The objective of this study is to answer the questions of what similarities exist between LLCs and Partnerships and what are the benefits of an LLC over a Partnership as well as what issues may arise with the taxation of a trust. Finally, this study will answer whether the rules are clearly defined as to whether the treatment flows through to the grantor of the beneficiaries.
LLC and Partnership Differences
A partnership is reported to involve two or more individuals "who share ownership responsibilities in a business." (Carter, 2013, p.1) Carter additionally reports that a partnership business "does not have a legal identity separate from the owners of the business. A limited liability company combines the operational flexibility of a partnership with the personal asset protection that comes with operating a corporation." (Carter, 2013, p.1) The LLC is reported to have a legal existence that is separate from that of the owner's legal entity. (Carter, 2013, paraphrased)
A partnership business is automatically formed when two individuals make the decision to enter into business together. Partnerships are not under any type of requirement to file documents with the state in order for the business to start. However, LLCs are under a requirement to file articles or organization, which are reported to also be known as "a certificate of formation." (Carter, 2013, p.1) The certificate of formation is filed within the state in which the LLC conducts its business. A fee is charged in every state to file the articles of organization. While the LLC does have to pay these fees, the partnership business does not have to pay such fees. An LLC is such that may be formed with only a single member however; the partnership must involve at least two individuals in order for it to be legally formed. LLCs may be comprised of other businesses including the corporation, partnership or even another LLC. The LLC may involve foreign individuals and businesses who participate in the company's ownership. A partnership business however, may not have other businesses that are acting partners of the business. The issue of liability is one of the primary differences existing between the partnership and LLC. The partners of a company in partnership have "unlimited liability for business lawsuits, debts and liabilities" meaning that should the partnership be served a lawsuit, then the partners would be in a position to lose their belonging, both personal and real estate in the event the assets of the business are not enough to cover the debt arising from a lawsuit. In addition, one partner may be held liable for another partner's negligence. Owners of an LLC are reported to "have limited liability protection against lawsuits and other business-related liabilities. In other words, the personal assets of an LLC member may not be used to cover the company's business debts. An LLC member's liability for business debts does not extend beyond the amount invested in the company." (Carter, 2013, p.1) In a partnership, the partners hold responsibility for management of the company operations that take place each day. Each partner's responsibilities and duties are described in the company's partnership agreement. The member of an LLC may make the choice to control the daily activities of the company or they may hire others who are not members of the LLC to manage the company's daily activities. This is a flexible characteristic of the LLC that enables the LLC to operate in the form of a corporation as compared to a partnership in the event the owners of the LLC make the choice not to manage the daily activities of the company. The partnership business may terminate if one partner decides to sell his or her ownership interest or in the event that another partner dies. The LLC, however may have an unlimited life "unless a specific dissolution date is listed in the company's articles of organization. Typically, a buy-sell agreement will allow a partner to buy out a partner who decides to sell his interest in the business. However, a partnership business is still treated as a business with a limited lifespan, as explained by the Small Business Notes website." (Carter, 2013, p.1)
II. Taxation of a Trust
Subchapter K of the Internal Revenue Code is reported to contain the rules that govern taxation of partners and partnerships. The limited liability company (LLC) with more than one member is reported to be "treated as a partnership for tax purposes" meaning that Subchapter K is that which "generally governs the taxation of LLCs and their members." (Friedland, 2003, p.1) It is additionally reported that while the partnership is not a taxable entity, the partnership "must compute and characterize the amount of income that passes through it to be reported on its partners' returns. For this purpose, a partnership adopts its own tax year and accounting method. With important exceptions, a partnership must adopt the same tax year as the partners who own a majority of its interests." (Friedland, 2003, p.1) It is reported that the choice of business entity is a complex process due to the state law changes that allow "additional pass-through entities for tax purposes. Although such entities are generally treated similarly, some of the subtle differences in the taxation of partnerships, LLCs, LLPs, and S corporations could have a substantial effect on the taxation of the owners in different situations." (Altieri and Cenker, 2012, p.1) It is reported that all U.S. states allow the formation of LLC or LLPs, which are reported to have "replaced general partnerships as the entities of choice. It is reported that many make the assumption that the taxation of thee entities and specifically the LLCs electing to be taxed as partnerships "is uniformly the same as for general partnerships, although this is not always the case." (Altieri and Cenker, 2012, p.1) It is reported that under I.R.C. Section 469 "…certain taxpayers cannot deduct losses incurred in passive activities that exceed their income from other passive activities. Taxpayers subject to these limitations include individuals, estates, trusts, closely held C corporations, and personal service corporations. An activity is passive for these taxpayers if it is a trade or business in which they do not materially participate. The passive loss rules are applied to partners, LLC members, and S corporation shareholders in a similar manner. Based on his participation in each partnership or corporate activity, each partner or shareholder separately determines if his income or loss from the activity is passive. With important exceptions, a limited partner's share of all partnership income or loss is passive." (Altieri and Cenker, 2012, p.1) It is reported that the "basic consequence of the rules under IRC § 641 through 685 is to treat the trust or estate as a taxable entity but, in certain circumstances, to allow the pass-through of income and deductions to the beneficiaries, who report the income and deductions on their individual returns. As with partnerships, these fiduciary taxation rules generally attempt to assign the burdens of taxation in an equitable manner to those who receive a benefit from the trust or estate. To the extent income cannot either be offset by deductions or passed to beneficiaries, the entity will be taxed." (Altieri and Cenker, 2012, p.1) Due to the hybrid nature of trusts and estates, it is reported, "several unique tax concepts apply such as Distributable Net Income (DNI), Fiduciary Accounting Income (FAI), and the distribution deduction." (KSB Law Office, nd, p.1) As well, there may be a distinction drawn "between gifts of principal to a beneficiary through a trust or estate and the income that is produced by that principal. In general, the computation of the entity's taxable income begins in the same manner as for an individual, with a few modifications, to obtain a "tentative" taxable income. The fiduciary taxation rules are then applied to determine the amount of the entity's taxable income that passes to the beneficiary." (KSB Law Office, nd, p.1) The result is stated to be that the tentative taxable income of the entity "is reduced by the least of DNI, FAI, or the distribution deduction. Any taxable income in excess of the least of these three items is taxed in the trust. It is generally beneficial to pass income to the beneficiary as the fiduciary tax rates are highly compressed, reaching the 35% bracket for 2003 at $9,350 of taxable income. In addition, the personal exemption for trusts is either $100 or $300, and the exemption for estates is $600, allowing for little ability to shelter income within the entity." (KSB Law Office, nd, p.1) Special rules are reported to address the issue of whether the grantor of the trust of someone else is treated as owning all or part of the trust for the purposes of federal income tax. Items of income, deduction, and credit attributable to any part of a trust that is treated as a grantor trust are shown on a separate statement and attached to the trust on Form 1041. (KSB…