ROBERT L. SOMMERS
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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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.
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
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.
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.
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.
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.
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
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.**