The Treasury has announced new regulations that allow most noncorporate entities to elect to be taxed under the partnership tax law provisions of the Code. Previously, this coveted tax treatment depended upon a favorable analysis of four “corporate characteristics” of the entity: continuity of life, centralization of management, limited liability, and free transferability of interests. If the entity possessed more than two, it was taxed as a corporation and (potentially) subject to two levels of taxation; otherwise, it was taxed, for federal income tax purposes, as a partnership.
The new regulations will eliminate the need for partnerships and LLCs to carefully structure their operating agreements (and to seek advance rulings from the Service) in order to ensure partnership tax treatment. Often, the need to avoid corporate classification has required provisions and restrictions in the partnership agreement that were at variance with the business objectives of the owners. Providing, as it does, a virtual “safe harbor” for many newly formed entities, the new regulations will add a measure of tax certainty into what had at times been a murky area of federal tax law.
Until now, the Service has on occasion attempted to reclassify as associations entities actually formed as partnerships under state law when those entities possessed more than two corporate characteristics. The result of this reclassification was the unwanted application of the corporate tax sections of the Code, which impose of two levels of taxation. The recalssification also resulted in the loss of the application of the favorable partnership tax provisions of the Code, which provide for a flow through of income and losses to the partners.
Even under the new regulations, not all entities will be permitted to elect partnership tax treatment. Most prominent among those entities that will continue to be taxed as corporations are entities which begin life as corporations under state law in any of the fifty states. Other entities (among eight) which will automatically attract corporate tax treatment are certain publicly traded partnerships, and any business entity wholly owned by a state or a political subdivision.
Entities not subject to automatic corporate tax treatment may elect to be taxed either as corporations or as partnerships. The election must be signed by all owners of the entity or by an officer authorized to file the election. In the event an entity fails to make an election, partnership tax treatment will generally obtain in any event under the “default rules.” (An election to be taxed as a corporation might be desirable in unusual circumstances, e.g., where no current distribution of profits is envisioned.)
The proposed regulations provide specific guidance for entities in existence prior to 1997. First, entities attracting mandatory corporate tax treatment under the new regulations will be taxed as corporations. Second, entities not subject to automatic tax treatment under the new regulations and which desire to retain the tax treatment previously claimed, need not taken any action. Although the regulations apply prospectively, they nevertheless preclude the IRS from challenging classification of an organization that has “consistently” claimed the same classification for prior periods and had a “reasonable basis” for doing so.
Since New York State income tax laws generally track federal tax laws, the new regulations will collaterally effect — and simplify — state (and local) income tax treatment for many entities. One must remember, however, that many legal questions relating to the entity at the state level do not involve issues of taxation. In such cases, the new treasury regulations are likely to have less impact.