Tax News: Entity Classification

The Internal Revenue Service (the "IRS") recently announced that it is considering simplifying the entity classification rules. The IRS and courts have established these rules to allow the IRS to determine whether an unincorporated entity is taxed as a partnership or as a corporation. With the recent advent and popularity of limited liability companies, these rules have become increasingly important.

Under the current classification rules, an unincorporated organization that has associates and an objective to carry on a business is classified as a corporation if it satisfies at least three of the following four corporate characteristics: (1) continuity of life, (2) centralization of management, (3) liability for organization debts limited to organization's assets (i.e., limited liability), and (4) free transferability of interests in the organization. If an organization has no more than two of these characteristics, the organization is taxed as a partnership. In the context of a limited liability company, because liability for debts is limited to company assets, the company must satisfy no more than one of the remaining three characteristics to be taxed as a partnership.

The existing classification system is based upon historical differences under local law between partnerships and corporations. However, the differences between partnerships and corporations have eroded through legislation changing the traditional forms of doing business. For example, limited liability companies and limited liability partnerships have established limited liability for non-corporate entities. As a result, taxpayers generally can structure a given organization so that it is taxed as either a corporation or a partnership, and the entity will not significantly differ from a "traditional" corporation. Notwithstanding the changes in traditional business entities, the classification rules continue to burden taxpayers because their application is subject to differing interpretations and the "cost" of incorrect interpretation is high.

Somewhat unexpectedly, the IRS recently recognized the changing business environment and the formalistic nature of the entity classification rules. The IRS has proposed, in very general terms, new classification rules and has scheduled hearings on the rules for in July 1995. Under the new format, taxpayers would merely elect to have a domestic unincorporated business treated as a partnership. The old four factor test would have no significance. The proposed rules would not allow a domestic corporation to elect treatment as a partnership for tax purposes. Entities whose classification is determined under another Internal Revenue Code provision, such as publicly traded partnerships, would not be eligible to make an election. If adopted, the new classification system would simplify the formation of many types of business entities and would allow business owners and their advisers to focus on more substantive issues.