Source: http://taxhub.net/Business-Forms-for-Conduct-of-a-Trade-or-Business.html
Timestamp: 2017-08-18 06:43:49
Document Index: 692032730

Matched Legal Cases: ['§ 7701', '§ 1361', '§ 1378', '§ 585', '§ 936', '§ 1374', '§ 1375', '§ 1374', '§ 1363', '§ 6655', '§ 761', '§ 263', '§ 1', '§ 301', '§ 7704', '§ 1', '§ 469', '§ 1', '§ 469', '§ 1031', '§ 1031', '§ 301', '§ 301', '§ 301', '§ 301', '§ 7701', '§ 7701', '§ 7704', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 7701', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 708', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 301', '§ 336', '§ 331', '§ 721', '§ 351', '§ 731', '§ 351', '§ 338', '§ 338']

-Business Forms for Conduct of a Trade or Business
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Business Forms for Conduct of a Trade or Business.
A partnership, an S corporation and a regular C corporation are the three most common business forms suitable for the operation of an investment or active business for federal income tax purposes. A sole proprietorship may also be used, as long as there is only one owner of the business. In determining which business form best suits the needs of the owners, many factors need to be considered. These include both tax and nontax factors. Each form is encumbered by unique advantages and disadvantages in both the tax and nontax considerations. The nontax considerations weigh as heavily as the tax considerations to most entrepreneurs. The recent legislative changes have created new complexities which must be considered by the tax practitioner in advising clients on the optimum business form. Even though the tax rates for individual taxpayers are higher than they are for corporations for years beginning after 1992, emphasis is placed on operating as a partnership or as an S corporation.
The goal of the practitioner in recommending a business form for either a new venture or for an existing enterprise is to structure it such that the form meets the taxpayers' nontax objectives, while maximizing any current and future tax benefits. Often multiple objectives are applicable: to choose that business entity form which provides both (a) the best income tax planning benefits and (b) advantages for business law planning (particularly the limitation for potential liabilities which could be applicable to the business owners). Similar considerations are relevant when the new business being organized is an investment for profit activity, although not an enterprise created to engage in active business operations.
For income tax planning, a variety of the objectives may be pursued, including, for example:
How can income taxes on the business profits be minimized or deferred?
How can any business tax losses be advantageously used (particularly to offset other income, including, possibly, income of the owners of the business)?
How can increases in the value of the equity of the business best be protected for income and estate tax?
For business law purposes, the planning concerns might include, for example:
How can exposure to potential liabilities being incurred by the business entity be limited so that the owners of the enterprise are not exposed to such liabilities?
What is the most efficient entity arrangement from a management perspective?
Which business form permits the most flexible structure for the possible transfer of ownership interests in the business organization?
Which business forms might limit the types of activities which can be engaged in by the particular entity?
What local law reporting and information complexities might be applicable?
Which entity structure enables the most preferable equity and capital financing arrangements?
Corporations - A corporation is an artificial being, separate and distinct from its shareholders. According to § 7701(a), a corporation is defined so as to include associations, joint stock companies, and insurance companies. A corporation is a separate legal entity that is created under state law. A corporation can be formed by one or more persons filing the appropriate documents with the state in which they wish to be incorporated. The corporation must comply with the normal state filing requirements, such as franchise and business tax returns, in order to retain its corporate status. The filing requirements and franchise tax fees vary from state to state. Thus, a tax advisor should be familiar with the necessary filing requirements of the states in which his client intends to conduct business or to be incorporated. It may be possible to minimize the state tax burden by incorporating in one state instead of another.
A corporation is a popular legal vehicle for a small or large number of investors. The corporation allows such investors or entrepreneurs to pool or contribute capital to a business entity that offers the attractive feature of limited liability. In an investor context, they can effectively control the operations of the corporation by selecting the management and board of directors they feel will serve their best interests. The shareholders of a corporation share in the profits through the receipt of current dividends, increases in the value of their stock, and upon distributions in partial or complete liquidation. The receipt of increased value through liquidations, however, is generally limited to closely held corporations. Large publicly-held corporations generally merge with or are purchased by another corporation or investor group and the shareholders benefit from such mergers or acquisitions with either increased holdings or increases in the value of their stock. The term "close or closely-held" corporation refers to those entities in which a small number of shareholders both own and manage the corporation.
S Corporations - An S corporation is a small business corporation that satisfies the requirements of subchapter S (§ 1361 - § 1378) and has made an election to be taxed as an S corporation. An S corporation is a tax vehicle only, and in all other respects the S corporation is a regular corporation for state law purposes. The key difference between a regular corporation and an S corporation for tax purposes is that the income, losses, deductions, and other tax attributes of the S corporation flow through to the shareholders rather than being taxed at the corporate level. From a nontax perspective, the shareholders of an S corporation, like a corporation, enjoy the aspect of limited legal liability. Several states, however, do not recognize S corporation status for state income tax purposes. In most cases, the S corporation may be required to pay tax at the corporate level similar to a regular corporation.
The following statutory requirements must be met for a corporation to elect to be taxed as an S corporation:
It must have 75 or fewer shareholders.
All shareholders must be individuals, estates or qualified trusts.
There must be only one class of stock.
The corporation cannot have a shareholder that is a nonresident alien.
In addition to meeting the above requirements, there are certain corporations that are ineligible to elect S corporation status. The prohibited corporations include:
Insurance companies that are subject to tax under the special rules of subchapter L.
A financial institution that is a bank as defined in § 585.
A domestic international sales corporation (commonly known as a DISC) or a former one.
A corporation electing the tax credit under § 936 (this refers to a possession tax credit for companies doing business in Puerto Rico).
An S corporation, like a partnership, is referred to as a flow-through entity. In general, this means that all items of income, loss, deduction and credit flow through to the shareholders (primarily individuals) and are taxed on a pro rata basis to each shareholder. In most cases, a corporation electing S corporation status will not pay any tax at the corporate level. However, there are five cases in which the S corporation may be required to pay the tax at the corporate level. These include:
The capital gains tax of old § 1374 may apply if certain conditions are met.
If passive income of the S corporation exceeds 25% of the gross receipts and the S corporation has undistributed regular C corporation earnings and profits, a tax under § 1375 may apply.
Under § 1374, a tax may also apply on recognized built-in gains if an S corporation was previously a C corporation and an election to be taxed as an S corporation was made after December 31, 1986 (with certain exceptions for small closely-held corporations).
Under § 1363(d), a LIFO recapture will apply on conversion from a C to an S corporation if the S corporation election is made after December 16, 1987.
Under § 6655, the S corporation may be subject to making estimated tax payments and might be liable for a penalty for underpayment of its estimated tax.
If the corporation has always been an S corporation or if the S corporation is not a successor of a C corporation, no corporate level taxes are generally required to be paid.
It is often common for a tax advisor to refer to an S corporation as a corporation which is taxed like a partnership. It is true in many cases that the provisions of subchapter K that apply to partnerships are similar to the flow-through concept that applies to S corporations. However, significant differences exist between the taxation of an S corporation and a partnership. In many cases, partnerships offer much more flexibility than do S corporations. The attractiveness of an S corporation is from the limited legal liability to the shareholders and the flow-through of income and losses to the shareholders.
Partnerships - The definition of a partnership for Federal income tax purposes is much broader than the definition for state law purposes in the Uniform Partnership Act. Thus, an organization which may not meet the common law definition of a partnership may be considered a partnership for Federal income tax purposes. The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on a business as co-owners for profit. This definition is expanded significantly for Federal income tax purposes as provided in § 761(a), which states that a syndicate, group, pool, joint venture or other unincorporated organization through or by means of which any business or financial venture is carried on and which is not, within the meaning of this title, a corporation or a trust or estate, constitutes a partnership. Generally, a partnership is said to be created when persons join together their money, goods, labor or skill for the purpose of carrying on a trade, profession, or business, and when there is a sharing in the profits and losses of the undertaking. The crucial factor in determining whether or not a partnership exists is if the partners really and truly intended to join together for the purposes of carrying on a business and sharing the profits or losses or both. Whether or not a partnership exists can only be ascertained by a review of the facts and circumstances in each case.
It is very important to determine if a partnership exists for Federal income tax purposes. For example, elections that affect the computation of taxable income of a partnership are required to be made by the partnership. The down side of not knowing whether or not a partnership exists for Federal income tax purposes is illustrated with the following example:
Example 1: Two individuals agree to share the profits and losses equally in an oil and gas partnership. In year l, expenditures of $20,000 were incurred for intangible drilling costs. A partnership return was not filed for this joint venture. For an oil and gas partnership, the election to deduct intangible drilling costs, contained in § 263(c), must be made by the partnership in accordance with Reg. § 1.612-4(d). Thus, since the two individuals were not aware that a partnership existed for Federal income tax purposes, the required election was not made. Accordingly, the two individuals may be required to capitalize, rather than deduct, the $20,000 of intangible drilling costs.
Another aspect of the formation of a partnership for Federal tax purposes is the possibility of the partnership electing to be classified as an association. This is commonly referred to as an association taxable as a corporation.
Reg. § 301.7701-3 adopts a pass-through default for domestic entities, under which a newly formed eligible entity will be classified as a partnership if it has at least two members, or will be disregarded as an entity separate from its owner if it has a single owner.
The default for foreign entities is based on whether the members have limited liability. Thus, a foreign eligible entity will be classified as an association (i.e., a corporation) if all members have limited liability. A foreign eligible entity will be classified as a partnership if it has two or more members and at least one member does not have limited liability; the entity will be disregarded as an entity separate from its owner if it has a single owner and that owner does not have limited liability.
Under the Revenue Act of 1987, many types of publicly traded limited partnerships will be taxed as corporations under § 7704. For the most part, these include those publicly traded partnerships that are involved in an active trade or business rather than mere investment activities (e.g., Boston Celtics).
A sole proprietorship is a business conducted in one owner's individual capacity and without the organization of a separate legal entity for holding and conducting that business. The business owner merely utilizes a certain portion of his directly owned assets for business purposes.
Since no separate entity exists, no separate income tax return is required for this business. Rather, the owner of a proprietorship separately reports the income from that activity directly on the owner's federal tax return (the income (or loss) is reported on the Schedule C or Schedule F of the sole proprietor's Form 1040. If several sole proprietorships are conducted, multiple Schedule C's or Schedule F's are required). Although no separate identity exists for federal income tax purposes, the proprietor may adopt a separate name under which the business is conducted. That name may be required to be registered with state or local authorities under an assumed name or similar state statute.
For federal income tax purposes, the disposition of a sole proprietorship is not the disposition of a separate business entity. Instead, the transfer of the various individual assets of the proprietorship will be treated as separate property disposition transactions (see Williams v. McGowan, 152 F.2d 570 2nd Cir. (1945)). Accordingly, the amount of gain or loss, and the character of the gain or loss, will be measured by reference to the various specific assets being transferred, rather than by reference to the sole proprietorship business as an entity.
No separate transfers of business assets to a proprietorship are required to enable a sole proprietorship to begin business activities. Therefore, the transfer of appreciated assets for use in a sole proprietorship has no federal income tax significance. The use in a proprietorship of previously personally used assets is not treated as a transfer from the individual owner to the proprietorship (see Reg. § 1.165-9(b)).
For tax purposes, the sole proprietorship does not have a capital structure which is independent of the sole proprietor. For business reasons, the sole proprietor may leverage his investment through borrowing from third-party sources. The interest paid on the cost of borrowing is generally deductible as a trade or business expense (assuming that the passive activity loss provisions of § 469 do not otherwise apply). (In addition, the various tracing rules of Reg. § 1.163-8T may apply to determine whether the interest paid on the borrowing is deductible as a trade or business expense.)
By definition, the sole proprietorship has only one owner. If multiple owners are involved, the arrangement is generally classified as a joint venture, a partnership, or other similar arrangement.
Income of the sole proprietorship is reported on the federal income tax return of the individual owner. When so reported, the income or loss is combined with the proprietor's other income to determine that taxpayer's adjusted gross income and, after personal exemptions and deductions, taxable income. When so determined, that income is subject to the ordinary income tax rates (or capital gains tax rates) generally applicable to individual taxpayers. In addition, all of the special rules that apply to the calculation of taxable income and tax liability for an individual apply to the sole proprietor, as well as the rules that apply to calculate self-employment tax.
Generally, there is no opportunity to specially allocate income since the business is owned only by one individual. However, income can be deflected by the proprietor to others through the use of non-ownership income distributions. For example, income can be allocated to other family members by paying for services or goods provided, for property leased, for loans of money, and for rental of goods or technology from other family members.
Any election which affects the taxable income of the sole proprietor is made by the sole proprietor on his or her Schedule C or Schedule F and most sole proprietors report their taxable income using the calendar year.
A sole proprietor can transfer funds from a separate proprietorship account to an account holding that proprietor's personal funds. Since the funds are not distributed from an entity, the transfer of funds has no income tax consequences analogous to a dividend distribution by a corporation.
The sole proprietor can terminate an interest in a sole proprietorship by selling that interest to a third party or by simply discontinuing the business operation. The sole proprietor can also partially terminate an interest in a sole proprietorship by selling to another only a portion of the entire interest in the proprietorship business. When that occurs, the proprietorship is transformed into a partnership for tax purposes, even though under state law it might be considered as a joint venture if the sole proprietor has a continuing ownership interest in the new business.
When a complete or partial sale of the sole proprietorship occurs, the gain (or loss) to the sole proprietor, and the income tax consequences that result, is ascertained by reference to the individual components of the sole proprietorship. Consequently, adjusted tax basis, holding period, and other relevant tax characteristics for each separate proprietorship asset are important in measuring the income tax results to the proprietor when the proprietorship interest is sold.
An individual sole proprietor can have several different business activities which constitute separate sole proprietorships. The federal income tax results of each sole proprietorship are computed separately for tax purposes. However, those results are combined for purposes of determining the total gross income of the sole proprietor which are all reportable on one income tax return. (This means that a loss from one sole proprietorship may offset the income from another sole proprietorship without the general application of the passive activity loss rules of § 469.)
A sole proprietor may participate in a joint venture, i.e., one not treated as a partnership under state law. If the sole proprietor participates in a joint venture, a sole proprietorship no longer exists. The sole proprietor is transformed into a partner in a partnership for federal income tax purposes.
A sole proprietor may also own shares in a regular C corporation or in an S corporation. To qualify as an S corporation shareholder, the shareholder must be an individual (citizen or resident), an estate or a qualifying trust. The income from the S corporation is treated as received by the shareholder of the S corporation and is required to be included with the other income on the individual's tax return for the current taxable year.
A sole proprietorship is not itself a separately identifiable asset which can be transferred for federal income tax purposes. Instead, each of the various assets of the sole proprietorship are treated as separately transferred. Consequently, the transfer of each asset constitutes a distinct gain (or loss) realization/nonrealization or recognition/nonrecognition event. Therefore, the income tax character of gain or loss from each asset transfer is determined by reference to the tax nature of each of those assets. In addition, the postponement of gain recognition is ordinarily dependent upon the income tax characterization of each asset, since the sole proprietor cannot rely on a general gain postponement provision effective as to the entire interest in the entity.
Two choices are generally available in transferring sole proprietorship assets without recognition of gain: the like-kind exchange provisions of § 1031 or a corporate tax-free acquisitive reorganization provision, utilized after transferring the sole proprietorship assets into a corporation.
Certain assets of a sole proprietorship can be exchanged for like-kind assets without gain recognition being immediately recognized (§ 1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if such a property is exchanged solely for property of a like-kind which is to be held either for productive use in a trade or business or for investment). Assets eligible for this treatment include land, buildings, machinery, technology, patents, trademarks and trade names. However, property not eligible include inventory, stocks, bonds, or notes, other securities or evidence of indebtedness or interest, interests in a partnership, certificates of trusts or beneficial interests, choses in action, or goodwill.
If the sole proprietor wishes to transfer the entire proprietorship on a gain deferral basis, this can possibly be accomplished by transferring the enterprise into corporate form in a tax-free incorporation and, thereafter, exchanging those shares in a tax-free corporate reorganization. However, this incorporation transaction ultimately causes an additional layer of income tax to be incurred, since the corporation will thereafter recognize the gain on the transferred assets and the shareholder must recognize gain on the sales proceeds received from any liquidation of the corporation. The objective, of course, might be to exchange the stock of the newly formed corporation in a tax-free corporate organization and to thereafter hold those shares of the purchaser corporation until death, at which time an income tax basis step-up to fair market value occurs. If stock is subsequently exchanged in a nontaxable reorganization, no tax is incurred at the shareholder level or at the entity level.
Tax Factors in Choosing a Business Entity.
There are a number of factors to take into account in selecting the optimal business entity. The factors to take into account include the type of property and/or investment that the owners of the entity wish to operate, the marginal tax rates, and seven specific tax factors which should be considered in advising the client as to the proper form of operating a trade or business. For example, it is generally not advisable to transfer real estate and/or securities into a corporation, since it is impossible to get the property back out of the corporation tax-free. In addition, if the particular business or venture is expected to operate at a loss in its initial years, it is almost always more advantageous to transfer the property to a partnership or to transfer the property to a corporation and have the corporation make an S election.
In comparing the difference in the marginal rates for individuals and for corporations, it is also necessary to look at the fact that if a regular C corporation makes a dividend distribution, that the amount distributed is subject to a double-tax, i.e., a tax on the income generated by the C corporation and another tax generated by the dividend distribution. Of course, it is possible to avoid the imposition of the double tax, if the amounts distributed are taken out of the corporation as compensation. However, if too much compensation is paid, it is always possible for the compensation to be subject to IRS scrutiny and for the determination to be made by the IRS that the compensation paid was unreasonable compensation, thereby subjecting the amount distributed to a double-tax.
As for the tax factors that should be considered in advising a client as to the proper form of operating a business entity, the following factors should be considered:
Formation - What rules apply to the formation of the entity? May property be transferred to the entity tax-free? What are the federal income tax consequences that result if an interest in the entity is transferred to a third party for the performance of services? Is it possible for the Service to recharacterize the business organization as an association taxable as a corporation?
Operational Issues - There are several operational issues which must be considered in advising the client as to proper business form. These include:
What taxable year-end is the entity restricted to?
What method of accounting is the entity restricted to?
Are there any special rules that apply in the calculation of the entity's taxable income? For example, what are the rules that apply to dividends received by the entity? What happens to capital losses and net operating losses? What is the maximum charitable contribution that the entity may take? What results if the entity collects tax-exempt income and distributes that tax-exempt income to the owners of the entity? And, are there any special rules that apply to the entity's organizational expenses?
What tax returns are required to be filed by the entity? What is the due date of the respective tax returns?
What taxes are required to be paid by the entity? For example, is the entity required to pay a regular income tax? Is the entity perhaps potentially subject to the alternative minimum tax? And is it required to make the ACE adjustment? Is the entity required to make estimated tax payments? Will the entity be subject to any penalties for underpayment of estimated tax? Will the entity be subject to the personal holding company tax and/or the accumulated earnings tax?
Distributions - What are the federal income tax consequences that result to the owners and to the entity if the entity makes a distribution of cash or property to the owners of the entity? In addition, are there any special rules which require the entity to make distributions to the owners in proportion to their ownership interests in the entity? What federal income tax consequences result to the owners and to the entity if the entity makes a distribution of an additional ownership interest in the entity to the owners (such as a stock dividend)?
Redemptions - Are there any special rules which apply if the entity redeems all or a portion of an owner's interest?
Sale of an Interest in the Entity - If an owner of the entity decides to dispose of its interest in the entity, what is the character of the gain or loss that is required to be recognized by the owner on the disposition of such interest? Is the character of the gain automatically capital gain and is the character of the loss automatically capital loss? Are there any special rules which allow the owner of the entity to deduct a portion of the loss as an ordinary loss? If the owner of the entity disposes of its interest in the entity at a gain, are there any special rules which allow the owner of the entity to exclude a portion of the gain?
Liquidation - What are the federal income tax consequences that result to both the owners and the entity if the entity is liquidated some time in the future? Is it possible for the entity to liquidate tax-free? If it is not possible to liquidate the entity tax-free, is there a double-tax that is required to be paid, i.e., what federal income tax consequences result if the entity distributes out appreciated or depreciated property and what federal income tax consequences result to the owners of the entity upon the receipt of such property?
Reorganizations - Is it possible for the owners of the entity to exchange their interest in the entity for an interest in another entity without such exchange being recognized as a taxable disposition? For example, is it possible for a partner in a partnership to exchange its interest in a partnership for an interest in another partnership and do so without the recognition of a gain or loss? Is it possible for a shareholder in a C corporation to exchange its shares of stock for other shares of stock in another corporation and do so without the recognition of a gain or loss?
Estate Tax Considerations - What result if the owner of the entity dies during the year? Is it possible for the heirs or the estate who succeed to the owner's interest in the entity to step-up the owner's interest in the assets of the entity inside the business? Are minority discounts available?
In evaluating the proper form of business operation, the life cycle of the business should be considered. A decision as to the final form should weigh each of the factors and a decision should be made only after all the advantages and disadvantages of each form are compared and contrasted.
Check the Box Classification Regulations.
Introduction - The IRS has issued regulations that generally would permit unincorporated entities to choose whether to be taxed as partnerships or corporations. The regulations spell out whether an organization is a separate entity for federal tax purposes (Reg. § 301.7701-1), and specify which entities automatically are classified as corporations for federal tax purposes (Reg. § 301.7701-2). Other business entities that are recognized for federal tax purposes could choose their classification under rules in Reg. § 301.7701-3. The regulations implement the check the box entity classification proposal announced in Notice 95-14, 1995-1 C.B. 297, and open the elective classification system to business entities with two or more members. Modified rules are provided for foreign organizations and single-member entities. The regulations replace the prior regulations (see Reg. § 301.7701-1, -2, and -3).
Prior Provisions - Section 7701(a)(2) defines a partnership to include a syndicate, group, pool, joint venture, or other unincorporated organization, through or by the means of which any business, financial operation, or venture is carried on, and that is not a trust or estate or a corporation. Section 7701(a)(3) defines a corporation to include associations, joint stock companies, and insurance companies.
The prior regulations for classifying business organizations as associations (which are taxable as corporations under § 7701(a)(3)) or as partnerships under § 7701(a)(2) were based on the historical differences under local law between partnerships and corporations. However, many states revised their statutes to provide that partnerships and other unincorporated organizations may possess characteristics that traditionally have been associated with corporations, thereby narrowing considerably the traditional distinctions between corporations and partnerships under local law. For example, some partnership statutes now provide that no partner is unconditionally liable for all of the debts of the partnership. Similarly, almost all states have enacted statutes allowing the formation of limited liability companies. These entities provide protection from liability to all members, but may qualify as partnerships for federal tax purposes under the existing regulations (see, e.g., Rev. Rul. 88-76, 1988-2 C.B. 360).
One consequence of the increased flexibility under local law in forming a partnership or other unincorporated business organization is that taxpayers generally can achieve partnership tax classification for a non-publicly traded organization that, in all meaningful respects, is virtually indistinguishable from a corporation. To accomplish this, however, taxpayers and the IRS must expend considerable resources on classification issues. For example, since the issuance of Rev. Rul. 88-76, the IRS has issued 17 revenue rulings analyzing individual state limited liability company statutes, and has issued several revenue procedures and numerous letter rulings relating to classification of various business organizations. Meanwhile, small business organizations may lack the resources and expertise to achieve the tax classification they want under the current classification regulations.
Reacting to the fact that publicly traded entities could easily qualify as partnerships, in 1987 Congress enacted § 7704 to require most publicly traded partnerships to be taxable as corporations. Thus, even if an organization could be classified as a partnership under the previous regulations, it will nevertheless be classified as a corporation in most cases if its ownership interests are publicly traded.
With respect to foreign organizations, Notice 95-14, 1995-1 C.B. 297, observed that, while the distinctions are similarly formalistic, the classification process under the current regulations involves even more complexities and requires greater resources than does the classification process for domestic organizations. For example, the classification of a foreign organization involves not only a review of organizational documents, but also a thorough understanding of the controlling foreign law.
Business Entities Under Regulations.
Reg. § 301.7701-1 provides an overview of the rules applicable in determining an organization's classification for federal tax purposes. The first step in the classification process is to determine whether there is a separate entity for federal tax purposes (which is a matter of federal tax law). Reg. § 301.7701-1(a)(2) explains that certain joint undertakings that are not entities under local law may nonetheless constitute separate entities for federal tax purposes; on the other hand, not all entities formed under local law are recognized as separate entities for federal tax purposes. For example, individuals who own property as tenants in common may create a separate entity for federal tax purposes if the individuals actively carry on a trade, business, financial operation, or venture and divide the profits therefrom. On the other hand, an organization wholly owned by a state is not recognized as a separate entity for federal tax purposes if it is an integral part of the state. Similarly, mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes. For example, if an individual owner of farm property leases its to farmer for a cash rental or a share of the crops, they do not necessarily create a separate entity for federal tax purposes.
An organization that is recognized as a separate entity for federal tax purposes is either a trust or business entity. Reg. § 301.7701-1(b) provides that trusts generally do not have associates or an objective to carry on business for profit. While Reg. § 301.7701-1(b) restates the distinction between trusts and business entities, the determination of whether an organization is classified as a trust for federal tax purposes is intended to remain the same as under current law.
Reg. § 301.7701-2 specifies those business entities that automatically are classified as corporations for federal tax purposes. Any other business entity that is recognized for federal tax purposes may choose its classification under the rules of Reg. § 301.7701-3. Those rules provide that a business entity with at least two members can be classified as either a partnership or an association (i.e., corporation), and that a business entity with a single member can be classified as an association (i.e., as a corporation) or can be disregarded as an entity separate from its owner (a single member cannot elect partnership classification).
The regulations clarify that business entities that are classified as corporations for federal tax purposes include corporations denominated as such under applicable local law, as well as associations, joint stock companies, insurance companies, organizations that conduct certain banking activities, organizations wholly owned by a state, organizations that are taxable as corporations under a provision other than § 7701(a)(3), and certain organizations formed under the laws of a foreign jurisdiction or a U.S. possession, territory, or common wealth (Reg. § 301.7701-2(b)). (See Appendix A for a list of entities formed in different countries which are automatically treated as corporations.)
The regulations define corporation to include any business entity recognized for federal tax purposes that is organized under a federal or state statute, or under a statute of a federally recognized Indian tribe, that describes or refers to the entity as incorporated or as a corporation, body corporate, or a body politic.
The regulations define an association by reference to Reg. § 301.7701-3. As discussed below, that section permits certain business entities to choose whether to be classified as an association or as a partnership (or, if the entity has a single owner, as a non-entity).
The regulations classify as corporations certain foreign business entities (including entities organized in U.S. possessions, territories, and commonwealths) that are listed in Reg. § 301.7701-2(b)(8)). Under Reg. § 301.7701-2(b)(8), a list of more than 80 foreign limited liability entities will always be classified as corporations. (See Appendix A for a list.)
A new foreign eligible entity will automatically be a partnership if it has two or more members and any member has unlimited liability. It will be an association if no member has unlimited liability, or it will be disregarded as a separate entity if it has a single owner that does not have limited liability (Reg. § 301.7701-3(b)(2)).
Elective Classification of Certain Entities.
Reg. § 301.7701-3 sets forth rules permitting a business entity that is not required to be classified as a corporation (referred to in the regulation as an eligible entity) to elect its classification for federal tax purposes. An eligible entity that has at least two members may elect to be classified as an association (i.e. a corporation) or a partnership, and an eligible entity with a single owner may elect to be classified as an association (i.e., a corporation) or to be disregarded as an entity separate from its owner.
The regulations are designed to provide most eligible entities with a classification they would choose without requiring them to file an election. Thus, the regulations provide default classification rules that aim to match expectations. An eligible entity that wants the default classification need not file an election.
Thus, a newly formed domestic eligible entity will be classified as a partnership if it has two or more members unless an election is filed to classify the entity as an association (i.e., a corporation); no affirmative action need be taken by the entity to ensure partnership classification. Similarly, if that entity has a single member, it will not be treated as an entity separate from its owner for federal tax purposes unless an election is filed to classify the organization as an association.
As for foreign eligible entities, Reg. § 301.7701-3(b)(2) provides that if one or more of an entity's members have unlimited liability, the entity will be classified as a partnership if it has two or more members; and it will be disregarded as a separate entity if it has a single owner. Only if all of the entity's members have limited liability will its default classification be as an association (i.e., a corporation).
Generally, existing eligible entities would not be required to file elections to prevent reclassification under the default rules. Under Reg. § 301.7701-3(b)(3), eligible entities existing before the effective date of the regulations that choose to retain their current classification are not required to file an election. A foreign entity, however, is considered an existing entity for these grandfathering purposes only if its classification immediately before the effective date of the regulations is relevant to any person for federal tax purposes.
When a partnership terminates by operation of § 708(b)(1) on the sale or exchange of 50% or more of the interest in its capital and profits within a twelve month period, the resulting entity created is also treated as a partnership. No additional election is required (Reg. § 301.7701-3(e)).
Reg. § 301.7701-3(c) describes the election procedures. An eligible entity that does not want the classification provided by the applicable default provision, or wants to change its classification, may file an election to obtain the chosen classification.
An eligible entity may elect its classification by filing an election with the appropriate Service Center. The regulations require that the election specify the name, address, and the taxpayer identifying number of the entity, the chosen classification, whether the election results in a change in classification, and whether the entity is a domestic or foreign entity.
An eligible entity may affirmatively elect its classification on Form 8832, Entity Classification Election.
The election will be effective on a date specified on the election if that date is not more than 75 days prior to the date on which the election is filed, or on the date filed if no such date is specified on the election. In addition to the original election, a business entity that makes an election shall file a copy of its election with its federal tax return for the year in which the election is effective. If the entity is not required to file a return, the Commissioner will require direct or indirect owners of the entity to include copies of the election with their federal tax returns.
Unanimous consent of an entity's membership is not required: an election could be signed by either all the members or an authorized officer, manager, or owner.
The regulations prohibit an entity from changing its classification for 60 months after the initial election takes effect. However, an entity that elects to change its classification as of the effective date of the proposed regulations may elect to change again within the first 60 months following the election's effective date.
Late Entity Classification Elections.
Rev. Proc. 2002-15 was issued in January 2002 and permitted a newly formed entity to request relief for a late initial entity-classification election filed within six months of its due date and before the entity's unextended tax return due date. The IRS has now issued Rev. Proc. 2002-59, giving new entities until their unextended tax return due dates to request relief from a late election, even if that date is more than six months after their initial classification election should have been made.
Under the "check-the-box regulations," a business entity that is not classified as a corporation may elect its classification for federal tax purpose. An eligible entity with at least two members is automatically classified as a partnership unless it elects to be taxed as a corporation. An eligible entity with a single owner is automatically classified as a disregarded entity, but may elect to be classified as a corporation (Reg. § 301.7701-3(c)). Entity-classification elections are made by filing Form 8832, Entity Classification Election. An election is effective on the date specified by the entity on Form 8832 or on the date filed if no date is specified on the election form (Reg. § 301.7701-3(c)(1)(iii)). The effective date specified on Form 8832 may not be more than 75 days before the date on which the election is filed. If an election specifies an effective date more than 75 days before the date on which it is filed, it will be effective 75 days before the date it was filed.
Rev. Proc. 2002-15 provided a simplified method to request relief for a late initial classification election, i.e., an election by an eligible entity newly formed under local law to be classified effective on the date of its formation as other than the default classification provided under Reg. § 301.7701-3(b). This procedure was in lieu of the private letter ruling procedure that otherwise would have to be used to obtain relief for a late entity classification election.
The IRS has modified and superseded Rev. Proc. 2002-15 by extending the time for filing a late initial entity-classification election beyond six months, to the unextended due date for the federal tax return of the entity's desired classification for the year of its formation. The tax return due date for an entity desiring to be disregarded as an entity separate from its owner is its sole owner's tax return due date for the tax year in which the entity was formed.
Rev. Proc. 2002-59 is in lieu of the letter ruling procedure that would otherwise have to be used. Therefore, user fees do not apply to corrective action under the revenue procedure. An entity that is not eligible for relief under this revenue procedure, or is denied relief by the service center, may request relief by applying for a letter ruling.
An entity is eligible for relief under Rev. Proc. 2002-59 for a late initial classification election if:
It failed to obtain its desired classification as of the date of its formation solely because Form 8832 was not filed timely under Reg. § 301.7701-3(c)(1);
The due date for the tax return of the entity's default classification (excluding extensions) for the tax year beginning with the date of the entity's formation has not passed; and
The entity has reasonable cause for its failure to timely make the initial entity classification election.
By the original due date of the first federal tax return of the entity's desired classification, the entity must file a completed Form 8832, signed in the manner required by Reg. § 301.7701-3(c)(2). Write "FILED PURSUANT TO REV. PROC. 2002-59" on the top of Form 8832 and attach a statement to it explaining the reason for the failure to file a timely initial classification election. After receiving the request, IRS will notify the entity whether it qualifies for relief.
Final regulations have been issued which describe how elective changes in an entity's classification will be treated for federal tax purposes. (Reg. § 301.7701-3). Under the final regulations, there are four possible changes in classification by election. These include (1) a partnership elects to be an association; (2) an association elects to be a partnership; (3) an association elects to be a disregarded entity; and (4) a disregarded entity elects to be an association.
There are two other possible ways in which an entity's classification could change (a partnership converts to a disregarded entity or a disregarded entity converts to a partnership) but these changes occur only as a result of a change in the number of members, not as a result of an elective change. The final regulations do not address the form of these two possible types of changes. The final regulations provide a specific characterization for each of the four possible elective changes. In each case, the characterization provided in the final regulations attempts to minimize the tax consequences of the change in classification and achieve administrative simplicity.
Association to Partnership - The final regulations provide that if an association elects to be classified as a partnership, the association is deemed to liquidate by distributing its assets and liabilities to its shareholders. Then, the shareholders are deemed to contribute all of the distributed assets and liabilities to the partnership. This characterization of an elective change from an association to a partnership is consistent with Rev. Rul. 63-107, 1963-1 C.B. 71.
Partnership to Association - If a partnership elects to be classified as an association, the partnership is deemed to contribute all of its assets and liabilities to the association in exchange for stock in the association. Then, the partnership is deemed to liquidate by distributing stock in the association to its partners. Prop. Reg. § 301.7701-3 does not affect the holdings in Rev. Rul. 84-111, 1984-2 C.B. 88, in which the IRS ruled that it would respect the particular form undertaken by the taxpayers when a partnership converts to a corporation.
Association to Disregarded Entity - If an association elects to be disregarded as an entity separate from its owner, the association is deemed to liquidate by distributing its assets and liabilities to its sole owner.
Disregarded Entity to Association - If an eligible entity that is disregarded as an entity separate from its owners elects to be classified as an association, the owner of the eligible entity is deemed to contribute all of the assets and liabilities of that entity to the association in exchange for stock of the association.
The final regulations also provide that the tax treatment of an elective change in classification is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step-transaction doctrine. This provision in the final regulations is intended to insure that the tax consequences of an elective change will be identical to the consequences that would have occurred if the taxpayer had actually taken steps described in the final regulations.
Therefore, if an entity elects to convert from corporate status to partnership status, the deemed liquidation will result in gain or loss recognition to (1) the corporation under § 336 and (2) the shareholders under § 331. However gain or loss generally will not be recognized on the transfer to the partnership under § 721. Similarly, if a corporation is converted to a disregarded entity, there will be corporate and shareholder gain or loss recognition on the deemed liquidation.
Conversion from partnership status to corporate status, on the other hand, can be accomplished without gain or loss recognition. In general, no gain or loss is recognized to the partnership on the deemed transfer to the corporation under § 351 or on the distribution by the partnership of the stock to the partners under § 731. Similarly, conversion from disregarded entity status to corporate status also generally may be accomplished without gain or loss recognition under § 351.
Change in Number of Members - The final regulations also address the effect of a change in the number of members on the classification of an entity. Under the final regulations, if there is a change in the number of members of an association, the classification of the entity is not affected. If an eligible entity classified as a partnership subsequently has only one member (and is still treated as an entity under local law), the entity will be disregarded as a separate entity from its owner.If a single-member entity that is disregarded as an entity separate from its owner subsequently has more than one member, the entity is classified as a partnership as of the date the entity has more than one member. The classification provided in the final regulations can be changed by election, assuming that the entity is not subject to the 60-month limitation on elections.
Timing of Elective Changes in Classification - The final regulations provide that an election to change the classification of an entity is treated as occurring at the start of the day for which the election is effective. Any transactions that are deemed to occur as a result of the change in classification are treated as occurring immediately before the close of the day before the effective date of the election. For example, if an election is made to convert from an association to a partnership effective on January 1, the entity is treated as a partnership on January 1, and the deemed transactions specified in the final regulations are treated as occurring immediately before the close of December 31. As a result, the last day of the association's taxable year will be December 31 and the first day of the partnership's taxable year will be January 1.
Coordination With § 338. - To avoid any conflicts with § 338, special timing rules now apply. If a taxpayer elects to treat a stock purchase as an asset purchase, an election to convert the target corporation's classification cannot be effective before the day after the acquisition date of the target corporation. If elections for a series of tiered entities are effective on the same day, and no order is specified for these elections, any transactions deemed to occur as a result of the classification change will be treated as occurring first for the highest tier entity's classification change, then for the next highest tier entity's change and so forth, down the chain of entities.
Signature Rule - To ensure that taxpayers who recognize the tax consequences of a conversion election actually approve of that election, the election statement must be signed by every party who was an owner on the date of the deemed conversion transactions.
Employer Identification - When an entity's classification changes, the entity will retain its employer identification number (EIN). A disregarded entity must use its owner's taxpayer identification number (TIN) for federal tax purposes (not the EIN of the disregarded entity).
Furthermore, if and when a disregarded entity becomes respected as a separate entity from its owner, the entity must use its own EIN and not the TIN of the owner.