Pass-through entities (PTEs) continue to gain popularity with business people and investors. Once largely the province of smaller businesses or real estate investments, PTEs are now just as likely to turn up in larger multi-state and even multinational business enterprises. By some estimates, unincorporated firms, including general and limited partnerships and limited liability companies, represent about a third of the firms in the United States and even larger percentages elsewhere in the world.

In general, a PTE can be defined as any business vehicle that is not subject to federal income tax as a separate entity. Instead, the PTE's items of income, loss, deduction and credit are typically "passed through" and taxed to its member or members. Many states follow this basic federal approach, though there are some important exceptions to this rule.

From a legal perspective, PTEs can take a number of forms. The most common are limited liability companies (LLCs), general partnerships, limited partnerships and business trusts. Thanks to Subchapter S of the Internal Revenue Code, even certain corporations and their shareholders can enjoy such pass-through tax treatment.

The popularity of PTEs is largely attributable to two developments in the 1990s. One was the advent of state laws creating what was then a novel type of business entity in the U.S.-the limited liability company. The first LLC statute was enacted by Wyoming in 1977, but did not really arrive until Delaware followed suit in 1992. By 1996, nearly every state had some form of LLC legislation.

Much has been written about LLCs over the years. In brief, they can be seen as hybrid entities that combine some of the most attractive features of corporations and partnerships. In particular, they provide their members with limited liability protection similar to that enjoyed by corporate shareholders, while at the same time giving them considerable flexibility in management, voting rights and the allocation of economic rights and obligations.

The second development was the promulgation of the federal income tax "check the box" regulations in 1997. As their name implies, these regulations generally permit taxpayers to elect pass-through treatment for any eligible business entity by literally checking a box on the appropriate tax form. Under the old regime, taxpayers and practitioners had to cope with a complicated, multi-factor facts and circumstances approach to entity classification, an approach that led to a great deal of time, money, ingenuity and anxiety being spent in trying to achieve pass-through treatment without sacrificing limited liability protection for the owners of the enterprise. Almost overnight, the "check the box" regulations brought simplicity and certainty to this troubled area of tax law.

Critically, the "check the box" regulations classified LLCs as eligible business entities. But for this concession, LLCs might have remained something of a curiosity, a corporate entity with unusual features but subject nonetheless to two levels of tax on its income just like any other corporation. Instead, LLCs were now able to couple corporate-shareholder-type limited liability protection with the pass-through tax treatment traditionally available only to partnerships.

LLCs did not catch on immediately. Lawyers in particular initially had concerns about whether or to what extent the limited liability protection promised by these new entities would hold up in court. Indeed, even today there is a paucity of case law on this subject, and while a number of courts have found in favor of members' claims for liability protection, members still need to be mindful of doctrines that permit parties to "pierce the corporate veil" where, for example, an entity is found to be a mere sham or "alter ego" of the owners.

The growing acceptance of LLCs is reflected in statistics published by the Internal Revenue Service regarding entities filing as partnerships for tax purposes each year. For 1997, the year in which the "check the box" regulations were adopted, these statistics indicate that there were approximately 1.76 million partnerships. By 2000, this number had increased to nearly 2.1 million, an increase of about 17%. From 2000 to 2007, however, the number jumped to 3.1 million, an additional increase of about 50%.

PTEs are not without their disadvantages from a tax perspective, and selecting the proper entity and tax classification for any venture still requires careful consideration of all the pros and cons. Members of a PTE are subject to tax on their "distributive share" of a PTE's taxable income each year, whether or not the PTE actually makes any distributions. A current deduction for a PTE's losses may sound like an attractive prospect, but actually getting there for individual investors requires negotiating both the "at risk" and "passive activity loss" rules in the code, in addition to the rules, applicable to all taxpayers, that limit current deductions to the "adjusted basis" in a member's interest in the PTE. The potential impact of self-employment taxes adds another wrinkle.

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