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corporation that converted from a C same transaction.40 In addition, there Reason 8: Other S
corporation, or for an S corporation is no counterpart for partnerships corporation restrictions and
that receives a transfer of assets from with respect to entity-level taxation limitations
a C corporation in a nonrecognition that exists for S corporations under In addition to restrictions discussed
transaction, during the five-year rec- Sec. 1374. above regarding the one-class-of-
ognition period.35 Therefore, partnerships offer stock rule and pro rata allocations, S
On the other hand, a partnership significantly more flexibility and corporations have other qualifications
that distributes appreciated property planning opportunities. For example, and restrictions as follows:43
to a partner generally does not rec- partnership breakups where partners ■ The number of shareholders is
ognize gain.36 An exception to this divide up partnership assets can be limited to 100.
general rule exists with respect to accomplished without immediate tax ■ S corporations restrict the type of
disproportionate distributions to a consequences (subject to Sec. 751 dis- shareholders to individuals and
partner relating to certain ordinary in- cussed above). Also, partnerships offer only certain trusts and to estates.
come assets.37 Further, distributions of planning opportunities for distribu- Corporations and partnerships
property in kind (not cash) generally tions of real estate to the partners to cannot be shareholders in an S
do not result in a partner-level gain. be held as tenants in common where corporation.
Except as provided in Sec. 751(b) there is not unanimous agreement ■ Nonresident aliens are not eligible
mentioned above, in the case of a dis- regarding a like-kind exchange under shareholders of an S corporation.44
tribution by a partnership to a partner, Sec. 1031. ■ S corporations can be subject to
gain is only recognized to the extent entity-level taxation under Sec.
that any cash distributed exceeds the Reason 7: No inside asset 1374 (the built-in gains tax) and
adjusted basis of the partner’s interest tax basis step-up when Sec. 1375 (excess passive invest-
in the partnership.38 members change or exit ment income).
In the case of a current distribu- There is no provision in Subchapter S
tion, the tax basis of the distributed that permits the inside tax basis of the Reason 9: Investor
property in the hands of the partner is corporation’s assets to achieve a step- opportunity is limited
the same as the basis of the property up in tax basis when a shareholder Except for differing rights with
to the partnership immediately before dies, when a person acquires the stock respect to voting, an S corporation
the distribution, limited to the adjust- of a shareholder, or when there is a cannot have different classes of own-
ed tax basis of the partner’s interest in distribution of property or cash to a ers under the one-class-of-stock
the partnership reduced by any cash shareholder.41 Conversely for partner- rule.45 Many modern-day LLCs are
received in the same transaction.39 ships, an election under Sec. 754 per- structured with different member-
In the case of a liquidating distribu- mits adjustment of the inside tax basis ship classes (or C corporations with
tion, the tax basis of the distributed of assets with respect to an acquisition varying preferred and common stock
property in the hands of the partner of a partner’s interest by another, upon classes) to entice investors that have
is equal to the adjusted basis of the the death of a partner, or upon certain disparate investment needs and
partner’s interest in the partnership, distributions of cash or property to a requirements. Varying classes of
reduced by any cash received in the partner.42 membership, e.g., Class A, Class B,

35. Sec. 1374. Sec. 1374 is not likely implicated when an LLC initially elects S of 80% of the stock of the corporation by a seller making an election under
corporation status. Nevertheless, Sec. 1374 may be implicated for possible Sec. 336(e).
subsequent nontaxable transfers of assets from a C corporation. 42. The operative Code sections are Sec. 743(b), dealing with acquisitions of a
36. Sec. 731(b). partner’s interest or death of a partner, and Sec. 734(b), dealing with part-
37. Sec. 751(b). nership distributions.
38. Sec. 731(a). This result is aligned with the aggregate theory of partner- 43. See Sec. 1361 for rules relating to S corporation qualifications.
ship taxation. 44. But see Sec. 1361(c)(2)(B)(v), as amended by the law known as the Tax Cuts
39. Sec. 732(a). and Jobs Act, P.L. 115-97, permitting nonresident aliens as potential current
40. Sec. 732(b). beneficiaries of an electing small business trust, effective Jan. 1, 2018.
41. A step-up in tax basis of the inside tax basis of assets of an S corporation 45. An S corporation can maintain voting and nonvoting common stock (Sec.
can be achieved, however, when there is an 80% acquisition of the stock by 1361(c)(4)).
a purchasing corporation making an election under Sec. 338(h)(10) or a sale

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