TCP Area III: Entity Tax Planning

Choice of entity, formation & capitalization planning, corporate distributions & redemptions, liquidations, reorganizations, and multistate considerations

Choice of Entity §199A / Subchapters C, K, S

Selecting an entity form is the foundational planning decision. The form drives who can own the business, how earnings are taxed, whether owners face self-employment tax, how losses pass through, and how easily outside capital can be raised. The four common forms compared below are the C corporation, S corporation, partnership (including the multi-member LLC taxed as a partnership), and sole proprietorship (including the single-member LLC, a disregarded entity).

Comparison across planning factors

Factor	C corporation	S corporation	Partnership / LLC	Sole proprietor
Owners allowed	Unlimited; any type (individuals, entities, foreign, trusts)	≤100 shareholders; only U.S. individuals, estates, and certain trusts; one class of stock; no nonresident aliens, C corps, or partnerships as owners	≥2 owners; any type permitted	One owner only
Taxation	Double taxation: 21% entity tax, then tax on dividends	Pass-through; one level of tax at owner level	Pass-through; one level of tax at owner level	Pass-through; reported on owner's Schedule C
Self-employment (SE) tax	None on shareholders; wages bear FICA	None on distributive share; only reasonable wages bear FICA	General partners owe SE tax on their distributive share; guaranteed payments are SE income	Full SE tax on net profit (Schedule SE)
Basis for entity debt	N/A (stock basis only)	Shareholder gets basis only for direct loans to the corporation, not for entity-level third-party debt	Partners increase outside basis for their share of partnership liabilities (recourse and qualifying nonrecourse)	N/A
Fringe benefits	Most favorable; owner-employees deduct and exclude benefits like health insurance	>2% shareholders treated like partners; benefits included in W-2 wages	Partners treated as self-employed; many benefits not excludable	Owner is self-employed; limited exclusions
Raising capital	Easiest; multiple stock classes, public markets, broad investor base	Constrained by one-class-of-stock and shareholder eligibility limits	Flexible allocations possible, but transfers can be cumbersome	Hardest; limited to owner's resources and debt
§199A QBI deduction	Not eligible	Eligible (pass-through); subject to wage/UBIA limits and SSTB phase-outs	Eligible (pass-through); same limits	Eligible; same limits

S corp eligibility: “100 SHOTS” 100 shareholder maximum, one Share class, Human owners (no C corps or partnerships), Only U.S. citizens or residents, Trusts of limited types, and a calendar-year (or business-purpose) tax year. A family electing under §1361(c)(1) counts as one shareholder.

When the 21% C corp rate favors a particular form

The flat 21% corporate rate is attractive when the business reinvests earnings rather than distributing them, because the second layer of tax is deferred until a dividend or sale. A C corporation also shines for an SSTB (specified service trade or business, such as health, law, consulting, or accounting) whose owners are phased out of §199A, since QBI ineligibility is then irrelevant. By contrast, a pass-through is generally superior when earnings are distributed currently, when owners want to use entity losses against other income, or when the §199A deduction (up to 20% of QBI) meaningfully lowers the effective pass-through rate. Compare the combined two-layer C corp burden (21% entity plus the qualified-dividend or capital-gains rate, plus the 3.8% net investment income tax) against the single-layer pass-through rate net of any QBI deduction.

Do not forget the accumulated earnings tax (§531) and personal holding company tax (§541). These penalty taxes police a C corporation that hoards earnings to dodge the shareholder-level dividend tax, blunting the “just retain everything” deferral strategy.

Corporate Formation & Capitalization §351 / §357 / §385

Forming a corporation is generally a nonrecognition event so that taxpayers can incorporate a going business without a current tax cost. The capitalization mix of debt versus equity is a separate planning lever that affects deductibility, basis, and loss character.

§351 nonrecognition on transfer to a controlled corporation

No gain or loss is recognized when one or more persons transfer property to a corporation solely in exchange for stock, if those transferors are in control immediately after the exchange. Control means ownership of at least 80% of the total combined voting power and at least 80% of each class of nonvoting stock (the §368(c) test). Key planning points:

Property includes cash, tangible and intangible assets, but excludes services. A transferor who contributes only services receives stock that is compensation (ordinary income) and is not counted toward the 80% control group. Contributing some property along with services can pull a service provider into the control group if the property is not nominal.
Control is tested immediately after the exchange, treating all qualifying transferors as a group. A prearranged sale of the stock can break control.

Boot and gain recognition

If a transferor receives boot (cash or other non-stock property), gain is recognized to the lesser of the realized gain or the boot received. Losses are never recognized under §351, even when boot is present.

Assumption of liabilities under §357

§357(a): the corporation's assumption of the transferor's liabilities is generally not treated as boot.
§357(b): if the principal purpose of the assumption is tax avoidance or there is no bona fide business purpose, all assumed liabilities are treated as boot (not just the excess).
§357(c): if total liabilities assumed exceed the aggregate adjusted basis of the property transferred, the transferor recognizes gain equal to that excess.

Basis after formation

Shareholder (substituted) basis: basis of property transferred, plus gain recognized, minus boot received and minus liabilities assumed by the corporation.
Corporation (carryover) basis: transferor's basis, plus any gain the transferor recognized. (Built-in loss property is subject to the §362(e)(2) basis-limitation or election.)

Debt versus equity capitalization planning

Funding the corporation partly with shareholder debt has tax advantages: interest is deductible to the corporation (dividends are not), and a debt repayment returns capital tax-free. The IRS can recharacterize purported debt as equity under the §385 factors when the structure is “thinly capitalized” (a very high debt-to-equity ratio, no fixed maturity, no realistic intent to repay, or debt held pro-rata to stock). Recharacterization turns deductible interest into nondeductible dividends and converts a bad-debt loss into a capital loss.

§1244 small-business stock Stock issued by a domestic small corporation (aggregate capital not over $1,000,000) for money or property lets the original holder treat a loss on sale or worthlessness as an ordinary loss (up to $50,000, or $100,000 on a joint return) rather than a capital loss. Build this into the capitalization plan at issuance, because it cannot be added later.

§357(c) trap: when assumed liabilities exceed the basis of contributed property, the transferor recognizes gain on the excess even though no boot changed hands. A common fix is for the shareholder to contribute additional basis (for example, a personal note or cash) or to pay down liabilities before the transfer so basis is at least equal to the liabilities assumed.

Earnings & Profits and Distributions §301 / §316 / §312

Whether a corporate distribution is taxed as a dividend depends on earnings and profits (E&P), an economic measure of the corporation's ability to pay a dividend out of accumulated economic income. E&P is not the same as taxable income or retained earnings; it is adjusted for items like tax-exempt income (added), federal income tax paid (subtracted), and differences in depreciation and certain timing items.

Current versus accumulated E&P

Current E&P is measured for the entire year as of year-end.
Accumulated E&P is the running total of prior years' undistributed E&P measured as of the first day of the year.

Distribution ordering under §301 and §316

A distribution is applied in three tiers:

Tier	Treatment	Effect on shareholder
1. Dividend	Distribution to the extent of E&P (§316)	Ordinary income (qualified dividends taxed at capital-gains rates); does not reduce stock basis
2. Return of capital	Excess over E&P, up to remaining stock basis	Nontaxable; reduces stock basis
3. Capital gain	Any excess over remaining stock basis	Taxed as gain on sale of the stock (usually long-term capital gain)

Sourcing current versus accumulated E&P

Current E&P is allocated pro-rata across all distributions made during the year, regardless of timing.
Accumulated E&P is applied in chronological order to distributions until exhausted.
If current E&P is positive but accumulated E&P is negative (a deficit), distributions are dividends only to the extent of current E&P; the deficit does not net against current E&P. If current E&P is a deficit and accumulated E&P is positive, the current deficit is prorated to the distribution date and netted against accumulated E&P.

Property distributions

When a corporation distributes appreciated property, it recognizes gain under §311(b) as if the property were sold at fair market value (FMV). Loss on distributed property is not recognized by the corporation. The shareholder takes the property at FMV and treats the distribution as a dividend to the extent of E&P (FMV reduced by any liability assumed). The corporation's E&P increases by the gain recognized and decreases by the greater of the property's FMV or basis, net of liabilities.

Constructive dividends: economic benefits flowing to a shareholder outside of a formal dividend can be recharacterized as dividends. Watch for excessive compensation, below-market loans to shareholders, bargain use of corporate property, and corporate payment of a shareholder's personal expenses. These are taxable as dividends to the extent of E&P and are nondeductible to the corporation.

Stock Redemptions §302 / §318

A redemption is the corporation's reacquisition of its own stock from a shareholder. The planning question is whether the redemption is taxed as a sale or exchange (capital gain, recovering basis) or as a §301 distribution (dividend to the extent of E&P, no basis recovery first). Exchange treatment is generally preferred because it allows basis recovery and capital-gain rates.

The §302(b) qualifying tests for exchange treatment

A redemption is treated as an exchange if it meets any one of these tests:

Substantially disproportionate (§302(b)(2)): after the redemption the shareholder owns less than 80% of the percentage of voting stock owned before, and owns less than 50% of total voting power.
Complete termination (§302(b)(3)): the shareholder's entire interest is redeemed.
Not essentially equivalent to a dividend (§302(b)(1)): the redemption results in a meaningful reduction of the shareholder's proportionate interest (a facts-and-circumstances test).
Partial liquidation (§302(b)(4)): a distribution that is not essentially equivalent to a dividend at the corporate level (for example, a genuine contraction of the business), tested for noncorporate shareholders.

§318 constructive ownership (attribution)

The §302 percentage tests apply ownership after attribution, so a shareholder is treated as owning stock held by related parties:

Family: stock owned by spouse, children, grandchildren, and parents (not siblings or grandparents).
Entity-to-owner: stock owned by a partnership, estate, trust, or corporation flows up to its owners/beneficiaries (for corporations, only owners holding ≥50%).
Owner-to-entity: stock owned by an owner/beneficiary flows down to the entity (for corporations, only owners holding ≥50%).
Option: a person holding an option to acquire stock is treated as owning that stock.

Waiver of family attribution

On a complete termination, an individual can waive family attribution under §302(c)(2) if: the person retains no interest other than as a creditor, does not reacquire an interest (other than by inheritance) for 10 years, and files the required agreement. This lets, for example, a parent fully redeem out even though a child remains a shareholder.

Attribution trap: a redemption that looks like a complete termination on paper can fail because the shareholder is deemed to still own stock held by a spouse or child. Always re-run the §302(b) percentages after applying §318. If exchange treatment fails, the entire redemption (not just the dividend portion) is taxed under §301, and the redeemed shareholder's basis shifts to the remaining related shareholders.

Corporate Liquidations §331 / §332 / §336 / §337

A complete liquidation winds up the corporation by distributing all assets to shareholders in exchange for their stock. The tax result differs sharply between a liquidation to noncorporate (or minority) shareholders and a parent-subsidiary liquidation.

General complete liquidation (taxable)

Shareholder, §331: treats the liquidation as a sale of the stock. Gain or loss equals FMV of property received minus the shareholder's stock basis. The shareholder takes a FMV basis in property received.
Corporation, §336: recognizes gain or loss as if it sold all its assets at FMV to the shareholders. (Certain losses to related parties or on recently contributed property may be disallowed.)

This produces two layers of tax, mirroring the double tax of the C corporation regime, which is why liquidating a corporation with appreciated assets is costly.

Parent-subsidiary liquidation (nonrecognition)

Parent, §332: recognizes no gain or loss on liquidation of a subsidiary it controls, where control means ownership of at least 80% of voting power and value.
Subsidiary, §337: recognizes no gain or loss on distributions of property to the 80% parent.
The parent takes a carryover basis in the subsidiary's assets and inherits the subsidiary's tax attributes (E&P, NOLs, and so on) under §381.

Item	Taxable liquidation (§331 / §336)	§332 subsidiary liquidation
Trigger	Liquidation to shareholders generally	Liquidation of an 80%-owned subsidiary into its parent
Corporation gain/loss	Recognized as if assets sold at FMV (§336)	Not recognized on distributions to parent (§337)
Shareholder/parent gain/loss	Recognized: FMV − stock basis (§331)	Not recognized by parent (§332)
Basis of assets received	FMV (stepped to fair value)	Carryover from subsidiary
Tax attributes	Disappear with the corporation	Carry over to parent (§381)

Minority shareholders in a §332 liquidation are not covered by nonrecognition; they are taxed under §331, and the subsidiary recognizes gain (but not loss) on property distributed to those minority holders. The 80% control must trace to a single corporate parent.

Tax-Free Reorganizations & Restructuring §368

A qualifying reorganization lets corporations combine, divide, or restructure with deferred gain, on the theory that the shareholders' investment continues in modified form. Boot (cash or non-stock property) triggers limited gain recognition, but exchanges of stock for stock generally remain tax-free.

The reorganization types under §368(a)(1)

Type	Name	Essence
A	Statutory merger or consolidation	Target merges into acquirer under state law; flexible consideration mix
B	Stock-for-stock	Acquirer uses solely its voting stock to acquire control (≥80%) of target; no boot allowed
C	Stock-for-assets	Acquirer uses voting stock to acquire substantially all of target's assets; limited boot tolerated
D	Divisive or acquisitive transfer	Transfer of assets to a controlled corporation; divisive D often paired with a §355 spin-off, split-off, or split-up
E	Recapitalization	Reshuffling of a single corporation's capital structure (for example, exchanging bonds for stock)
F	Mere change in form	Change in identity, form, or place of organization of one corporation
G	Bankruptcy reorganization	Transfer of assets in a Title 11 or similar court proceeding

Common-law and statutory requirements

Continuity of interest: target shareholders must retain a meaningful equity stake in the acquirer.
Continuity of business enterprise: the acquirer must continue the target's historic business or use a significant portion of its assets.
Valid business purpose: the transaction must have a non-tax business reason.
Plan of reorganization: a written plan adopted by the parties.

Boot and gain recognition

Shareholders recognize gain to the lesser of realized gain or boot received; losses are not recognized. Boot received may be taxed as a dividend to the extent of E&P if the exchange has the effect of a dividend. Basis in the new stock carries over, increased by gain recognized and decreased by boot received.

Carryover of attributes and the §382 limitation

The acquiring corporation inherits the target's tax attributes (NOLs, E&P, credits, and capital loss carryovers) under §381. However, after an ownership change (broadly, a greater-than-50-percentage-point shift in ownership by 5% shareholders), §382 caps the annual use of the acquired corporation's pre-change NOLs. The annual limitation equals the value of the loss corporation's stock immediately before the change multiplied by the long-term tax-exempt rate. This is a central planning constraint when buying a company for its losses.

Reorganization checklist: “C-O-P-B” Continuity of interest, Continuity of business enterprise, Overall valid business Purpose, and a written Plan of reorganization. Fail any of these and the “tax-free” deal becomes a fully taxable sale.

Multijurisdictional & Consolidated Planning state nexus / §1501

Operating across state lines and within a corporate group raises a separate layer of planning: where income is taxed (nexus and apportionment), and how members of a federal affiliated group are taxed together.

State nexus

Physical presence: property, employees, inventory, or owned facilities in a state create nexus.
Economic nexus: after South Dakota v. Wayfair (2018), a state may impose tax based on economic thresholds (sales volume or transaction counts) even without physical presence, principally for sales and use tax but increasingly for income tax.
P.L. 86-272: a federal statute that protects an out-of-state seller from a state's net income tax when its only in-state activity is the solicitation of orders for tangible personal property, with orders approved and shipped from outside the state. It does not protect sales of services or intangibles, and states increasingly treat certain internet activities as exceeding mere solicitation.

Apportionment and allocation

Business income is apportioned among states using a formula; nonbusiness income is allocated to a single state (typically the state of commercial domicile or the situs of the asset).

Three-factor formula: averages the sales, payroll, and property factors (each a ratio of in-state to everywhere).
Single-sales-factor: many states now apportion using only the sales factor, often with market-based sourcing of receipts, which shifts tax toward states where customers are located.

Unitary and combined reporting

Many states require a unitary group of commonly controlled, functionally integrated businesses to file a combined report, blending the group's income and apportionment factors. This limits planning that shifts income to low-tax affiliates.

Federal consolidated returns

An affiliated group (a common parent and chains of subsidiaries connected by ≥80% vote and value) may elect to file a consolidated federal return under §1501.
Benefits: group members' losses offset other members' income, and intercompany transactions are deferred until the gain or loss is recognized outside the group.
SRLY rules (separate return limitation year): losses a member generated before joining the group can generally offset only that member's own income, preventing loss-trafficking into the consolidated group.

International planning levers (high level)

Subpart F: certain passive and mobile income of a controlled foreign corporation (CFC) is taxed currently to U.S. shareholders.
GILTI (global intangible low-taxed income): a current inclusion of a CFC's income above a routine return on tangible assets, partially offset by a deduction and foreign tax credits.
FDII (foreign-derived intangible income): a preferential deduction encouraging U.S. corporations to earn export-related intangible income domestically.
Foreign tax credit: relieves double taxation on foreign-source income, subject to separate-basket limitations.

P.L. 86-272 protects only the solicitation of orders for tangible personal property. It does not shield service revenue, licensing of intangibles, or (under many states' updated guidance) interactive website activity that goes beyond mere solicitation. Economic nexus under Wayfair can still reach a seller for sales and use tax even where P.L. 86-272 blocks an income tax.