To: Penelope Wang; Mark Martinez; John Smith
From: Joseph Escobar
Subject: Re: How to structure your new business
Memorandum
Part I: Available organizational forms
In consideration of the various organizational forms available in structuring a business the best
solution will always depend on the most applicable concerns of the principals as it intersects with real
world practicalities, and the involved parties’ capabilities to implement the structural advantages of the
particular formation chosen. Itemized is a list of business entity types:
Sole Proprietorship: The easiest business entity to form. Tax filing can be completed with the social
security number of the proprietor, or an EIN number. This involves a Schedule C (Profit or Loss From
Business (Sole Proprietorship)) of Form 1040.
General Partnership: Under the Uniform Partnership Act partnerships are governed requiring separate tax
returns, Form 1065 (U.S. Partnership Return of Income) including K-1s. A partnership agreement is
drafted outlining separation of assets, actionable transactions, distributions, partnership responsibilities,
ownership, and initial contributions.
Limited Liability Partnership (LLP): A partnership allowing principals to separate personal liability from
actions of involved parties, in the course of business, actions performed by other partners, and business
transactions. Filing of the LLP is handled in a similar manner to general partnerships.
S Corporation: A formed corporation with the purpose of acting as a pass-through entity. An S corporation
files Form 1120S providing appropriate K-1s to shareholders. An S corporation has specific restrictions
and limitations provided special tax benefits.
C Corporation: A separate taxpaying entity (Form 1120) reporting income segregating shareholder liability
from personal liability governed by different rules and regulations depending on state filed, and state of
operation.
Limited Liability Company (LLC): An LLC can file as sole owned, corporations, or as partnerships.
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Managing members avoid double taxation and allow principals to avoid certain personal liabilities.
Part II: Recommendation
To avoid structural limitations, liability, and over-taxation I would recommend avoiding any
consideration of a sole proprietorship, general partnership, or C Corporation. In organization of your
prospective firm there are benefits and advantages to filing as a LLP, LLC or S corporation. Discuss the
vision of the firm as defined by each individual’s investment into the firm, the structuring of future
contributions, and your current plan for investment, distributions of dividends and income, and the impact
of the firm on income. With these important matters in mind, and in consideration of the inherent structural
simplification it would provide my recommendation would be to establish a LLP.
The formation of a LLP will hopefully identify a means to focus your efforts, harbor a profitable
partnership, limit your tax liabilities, and personal liabilities. As a professional business partnership each
partner’s liability will be limited by the equity invested, give flexibility with filing a Form 8832 (Entity Class
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Election) , provide a standard basis adjustment, allow for deductions of start-up costs (in excess of
$50,000), no income tax, ordinary deductions, partnership autonomy through separate reportable items,
and availability of cash basis accounting.
Part III: Tax consequences: Start-up costs, contributions, services and property
Per Code Sec. 7701(a)(44) initial partnership interest is defined by:
1. The adjusted basis of any property contributed by an incoming partner to the partnership,
2. any ordinary income recognized by incoming partners who contribute services in exchange
for a partnership interest, and
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3. the incoming partner’s share of partnership liabilities.
Tax consequences measured by each partner will be on each individual’s tax return and receipt of a
subsequent schedule K-1 reflecting the additional basis accumulated from above referenced item three.
Penelope, Mark, and John will record outside basis of invested contributions, value of services, and
property separately. Record of these items are to be taken note of as having impact on the partnership
agreement, ownership, intended purpose, and tax consequences. Initial formation of the partnership is
considered as transfer of assets and a nontaxable event.
Part IV: Filing requirements and the Internal Revenue Service (IRS)
Per Code Sec. 701; Reg. 1.701-1; Code Sec. 6031 the partnership will file an informational return
either for the calendar year or during the same tax year as majority partnership. The Form 1065 must be
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filed on or before April 15 (calendar year filing) or the 15 day of the fourth month following the fiscal
year. The return will contain: gross income, deductions, ordinary net income, names and address of
partners, distributive shares, and special credits. The IRS does allow a LLP to file via cash-basis
methods, and will generally not be taxed. Lastly, only individuals can be partners in a LLP. Corporations
are ineligible for the tax benefits given LLPs.
Part V: Current Income Distributions and “draws”
Partnership distributions are nontaxable, including most property distributions. Gains are
recognized as taxable only when the amount of cash received exceeds the partner’s basis. In order to
pay expenses partners can draw against earnings as if withdrawn on the last day of the taxable year.
Generally the amount of the draws during the course of a taxable year will be equal between partners. In
the formation of your professional partnership distributions for each partner can be recorded as needed
and recognized as a capital transactions.
Part VI: Profit sharing, partner taxation, and the IRS
As partners Penelope, Mark, and John will generally not recognize distributions on individual tax
returns unless the distribution amounts exceed basis. Any profit sharing will be reflected on individual tax
returns as partnership income. Draws are calculated at year end. Each partner is individually responsible
for filing of taxes and reporting of net profits to the IRS.
Part VII: Calculation of ownership “basis”
Contributions increase an individual’s basis; whereas distributions will decrease an individual’s
basis. Initial contributions amounts unless explicated stated otherwise as means of services rendered,
property contributed, or otherwise establishes each partner’s respective percentage of ownership.
Designation of contributions and distributions as capital transactions is important and should be outlined
early in partnership meeting to ensure all individuals understand the structure and timeframes when and
how distributions and contributions should be executed as they have most impact on basis.
Recourse liabilities bear economic risk of loss on the partner providing acknowledgement. These
items are calculated given hypothetical liquidation meaning if a negative balance occurs a partner will be
legally responsible to resolve the debt. Nonrecourse liabilities are calculated as a sum of the partner’s
minimum share in gains, liquidation gain, and excess of nonrecourse liabilities. The excess is then
allocated by percentage of ownership.
Part VII: The LL in LLP
Partners are liable for the “at-risk” amount equal to their basis in the partnership. The “at-risk”
amount is not increased by nonrecourse debt. Stop-loss agreements, indemnity agreements,
nonrecourse loans, or like agreements and/or loans are not considered “at-risk.”
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Federal Taxation: Comprehensive Topics – Harmelink, and Hasselback, et al. Smith; CCH Inc. (April 3, 2012)
Chapter 14 Taxation of Corporations – Basic Concepts 14-3 & 14-4
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Federal Taxation: Comprehensive Topics – Harmelink, and Hasselback, et al. Smith; CCH Inc. (April 3, 2012)
Chapter 19 Partnerships – Formation and Operation 19-4
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Federal Taxation: Comprehensive Topics – Harmelink, and Hasselback, et al. Smith; CCH Inc. (April 3, 2012)
Chapter 14 Taxation of Corporations – Basic Concepts 19-8
Additional Resources Used:
Article: “Is there a way to avoid self-employment tax?” (http://www.watsoncpagroup.com/kb/Is-there-a-way-to-avoid-SelfEmployment-tax_74.html) Watson CPA Group
Article: “LLP Members in Law Firm Subject to Self-Employment Tax-Not “Like” Limited Partners”
(http://ascpa.wordpress.com/2011/02/12/llp-members-in-law-firm-subject-to-self-employment-tax-not-like-limited-partners/)
Article: “Tax Issues for LLCs & LLPs (www.mmmlaw.com/media-room/publications/articles/tax-issues-for-llcs-llps) Morris, Manning
& Martin, LLP
LLC vs LLP (http://www.diffen.com/difference/LLC_vs_LLP)