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IRS Proposes a Major Simplification of Entity Classification Rules

By William D. Bagley

Attorney at Law

Cheyenne, WY 82001

wdbagley@llc-reporter.com

On May 13, 1996, the Internal Revenue Service published its long anticipated "Notice of Proposed Rulemaking and Hearing on Simplification of Entity Classification Rules". This simple but innovative proposal seeks to replace existing complex entity classification regulations "with an elective regime" first introduced by the Service April 3, 1995, in its Notice 95-14, which addressed classification of business organizations for federal tax treatment under Section 7701 of the Regulations (26 CFR part 301).

Under the new proposed regulations an "eligible" unincorporated entity, such as a limited liability company ("LLC") would simply be allowed to "check the box" to indicate whether it would prefer to be recognized as a partnership or a corporation for federal tax purposes. The proposal, if adopted, will greatly simplify the existing classification rules.

Current IRS Entity Classification - The Need to Change

What happens when a new unincorporated entity shows up on the IRS doorstep? Will it be recognized as a corporation, a trust or a partnership for federal tax purposes?

This question was answered by the Service in its 1988 Wyoming Revenue Ruling, Rev. Rul. 88-76 (1988-2C.B.360). In response to Wyoming's 1977 adoption of the first U.S. Limited Liability Company Act, and after eleven years of internal debate, the Service found that this new entity would be recognized as a partnership for federal tax purposes if it had no more than two of four critical corporate characteristics.

The limited liability company ("LLC") revolution was underway. Now all states and the District of Columbia have enacted LLC Acts to allow formation of these flexible new entities with the advantage of corporate like limited liability and the partnership tax treatment.

Since its Wyoming LLC ruling the Service has issued eighteen additional LLC Revenue Rulings, one "clarification" (26 CFR 301.7701-2(b)(1)) and two Rev Procs. (94-46 and 95-10), all clarifying and lowering the hurdles to be cleared for the LLC to be recognized for partnership tax treatment. The states have responded by adopting less restrictive "flexible" LLC Acts, narrowing considerably the traditional distinctions between corporations and partnerships.

Now, according to the Service, "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 nonpublicly traded organization that, in all meaningful respects, is virtually indistinguishable from a corporation."

The Service has found that, unfortunately, under existing classification regulations both the taxpayer and the Service must expend considerable resources on classification issues. To its credit, the Service initiated the inquiry as to whether this classification exercise serves any useful purpose, and found that it did not. It further found that "small business organizations may lack the resources and expertise to achieve the tax classification they want under the current classification regulations." Therefore, in its Notice 95-14, issued April 5, 1995, the Service suggested regulations that would allow an "eligible entity" to chose between partnership or corporate tax treatment on "an elective basis", the check-the-box proposal. More than a year of positive public input has reinforced the tentative decision to change course and resulted in the proposed new regulations.

Proposed New Regulation

The newly proposed ß301.7701-1 provides an overview of the rules to be applied in determining an organization's classification for federal tax purposes. Under the new proposal, any unincorporated undertaking by two or more persons to carry on a business and divide profit may be eligible to elect to be treated for federal tax purposes as a corporation or a partnership. A single member LLC can elect to be treated as a corporation or can be treated as a proprietorship. Therefore, subject only to the limitations of state law, a LLC with two or more members can achieve partnership tax treatment without regard to its corporate characteristics, and a LLC with one member can elect classification as corporation or be treated as a proprietorship.

The proposed new regulations define partnership to include any business entity that has at least two members that is not a corporation. Not eligible are corporations, associations, joint stock companies, insurance companies and certain banking organizations. The main beneficiary is the limited liability company, the new universal entity, now enacted in all fifty states.

Proposed Default Classification

A newly formed "domestic eligible entity" (i.e. LLC) will automatically be classified as a partnership if it has two or more members, unless an election is filed to classify the entity as a corporation. If the newly formed LLC has a single member, the "default classification" provides that it will not be treated separate from its owner - it will be treated as a proprietorship, unless an election is filed to classify the entity as a corporation. Eligible entities existing prior to the effective date of the regulation that choose to retain their current classification will not be required to file an election.

Change of Classification Under the Proposed New Regulations

Under the proposed regulations an existing entity that makes an election to change its classification cannot change its classification again for five years succeeding the effective date of the election. However, an existing entity that elects to change its classification as of the effective date of the proposed regulations may elect to change again within the first sixty months following the election. As before, change of classification will have certain tax consequences that must be reported. For example, if an eligible entity that has been taxed as a corporation elects to be classified as a partnership, the entity and its owners must recognize and report gain, if any, under the rules applicable to corporations. The conversion of a partnership to a LLC is not a change of classification and is treated as a continuation by the Service with no federal tax consequences. Rev. Rul.95-37.

Effect of the New Regulations

When the new regulations are adopted all state LLC Acts and the Model Act will need to be amended to take advantage of the new freedom allowed by the Service. Most state acts now allow the flexibility to draft around provisions intended to cope with the old classification regulations, yet, the Service simplification will make this unnecessary. State statutory language dealing with continuity of life, centralized management and free transferability of interest will be baggage that can be eliminated. If restrictions of this type are desired they can be adopted by the members in their operating agreement and need not be mandated by the state. The following topics need to be revisited:

Continuity of Life: The state act can eliminate provisions intended to avoid continuity of life including, (1) the events of dissolution or disassociation, (2) a period of duration and (3) the process of continuation or winding up after withdrawal of a member. If desired, the Members can adopt these limitations in their operating agreement.

Centralized Management: The state act can eliminate provisions intended to help avoid centralized management, including the requirement to specify in the articles either management by members or management by managers. This is no longer a concern of the Service and it should not be a concern of the state.

Free Transferability of Interest: Like corporate shares, LLC ownership coupled with the right to vote in management will be fully transferable without concern for tax consequences. Again, desired restrictions can be adopted by the members in their operating agreement and need not be mandated by the state.

One Person LLCs: All state acts should now be amended to allow the one person LLC. The Service will recognize it as a proprietorship. If there is no state policy against the one person corporation, there should be none against the one person LLC.

Effective Date

The new rules apply to periods beginning on or after the date the final regulations are published in the federal reports.

Conclusion

The Service will adopt its proposed simplification and will continue to collect due taxes without regard to the outdated complexities in the old entity classification regulations. The ball will then pass to the states to consider whether their interests are best served by allowing the full range of flexibility made possible by the Service, or whether there are overriding state policy reasons to add their own complexities. Entity formation will gravitate to the states with the least unnecessary restrictions.

TEXT OF THE PROPOSED REGULATIONS

Section 301.7701-1, 301.7701-2 and 301.7701-3 are revised to read as follows:

ß301.7701-1: Classification of organizations for federal tax purposes.

(a) Organizations for federal tax purposes.

• (1) In general. The Internal Revenue Code prescribes the classification of various organizations for federal tax purposes. Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.
• (2) Certain joint undertakings give rise to entities for federal tax purposes. A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. For example, a separate entity exists for federal tax purposes if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent. Nevertheless, a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes. For example, if two or more persons jointly construct a ditch merely to drain surface water from their properties, they have not created a separate entity for federal tax purposes. 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, or tenants in common, of farm property lease it to a farmer for a cash rental or a share of the crops, they do not necessarily create a separate entity for federal tax purposes.
• (3) Certain local law entities not recognized. An entity formed under local law is not always recognized as a separate entity for federal tax purposes. For example, 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, tribes incorporated under section 17 of the Indian Reorganization Act of 1934, as amended, 25 U.S.C. 477, or under section 3 of the Oklahoma Indian Welfare Act, as amended, 25 U.S.C. 503, are not recognized as separate entities for federal tax purposes.
• (4) Single owner organizations. Under ßß 301.7701-2 and 301.7701-3, certain organizations that have a single owner can choose to be recognized or disregarded as entities separate from their owners.

(b) Classification of organizations. The classification of organizations that are recognized as separate entities is determined under ßß 301.7701-2, 301.7701-3, and 301.7701-4 (unless a provision of the Internal Revenue Code provides for special treatment of that organization). For the classification of organizations as trusts, see ß301.7701-4. That section provides that trusts generally do not have associates or an objective to carry on business for profit. Sections 301.7701-2 and 301.7701-3 provide rules for classifying organizations that are not classified as trusts.

(c) Qualified cost sharing arrangements. See ß301.7701-3(e) as contained in 26 CFR Part 301 as revised as of April 1, 1996.

(d) Domestic and foreign entities. For purposes of this section and [*21995] ßß301.7701-2 and 301.7701-3, an entity is a domestic entity if it is created or organized in the United States or under the law of the United States or of any State; an entity is foreign if it is not domestic. See sections 7701(a)(4) and (a)(5).

(e) State. For purposes of this section and ß301.7701-2, the term State includes the District of Columbia.

(f) Effective date. The rules of this section apply to periods beginning on or after the date that final regulations are published in the Federal Register.

ß301.7701-2: Business entities; definitions.

(a) Business entities. For purposes of this section and ß301.7701-3, a business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under ß301.7701-3) that is not properly classified as a trust under ß301.7701-4 (or otherwise subject to special treatment under the Internal Revenue Code). A business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership. A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.

(b) Corporations. For federal tax purposes, the term corporation means:

• (1) 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;
• (2) An association (as determined under ß301.7701-3);
• (3) 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;
• (4) A business entity that is taxable as an insurance company under subchapter L, chapter 1 of the Internal Revenue Code;
• (5) A State-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act, as amended, 12 U.S.C. 1811 et seq., or a similar federal statute;
• (6) A business entity wholly owned by a State or any political subdivision thereof;
• (7) A business entity that is taxable as a corporation under a provision of the Internal Revenue Code other than section 7701(a)(3); and
• (8) Except as provided in paragraph (d) of this section, the following business entities formed in the following jurisdictions:
  • American Samoa, Corporation
  • Argentina, Sociedad Anonima
  • Aruba, Naamloze Vennootschap
  • Australia, Public Limited Company
  • Austria, Aktiengesellschaft
  • Barbados, Limited Company
  • Belize, Public Limited Company
  • Belgium, Societe Anonyme or Naamloze Vennootschap
  • Bolivia, Sociedad Anonima
  • Brazil, Sociedade Anonima
  • Canada, Corporation
  • Chile, Sociedad Anonima
  • People's Republic of China, Company Limited by Shares
  • Republic of China (Taiwan), Company Limited by Shares
  • Colombia, Sociedad Anonima
  • Costa Rica, Sociedad Anonima
  • Cyprus, Public Limited Company
  • Czech Republic, Akciova Spolecnost
  • Denmark, Aktieselskab
  • Ecuador, Sociedad Anonima or Compania Anonima
  • El Salvador, Sociedad Anonima
  • Egypt, Sharikat Al-Mossahamah
  • Finland, Osakeyhtio/Aktiebolag
  • France, Societe Anonyme
  • Germany, Aktiengesellschaft
  • Greece, Anonymos Etairia
  • Guam, Corporation
  • Guatemala, Sociedad Anonima
  • Guyana, Public Limited Company
  • Honduras, Sociedad Anonima
  • Hong Kong, Public Limited Company
  • Hungary, Reszvenytarsasag
  • Iceland, Hlutafelag
  • India, Public Limited Company
  • Indonesia, Perseroan Terbatas
  • Ireland, Public Limited Company
  • Israel, Public Limited Company
  • Italy, Societa per Azioni
  • Jamaica, Public Limited Company
  • Japan, Kabushiki Kaisha
  • Kazakstan, Ashyk Aktsionerlik Kogham
  • Republic of Korea, Chusik Hoesa
  • Liberia, Corporation
  • Luxembourg, Societe Anonyme
  • Malaysia, Berhad
  • Malta, Partnership Anonyme
  • Mexico, Sociedad Anonima
  • Morocco, Societe Anonyme
  • Netherlands, Naamloze Vennootschap
  • Netherlands Antilles, Naamloze Vennootschap
  • New Zealand, Limited Company
  • Nicaragua, Compania Anonima
  • Nigeria, Public Limited Company
  • Northern Mariana Islands, Corporation
  • Norway, Aksjeselskap
  • Pakistan, Public Limited Company
  • Panama, Sociedad Anonima
  • Paraguay, Sociedad Anonima
  • Peru, Sociedad Anonima
  • Philippines, Stock Corporation
  • Poland, Spolka Akcyjna
  • Portugal, Sociedade Anonima
  • Puerto Rico, Corporation
  • Romania, Societe pe Actiuni
  • Russia, Otkrytoye Aktsionernoy Obshchestvo
  • Saudi Arabia, Sharikat Al-Mossahamah
  • Singapore, Public Limited Company
  • Slovak Republic, Akciova Spolocnost
  • South Africa, Public Limited Company
  • Spain, Sociedad Anonima
  • Surinam, Naamloze Vennootschap
  • Sweden, Aktiebolag
  • Switzerland, Aktiengesellschaft or Societe Anonyme
  • Thailand, Borisat Chamkad (Machachon)
  • Trinidad & Tobago, Public Limited Company
  • Turkey, Anonim Sirket
  • Tunisia, Societe Anonyme
  • Ukraine, Aktsionerne Tovaristvo Vidkritogo Tipu
  • United Kingdom, Public Limited Company
  • United States Virgin Islands, Corporation
  • Uruguay, Sociedad Anonima
  • Venezuela, Sociedad Anonima or Compania Anonima

(c) Other business entities. For federal tax purposes- (1) The term partnership means a business entity that is not a corporation under paragraph (b) of this section and that has at least two members; and

• (1) A business entity that has a single owner and is not a corporation under paragraph (b) of this section is disregarded as an entity separate from its owner.
• (d) Special rule for certain foreign business entities. A foreign business entity described in paragraph (b)(8) of this section is classified as a partnership if:
• (1) The entity was in existence and claimed to be a partnership on May 8, 1996 and for all prior periods;
• (2) That classification was relevant to any person for federal tax purposes at any time during the period that includes May 8, 1996;
• (3) The entity had a reasonable basis (within the meaning of section 6662) for claiming partnership classification; and
• (4) Neither the entity nor any member has been notified in writing on or before May 8, 1996 that the classification of the entity is under examination (in which case the entity's classification will be determined in the examination).

(e) Effective date. The rules of this section apply to periods beginning on or after the date that final regulations are published in the Federal Register. [*21996]

ß301.7701-3: Classification of certain business entities.

(a) In general. A business entity that is not classified as a corporation under ß301.7701-2(b) (1), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes as provided in this section. An eligible entity with at least two members can elect to be classified as either an association (and thus a corporation under ß301.7701-2(b)(2)) or a partnership, and an eligible entity with a single member can elect to be classified as an association or to be disregarded as an entity separate from its owner. Paragraph (b) of this section provides a default classification for an eligible entity that does not make an election. Thus, elections are necessary only when an eligible entity chooses to be classified initially as other than the default classification or when an eligible entity chooses to change its classification. Paragraph (c) of this section provides rules for making express elections. Paragraph (d) of this section provides a special rule for classifying an entity created pursuant to a termination of a partnership under section 708(b)(1)(B). Paragraph (e) of this section sets forth the effective date of this section and a special rule relating to prior periods.

(b) Classification of eligible entities that do not file an election

• (1) Domestic eligible entities. Except as provided in paragraph (b)(3) of this section, unless the entity elects otherwise, a domestic eligible entity is:
  • (i) A partnership if it has two or more members; or
  • (ii) Disregarded as an entity separate from its owner if it has a single owner.
• (2) Foreign eligible entities-(i) In general. Except as provided in paragraph (b)(3) of this section, unless the entity elects otherwise, a foreign eligible entity is:
• (A) A partnership if it has two or more members and any member has unlimited liability;
• (B) An association if no member has unlimited liability; or
• (C) Disregarded as an entity separate from its owner if it has a single owner that has unlimited liability.
  • (ii) Definition of unlimited liability. For purposes of paragraph (b)(2)(i) of this section, a member of a foreign eligible entity has unlimited liability if the member has personal liability for the debts of or claims against the entity, by reason of being a member, based solely on the statute or law pursuant to which the entity is organized. A member has personal liability if creditors of the entity may seek satisfaction of debts of or claims against the entity from the member as such. A member has personal liability for purposes of this paragraph even if the member makes an agreement under which another person (whether or not a member of the entity) assumes such liability or agrees to indemnify such member for any such liability.
• (3) Existing eligible entities. Unless the entity elects otherwise, an eligible entity in existence prior to the effective date of this section will have the same classification that the entity claimed under ßß 301.7701-1 through 301.7701-3 as in effect on the date prior to the effective date of this section; except that if an eligible entity with a single owner claimed to be a partnership under those regulations, the entity will be disregarded as an entity separate from its owner under this paragraph. For special rules regarding the classification of such entities for periods prior to the effective date of this section, see paragraph (e)(2) of this section. For purposes of this paragraph, a foreign eligible entity is treated as being in existence prior to the effective date of this section only if the entity's classification is relevant to any person for federal tax purposes at any time during the period that includes the date immediately prior to the effective date of this section.

(c) Elections-(1) Time and place for filing

• (i) In general. Except as provided in paragraphs (c)(1)(ii) and (iii) of this section, an eligible entity may elect to be classified other than as provided under paragraph (b) of this section, or to change its classification, by filing an election with the appropriate service center. Such an election shall specify the name, address, and 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. The election will be effective on the 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. If the Commissioner prescribes a form for this purpose, the election shall be made on such form. See ß301.6109-1 for rules on applying for and displaying Employer Identification Numbers.
• (ii) Limitation. If an eligible entity makes an election under this paragraph (c) to change its classification (other than an election made by an existing entity to change its classification as of the effective date of this section), it cannot change its classification by election again during the sixty months succeeding the effective date of the election.
• (iii) Special rule for exempt organizations. An eligible entity that has been determined to be, or claims to be, exempt from taxation under section 501(a) is treated as having made an election under this section to be classified as an association. Such election will be effective as of the first date for which exemption is claimed or determined to apply, regardless of when the claim or determination is made, and will remain in effect unless an election is made under paragraph (c)(1)(i) of this section after the date the claim for exempt status is withdrawn or rejected or the date the determination of exempt status is revoked.
• (iv) Examples. The following examples illustrate the rules of this paragraph (c)(1):
• Example 1. On July 1, 1998, X, a domestic corporation, purchases a 10% interest in Y, an eligible entity formed under Country A law in 1990. The entity's classification was not relevant to any person for federal tax purposes prior to X's acquisition of an interest in Y. Thus, Y is not considered to be in existence on the effective date of this section for purposes of paragraph (b)(3) of this section. Under the applicable Country A statute, no member of Y has unlimited liability as defined in paragraph (b)(2)(ii) of this section. Accordingly, Y is classified as an association under paragraph (b)(2)(i)(B) of this section unless it elects under paragraph (c) of this section to be classified as a partnership. To be classified as a partnership as of July 1, 1998, Y must file the election by September 13, 1998. See paragraph (c)(1)(i) of this section. Because an election cannot be effective more than 75 days prior to the date on which it is filed, if Y files its election after September 13, 1998, it will be classified as an association from July 1, 1998, until the effective date of the election. In that case, it could not change its classification by election under paragraph (c) of this section during the sixty months succeeding the effective date of the election.
• Example 2. (i) Z is an eligible entity formed under Country B law and is in existence on the effective date of this section within the meaning of paragraph (b)(3) of this section. Prior to the effective date of this section, Z claimed to be classified as an association. Unless Z files an election under paragraph (c) of this section, it will continue to be classified as an association under paragraph (b)(3) of this section.
• (ii) Z files an election under paragraph (c) of this section to be classified as a partnership, effective as of the effective date of this section. Z can file an election to be classified as an association at any time thereafter, but then would not be permitted to change its classification by election during the sixty months succeeding the effective date of that subsequent election.
• (2) Authorized signatures. An election made under paragraph (c)(1)(i) of this section must be signed by- [*21997]
  • (i) Each member of the electing entity; or
  • (ii) Any officer, manager, or member of the electing entity who is authorized to make the election and who represents to having such authorization under penalties of perjury.
• (3) Further notification of elections. An eligible entity required to file a federal tax return for the taxable year for which an election is made under paragraph (c)(1)(i) of this section shall attach a copy of the form filed in accordance with paragraph (c)(1)(i) of this section to its federal tax return for that year. If the entity is not required to file a return for that year, the Commissioner will require that a copy of such form be attached to the federal income tax return of any direct or indirect owner of the entity for the taxable year of the owner that includes the date on which the election was effective.

(d) Special rule for certain partnership terminations. When a partnership terminates by operation of section 708(b)(1)(B) (on the sale or exchange of fifty percent or more of the total interests in partnership capital or profits within a twelve month period), the resulting entity created by such termination is a partnership.

(e) Effective date-(1) In general. The rules of this section apply to periods beginning on or after the date that final regulations are published in the Federal Register.

• (2) Prior treatment of existing entities. In the case of a business entity that is not described in ß 301.7701-2(b) (1), (3), (4), (5), (6), or (7), and that is in existence prior to the effective date of this section, the entity's claimed classification will be respected for all periods prior to the effective date of this section if:
  • (i) The entity had a reasonable basis (within the meaning of section 6662) for its claimed classification;
  • (ii) The entity claimed that same classification for all prior periods; and
  • (iii) Neither the entity nor any member has been notified in writing on or before May 8, 1996 that the classification of the entity is under examination (in which case the entity's classification will be determined in the examination).

Comments and Public Hearing

DATES: Written comments and requests to speak (with outlines of oral comments) at a public hearing scheduled for August 21, 1996, at 10 a.m. must be submitted by August 12, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (PS-43-95), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (PS-43-95), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Armando Gomez, (202) 622-3050; concerning foreign organizations, Ronald M. Gootzeit or William H. Morris, (202) 622-3880; concerning submissions and the hearing. Evangelista Lee (202) 622-7190 (not toll-free numbers).

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