Frequently Asked Tax Questions - March 9, 1997

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday March 9, 1997.


Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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"Check-the-Box" Regulations Can Simplify Business Classification

Starting January 1, 1997, choosing whether your company will be taxed as a partnership (the owners are taxable) or a corporation (the entity is taxable) may be as easy as checking a box! Say good-bye to the tortuous analysis often used to discern the differences between corporations and partnerships.

In the past, if a business had any three of four corporate characteristics -- continuity of life, centralized management, limited liability or free transferability of interests -- it was taxed as a corporation. Unfortunately, merely possessing certain powers, terms and conditions could hand the business a large and unexpected tax liability.


Businesses required to be taxed as corporations, and thus ineligible to check the box, include entities incorporated under specific federal and state statutes, associations treated as corporations under state law, wholly-owned state organizations, joint stock companies, insurance companies, banks, publicly traded partnerships, taxable mortgage pools, and specified foreign organizations.

The current distinction between a business and a trust (trusts generally lack an objective to carry on a business and divide profits, as well as lacking associates) remains intact. The regulations, however, treat any entity that is not classified as a trust as a business entity.

Electing Tax Treatment

Even if an entity may elect to be taxed as either a corporation or a partnership, not many corporate elections are anticipated, since corporate taxes are generally more complicated and expensive.

Any eligible single-owner entity may classify itself as either an association taxable as a corporation, or be disregarded as a separate taxable entity (the owner is taxed directly). However, single-member entities that may be disregarded for federal tax purposes might not receive identical state tax treatment, unless that state adopts the federal procedure.

Note: The Franchise Tax Board has announced that since California law does not automatically incorporate federal regulations governing entity classifications, the IRS check-the-box regulations will not apply for state tax purposes. Expect new legislative action to adopt check-the-box regulations in California.

Default Rules

If no election is made, default rules apply: A newly formed domestic entity of two or more members will be classified as a partnership; and a single-member entity will be regarded as a sole proprietorship. If an entity is unsure of its status under the default classification, it should probably file a protective election.

Foreign Corporations

Certain foreign organizations are required by the IRS to be taxed as corporations, despite their classifications by the foreign country. Grandfather rules provide that entities previously treated as partnerships or disregarded as entities may continue as such, if they were in existence and not treated as corporate entities as of May 8, 1996.

LLCs: The Entity of Choice

With new regulations in effect, entities with limited legal liability and pass-through tax liability (owners are taxed directly) -- generally "S" corporations, general partnerships, limited partnerships and LLCs -- will probably become the most common business organizations, with the LLC taking the lead as the favored pass-through entity for family business planning.

Proposed amendments to state LLC laws would eliminate the current requirement that, in general, an LLC must dissolve (stop doing business) either on the withdrawal or death of a member, thereby allowing the same continuity of life enjoyed by corporations.

Switching Business Entities: Watch the Tax Consequences

Changes in classification, or converting to a different business form, may have adverse tax consequences. If an entity previously classified as an association or corporation elects partnership tax treatment, the entity and its owners must recognize any gain generated under the corporate liquidation rules. Likewise, if an S corporation converts to an LLC, gain on liquidation is probable.

Usually, transforming a partnership to an LLC is tax-free. However, converting a partnership to another entity might trigger taxable income if the partnership's debts and liabilities are significant and the partner's share of those liabilities is reduced by the conversion.

Rules and Procedures

Eligible entities choosing not to be classified under the default rules or desiring to change their previous classification must file Form 8832 (Entity Classification Election) at the service center designated on the form. The election must be signed by each owner or by an authorized person. A copy of the form must also be attached to the entity's tax return in the year of the election. The effective date cannot be more than 75 days prior to the filing date, nor more than 12 months after the filing date.

Once a business entity selects its classification, it is locked into the classification for 5 years, unless the business is actually transferred to another business. The IRS may waive the 60-month period by a letter ruling, for a more than 50 percent ownership change.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**