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LIMITED LIABILITY
COMPANIES:
II.
FULLY USING TAX ADVANTAGES
By: Richard
M. Colombik, JD, CPA &
Daniel A. Edelstein,
JD1
Richard M. Colombik
& Associates, P.C.
www.colombik.com
A.
Taxation as a Partnership or Corporation
- Default Classification
Rules
In
order to distinguish between taxation as a partnership or corporation,
a brief description of the default classification rules should be provided.
The classification rules will be discussed in greater detail at the
end of this presentation (see, infra, F. ?Check
the Box? Income Tax Regulations?). To begin with, an eligible
entity will be classified under the default rules if it does not elect
its desired entity classification. Unless the ?eligible
entity? elects otherwise, it will be classified as a disregarded entity
if it has a single owner or as a partnership if it has two or more members.2
An eligible entity having two or more members has the option of electing
classification as either an association or a partnership.3
A single member eligible entity can elect to be classified as a corporation
or as a disregarded entity separate from its owner.4
An entity electing to be disregarded will be treated as a sole proprietorship.
A
limited liability company (?LLC?) taxed as a partnership is more
limited in its choice of a taxable year than a C corporation, because
of the potential for the LLC?s members to obtain, in essence, varying
terms of interest-free loans from the federal government on the deferral
of their tax liabilities.5 The determination of a partnership?s
taxable year is made under one of three methods prescribed by Internal
Revenue Code (?Code?) §706(b)(1)(B) (with the second or third methods
only being employed if the first or second, respectively, are not applicable),6
unless a business purpose can be established under Code §706(b)(1)(C),
or an election under Code §444 is taken (and any payments required
by Code §7519 are made).
- First Method
Under Code §706(b)(1)(B)
The
taxable year of a partnership must be, under Code §706(b)(1)(B)(i),
that taxable year which begins on a day within ?. . . the taxable
year of 1 or more partners having (on such day) an aggregate interest
in partnership profits and capital of more than 50 percent.?7
In other words, a partnership, and a LLC taxed as a partnership, cannot
select a tax year for which the tax consequences of any items of income
or loss would be automatically deferred for the majority of the profits
and capital interest-holders.8
A
degree of relief is afforded from the complexities imposed by the determination
under Code §706(b)(1)(B)(i), especially in the case of partnerships
with many partners. If a change to a partnership?s taxable year
is required by that paragraph, then, unless another change is required
by regulations aimed at preventing the avoidance of Code §706, another
change will not in fact be required after the year of change for the
two succeeding taxable years.9
- Second Method
Under Code §706(b)(1)(B)
Should
the analysis of the partners taxable years under Code §706(b)(1)(B)(i)
not result in a taxable year for the partnership, its taxable year must
then be the same as the taxable year of all of its principal partners.10
A principal partner is defined, for purposes of Code §706(b), as ?.
. . a partner having an interest of 5 percent or more in partnership
profits or capital.?11
- Third Method
Under Code §706(b)(1)(B)
In
the event the analysis of the partners taxable years under Code §706(b)(1)(B)(ii)
does not result in a taxable year for the partnership, its taxable year
must then be the calendar year (unless otherwise prescribed by regulations).12
- Business Purpose
Under Code §706(b)(1)(C)
The
three methods described above, under Code §706(b)(1)(B), for determining
the taxable year of a partnership, need not be followed if the partnership
establishes a business purpose for a different taxable year.13
The deferral of the partners? income tax liabilities is not, however,
a business purpose here.14
- Elections Under
Code §444
A
LLC taxed as a partnership may elect, under Code §444, to have its
taxable year be different from its ?required taxable year,? which
means ?. . . the taxable year determined under section 706(b) . .
. without taking into account any taxable year which is allowable by
reason of business purposes.?15 In the case of taxable
years other than the LLC?s first taxable year beginning after December
31, 1986,16 the desired taxable year must have a ?deferral
period? no longer than three months.17 Such term
is defined (except as otherwise provided in regulations) as the length
of time between the beginning of the desired taxable year and the end
of the first required taxable year to end within the desired taxable
year.18
For
example, a multi-member LLC organized on July 1 of calendar year one
(which does not elect out of default classification as a partnership),
will, if the required taxable year of the LLC under Code §706(b) is
a calendar year, have a first required taxable year as a short year
ending on December 31 of calendar year one. Should the LLC, during
calendar year two, wish to elect a taxable year of April 1 of calendar
year two through March 31 of calendar year three, such election would
be prohibited by Code §444(b)(1) because there is a nearly eight-month
span between the beginning of the desired taxable year (April 1) and
the end of the first required taxable year to end within such desired
taxable year (December 31).19
B.
Tax Advantages Over Other Entities
- Equity-Based
Compensation for Members
Equity
based compensation is used by many corporate employers to motivate their
employees. A LLC can transfer an interest to an employee or existing
member in the form of a capital and profits interest, a capital interest
or a profits interest, or as an option to acquire either a capital or
profits interest or both. This type of transfer may be treated
as an ordinary income distribution of property, but in some cases it
may be treated as a nontaxable distribution of unit interests.
- Options to Acquire
LLC Interests
LLCs
can issue nonqualified options to purchase LLC units. The grant
of an option to purchase LLC units to either an existing member or an
employee does not have a taxable consequence for the LLC. It would
be treated as a guaranteed payment. The difference between the
fair market value of the option and the strike price would be a "payment"
in the year received or the year the restriction lapses. This
creates a deduction for the LLC and income to the LLC member.
- Changes in Income
Interests
Any
change in income interests is recognized in the year the partner recognizes
his distributive share of the partnership profits. The amount
recognized shows the change in the income interests.
- Changes
in Capital Interests
The
acceptance by a partner of an additional capital interest in the partnership
may be treated as an income event or the receipt of a gift from another
partner, or be classified in accordance with its economic consequences.
- Partnership
Distributions
Cash
or property distributions received by a partner from a partnership will
reduce the partner's basis in his interest. Unless the cash distribution
is in excess of the basis, it will usually not be a taxable event to
the partner or the partnership. Property distributed to a partner
takes the same basis and holding period it had in the partnership.
Cash distributions will reduce the partner's basis in his interest dollar
for dollar.20 Gain is recognized by the distributee
partner only if the cash received exceeds his basis in his interest
before the distribution.21 Gain recognized is taxed as gain
from the sale or exchange of a partnership interest.22
Distributions of non-cash property will reduce the partner's basis in
the partnership interest to the extent of the adjusted basis of the
property in the hands of the partnership.23
- Non-Liquidating
Distributions
A
partner does not recognize loss in a non-liquidating distribution.24
A partner also does not recognize gain as a result of a non-liquidating
distribution, unless the amount of cash is greater than the partner's
outside basis.25 Cash distributed up to the amount
of the basis represents amounts the partner has already accounted for
under the income tax system. Only cash distributions in excess of outside
basis represent income for the partner.
A
partner does not recognize gain with respect to property distributions
in a non-liquidating distribution. The partner's previously unrecognized
gain or loss in the partnership interest is preserved by allocating
the adjusted basis to the distributed property and making a reduction
to the partner's basis. The basis of the distributed property in the
partner's hands is the same as the basis of the property in the partnership's
hands. But it cannot be greater than the partner's adjusted basis
in the partnership.26
Because
the goal is to preserve the partner's tax position in regard to the
partnership investment in a non-liquidating property distribution, the
partner's basis is reduced by the amount of money distributed, and the
adjusted basis of the distributed noncash property.27
The partner is treated as having converted a single asset, a partnership
interest, into multiple assets, the partnership interest, the distributed
property and the distributed money, and the partner's basis is divided
among these assets.
- Tax-Qualified
Retirement Plans
Much
of the planning concerning the use of and choice between different taxable
entities has evolved from the historic differences between the treatment
of employees (of incorporated entities) and self-employed individuals
(providing services for unincorporated entities) for purposes of tax
qualified retirement plans.28 Though unincorporated
entities, if they are for-profit employers, can select from any type
of employee benefit plan,29 H.R. 10 or "Keogh"
plans are the income deferral arrangements most commonly used by self-employed
individuals and unincorporated entities.30
However,
the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) made modifications
that included "top heavy plan" limitations, along with eliminating
some of the more restrictive aspects of H.R. 10 plans or extending them
to corporate plans as well. As a result, tax qualified retirement
plan choices are now a more neutral factor in the decision concerning
the choice of entity.31 However, the laws governing
employee benefit plans of unincorporated entities remain more restrictive
than those applicable to corporate plans.32 One example
of such restrictions is the annual limits on contributions, in regard
to an employee?s compensation, and on deductions available to an employer.
Code
§415(c) limits the amount of compensation which may be contributed
annually to qualified defined contribution plans.33
For both incorporated and unincorporated entities, the annual limit
for each plan participant under this Section is the lesser of one hundred
percent of such participant?s compensation, or $40,000.34
Yet the participant?s compensation, if he or she is a ?self-employed
individual? (meaning, in general, an individual with net self-employment
earnings, pursuant to Code §§401(c)(1)(B) and (c)(2)(A)), but not
otherwise, will be decreased by the deductions the employer is permitted
to take under Code §404.35 Thus, the limit on annual
deductions by the employer, if an unincorporated entity, will also be
less than the corresponding limit for an incorporated entity.36
- Qualified Domestic
Production Activities Deduction
In
order to assist domestic businesses in competing with outside market
forces, the American Jobs Creation Act of 2004 contained a new deduction
for income associated with qualified domestic production. The
broad definition of domestic production under this new law, Code §199,
has the potential to benefit nearly all business operating in the country.
Code §199 places several limitations on the deduction. One of
these limits, which deserves more attention here, is the limit of the
deduction to the wages paid by the business to its employees, and this
limitation has been criticized for its potential to unfairly impact
small businesses.37 More specifically, the amount of the
deduction under Code §199 can be no more than fifty percent of a business?
W-2 wages38 (which is the sum of the wages and deferred compensation
of the business? employees).39
The
wage limitation on the Code §199 deduction may have a lesser affect
in the case of partnerships, and LLCs taxed as partnerships, due to
the pass-through nature of partnerships. Code §199 explicitly
requires that it be applied at the partner level.40
Items of gross receipts, or costs or expenses, which must be allocated
to a partner from the partnership, if engaged in a trade or business,
will be considered in determining the Code §199 deduction.41
However, the partner cannot take into account all of the partnership?s
W-2 wages in evaluating the effect of the Code §199(b) wage limitation,
but instead, is limited to the partner?s allocable share of such wages.42
C.
Election Out of Partnership Status
Corporation
or Partnership Elects to Be Disregarded Entity
When
a corporation elects to be a disregarded entity, the corporation is
deemed to have liquidated by distributing its assets and liabilities
to its sole owner.43 If an LLC classified as a partnership
becomes a single-member LLC, the partnership status terminates.
The
Internal Revenue Service (?IRS?) issued guidance in Revenue Ruling
(?Rev. Rul.?) 99-644 on an LLC classified as a partnership
that becomes a single member LLC. The IRS ruled that Code §708(b)(1)(A)
states that the LLC's partnership status will terminate because the
operations of the partnership are no longer carried on by any of its
partners as a partnership. If no election is made to treat the
LLC as a corporation for federal tax purposes, the LLC then becomes
a disregarded entity.
D.
Flexibility in Allocations
- General Compensation
Issues
The
payment to a partner for services or the use of capital that is determined
without regard to the income of a partnership is classified as a guaranteed
payment and generally is treated as a non-partnership transaction.45
The partner includes the payments in income using the same standards
as a non-partner.46 The partnership may be permitted
to deduct the guaranteed payment.47 The guaranteed
payment is treated as an ordinary partnership transaction.
On
the other hand, the use of LLC interests to compensate LLC employees
may result in the employees being treated as members of the LLC rather
than as employees for federal tax purposes. There is a difference
in the treatment of compensation paid to an employee and compensation
paid to a LLC member.
Code
§707(a) states that if a partner engages in a transaction with a partnership
other than in his capacity as a member of such partnership, the transaction
will be considered as occurring between the partnership and one who
is not a partner. It is possible an LLC member could be classified
as an employee if he provided services and there was a related allocation
or distribution to him.
If
payments are made to a partner for services, without regard to partnership
income, under Code §707(c) the partnership deducts such amounts and
the partner has ordinary income.
Compensation
to a member must be analyzed to determine the relationship between the
member and the LLC for tax purposes. The following five factors
must be considered:
Whether
the payment is subject to entrepreneurial risk. An employer-employee
relationship would be supported by a lack of entrepreneurial risk.
Whether
the recipient's interest in the partnership is small in relation to
the payment or allocation in question.
- Deferred Compensation
Arrangements
A
nonqualified deferred compensation plan is a contractual arrangement
between employer and employee providing for the deferred payment of
compensation in the future. An effective deferral requires avoiding
constructive receipt.
An
LLC member's distributive share of the LLC's income and losses cannot
be "deferred."48 These items pass through
to the LLC member under Code §702 and are taxable. Special allocations
can be made in the LLC operating agreement to allocate certain items
away from specific LLC members if the other partners agree.
It
is possible to set up a nonqualified arrangement to defer the guaranteed
payments the LLC member is to receive under Code §707(c). Treasury
Regulations (?Regulations,? or ?Reg.?) §1.707-1(c) states these
payments will be ordinary income that is taxable to the member.
Because of the deferred compensation arrangement between the LLC and
the member, the LLC may control when the payment is made. The deferred
amounts will increase the distributable income of the LLC members based
on the LLC agreement to allocate income. Because the member receiving
the guaranteed payments cannot defer his allocable share of LLC income,
a portion of the deferred income will flow through to him in the year
of deferral.
- Partnership Unit
Distributions
A partnership or limited liability
company treated as a partnership may distribute ownership units to its
partners.
- The partnership
may reallocate the ownership percentages between the partners because
of new partners, the retirement of partners, or an agreement between
the partners to alter their interests.
- When the partnership
has multiple levels of partnership interests, the partners at one level
may receive additional interests and the partners at another level may
not receive any additional interests, which will cause a reduction of
the latter group?s percentage interests in the partnership.
- Some partners may
receive interests in the same partnership tier and other partners may
receive interests in a higher or lower tier. The income tax results
will be dependent on whether the partnership interests being adjusted
are income interests or capital interests.
- Character and
Holding Period of Distributed Property
When
property is distributed by a partnership to a partner, its character
is determined under the Code?s general principles of characterization.49
A limited set of principles serves to prevent the conversion of ordinary
income into capital gain. First, unrealized receivables distributed
to a partner are permanently classified as ordinary assets, and any
gain or loss recognized from their disposition is treated as ordinary
gain or loss.50 Second, inventory items distributed
to a partner are subject to mandatory classification as ordinary assets
for the first five years after distribution. If a partner disposes
of the inventory during the five-year period following the distribution,
any gain or loss must be classified as ordinary gain or loss.51
After that five-year period, the gain is classified according to the
general characterization rules. A partner's holding period for distributed
property includes the partnership's holding period for that property.52
- Disproportionate
Distributions
The
"hot asset" rules limit the taxpayers' ability to route capital
gain and ordinary income selectively among the partners.53
The term "hot assets" refers to unrealized receivables, and
substantially appreciated inventory items.54 Inventory
is "substantially appreciated" if its fair market value is
at least 120% of its basis.55
The
?hot asset? rules apply to any disproportionate distribution of
property that alters a partner's share in the partnership's ?hot assets?.
This can be accomplished by a disproportionate distribution of the ?hot
assets? themselves or a disproportionate distribution of other assets.
The partner is treated as though he has received a proportional share
of each partnership asset, to which the basic distribution rules apply,
and then engaged in a taxable exchange with the partnership in which
he exchanged a fractional interest in the assets received for a fractional
interest in the assets the partnership retained.56
This is accomplished in a four-step process:57
- Identification of
the assets for which the hypothetical exchange occurs;
- A deemed distribution
to the partner of the assets in which the partner's proportionate share
is reduced, but only to the extent of the reduced share of those assets;
- A deemed taxable
exchange in which the partner is deemed to transfer back the assets
deemed received in exchange for assets in which the partner's interest
is increased, but only to the extent of the increased share of those
assets; and
- The distribution
of the partner's pro-rata share of the partnership's assets which is
treated as an ordinary distribution.
These
?hot asset? rules also apply if the distribution is a liquidation
of the distributee partner's complete interest, but only to the extent
that he either receives ?hot assets? in exchange for his interest
in other property, or he receives other property in exchange for his
interest in the ?hot assets?58
- Dispositions
of Partnership Interests
The
general rule is that the sale or exchange of a partnership interest
is treated as the taxable sale of a single asset.59
The normal rule is the gain is the excess of the amount realized over
the selling partner's outside basis.60 The partnership interest
is classified as a capital asset, which makes the gain or loss recognized
as capital gain or loss.61
This
is then modified in two respects. First, a portion of the sales
price is allocated to the selling partner's share of the partnership's
unrealized receivables and inventory, converting a portion of the capital
gain or loss into ordinary income or loss. Second, an adjustment
is made to the partnership's inside basis in its assets to reflect the
gain or loss recognized by the disposition of the partnership interest.
- Ordinary
Income for "Hot Assets"
A
portion of the sales price for a partnership interest reflects the value
of the selling partner's share in the partnership's unrealized receivables
and inventory. If the partnership recognizes income with respect to
these items, it is ordinary income, a portion of which is allocated
to the selling partner. The Code §751 "hot asset" rule
ensures that a partner who accesses this value by selling his partnership
interest does not convert ordinary income into capital gain.62
This
is very much like the ?hot asset? rule that applies to disproportionate
distributions of property, but with two significant differences.
First, in the disproportionate distribution the rule applies only to
inventory items that have substantially appreciated in value, but in
the sale of partnership interests, the rule applies to all inventory
items.63 Unrealized receivables are subject to the
?hot asset? rule in both cases.64
Second,
the application of the ?hot asset? rule is simpler in the disposition
of a partnership interest. Its implementation requires a four-step
procedure:65
- The partner calculates
gain or loss as though the sale of the partnership interest were the
sale of a single asset;
- The partner calculates
the amount of gain or loss the partnership would recognize if it disposed
of all of its unrealized receivables and inventory at their fair market
values;
- The partner determines
how much of the hypothetical gain or loss calculated in Step ii. would
be allocated to the partner, and treats that amount as ordinary income
or loss; and
- The partner subtracts
the amount determined in Step iii. from the amount determined in Step
i. The result is the capital gain or loss from the sale of the
partnership interest.
It
is possible to generate ordinary income in a transaction that generates
an overall loss, which would make the capital loss amount greater than
the overall loss.
The
?hot assets? may generate an ordinary loss in a transaction that
generates an overall gain, thereby making the capital gain amount greater
than the overall gain.
E.
How Self-Employment Taxes Are Covered
An
individual is subject to either social security tax as an employee,
or self-employment tax as an equivalent to the social security tax.
The employer is required to match the social security contribution of
the employee. The self-employed person is required to pay the
full cost of this tax.
Sole
proprietors, members of a partnership and members of a limited liability
company treated as a partnership are subject to the self-employment
tax. The distributive share of partnership income is included
in a partner?s net earnings from self-employment. A limited
partner does not include the distributive share of partnership income
or loss from self-employment income. Unless a limited partner?s
distributive share of income or loss from the self-employment income
is received as guaranteed payments, it will not be included in his self-employment
income.66
It
is not clear how self-employment taxes apply to members of an LLC classified
as a partnership. The members are not either general partners
or limited partners. There are proposed regulations defining which
partners of a federal tax partnership are considered limited partners.
These regulations apply to all entities that are classified as partnerships
for federal tax purposes.
"Net
earnings from self-employment" includes the gross income derived
from any trade or business carried on by a sole proprietor or partner
in a partnership, less any deductions. Code §1402(a). Any partner's
share of income or loss from any trade or business carried on by a partnership
is also considered as net earnings from self-employment.
There
are exceptions to what must be included in self-employment earnings.
Some of the exceptions are:
- Rentals from real
and personal property (Code §1402(a)(1));
- Interest and dividends
(Code §1402(a)(2));
- Gains or losses
from sales or exchanges of capital assets (Code §1402(a)(3));
- Distributive share
of a limited partner (Code §1402(a)(13)); and
- Partnership retirement
benefits (Code §1402(a)(10)).
- Limited
Partners Not Subject to Self-Employment Tax
A
limited partner's distributive share of income or loss is excluded from
self-employment net earnings. A limited partner's guaranteed payments
in exchange for services are subject to the self-employment tax.67
When a partner is a general and a limited partner, only the general
partnership income and loss is subject to self-employment tax.68
- Is
the LLC Member a General or Limited Partner?
Proposed
regulations define which partners are considered limited partners for
purposes of Code §1402(a)(13). They are to apply to all entities
classified as a partnership for federal tax purposes.69
The same standards will apply when determining the status of an individual
owning an interest in an LLC. The proposed regulations will adopt
an approach that depends on the relationship between the partner, the
partnership and the partnership's business.70
The
proposed regulations will treat an individual as a limited partner unless
the individual: has personal liability for the debts of, or claims
against, the partnership because he is a partner; has authority to contract
on behalf of the partnership; or participates in the partnership's
trade or business for more than 500 hours during the year.71
If substantially all of the activities of a partnership involve the
performance of services in the fields of health, law, engineering, architecture,
accounting, actuarial science or consulting, the proposed regulations
state an individual will not be considered a limited partner.72
An
individual who is not a limited partner is allowed to exclude from his
net earnings from self-employment a portion of his distributive share
if he holds more than one class of interest in the partnership.73
The
Taxpayer Relief Act of 1997 added a provision that prevented the IRS
from finalizing these regulations until July 1, 1998.74
To date these regulations have not been finalized by the IRS.
- Limited
Liability Companies, Limited Liability Partnerships and Other "New"
Entities
The exclusion for limited partners
was incorporated into the statute at a time when there essentially were
only two types of partnerships, the general partnership and the limited
partnership. With the advent of limited liability companies, limited
liability partnerships and other types of entities that are being treated
as partnerships for federal tax purposes, a great amount of confusion
has arisen as to what type of partners may exclude their distributive
share of income or loss in determining net earnings from self-employment.
The first case to consider is Johnson
v. Comr.75 This case involved the determination as to
whether the taxpayer's net income from oil and gas working interests
should be taxed as net earnings from self-employment. The taxpayer
argued that she was not involved in a trade or business and her role
was passive participation. The Tax Court held her involvement
in a trade or business to be irrelevant since she was a partner in a
partnership. The taxpayer also argued that if she is a partner,
she should be considered a limited partner due to her limited involvement.
The court rejected her argument stating "limited partnerships are
creatures of agreement cast in the form prescribed by State law . .
. Petitioner's argument is not persuasive because she and the other
working interest owners did not take the necessary steps to comply with
Texas law.?76
The
partnership in Mammoth Lakes Project, et al. v. Comr. was a general
partnership. These taxpayers argued they were entitled to include
their share of net losses from the partnership in calculating their
net earnings from self-employment. The government argued that there
was limited liability and they did not participate in the management
of the partnership. The court considered the government's argument to
be a "superficially correct argument." Because the taxpayer
did not address that argument, the court considered the taxpayer to
have conceded the issue.
The Tax Court in Perry v. Comr77
ruled on the status of a person holding a working interest in an oil
and gas venture. The court rejected the taxpayer's argument that
he should be treated as a limited partner. The court stated, "[s]tate
law requires that certain formalities be observed to create a limited
partnership . . . There is no evidence of such formalities having been
observed by the owners of interests in the wells.?78
The
status of a passive state law general partner for Self-Employment Contributions
Act (?SECA?) tax purposes was ruled on by the Tax Court in Norwood
v. Comr.79 The taxpayer previously
had been an active partner in a medical supply partnership. He
had reduced his hours to only forty-one. He still held a 50.95%
capital and profits interest in the partnership. He argued his
interest in the partnership was passive and he should not be subject
to SECA tax on his partnership income. The court rejected this
argument. The court stated, "[t]hat petitioner spent a minimal
amount of time engaged in the operations of [the partnership] is irrelevant
. . . Petitioner's lack of participation in or control over the operations
of [the partnership] does not turn his general partnership interest
into a limited partnership interest. A limited partnership must
be created in the form prescribed by State law."80
- Structures For Avoiding SECA Tax
- S
Corporation Leases Worker to Partnership
A member forms an S corporation to
hold his or her interest in an LLC. The S corporation
would then employ the individual and lease him to the LLC. Because
the S corporation is not an individual, there is no SECA tax due with
respect to the S corporation's distributive share of the LLC's income
or the lease payments made for the individual's services. Employment
taxes are due on the individual's salary paid by the S corporation,
but the individual generally will take income from the S corporation
in part as salary and in part as a distribution. The distribution
of S corporation income is not subject to SECA or employment tax.
- Segregate
Service and Capital Intensive Portions of Business into Two Separate
Entities
F.
?Check the Box? Income Tax Regulations
Effective
January 1, 1997, the IRS issued final regulations that implemented the
entity classification system. These "Check-the-Box"
rules allow unincorporated organizations to elect to be treated as either
corporations or partnerships for federal income tax purposes.
Certain business entities that are excluded from these rules are corporations
organized under state statutes, foreign entities that resemble U.S.
corporations, entities taxable as corporations under special Code provisions,
and trusts.81
An
entity that does not elect a particular classification is classified
under the default rules that state, for federal tax purposes, non-corporate
domestic organizations with more than one member are treated as partnerships,
and single-member domestic entities are disregarded.
There
are three steps that must be performed in order to determine if an organization
qualifies to choose its entity.
- Identifying
Separate Entities
It
must first be determined if the organization at issue is a separate
entity. The ?business entity? concept is the basis of the
?Check-the-Box? rules. The federal tax law determines if the
entity is separate from its owners for federal tax purposes and does
not depend on the organization being recognized as a separate entity
under local law.82
"Business entity" is defined by the Regulations as any entity
recognized for federal tax purposes that is not classified as a trust
or subject to special treatment under the Code.83
- Single-Owner
Organizations
A disregarded entity is a business
entity that is not a corporation, has a single owner, and is disregarded
as an entity separate from its owner.84 The Check-the-Box
Regulations allow a single owner to elect to be disregarded as an entity
separate from its owner. The disregarded entity may retain its
entity status for state law purposes, but is disregarded for federal
tax purposes.
- Community Property
Entity
The IRS has stated that it will respect
the taxpayers? choice of the entity as either a disregarded entity
or as a partnership, in the case of a qualified entity owned exclusively
by a husband and wife as community property. This qualified entity
is a business entity entirely owned by a husband and wife as community
property under the law of a state, is not treated as a corporation,
and is one in which no other person would be considered an owner for
tax purposes.85
- A business entity
organized under a federal or state statute, or under a statute of a
federally-recognized Indian tribe, if the statute describes or refers
to the entity as incorporated or as a corporation, body corporate or
body politic;
- A business entity
organized under a state statute, if the statute describes or refers
to the entity as a joint-stock company or joint-stock association;88
- A state-chartered
business entity conducting banking activities, if any of its deposits
are insured under the Federal Deposit Insurance Act or a similar federal
statute;90
- A business entity
wholly owned by a state or any political subdivision thereof;
- A business entity
that is taxable as a corporation under a provision of the Code other
than Code §7701(a)(3); or
- A business entity
formed in one of numerous designated foreign jurisdictions.
- Eligible
Entities
The second step is to determine whether
the entity in question qualifies as an "eligible entity."
Only an "eligible entity" may elect the federal tax classification
it wishes. The definition of an "eligible entity" is
a business entity that is not classified as a corporation under Regs.
§§301.7701-2(b)(1), (3), (4), (5), (6), (7) or (8).
There are only two situations that
require an eligible entity to file a classification election.91
The first situation is if the entity wishes to be classified differently
than it would be under the default rules. The second situation
is if the entity wishes to change its classification.
In order to make a classification election,
an eligible entity must file Form 8832, Entity Classification Election.92
A copy of Form 8832 must be attached to the federal tax or information
return of the entity for the taxable year for which an election is made.93
Where an entity is not required to file a return for the year an election
is made, a copy of the Form 8832 must be attached to the federal income
tax or information return of all direct or indirect owners of the entity
for the taxable year of the owner that includes the date on which the
election was effective.94 Failing to attach a copy
of a Form 8832 to the return will not invalidate the election.
An election must be signed by either
(i) each member of the electing entity who is an owner at the time the
election is filed, or (ii) an officer, manager or member of the electing
entity who is authorized to make the election.95
An entity that has an employer identification
number (?EIN?) will keep its EIN even if the entity's federal tax
classification changes under Regs. §301.7701-3.96
A single owner disregarded entity must use the owner's taxpayer's identifying
number (?TIN?) for federal tax purposes,97 except when
the entity chooses to have employment taxes, as opposed to other federal
tax obligations, reported and paid with respect to its employees at
the entity level rather than the owner level, in which case the entity
must use its EIN with respect to such employment tax obligations.98
With respect to wages paid on or after January 1, 2009, however, a single
owner disregarded entity will automatically be treated as a corporation
for purposes of its employment taxes and required to use its EIN with
respect to such employment tax obligations.99 When
a single owner entity's classification changes and becomes recognized
as a separate entity for federal tax purposes, that entity must use
the EIN, not the TIN of the single owner.
- Restriction on
Classification Changes
Only an election to change classification
will begin a sixty-month waiting period. If a new eligible entity
elects out of its default classification effective from the beginning,
that election is not a change in the entity's classification and does
not prevent the entity from changing its classification by election
within the next sixty months.
- Potential Tax
Impact on Changing Classification
- Corporation Status
Elected
- Election
by Disregarded Entity to Be a Corporation
- Changing
from Corporation to Partnership Status
References
1Nearly
all of this presentation is drawn from and based on materials previously
prepared by Richard M. Colombik, JD, CPA & Linda Godfrey, JD, CPA.
2Treasury
Regulations (?Regs.?) §301.7701-3(b)(1).
3Regs.
§301.7701-3(a).
4Id.
5Starr,
Case, Garre-Lohnes, Rosenberg, Schmalz, 725-2nd T.M., Limited Liability
Companies, I.B.10.
6Internal
Revenue Code (?Code?) §§706(b)(1)(B)(i), (ii), (iii).
7Code
§§706(b)(1)(B)(i), (4)(A), (4)(A)(i), (4)(A)(ii), (4)(A)(ii)(I).
8Id.
9Code
§706(b)(4)(B).
10Code
§706(b)(1)(B)(ii).
11Code
§706(b)(3).
12Code
§706(b)(1)(B)(iii).
13Code
§706(b)(1)(C).
14Id.
15Code
§444(a), (e).
16See
Code §444(b)(3).
17Code
§444(b)(1).
18Code
§§444(b)(4), (b)(4)(A), (b)(4)(B).
19Code
§444(b)(1).
20Code
§733.
21Code
§731.
22See
Code §751(b).
23Code
§§732, 733.
24Code
§731(a)(2).
25Code
§731(a)(1).
26Code
§732(a).
27Code
§733.
28Bosley
and Hutzelman, 353-3rd T.M., Employee Benefits for Small and Mid-Sized
Employers (?Bosley and Hutzelman?), III.D.
29Id.,
II.C.
30Id.,
III.D.
31Id.,
III.D.2.
32Id.,
III.D.3.
33Code
§§415(a)(1), (a)(1)(B).
34Code
§§415(c)(1), (c)(1)(A), (c)(1)(B).
35Code
§§415(c)(3)(A) and (c)(3)(B), 401(c)(2)(A)(v); Bosley and Hutzelman,
III.D.3.a.
36Bosley
and Hutzelman, III.D.3.b.
37Benko
and Glover, 510 T.M., Section 199: Deduction Relating to Income
Attributable to Domestic Production Activities (?Benko and Glover?),
II.C.1.
38Code
§199(b)(1).
39Code
§§199(b)(2)(A), 6051(a)(3) and (8).
40Code
§199(d)(1)(A)(i).
41Regs.
§1.199-8(c)(2).
42Code
§199(d)(1)(A)(iii).
43Regs.
§301.7701-3(g)(1)(iii).
441999-6
I.R.B. 6.
45Code
§707(c).
46Code
§61.
47Code
§707(c). See Code §§263, 263A.
48410
U.S. 441 (1973).
49Code
§1221.
50Code
§735(a)(1).
51Code
§735(a)(2).
52Code
§735(b).
53Code
§751.
54Code
§751(b)(1).
55Code
§751(b)(3)(A).
56Code
§751(b)(1).
57Regs.
§1.751-1(b).
58Regs.
§1.751-1(b)(1)(i).
59Code
§741.
60Code
§1001.
61Code
§741.
62Code
§751(a).
63Code
§751(b)(1)(A)(ii).
64Code
§§751(a)(1), (b)(1)(A)(i).
65Regs.
§1.751-1(a).
66Code
§1402(a)(13).
67Id.
68Proposed
Regulations (?Prop. Regs.?) §1.1402(a)-2(h).
69Preamble
to REG-209824-96, 62 Fed. Reg. 1702 (1/13/97).
70Prop.
Regs. §1.1402(a)-2(g).
71Prop.
Regs. §1.1402(a)-2(h)(2).
72Prop.
Regs. §1.1402(a)-2(h)(5).
73Prop.
Regs. §1.1402(a)-2(h)(3).
74P.L.
105-34, §935.
7560
T.C.M. 603 (1990).
76Id.
7767 T.C.M. 2966 (1994).
78Id.
7979
T.C.M. 1642 (2000).
80Id.
81Regs.
§ 301.7701-2(b).
82Regs.
§ 301.7701-1(a)(1); Regs. §301.7701-1(a)(3).
83Regs.
§301.7701-2(a).
84Regs.
§301.7701-2(c)(2).
85Revenue
Procedure 2002-69, 2002-45 I.R.B. 831.
86Regs.
§301.7701-2(c)(1).
87Regs.
§301.7701-2(b).
88Regs.
§301.7701-2(b)(3).
89Regs.
§301.7701-2(b)(4).
90Regs.
§301.7701-2(b)(5).
91Regs.
§301.7701-3(c)(1)(i).
92Id.
93Regs.
§301.7701-3(c)(1)(ii).
94Id.
95Regs.
§301.7701-3(c)(2)(i).
96Regs.
§301.6109-1(h)(1).
97Regs.
§301.6109-1(h)(2)(i).
98Revenue
Ruling 2001-61, 2001-50 I.R.B. 573.
992007-39
I.R.B. 675; Regs. §§301.7701-2(c)(2)(iv), (e)(5).
100Regs.
§301.7701-3(c)(1)(iii).
101Regs.
§301.7701-3(c)(1)(iv).
102Regs.
§301.7701-3(g)(1)(i).
103Regs.
§301.7701-3(g)(1)(iv).
104Regs.
§301.7701-3(g)(1)(ii).
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