This article appeared in the August 1997 issue of Nevada Lawyer. It may be cited as Jeffrey L. Burr, Entity Choice: Just Check-the-Box, 5 Nevada Lawyer 12 (August 1997). Reprinted by permission of the State Bar of Nevada.

*Jeffrey L. Burr earned a B.S. in Accounting from Brigham Young University and his law degree from McGeorge School of Law. He is licensed to practice law in Nevada, California and Arizona. He is a member of the ABA Section on Taxation, the Southern Nevada Estate Planning Council and former chair of the Section on Taxation.

In the past, the Internal Revenue Service has classified business entities as either partnerships or corporations based on four factors, or characteristics. Attorneys have wrestled with and twisted the four factors when forming limited partnerships (LPs) and limited liability companies (LLCs) to ensure that the entity would have as many of the characteristics of a corporation as possible but still qualify to be taxed as a partnership. State legislatures have carefully worded legislation concerning LLCs and LPs to walk the tightrope of the "four factor" test in determining whether a business would receive corporate tax treatment or partnership tax treatment. The four factors include:

(1) Limited liability;

(2) Centralized management;

(3) Continuity of life; and

(4) Free transferability of interest.

If a business entity possessed two of the four characteristics, the entity would be taxed as a partnership. But if three of the four characteristics applied, the entity would be taxed under the double taxation regime of corporations. Over time, tax and business law practitioners have massaged and contorted the four characteristics for their own benefit while the Internal Revenue Service has spent a lot of time and effort trying to enforce the test and provide clear guidelines concerning the four characteristics.

In May of 1996, the Internal Revenue Service took a monumental step forward by issuing proposed regulations which eliminated the "four factor" test in place of a "check-the-box" regime. This regime allows entities to effectively determine the tax treatment they desire. The result is simplicity. Thus, in a tax world where complexity is the rule, the Internal Revenue Service has taken a positive step towards simplifying an area that had become increasingly complex. Most business and tax lawyers anxiously awaited the finalization of these proposed regulations. Finally, in December of 1996, the regulations were finalized and became effective January 1, 1997.

The "check-the-box" regulations are found in Income Tax Regulations §§ 301.7701-1 through 301.7701-3. The new regulations present many planning opportunities and a few hazards. The change in the law will allow business organizations such as LLCs and LPs to enjoy all of the beneficial characteristics of a corporation but still be taxed as partnerships.

The ability to be taxed as a partnership is important because in partnership taxation income and deductions flow through to the partners and there is only one level of tax imposed. On the other hand, if an entity is classified or determined to be a corporations, generally taxes will have to be paid by the corporation on income that it earns and then later when that accumulated income is dispersed to the shareholders in the form of dividends, they will have to pay another level of tax.

The finalized check-the-box regulations only apply to "eligible entities." To be an "eligible entity" the organization must be a separate entity, a business entity and not a corporation. The regulations indicate that to be classified as a partnership or a corporation for tax purposes, it is first necessary to have an "entity" that is separate from its owners for income tax purposes. Most corporations, LLCs, LPs and general partnerships are separate entities for tax purposes. However, it is important to note that not all business entities are separate from the individual taxpayers. For example, an LLC that is owned by one person would not qualify as a separate entity and would be taxed as a sole proprietorship unless the party elects to be taxed as a corporation.

Again, to qualify as an eligible entity, the organization must also be a business entity rather than being characterized as a trust. Usually, if the entity has associates and carries on a business for profit, the business entity test is met.

Any business entity that is not classified as a corporation can elect its classification for federal tax purposes under the check-the-box regulations. § 301.7701-3(a). The regulations define a "corporation" as:

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, a corporate body, or body politic;

2. 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;

3. An insurance company under subchapter L of the Internal Revenue Code;

4. A state chartered business entity conducting banking activities if any of its deposits are insured under the FDIC;

5. A business entity wholly owned by a state or a political subdivision thereof;

6. A business entity that is taxable as a corporation under a provision of the Internal Revenue Code other than § 7701(a)(3). An example would be a publicly traded partnership; and

7. Certain foreign business entities. (The finalized regulations also set out specific tax rules concerning foreign entities which is beyond the scope of this article.)

All eligible business entities that are not corporations under the above definition and have at least two members are classified as partnerships. § 301.7701-2(c)(1). If an entity that is not a corporation wants to be treated as being other than a partnership, they must elect out of partnership status. Single-owner business entities which are not corporations (and which do not elect corporation status) are disregarded as entities separate from their owners and partnership taxation is not available. These entities are classified as sole proprietorships.

For "eligible business entities" that want to be taxed as partnerships, no election is required under the finalized regulations. In sum, partnership taxation is the default rule. Eligible business entities and single-owner business entities that desire to be treated as a corporation must affirmatively elect to be treated as such. Eligible entities seeking to elect out of partnership treatment must do so by filing Form 8832, which is a new IRS form.

The election is effective on the date specified on the election form (which can be at any time during a taxable year) 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 election is specified on the form. § 301.7701-3(c)(1)(i). Furthermore, an election can be changed at any time. However, another election cannot be made until 60 months after the effective date of the last election. § 301.7701-3(c)(1)(iv). The Commissioner may waive the 60 month limitation if there has been a more than 50% ownership change. § 301.7701-3(c)(1)(v).

Eligible entities that are in existence prior to 1997 retain their status and do not have to file an election unless they desire to change their classification. The Internal Revenue Service will not challenge a classification in place prior to 1997 if the entity had a reasonable basis for the claimed classification and the entity had not been notified in writing that the classification was under examination. However, if a single owner entity is currently classified as a partnership, the Internal Revenue Service will disregard the business as being separate from its owner and sole proprietorship tax treatment will be the result unless corporate status is elected.

If an existing entity desires to change their status, the finalized regulations allow for that option. However, tax consequences could flow from the change. If a corporation desires to change its status and be treated as a partnership, the election would be treated as a complete liquidation of the corporation and the formation of a new partnership. A return would need to be filed for the liquidating corporation and gain, if applicable, would have to be recognized by the entity and its shareholders under the liquidation rules. The contributions to form a new partnership would most likely not be recognized for tax purposes under § 721, but the new partnership would need to make sure that the allocations are in accordance with § 704(b) and the regulations.

Partnerships that elect to be taxed as corporations will need to consider whether the change will be completely tax free under § 351 or whether § 357 might cause taxation because the debt of assets being transferred might exceed the basis.

Corporations and partnerships which elect to be taxed as corporations still have the option to elect "S" corporation status if they meet the requirements. The requirements for "S" corporation treatment were modified and relaxed in the Small Business Jobs Protection Act which now seems to make the "S" corporation a more attractive entity. An "S" corporation possesses most of the tax benefits of a partnership with a few exceptions. For example, if appreciated property is distributed pro-rata to the partners of a partnership, there is no tax to the partners at distribution. On the other hand, if appreciated property is distributed to shareholders of an "S" corporation, tax will be imposed even though there has not been a sale of the property.

It is important for practitioners to remember that the "check-the-box" regulations effect the tax status only of the various business entities. Practitioners must still look at state law to address the non-tax issues of the various entities.

Business and estate planners will not have more flexibility than ever when planning the organization and operations of LLCs, general partnerships and LPs. Planners, in many cases, will not only be able to elect the classification of the entity that they desire, but they will also have the flexibility to include options like centralized management, limited liability, continuity of life and free transferability of interests to entities that traditionally could not enjoy all of these options. The new regulations will make the partnership tax provisions much more important since the default rule for classification will be the partnership entity.

The Internal Revenue Service has taken a giant step forward towards simplicity in finalizing the "check-the-box" regulations. The "check-the-box" regulations replace the old and tired "four factor" test in determining how a business entity will be classified. Practitioners will no longer need to wrestle with limited liability, continuity of life, centralized management and free transferability of interest when attempting to ensure that the business entity will receive partnership tax treatment. While the "check-the-box" regulations provide more simplicity, practitioners still need to study the regulations and become familiar with the provisions.

Partnership agreements and LLC operating agreements now provide for all of the attributes of a corporation without the burdensome corporate formalities. Yet, it is important to consider the consequences. The traditional corporation default principles will not apply to the partnerships, so partnership and operating agreements might have to be more extensive or complete. Additionally, if the interests of a partnership become too freely transferable, the partnership might be taxed as a corporation under the publicly traded partnership rules.

Finally, since many states have based part of their LLC and LP legislation on the "four factor" test, state laws will need to be reconsidered to take into account the impact of the "check-the-box" regulations. State legislatures will be able to modify their statutes to allow for changes to those entities which the tax regulations will not permit. The Nevada Legislature is currently considering a bill which would update the state LLC laws. The proposed bill would allow LLCs to enjoy several aspects of corporations which LLCs in Nevada have not traditionally enjoyed, like continuity of life.

ENTITY CLASSIFICATION CHOICES¹

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