Classifying business entities under the check-the-box regulations

Under the check-the-box entity-classification regulations, an organization that is recognized for federal tax purposes as an entity separate from its owners can potentially be classified as: (1) an association taxed as a corporation, (2) a partnership, (3) a disregarded entity, or (4) a trust. Trusts are not considered business entities — see Regs. Sec. 301.7701-4. Under Regs. Secs. 301.7701-2 and -3, an entity that is formed as a corporation under local law is automatically classified as a corporation. When an entity is not a corporation under local law, its classification for federal tax purposes depends on whether it has more than one member (owner).

Determining if a separate entity exists

Federal tax law determines whether an organization is treated as a separate entity apart from its owner(s) for federal tax purposes. Local law is not the deciding factor. For example, if a business entity has more than one member, and if the participants carry on a trade, business, financial operation, or venture and divide the resulting profits, a separate entity is considered to exist (whether or not one is considered to exist under applicable state law). However, a mere expense-sharing arrangement or mere co-ownership of an asset does not create a separate entity (Regs. Secs. 301.7701-1(a)(1) and (2)).

Automatic classification as corporation

The following entities are automatically classified as corporations (Regs. Sec. 301.7701-2(b)):

• A business entity organized under a federal or state statute (or under the 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. Under this definition, any entity classified as a corporation under state law is automatically treated as a corporation for federal tax purposes.
• An association as determined under Regs. Sec. 301.7701-3. This generally means an unincorporated entity that elects to be taxed as a corporation, as explained later.
• 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.
• A business entity taxable as an insurance company under Subchapter L, Chapter 1, of the Code.
• A state-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act, as amended, or a similar federal statute.
• A business entity wholly owned by a state or any political subdivision thereof. Also, a business entity wholly owned by a foreign government.
• A business entity taxable as a corporation under a provision of the Code other than Sec. 7701(a)(3), such as a publicly traded partnership, real estate investment trust, regulated investment company, or tax-exempt entity.
• A foreign entity specifically designated as a corporation (see Regs. Sec. 301.7701-2(b)(8) for a list).
• A business entity with multiple charters that is treated as a corporation in any one of the jurisdictions.

Example 1. Classification as a corporation: J incorporated A Corp. under the laws of North Carolina during the current year. He has heard about the check-the-box regulations from business associates and calls his tax practitioner to ask if he can elect partnership classification. J’s tax practitioner informs him that a corporation under state law is still taxed as a corporation, even under the check-the-box regulations. There is no classification election available to state law corporations.

Classifying unincorporated domestic single-owner entities

A newly formed domestic single-owner entity that is not automatically classified as a corporation — including a single-member limited liability company (SMLLC) — is classified by default as a disregarded entity (Regs. Sec. 301.7701-3(b)(1)). A disregarded SMLLC owned by a corporation is treated as an unincorporated branch or division of the parent entity. Alternatively, an election can be made to classify such a single-owner entity as a corporation for federal tax purposes. This would rarely be advisable, mainly because of the C corporation double-taxation issue.

Example 2. Classification of a single-member entity: D wants to open a wholly owned retail florist in Texas. She has heard good things about LLCs and asks her tax practitioner if operation as an LLC is advisable for her new business. D’s practitioner advises her that SMLLCs are allowed in Texas and that under the regulations she can report the income and expenses from the business on a Schedule C, Profit or Loss From Business, attached to her Form 1040, U.S. Individual Income Tax Return. Her other option is to elect for the LLC to be taxed as a corporation (see below).

Classifying unincorporated domestic multi-owner entities

A newly formed domestic entity with two or more owners (an eligible entity) that is not automatically classified as a corporation — including a multimember LLC — is classified by default as a partnership (Regs. Sec. 301.7701-3(b)(1)). Alternatively, an election can be made to classify such a multimember entity as a corporation for federal tax purposes. This would rarely be advisable, mainly because of the C corporation double-taxation issue.

In Rev. Rul. 2004-77, the IRS ruled that if an eligible entity has two members under local law, but one of the members is a disregarded entity owned by the other member, the eligible entity cannot be classified as a partnership and is taxed as a disregarded entity or can elect to be taxed as a corporation.

Example 3. Classification options of a newly formed domestic entity: J and S form Q LLC to provide internet connection and content services. Since Q 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 Q to be classified as a partnership, they do not need to file an election. If they want Q to be classified as a corporation, they should file an election as described below.

Electing to change the default classification

The default classification of a newly formed entity can be changed by making an affirmative election to change that classification (Regs. Sec. 301.7701-3(c)(1)). An election can also be made to change the current classification of an existing entity. For example, an SMLLC that is classified by default as a disregarded entity can elect to instead be classified as a corporation. An entity with more than one owner that is classified by default as a partnership can also elect to instead be classified as a corporation.

Form 8832, Entity Classification Election, is used to make the election to change an entity’s classification. The effective date of the election is determined as follows (Regs. Sec. 301.7701-3(c)(1)(iii)):

• The effective date is the date specified on Form 8832 if that date is no more than 75 days prior to or no more than 12 months after the date on which the election is filed;
• If Form 8832 incorrectly specifies an effective date that is more than 75 days prior to the date on which the election is filed, the actual effective date is 75 days prior to the filing date; and
• If Form 8832 incorrectly specifies an effective date that is more than 12 months after the date on which the election is filed, the actual effective date is 12 months after the filing date.

Electing another classification change after an earlier election

Once an entity elects to change its classification, it cannot make another classification change election during the 60 months after the effective date of the first election (Regs. Sec. 301.7701-3(c)(1)(iv)). However, this restriction does not apply after a newly formed entity elects to change its default classification upon inception. If a more-than-50% change in ownership occurs within the 60-month period, the IRS has the discretion to approve an otherwise-prohibited classification change election.

Late election relief

Rev. Proc. 2009-41 provides relief from a late entity-classification election without having to obtain a letter ruling. To obtain relief, the entity must have timely filed all income tax returns consistent with the requested classification (unless those due dates have not yet passed); the entity must have reasonable cause for the failure to file; and the request for relief must be made before three years and 75 days from the requested effective date of the classification election. Reasonable cause might be that the taxpayer was relying on their tax preparer to file Form 8832, but the tax preparer missed the filing deadline. The request for relief can be made on Part II of Form 8832.

Beware of tax consequences of classification changes

All the tax ramifications of making a classification change must be considered. An election to change from C corporation to partnership status will result in a deemed liquidation of the corporation. This can trigger double taxation in the form of corporate-level taxable gain on the deemed distribution of appreciated assets and shareholder-level taxable gain if the fair market value of the assets deemed to be received by the shareholder as liquidation proceeds exceeds the shareholder’s basis in the stock. Similarly, an election to change from partnership to corporate status can trigger taxable gains if liabilities deemed to be transferred to the corporation exceed the basis of the assets deemed to be transferred.   

This case study has been adapted from PPC’s Tax Planning Guide — Closely Held Corporations, 33d Edition (March 2020), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).