1361-1(l).

Partnerships involving S corporations may be useful for establishing new business ventures and for restructuring existing ventures. Now that most states have recognized limited liability companies, the flexibility of LLCs compared to S corporations certainly is worth considering in structuring any new business venture. However, in some situations, simply conducting a venture through an S corporation may prove advantageous. For example, §704(c) limits a partner's ability to shift to other parties a preexisting gain or loss by contributing assets to a partnership. On the other hand, the investor could shift that preexisting gain or loss by contributing property to an S corporation. Additionally, under current law, S-corporation shareholders, unlike general partners, are not subject to self-employment tax on their pro-rata share of the organization's business income.

A partnership can be used to restructure a venture without recognizing gain on appreciation of the S-corporation's assets. If an S corporation liquidates, distributing its assets to its shareholders who then contribute them to a partnership, the corporation is subject to tax under §336. An S corporation can defer the tax by contributing its assets to a partnership, a transaction that generally qualifies for nonrecognition treatment under §721(a). In that case, the IRS will not recognize gain until the corporation distributes its partnership interest in a taxable liquidation. This technique also can "freeze" the accumulated appreciation and shift future appreciation to other partners.

In structuring any partnership involving S corporations, consider proposed regulation §1.701-2. Under this proposed rule, the IRS could attack perceived abuses of Subchapter K whether or not the partnership involves any S corporations. However, government representatives have stated that the IRS does not intend to invoke the rule against S corporations forming partnerships.

Limited Liability Companies
An LLC, like an S corporation, provides limited liability to its members, including those who participate in management. Accordingly, an LLC, if classified as a partnership for income tax purposes, is not subject to federal income tax at the entity level. However, the hybrid form of the LLC has created some uncertainty regarding the application of the passive-activity loss limitations.

In general, losses from passive activities are not deductible from other types of income such as wages, interest, or dividends. A passive activity involves the conduct of any trade or business in which the taxpayer does not participate materially. Material participation for S-corporation shareholders is determined under §469(h), which requires that the relevant facts and circumstances must establish that the shareholder's participation is regular, continuous, and substantial during the year. Another alternative is for the S-corporation shareholder to satisfy certain specific tests in temporary regulations §1.469-5T(a).

The test for LLC members, however, may be more stringent if they fall under the rules for determining material participation by limited partners. Under these rules, an LLC member generally could not establish material participation in the LLC's business unless the member spends at least 500 hours in the business during the year. It would seem more appropriate to apply the §469(h) rules to LLC members, considering the distinction between the two business structures. In a limited partnership, a limited partner who materially participates in the management would not have limited liability even if his partnership interest is designated as a limited partner interest. However, an LLC provides limited liability even to members who actively participate in managing the LLC's business. It also remains unclear whether limited partners and LLC members can elect under §469(c)(7) to aggregate separate interests in rental real estate. To the extent that separate limited partnership or LLC interests may be aggregated, it is also uncertain whether the resulting activity constitutes material participation.

The IRS should address these issues in the near future with further legal guidance. In the interim, LLC members should assume that they will have to meet all limited partner material participation rules for them to deduct LLC losses in excess of their passive activity income.

Bill McDermott and Trey Ford

Bill McDermott, CPA, JD, a tax partner with Ernst & Young in Richmond, Virginia, serves many of the firm\'s real estate and international clients. McDermott is a member of the Virginia Bar. Trey Ford, CPA, JD, a tax senior with Ernst & Young, is a member of the Virginia Bar.