New Tax Regulations Simplify the Choice of a Business Entity

The type and structure of an entity through which a business is conducted can have significant tax consequences. If an entity is taxed as a corporation, income earned by the entity is potentially subject to two levels of tax. First, a corporate income tax is imposed upon all the taxable income earned by the entity, and then dividend distributions made by the entity are subject to tax at the personal or corporate tax rates of the shareholder. On the other hand, income earned by an entity that is taxed as a partnership is subject to only one level of tax. Income and deductions of such an entity flow through to the partners of the entity (whether or not distributions are made) and are subject to tax at the partners own tax rates. Federal income tax law, rather than state law, determines whether an entity is taxed as a corporation or a partnership. Effective January 1, 1997, new tax regulations have been issued that simplify the considerations and analysis relevant to making this determination.

Prior Law. Prior to the issuance of the new regulations, the determination whether an entity was taxed as a corporation or partnership was made by a somewhat complex analysis of four factors: whether the entity had continuity of life, whether the entity had limited liability, whether the entity had centralized management and whether the interests held in the entity were freely transferable. The presence of two or less of these factors meant that the entity was taxed as a partnership; the presence of three or more of the factors meant that the entity was taxed as a corporation. Whether the entity was organized under state law as a corporation or partnership was irrelevant. This four factor analysis became particularly significant with the advent of limited liability companies, an entity for which most persons desired partnership tax treatment. Because limited liability companies have limited liability, the members forming the company had to be particularly careful that they did not inadvertently establish an entity that had two other corporate characteristics as well.

The New Regulations. Fortunately, with the issuance of the new regulations, this analysis is now a part of the past. The new regulatory scheme is simpler and more liberal, allowing many entities to elect whether they wish to be treated as a corporation or partnership for tax purposes. Under the new regulations, a business entity is generally defined as any entity other than a trust. A business entity that has two or more members may be classified as either a corporation or a partnership. A business entity that has a single owner either may be classified as a corporation or may be disregarded for federal income tax purposes. Under the new regulations somewhat differing sets of rules govern the determination of partnership or corporate status for domestic entities, those entities created or organized in the United States or under the law of the United States or of any state, and foreign entities.

Domestic Entities. An entity organized under a federal or state statute that refers to the entity as incorporated, a corporation, a body corporate, or body politic will be treated for federal income tax purposes as a corporation. In other words, corporations formed under state law will be taxed as corporations. In addition, an insurance company, a state chartered business entity conducting banking activities that has deposits insured under the Federal Deposit Insurance Act, and a business entity wholly owned by a state or political subdivision will also be taxed as a corporation. Other business entities with two or more members may generally be treated as either a partnership or a corporation at its member's election, and those entities with only one member may be either disregarded or treated as a corporation at its owner's election. If no election is made, those entities with two or more members will be taxed as a partnership and those entities with only one member will be disregarded. Accordingly, if no elections are made, a limited liability company will be taxed as a partnership if it has two or more members, or will be disregarded for tax purposes if it has one member.

If corporate tax treatment is desired for an entity that would not otherwise be taxed as such under the regulations, an election may simply be made by filing a Form 8832, Entity Classification Election. Such an election may be made effective any time not more than 75 days prior to the date on which the election is filed, nor more than twelve months after the date on which the election is filed. Generally, an election may not be changed for sixty months following its effective date. However, the Commissioner may permit an entity whose ownership interests change by more than fifty percent to change its election.

Unless they elect otherwise, entities formed prior to January 1, 1997, can generally retain their prior tax classification. Thus entities classified as partnerships or corporations under the prior regulations will continue to be so classified. If, however, an entity with one owner had claimed to be a partnership, it will now be disregarded for federal income tax purposes.

Foreign Entities. Certain foreign entities named in the regulations are automatically taxed as corporations. Those not named, unless they elect otherwise, will be taxed as follows:

Special rules apply to determine the tax classification of foreign entities that were in existence on May 8, 1996.

Pearl B. Doherty

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