by John C. Murray

© 2000. All rights reserved.

On December 18, 1996, the Internal Revenue Service ("IRS") issued final regulations in the Federal Register (61 Fed. Reg. 66584 et seq.) that will affect the planning for every form of business organization. The new regulations, which are effective as of January 1, 1997, automatically characterize every new domestic business entity with at least two members that is not required to be treated as a corporation for federal tax purposes under Section 303.7701-2(b) (1), (3), (4), (5), (6), (7), or (8) of the Treasury Regulations (an "eligible entity") as a partnership for federal income tax purposes, unless the eligible entity elects to be treated as a corporation. The new regulations clarify which organizations are classified automatically as corporations under the Internal Revenue Code, and provide other forms of business organizations with a simplified method of electing a classification. (Note: Special rules apply to certain foreign entities; a discussion of these special rules is beyond the scope of this article.)

Under the prior IRS regulations, an eligible entity had to satisfy a complicated six-factor test to be considered a partnership for taxation purposes; if the organization failed to satisfy the test results it would be classified as a corporation. The new regulations eliminate these factors as a basis for classification. Taxation as a partnership, as opposed to a corporation, is preferable to many business organizations because of the "pass through" tax advantages of a partnership, i.e., the tax benefits and liabilities flow directly to the owners; there is no double taxation, at both the entity level and the ownership level, as there would be with a corporation.

The new rules provide that any eligible entity may elect to be classified as either a partnership or an association (i.e., a corporation). However, an eligible entity with only a single member or owner that is not required to be classified as a corporation may only elect to be classified as an association or to have the business entity disregarded as an entity separate from its owner, in which case the entity would be treated for federal tax purposes as if it were a sole proprietorship, branch, or division of the organization's owner. The final regulations would therefore permit an individual or corporation to obtain the limited-liability advantage of a corporation, along with the single-level "pass through" tax advantage of a partnership, by forming a single-member limited liability company ("LLC") in a state such as Delaware, whose LLC statute (unlike the LLC statutes in almost all other states, including Illinois) permits the formation of a single-member LLC. If a domestic LLC with a single individual owner is disregarded as an entity separate from its owner, its individual owner is subject to federal income tax as if the company's business was operated as a sole proprietorship. The conversion of a partnership to an LLC is not considered a change of classification by the IRS and is treated as a continuation of the original entity with no federal tax consequences. Rev. Rul. 95-37. As a result of the issuance of the final regulations, the various state LLC statutes may have to be amended to remove the provisions that provide for "drafting around" the corporate tax characteristics formerly enumerated in Section 301.7701-2(a)(3) of the Treasury Regulations. (Section 301.7701-2(a)(3) provided that an "unincorporated organization shall not be classified as an association unless such organization has more corporate characteristics than non-corporate characteristics." Under Section 301.7701-2(a)(3), an LLC had to lack at least two of the following four corporate characteristics: (1) limited liability (which always exists in connection with an LLC); (2) continuity of life; (3) free transferability of interests; and (4) centralized management.) State LLC statutes (most of which do not permit single-member LLCs) may also need to be further amended to specifically permit the formation of a single-member LLC, which will be recognized by the IRS as a sole proprietorship. See William D. Bagley, "The IRS Steps Back - Entity Classification Rules Are Relaxed," Business Law Today, Business Law Section, American Bar Association, January/February 1997, p. 41.

Notwithstanding the federal tax benefits available to LLCs (and other eligible entities) as the result of the issuance of the final regulations, certain states, such as California and Texas, have indicated that they will not follow the new IRS regulations and will continue to tax LLCs and other eligible entities as corporations if too many "corporate characteristics" apply. Also, there may be an issue with respect to out-of-state LLCs and other eligible entities that do business in such states, i.e., an allocable share of their income may still be taxed at corporate rates. For these reasons, and until and unless state LLC statutes are amended to take account of the new IRS regulations, drafters of organizational documents for LLCs (and other eligible entities) may still need to take into account the "corporate characteristics" referred to above.

The new regulations apply to all business entities regardless of when they were originally formed. Eligible entities already in existence that choose to retain their current classification are not required to file an election and automatically retain the classification that existed prior to the effective date of the regulations, with the exception that an entity with a single owner that claimed to be a partnership under the prior regulations would be disregarded as an entity separate from its owner.

An eligible entity that existed before the effective date of the final regulations that does not wish to retain its current classification may change its classification by filing a completed Form 8832, "Entity Classification Election," with the appropriate IRS Service Center designated on Form 8832. Such an election is effective on the date specified in the Form 8832 if that date is not more than 75 days prior to the date on which the election is filed and not more than 12 months after the dated the election was filed, provided that no election will be effective before January 1, 1997. If the completed Form 8832 specifies an effective date that is more than 75 days prior to the filing date of the election, it will be effective 75 days prior to such filing date; if it specifies an effective date that is later than 12 months after the filing date, it will be effective 12 months after the filing date. If no effective date is specified in the Form 8832, the date of the filing will be deemed to be the effective date. The election must be signed by each member of the entity (which, in the case of a general partnership or a member-managed LLC, would include every member) or any officer, manager, member (which, in the case of a limited partnership, would include the authorized general partner or partners and in the case of a manager-managed LLC, would include the manager, or if there is more than one manager, the properly authorized manager or managers) or owner who is authorized under the applicable organizational documents and local law to make the election and who represents, under penalty of perjury, to having such authorization.

All information requested by Form 8832 and its instructions, including the entity's taxpayer identification number, must be provided on the form as submitted to the IRS or the election will not be accepted. An eligible entity that is required to file a tax return for the taxable year for which an election is made must attach a copy of its completed Form 8832 to its federal or tax information return for that year; if the entity is not required to file a tax return for that year, a copy of the completed form must be attached to the federal income or tax or information return of any direct or indirect owner of the entity for such taxable year. If an entity, or one of the direct or indirect owners of the entity, fails to attach a copy of its completed Form 8832 to its return, an otherwise valid election will not be invalidated, but the party who has failed to attach a copy of the form may be subject to penalties. An organization that makes such an election cannot again elect to change its classification for a period of five years after the effective date of the election, provided however that an existing entity that elects to change its current classification as of the effective date of the final regulations may elect to again change its classification within the first five-year period following the effective date, and further provided that a new eligible entity that, upon formation, elects out of its "default" classification under the new regulations, or an eligible entity that transfers the business of the organization to another entity, is not considered to have made a "change" in its classification that would invoke the five-year non-reclassification rule.

Any change in an eligible entity's classification, no matter how accomplished under the final rules, may nonetheless have certain other tax consequences; for example, an organization that was classified as an association and then elects to be classified as a partnership under the new regulations would be required to recognize gain (as well as gain on the part of any of the owners of the organization), if any, under the rules applicable to the liquidation of a corporation.

The final regulations reflect the continuing tendency of the IRS, as evidenced by the issuance of several revenue rulings and procedures during the past several years, to avoid "bright line" rules in determining the taxation of business entities as partnerships, and strongly support (to the delight of the business community) the classification of such entities as partnerships rather than associations for tax purposes.

Anyone seeking to take advantage of the final regulations in connection with the formation of a new business entity or a proposed change in the tax classification of an existing business organization, should consult their attorney, accountant or other tax or financial adviser.