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form, even at the risk of some unlimited liability. First, although profits and losses must be allocated
according to stock ownership in the subchapter S corporation, they are allocated by agreement in the
limited partnership. Thus, in order to give the investors the high proportion of losses they demand,
promoters did not necessarily have to give them an identically high proportion of the equity. The IRS
will attack economically unrealistic allocations, but has issued regulations that, if followed, will
protect most allocations. In addition, whereas the amount of loss the investor can use to shelter other
income is limited to the investor‟s tax basis in both types of entities, the tax basis in subchapter S
stock is essentially limited to direct investment in the corporation, while in a limited partnership it is
augmented by certain types of debt incurred by the entity itself.
Both types of entities are afflicted by the operation of the passive loss rules, added by the Tax
Reform Act of 1986 in the hope of eliminating the tax shelter. Thus, unless one materially participates
in the operations of the entity (virtually impossible, by definition, for a limited partner), losses
generated by those operations can normally be applied only against so-called passive income and not
against active income (salaries and bonuses) or portfolio income (interest and dividends).
Furthermore, owners of most tax pass-through real estate ventures are treated as subject to the passive
loss rules, regardless of material participation.
Limited Liability Companies
Limited liability companies (LLCs) are taxed in a manner substantially identical to limited
partnerships. This combination of limited liability for all members (without the necessity to construct
the unwieldy, double-entity limited partnership with a corporate general partner) and a pass-through of
all tax effects to the members‟ personal returns makes the LLC the ideal vehicle for whatever tax
shelter activity remains after the imposition of the passive activity rules.
Technically, LLCs, limited partnerships, and all other unincorporated business entities may choose
to be taxed either as partnerships or as taxable corporations. Recognizing that the vast majority of
these entities are formed to take advantage of the opportunity to have taxable income or loss pass
through to the owners, IRS regulations provide that these entities will be taxed as partnerships unless
the entity affirmatively chooses to be taxed as a corporation. Most corporations have already achieved
that level of comfort through the availability of the subchapter S election.
Although the LLC would seem to have the advantage of affording tax pass-through treatment
without the limitations of the subchapter S corporation rules, there are some disadvantages as well.
Since the nonelecting LLC is not a corporation, it is not eligible for certain provisions the Internal
Revenue Code grants only to the corporate entity. Among those are the right to grant incentive stock
options (ISOs) to employees and the right to take advantage of tax-free reorganizations when selling
the company. LLCs must be converted to corporate entities well before relying on these provisions.
Choice of Entity
The sole proprietorship, partnership, corporation (including the professional corporation and
subchapter S corporation), the limited partnership, and the LLC are the most commonly used business