An organization with two or more owners that is an entity separate from the owners and that is not a corporation is an eligible entity that can be classified as a corporation or a partnership. (See Regs. Sec. 301.7701-2(b) for a list of entities that are always classified as corporations.) The regulations provide a set of default rules that establish the classification of an eligible entity if no classification election is made. Entities that want to be classified under the default rules do not need to make an election. Entities that do not want to be classified under the default rules must file a written election on Form 8832, Entity Classification Election.
Observation: 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 provide services to the occupants. However, a joint undertaking to share expenses does not create a separate entity. This means, for example, that two persons who jointly construct a ditch merely to drain surface water from their properties have not created a separate entity for federal tax purposes.
Default Rule for Newly Formed Domestic Entities
A newly formed domestic eligible entity that does not file a classification election will be classified as a partnership (if it has two or more members) or a disregarded entity (if it has only one owner) (Regs. Sec. 301.7701-3(b)(1)).
Example: J and S formed A LLC to sell wholesale computer hardware and software to retail computer stores. Since A is considered a separate entity (because it operates a business), has two or more members, and is not a corporation, its default classification is partnership status. If J and S want A to be classified as a partnership, they do not need to file an election. If they want A to be classified as a corporation, they should file an election on Form 8832.
Default Rule for Newly Formed Foreign Entities
The default classification of newly formed foreign eligible entities depends on the personal liability of their members for the entity’s debts. Regs. Sec. 301.7701-3(b)(2) provides three possible default classifications:
- A foreign eligible entity with two or more members is classified as a partnership if at least one member does not have limited liability.
- A foreign eligible entity is classified as a corporation if all members have limited liability.
- A foreign eligible entity with only one member is disregarded as a separate entity if the member does not have limited liability.
A member of a foreign eligible entity has limited liability if the member is not personally liable for the entity’s debts, solely by reason of being a member of the entity. A member’s personal liability is based on the law under which the entity is organized, unless that law allows the entity to specify in its organizational documents whether members have limited liability (in which case the organizational documents may also be relevant). A member is considered personally liable if creditors can seek satisfaction of all or any portion of the entity’s debts from the member. The fact that members are indemnified for any entity liabilities does not alter their personal liability. In other words, a guarantee, asset pledge, or similar arrangement does not prevent a member from having limited liability.
Default Rule for Existing Domestic or Foreign Entities
In general, eligible entities in existence prior to January 1, 1997, retain the classification they claimed under the former classification regulations subject to certain conditions. However, single-member organizations that claimed partnership status cannot continue to be taxed as partnerships but instead will be disregarded as separate entities.
Information Reporting for Foreign Disregarded Entities
Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities, and Schedule M, Transactions Between Foreign Disregarded Entity of a Foreign Tax Owner and the Filer or Other Related Entities, provide information on a U.S. person’s direct or indirect ownership of a foreign disregarded entity. Form 8858 must be filed by U.S. persons that directly own foreign disregarded entities or by certain U.S. persons who own interests in foreign disregarded entities indirectly through controlled foreign corporations (CFCs) or controlled foreign partnerships (CFPs). Form 8858 is due on the due date of a direct owner’s income tax return or information return (including extensions) and should be attached to that return.
If a person owns a foreign disregarded entity indirectly, Form 8858, along with Schedule M, should be attached to any Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, for CFCs or Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships, for CFPs that is filed for the owner entity.
Special Rule for Exempt Organizations
Under the default rules of the regulations, an exempt organization under Sec. 501(a) is classified as if the organization made an election to be classified as an association taxable as a corporation (Regs. Sec. 301.7701-3(c)(1)(v)). The election is considered to be in effect from the date tax-exempt status is claimed (or determined to apply) until the exemption is withdrawn, rejected, or revoked. At such time, the organization may elect to be classified as a noncorporate entity under the general rules.
Special Rule for REITs
An eligible entity filing an election under Sec. 856(c)(1) to be treated as a real estate investment trust (REIT) is deemed to have made an election to be classified as an association taxable as a corporation. This deemed election is effective as of the first day the entity is treated as a REIT, which avoids the requirement that the entity elect to be classified as a corporation within 75 days of its first tax year.
Special Rule for S Corporations
Regs. Sec. 301.7701-3(c)(1)(v)(C) provides that an eligible entity that makes a timely S election is deemed to have made an election to be classified as a corporation, provided that the entity meets all the requirements to qualify as an S corporation. The election to be classified as a corporation is deemed to be made on the effective date of the S election and remains in effect until the entity makes a valid election to change its classification.
Special Rule for Partnership Terminations
A partnership or LLC classified as a partnership terminates under the rules of Sec. 708(b)(1)(B) upon the sale or exchange of 50% or more of the total interests in capital or profits within a 12-month period. Regs. Sec. 301.7701-3(e) provides that the resulting entity is classified as a partnership under the default provisions of the regulations, or the new entity can elect to be classified as a corporation.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 16th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.