CHAPTER 1

INTRODUCTION: BUSINESS FORMS AND

BUSINESS TAXATION
■ ■ ■

A. THE SUBJECT IN GENERAL

The subject of this book is the legal environment in which business in
the United States is conducted either by a single individual or
cooperatively by a few or many individuals. “Business” is a broad term
describing an extremely wide range of activities. At one extreme is the
summer lemonade stand opened for one afternoon by an enterprising
eleven-year-old. At the other is the Wal-Mart Corporation, which in 2013
had net sales of $466.1 billion and operating income of $27.8 billion, with
more than 10,700 stores in 27 countries and 2.2 million employees.
Business associations can be classified and analyzed in myriad ways,
including by the legal form of the business. The lemonade stand is an
example of a sole proprietorship. Wal-Mart, by contrast, is organized as a
corporation. Other traditional forms of business are the general
partnership and the limited partnership. In the 1990s, new forms of
business were created with names confusingly similar to the limited
partnership: the limited liability company, the limited liability
partnership, and in some states, the limited liability limited partnership.
As you will learn, the differences between these various legal forms are
significant.
Classification by legal form naturally breaks into two categories: (1)
corporations and (2) unincorporated associations, e.g., proprietorships,
partnerships, limited liability companies, etc. A further method of
classification, and the one basically followed in this book, is to divide
business organizations on the basis of whether they are closely held or
publicly held. In general, a closely held firm is a business with relatively
few owners whose ownership interests are not publicly traded on an
established market (e.g., a law partnership or a local air conditioning
corporation). In contrast, a publicly held firm is a business that typically
has a large number of owners with ownership interests that are routinely
bought and sold on a public market (e.g., Wal-Mart).
Closely held firms may be organized as corporations or
unincorporated associations. Virtually all publicly held firms, however,
are organized as corporations, and such firms confront certain
management, control, and regulatory issues that are largely inapplicable

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 INTRODUCTION: BUSINESS FORMS AND
2 BUSINESS TAXATION CH. 1

to closely held firms. Closely held firms that are organized as

corporations, however, are similar in formal respects to publicly held
corporations.
The closely held/publicly held classification does have disadvantages:
it ignores the fact that in the real world there is a continuum of business
size, complexity, and ownership, and it treats the world of business as
polar rather than continuous. This classification also tends to hide the
fact that closely and publicly held firms draw from a common reservoir of
principles and tradition, particularly with respect to the use of the
corporate form, and each therefore to some extent influences the other.
Developments during the last three decades have greatly increased
the attractiveness of unincorporated forms for closely held firms. The
most important developments are (1) the creation of new unincorporated
business forms that grant the advantage of limited liability for all owners
of the business, and (2) changes in the regulations promulgated under the
Internal Revenue Code that give unincorporated firms and their owners
considerable freedom in electing how their income is to be taxed. The net
result undoubtedly is to encourage firms with few owners to use
unincorporated business forms.

B. AN INTRODUCTION TO BUSINESS FORMS

Chapter Two of this book examines the law of agency—the law
governing the relationships between principals, agents, and third parties.
Although agency law applies to all forms of business, it is frequently
invoked when dealing with the most basic (and most common) form—the
sole proprietorship. A sole proprietorship is a business owned by a single
individual that is not operated as a corporation or other special legal
form. The major advantage of a sole proprietorship is that it is easy to
establish—the proprietor simply begins to conduct business. In some
jurisdictions, a proprietor using an assumed name for the business must
also file an “assumed name” or “fictitious name” certificate with the
county clerk specifying the name of the owner and the name of the
business. The major disadvantage of a sole proprietorship is that the
owner has unlimited personal liability for the obligations of the business.
Debts of the business, in other words, are viewed by the law as debts of
the owner, and the owner’s personal assets are at risk in lawsuits arising
out of business activities. When a sole proprietor engages others to help
conduct the business, such as employees, the relationships between (1)
the employee (the agent) and the employer/proprietor (the principal), (2)
the employee and third parties the employee has dealt with on behalf of
the employer, and (3) the employer and third parties the employee has
dealt with on behalf of the employer, are, in many respects, governed by
agency law. Agency law is also important because it serves as the

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SEC. B AN INTRODUCTION TO BUSINESS FORMS 3

foundation for many of the legal principles associated with the other
business forms discussed in this book.
Chapter Three explores the general partnership—an association of
two or more persons to carry on, as co-owners, a business for profit.
Among the modern forms of business organization that involve two or
more owners, the general partnership is unique in that it can be
informally created. Put differently, establishing a general partnership
does not require the filing of an organizational document with the state.
So long as two or more persons are carrying on, as co-owners, a business
for profit, a general partnership is created—regardless of whether the co-
owners intended that result.
Some statutes view a general partnership as a separate legal entity
whose identity is distinct from that of its owners (known as “partners”).
Other statutes view a general partnership as an aggregate of the
individual partners with no legal differentiation between the business
and the partners themselves. Under either view, all of the partners in a
general partnership have the right to participate in the management of
the business. Moreover, the general partnership form provides partners
with a relatively easy exit from the venture, as a partner’s withdrawal
typically causes a buyout of the partner’s interest or the dissolution of the
partnership itself. The general partnership is also characterized by
structural flexibility (the partners can contractually arrange to run the
business largely as they see fit), restricted transferability of ownership
interests (a transferee of a partnership interest can only become a partner
with the unanimous consent of the other partners), and pass-through
taxation (partnership income is only taxed at the partner level, rather
than “doubly taxed” at both the partnership and the partner levels). Like
a sole proprietorship, however, the primary downside of a general
partnership is that the law imposes unlimited personal liability on
partners for the obligations of the partnership. Further, the easy exit
from the general partnership makes it a rather unstable business form in
certain circumstances—a situation which may be unsuitable for
particular types of ventures.
Chapters 4–17 examine the corporation form of business. In economic
terms, the corporation dwarfs in importance all other business forms
combined. Under all corporation statutes, a corporation is viewed as a
separate legal entity whose identity is distinct from that of its owners
(known as “shareholders”). This notion that a corporation is an entity
independent of its shareholders is deeply ingrained. The corporation itself
enters into contracts, borrows money, owns property, sues and defends,
and otherwise conducts its business as if it were a real person.
Many of the basic attributes of the corporation form are diametrically
opposed to the basic attributes of the general partnership form. Examples
include the following:

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 INTRODUCTION: BUSINESS FORMS AND
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(a) A corporation is consciously formed by filing an organizational

document with the state.
(b) Shareholders have no right to participate in the management of
the business (except in certain extraordinary situations, such as mergers).
(c) A shareholder in a corporation typically has no ability to compel a
buyout of his ownership interest or the dissolution of the firm.
(d) Ownership interests in a corporation may be freely and fully
transferred without the consent of the other shareholders (although
finding a buyer may be difficult in a closely held corporation where, by
definition, there is no public market for the company’s ownership
interests).
(e) The income of a corporation is taxed twice—once at the
corporation level, and a second time at the shareholder level. Stated
differently, the corporation pays taxes on its income, and the
shareholders pay taxes on that income again when (and if) the income is
distributed to them. Whether this tax treatment is advantageous or
disadvantageous depends heavily on the individual and corporate tax
rates that exist at the time, as well as on the financial circumstances of
the shareholders. In today’s tax climate, however, this “double taxation”
is usually undesirable. Aside from income taxes, corporations (but not
partnerships) are also subject to state franchise taxes—taxes imposed for
the privilege of organizing a business in a state.
(f) A corporation provides its shareholders with limited liability for
the obligations of the business. In a lawsuit against a corporation, a
shareholder’s personal assets are not at risk; instead, the most that a
shareholder can lose is the amount of his investment. This limited
liability is one of the most important benefits of operating a business as a
corporation.
Chapter 18 begins the exploration of the “hybrid” business
organizations—i.e., business structures that combine attributes of the
general partnership and corporation forms. In particular, Chapter 18
addresses the limited partnership—a partnership comprised of two
classes of partners, general and limited, that is formed by filing an
organizational document with the state. Like a general partnership,
general partners in a limited partnership have unlimited personal
liability for the venture’s obligations (although individual liability
concerns are significantly lessened by the common use of limited liability
entities as general partners). Like a corporation, limited partners in a
limited partnership have limited liability for the venture’s obligations
(although, under many statutes, that limited liability can be forfeited in
certain circumstances if a limited partner participates in the control of
the business). In a limited partnership, the limited partners are largely
passive investors while the general partners manage the business. As
SEC. C THE STATUTES 5

with a general partnership, a limited partnership is characterized by

structural flexibility, restricted transferability of ownership interests, and
pass-through taxation. Exit rights, however, tend to be more restricted in
the limited partnership form.
Chapter 19 addresses the limited liability partnership (“LLP”). The
LLP is a general partnership that, depending on the relevant statute,
provides the partners with limited liability for the partnership’s tort
obligations or for both its tort and contract obligations. Chapter 19 also
addresses the limited liability limited partnership (“LLLP”)—a limited
partnership that provides LLP-like limited liability protection to some or
all of the partners. The filing of an organizational document with the
state is required to establish both of these business forms.
Chapter 20 examines the limited liability company (“LLC”). An LLC
is a business organization, formed by a required state filing, that adopts
many of the best features of the corporation and partnership forms. Like
a corporation, an LLC is a legal entity that is separate and distinct from
its owners (known as “members”). An LLC can be structured to provide
management rights to members or to a designated group of managers,
and it offers limited liability to the members for all of the venture’s
obligations (regardless of whether the members participate in the control
of the business). Exit rights in an LLC tend to be restricted in a
corporate-like manner, as many statutes prevent a minority member from
demanding a buyout of his interest or from compelling dissolution of the
enterprise. Like a partnership, an LLC is characterized by structural
flexibility, restricted transferability of ownership interests, and pass-
through taxation. Along with avoiding double taxation with respect to
income taxes, LLCs in most states avoid franchise taxes as well. Because
of this favorable combination of attributes, the LLC has emerged as the
preferred business form for many closely held ventures.

C. THE STATUTES
Unlike subjects such as property and torts, the subject of business
associations is largely governed by statute. This is true not only in the
large commercial states such as California, New York, and Texas, but in
the smaller states as well. Answers to many questions must be found in
the statutes and cannot be answered solely on the basis of common sense
or prior judicial decision. In this respect, the law of business associations
is similar to many other areas of law in the modern commercial and
government-oriented society.
An experienced attorney does not attempt to memorize the detailed
provisions of the numerous complex statutes and regulations with which
he or she must be familiar. Rather, the attorney becomes generally
familiar with the provisions and keeps copies of them available for easy
reference. Each student should follow approximately the same process.
 INTRODUCTION: BUSINESS FORMS AND
6 BUSINESS TAXATION CH. 1

Thus, statutory references should be looked up in the Supplement, as the

materials cannot be fully understood without doing so.
The statutes in most jurisdictions today are modern and draw from a
common core of model and uniform statutes. One should not assume,
however, that statutes always clarify and simplify. In specific
circumstances, statutory language may appear to require an unjust or
unreasonable result. This is more likely to be true in jurisdictions that
have not drawn from the common core of model and uniform statutes, but
it is true in some circumstances under the model and uniform statutes as
well.

D. FEDERAL INCOME TAXATION: BASIC

PRINCIPLES
Trends in the law of business associations can be understood only if
one has a passing familiarity with the modern federal income tax
structure. Moreover, when considering taxes in the business context, one
must take into account not only the taxation of the business itself, but
also the relationship with the taxation of the individual owners. This
Section provides a basic introduction to these topics. As you proceed
through the various business associations discussed in this book, you may
find it useful to return to this discussion.
Initially, all businesses compute income for tax purposes in the same
manner, deducting business expenses from receipts in order to compute
taxable income. After determination of the business’s taxable income,
however, the tax treatment to some extent depends on the business form.
In broad terms, the Internal Revenue Code recognizes two distinct
methods of taxing business income, which are generally described as
“corporate” and “partnership” taxation. Corporate income taxation is
described in Subchapters C and S of the Internal Revenue Code, while
partnership income taxation is described in Subchapter K. The
differences between these two basic methods of taxing business income
drive the selection of business form for specific enterprises.

1. CORPORATE TAX RATES

Corporations historically have been treated as separate taxable
entities under the Internal Revenue Code with their own sets of rules and
tax schedules. The rates applicable to traditional corporations are set
forth in Subchapter C. In 2014, corporations were subject to tax on
income at the following rates:a

a This table is a composite table building in special surtaxes at the $100,000 and
$15,000,000 levels.
SEC. D FEDERAL INCOME TAXATION: BASIC PRINCIPLES 7

Table 1

2014 Corporate Tax Rates

If Taxable But Not Over The Tax Is Of the

Income Amount
Is Over Over
–0– $50,000 15% –0–
$50,000 $75,000 $7,500 + 25% $50,000
$75,000 $100,000 $13,750 + 34% $75,000
$100,000 $335,000 $22,250 + 39% $100,000
$335,000 $10,000,000 $113,900 + 34% $335,000
$10,000,000 $15,000,000 $3,400,000 + 35% $10,000,000
$15,000,000 $18,333,333 $5,150,000 + 38% $15,000,000
$18,333,333 ________ $6,416,667 + 35% $18,333,333

NOTES
(1) It is important to distinguish between marginal tax rates and
average tax rates. The marginal tax rate applicable to a corporation with
exactly $75,000 of income is 34 percent because that is the rate applicable to
each additional dollar of taxable income that the corporation earns above
$75,000 (up to $100,000). The average tax rate on such income, however, is
18.33 percent because a corporation’s tax bill on exactly $75,000 of taxable
income is $13,750 (15 percent of $50,000 plus 25 percent of $25,000). A
corporation with precisely $100,000 of taxable income owes $22,250; that is
an average rate of 22.25 percent, but the marginal tax rate on each additional
dollar of income is 39 percent up to $335,000.
(2) Where do the mysterious numbers $7,500 and $13,750 in Table 1
come from? Hint: calculate the precise tax due on $50,000 of income taxed at
15 percent; then calculate the precise tax due on an additional $25,000 of
income taxed at 25 percent.
(3) The tax structure for corporations in general is mildly “progressive”
because additional income is taxed at increasingly higher rates. A tax
structure is “regressive” if lower amounts of income are taxed at higher rates
than higher amounts of income. When a corporation’s income is in the
$100,000–$335,000 range, it is subject to a marginal rate of 39 percent; above
$335,000 the rate reverts to 34 percent. (There is a similar pattern at the
$15,000,000–$18,333,333 range. The marginal tax rate rises to 38 percent
and then drops back to 35 percent.) These declines in marginal rates may be
viewed as regressive even though the average rate of taxation on corporate
income can never exceed 34 percent at any level of income up to $10,000,000,
or 35 percent at any level of income. These special surtaxes on corporations
are designed to gradually eliminate the benefit of the lower brackets for
corporations that have incomes over $100,000 and $15,000,000 respectively.
 INTRODUCTION: BUSINESS FORMS AND
8 BUSINESS TAXATION CH. 1

(4) Corporations subject to the tax rates set forth in Table 1 are called C
corporations, named after Subchapter C of the Internal Revenue Code. The
taxation of S corporations is discussed below.

2. INDIVIDUAL TAX RATES

There are four different individual income tax rate schedules based
primarily on marital status, plus elaborate sets of tax tables based on the
rate schedules that are used mostly by persons with relatively small
incomes. In addition, there is a special tax schedule for the income of
trusts and estates. For purposes of considering the interaction of personal
and corporate tax rates upon business income, however, a detailed
consideration of this complex structure is unnecessary. Instead, by way of
illustration, consider the tax schedule for married taxpayers filing a joint
return:

Table 2

2014 Income Tax Rates

(Married Taxpayers Filing Joint Return)

If taxable income is: The tax is:

Not over $18,150 10% of taxable income
Over $18,150 but not over $1,815 + 15% of excess over $18,150
$73,800
Over $73,800 but not over $10,162.50 + 25% of excess over
$148,850 $73,800
Over $148,850 but not over $28,925 + 28% of excess over $148,850
$226,850
Over $226,850 but not over $50,765 + 33% of excess over $226,850
$405,100 $109,587.50 + 35% of excess over
Over $405,100 but not over $405,100
$457,600
Over $457,600 $127,962.50 + 39.6% of excess over
$457,600

NOTE
In the years during and after World War II, marginal rates on individual
taxpayers were extremely high by modern standards—the top bracket rising
above 90 percent. As late as 1980, the highest marginal rate for joint returns
was 70 percent for taxable income in excess of $215,400. A major policy
implemented by the Reagan administration in the 1980s was to reduce high
marginal rates. This policy resulted in a maximum marginal rate of 28
percent in the significant 1986 Tax Reform Act. Between 1986 and the
present, however, the general trend has been toward higher marginal rates.
SEC. D FEDERAL INCOME TAXATION: BASIC PRINCIPLES 9

3. THE TAXATION OF CAPITAL GAINS AND LOSSES

Before 1986, at the same time that the maximum tax rates of 70
percent or more were in effect, the maximum tax rate on a different form
of income—long-term capital gains arising from the sale or exchange of
capital assets held for more than 6 months—was only 25 percent. Capital
assets are assets held for profit-making or investment purposes. In
general, most assets other than inventory and property used in the active
conduct of a trade or business are capital assets. This dramatic difference
in rates created strong incentives to structure transactions or establish
strategies that transmuted ordinary income into long-term capital gains
in order to make the 25 percent rate (rather than the 70 percent rate)
applicable. To a somewhat lesser extent, this same incentive exists today.
The technical rules with respect to the treatment of capital gains
were relatively complex before 1986 and are even more complex today.
Long-term capital gains or losses are presently defined as gains or losses
from the sale or exchange of capital assets held for more than one year. In
2014, the maximum tax rate on long-term capital gains with respect to
most assets was 20 percent. Short-term capital gains are taxed at
ordinary income tax rates. Capital losses are available to offset capital
gains plus up to $3,000 of ordinary income in any year; excess capital
losses may be carried over to offset capital gains in future years. In
making these various calculations and determining the net amount of
gain or loss (as well as the short-term or long-term character of the gain
or loss), short-term gains and losses are separately netted to determine
the net short-term capital gain or loss. Long-term capital gains and losses
are netted in the same manner to establish the net long-term gain or loss.
The two are then combined to determine the net capital gain or loss for
the year.

4. THE TAXATION OF PROPRIETORSHIPS,

PARTNERSHIPS, AND CORPORATIONS
(1) Proprietorships. Consider first the tax treatment of a
proprietorship—a business wholly owned by a single individual.

ROBERT W. HAMILTON, BUSINESS ORGANIZATIONS:

UNINCORPORATED BUSINESSES AND CLOSELY
HELD CORPORATIONS
Pages 46–47 (1996).

A proprietorship is not a separate taxable entity. Its income or loss is

reported on the proprietor’s personal income tax return. For example, if a
proprietor files a joint return with his or her spouse, the business income
or loss of each proprietorship owned by either or both of them must be
included in that joint return.
 INTRODUCTION: BUSINESS FORMS AND
10 BUSINESS TAXATION CH. 1

The manner of reporting the income and expenses of a proprietorship

is interesting because it reflects a pragmatic compromise between the
legal view that a proprietorship is not a separate entity from its owner
and the economic view that the proprietorship’s financial affairs should
not be intermixed with the proprietor’s personal affairs. The Internal
Revenue Code requires an individual taxpayer who is also an
entrepreneur to file the long-form personal income tax return—the form
1040. The Internal Revenue Code also requires a separate tax form,
Schedule C, to be prepared to record the gain or loss from each business
owned by the taxpayer. Schedule C must be attached to the taxpayer’s
form 1040 and the income or loss of the proprietorship is added to or
subtracted from the proprietor’s other income in order to determine her
final liability to Uncle Sam. A separate Schedule C must be filed for each
business. State income taxation works much the same way (though many
states base their tax on the taxpayer’s federal tax return and do not
require a completely separate accounting of income or loss). * * *
Every entrepreneur operating a sole proprietorship must also take
into account the requirements of the Self Employment Contributions Act
of 1954 [“SECA”], imposing a tax on Schedule C income equal (in [2014])
to 12.4 percent of proprietorship income up to [$117,000] for [social
security] and an additional uncapped [2.9 percent] for Medicare. If the
entrepreneur is also an employee of another firm, the [social security] tax
is applied first against the salary of the employee and the proprietorship
income is taxed only to the extent the salary is less than [$117,000].
———
(2) Unincorporated Business Forms. Under regulations adopted
by the Treasury Department in 1997, an unincorporated business entity
(including a business entity formed under state law as a general
partnership, limited partnership, limited liability partnership, or limited
liability company) that has at least two owners generally will be classified
for federal income tax purposes as a partnership, and therefore will be
subject to taxation under Subchapter K of the Internal Revenue Code.
Alternatively, the entity may elect to be classified for federal income tax
purposes as a corporation. An unincorporated business entity that has a
single owner generally will be disregarded as an entity separate from its
owner for federal income tax purposes (i.e., its activities will be treated in
the same manner as a sole proprietorship or branch or division of the
owner), unless the entity elects to be classified for federal income tax
purposes as a corporation. Because it is largely elective, this tax
classification regime is commonly referred to as “check the box.” There is
a statutory exception to this elective regime in the case of publicly traded
partnerships, which generally will be classified for federal income tax
purposes as corporations.
SEC. D FEDERAL INCOME TAXATION: BASIC PRINCIPLES 11

Under the partnership tax regime of Subchapter K, the partnership

itself does not pay any tax. It does, however, compute its taxable income
and file an informational return (Form 1065) with the IRS. For federal
income tax purposes, the income or loss reported by the partnership is
“passed through” to the partners in accordance with the partnership
agreement. The partnership must provide each partner with a statement
(Form K–1) informing the partner of her respective share of the
partnership’s income and deductions. Each partner must then include
these amounts directly on her income tax return. Taxation is therefore
imposed solely at the level of owners and not at the entity level.
It is important to appreciate that while both proprietorships and
unincorporated business forms are taxed as extensions of the individual
taxpayers who are the owners of the enterprise, the amounts allocated
are based on the income calculations of the proprietorship or
unincorporated business form and not on the amounts actually
distributed in cash or property to the proprietor, partner, or member.
There will be tax to pay on business income, in other words, even though
the business has not actually distributed any of that income to its owners.
The apparent simplicity of the pass-through tax treatment provided
by Subchapter K is quite deceptive. The allocation of losses among
general partners, in particular, opened the door to tax avoidance on a
major scale. With the development of limited liability for owners in
limited liability companies and limited liability partnerships, partnership
taxation easily became the most complex area of tax law. See, e.g.,
Christine R. Strong and Susan P. Hamill, Allocations Attributable to
Partner Nonrecourse Liabilities: Issues Revealed by LLCs and LLPs, 51
ALA. L. REV. 603 (2000).
In general terms, the SECA tax is imposed on general partners,
I.R.C. § 1402(a), but not on limited partners unless the payments
constitute “guaranteed payments.” I.R.C. § 1402(a)(13). The SECA tax is
applicable to earnings of individual members of limited liability
companies to the extent attributable to a trade or business.
(3) C Corporations. As mentioned above, C corporations have their
own special tax schedule. When comparing the tax consequences of
conducting a business in a corporate or unincorporated form, however, it
is essential to recognize that the corporate rate is not in lieu of, but is in
addition to, the tax on the ultimate shareholders. There is, in short,
double taxation of business earnings if a C corporation makes
distributions to shareholders.
An example should make this clear. If a C corporation has taxable
income of precisely $1,000,000, the corporation must pay a corporate
income tax of $340,000, which leaves $660,000 available for distribution
to the shareholders. If the corporation then distributes the $660,000 to its
shareholders, all of whom are in the 39.6 percent bracket, the
 INTRODUCTION: BUSINESS FORMS AND
12 BUSINESS TAXATION CH. 1

shareholders in the aggregate will owe another $261,360, for a total tax
bill at both levels (entity and owner) of $601,360. In contrast, if the
business were conducted in an unincorporated form, there is no tax at all
at the entity level, and the maximum owner-level tax (calculated at the
rate of 39.6 percent) would be $396,000. In other words, on the
assumption that all income is to be distributed to shareholders, the
failure to obtain pass-through tax treatment results in $205,360 of
additional federal income tax in a single year. Indeed, assuming corporate
and individual taxpayers at the highest levels of income, the combined
tax rate on a distribution by a C corporation that is subject to the 35
percent rate to its shareholders who are all in the 39.6 percent bracket is
about 61 percent. Thus, there is approximately a 21 percent differential
or bias against C corporation tax status at the highest levels of income.b
(4) S Corporations. The double tax treatment of C corporations was
widely viewed by shareholders in closely held corporations as unfair and
discriminatory. In the 1950s, Subchapter S was added to the Internal
Revenue Code to give some relief from the double tax treatment.
Subchapter S requires an affirmative election by the corporation and is
not available to all closely held corporations. A corporation that makes
this election is called an “S corporation” or a “sub S corporation.”
The S corporation election is a tax election and not a corporate law
election: an S corporation possesses all of the normal attributes of a
corporation under state law, but is taxed in a different way than C
corporations. To be eligible for S corporation treatment, corporations
must not have more than 100 shareholders. (The maximum number of
shareholders in an S corporation was originally set at ten and has
gradually increased over the years.) An S corporation, in addition to
meeting the maximum 100-shareholder requirement, is prohibited from
having shareholders who are nonresident aliens or who are non-
individuals (with certain exceptions), and it may not have issued more
than one class of stock (except for classes of common stock that differ only
in voting rights). There is no maximum size limitation for S corporations
in terms of assets or revenues, though doubtless most of them are
comparatively small on these measures.
S corporations are taxed on a modified pass-through basis that is
similar in many respects to unincorporated business taxation. The
corporation files a return showing the earnings allocable to each
shareholder, and the shareholder must include that amount in her
personal income tax return. That amount is includible whether or not any
distributions are made by the corporation. The tax treatment of S

b Many corporate dividends are “qualified dividends” which are taxed at the lower capital
gains rate. Thus, although there is still a double taxation of business earnings, the shareholder-
level tax may be lower than this example suggests. In fact, when small amounts of corporate
income are combined with qualified dividends, the double taxation associated with C corporation
status may produce a lower total tax bill than pass-through treatment.
SEC. D FEDERAL INCOME TAXATION: BASIC PRINCIPLES 13

corporations is not identical to that of unincorporated business forms,

however, and in several respects it is less advantageous to the taxpayer
than what Subchapter K would provide. Nevertheless, an S corporation
does have the basic feature of pass-through taxation that is typical of
unincorporated business forms. As a result, it is a plausible alternative to
a partnership from a tax standpoint.

NOTES
(1) The tax treatment of C corporations has been the subject of
considerable theoretical discussion, both historically and at present. At the
beginning of President Reagan’s second term, there was a brief flirtation with
the idea that the corporate income tax should be abolished. As the
compromises that eventually became the Tax Reform Act of 1986 were
hammered out, however, this idea was abandoned. Instead, there was
increased reliance on the corporate income tax as a source of revenue.
(2) There have been numerous proposals over the years to “integrate” the
corporate and individual income tax structures in order to eliminate the
double tax on corporate income. Other industrialized countries generally do
not have a double tax structure. President Reagan’s proposal to repeal the
corporate income tax is one example of such a proposal. Alternatively, one
could eliminate dividends from the taxable income of shareholders. Yet
another approach would treat the payment of tax by a corporation as a kind
of withholding tax with respect to income ultimately distributed to
shareholders. Finally, another approach would in effect extend S corporation
tax treatment to all corporations. These proposals have formidable problems
because of the different types of taxpayers, tax-exempt entities, foreign
shareholders, and the like. For interesting analyses of the double tax
structure and the problems of integration proposals, see AMERICAN LAW
INSTITUTE, FEDERAL INCOME TAX PROJECT: REPORTER’S STUDY OF CORPORATE
TAX INTEGRATION (1993); U.S. DEP’T OF THE TREASURY, INTEGRATION OF THE
INDIVIDUAL AND CORPORATE TAX SYSTEMS: TAXING BUSINESS INCOME ONCE
(1992).

5. TAX PLANNING FOR BUSINESSES

Tax planning for businesses involves several considerations. First,
everyone has to pay taxes on their income, or at least account to the
federal government by filing a tax return. In this respect, taxation is more
immediate and certain than the risk of unlimited liability for owners. The
danger that a business may incur a liability in excess of business assets
may or may not materialize depending upon what happens in the future.
Liability for taxes, however, is a certainty. Tax planning, therefore, is a
routine and often dominant aspect of every significant business venture.
Second, taxpayers quite legitimately expect to minimize their tax
liability to the extent they may legally do so. There is a basic distinction
between legitimate tax avoidance (usually called “tax planning”) on the
 INTRODUCTION: BUSINESS FORMS AND
14 BUSINESS TAXATION CH. 1

one hand, and tax evasion that may lead to fraud penalties (or worse) on
the other.c The selection of a business form in order to take advantage of
a difference in taxation is clearly permissible tax planning.
Third, in tax planning, one must usually concentrate on the marginal
rate of taxation and not the average rate. For example, an individual
considering an investment in a business venture may already have
income from other sources that exceeds $73,800. Every dollar of income
obtained from the business venture, therefore, will be taxed at 25 percent
or more. Where there are several different investors or owners, they are
likely to be in different individual tax brackets. Generally, the strategy
that minimizes the tax obligations of the investor or owner who is in the
highest tax bracket will be followed, although that is not always true.d
Fourth, in selecting the form of business, the total tax liability of both
business and owners must be taken into account.e As illustrated by the
above double tax versus pass-through example, under current tax rates, it
is usually advantageous to conduct a small business in a form that
permits pass-through tax treatment.f

c The claiming of personal exemptions for household pets is an example of criminal tax
evasion, while electing S corporation status is an example of acceptable tax avoidance. While this
may seem obvious, the line between legitimate avoidance and improper evasion is often shadowy.
d A revised version of the “Golden Rule” for business is “He who has the gold, rules.”
Typically, the person in the highest tax bracket will be contributing capital that is essential for
the success of the enterprise, and hence his tax minimization becomes the goal of tax planning.
e With respect to a newly formed corporation, the entity will be taxed at the 15 percent
rate for income up to $50,000, although the 5 percent surtax will wipe out the benefit of that
lower tax rate after the corporation’s taxable income grows. Because new businesses may be
placed in several different corporations, however, multiple uses of the 15 percent bracket may be
available in certain situations.
f When (a) a business produces relatively small amounts of income, (b) an individual
owner is in a high marginal tax bracket, and (c) there is no short-term need for the business to
distribute its income, a C corporation may produce a lower combined tax bill than a pass-through
entity. For example, assume that a C corporation earns only enough income to be taxed at the
low 15 percent and 25 percent brackets. Assume further that the corporation retains its income
over the years and makes no distributions to the shareholders. Ultimately, the stock of the
corporation is sold with the gain taxed at the long-term capital gains rate of 20 percent.
(Alternatively, the stock may be held until the death of the shareholder, where the step-up in
basis permits the capital gains tax to be avoided entirely.) Paying the entity-level tax at the low
rates plus the 20 percent capital gains rate may produce a smaller overall tax bill than if the
business were conducted in a pass-through form (with the shareholder paying taxes on the
business income at, say, a 39.6 percent marginal rate). This tax planning strategy is commonly
known as the “accumulation/bail-out” strategy.
SEC. D FEDERAL INCOME TAXATION: BASIC PRINCIPLES 15