Federal Tax Classification of Business Entities: What’s in a Name?

Romeo and Juliet

“What’s in a name? that which we call a rose / By any other name would smell as sweet….” So says Juliet. A couple acts later, she’s dead. Romeo’s dead. A couple other people are dead. Names killed them. (OK, also swords, poison, a dagger, all-around poor decision-making, etc.)

Names also matter in the rarefied realm of federal income taxation. How a business entity’s classified under the federal income tax determines how the entity’s taxed, which in turn can affect how the entity handles basic transactions. A disregard for an entity’s classification can lead to serious problems down the line.

Per the treasury regulations under section 7701 of the Internal Revenue Code (also known as the “check-the-box regulations”), a business entity’s classified for federal tax purposes as either a corporation, a partnership, an entity disregarded as separate from its owner (a “disregarded entity”), or an association.  (As corporations and associations are taxed the same, the separate classifications appear to exist only to differentiate which entities can change their classification and which can’t.) If the entity has been filing federal income tax returns, figuring out its classification may be fairly straight-forward: Just look at what sort of return the entity has been filing. For example, if it’s a Form 1120, 1120S, or 5471, it’s being classified as a corporation or an association; if it’s a Form 1065 or 8865, it’s being classified as a partnership; and if the entity isn’t filing a separate return, it’s being classified as a disregarded entity.

However, if the business hasn’t yet filed a federal income tax return or if there are still questions about its classification, the entity’s classification will need to be determined by applying the regulations. These regulations throw every entity by default into a classification based on factors such as how and where the entity was organized and the number of the entity’s owners. An entity classified by default as a corporation is stuck with that classification, but an entity that’s not so classified is considered an “eligible entity” and may elect to change its classification. Thus, a good starting point in determining an entity’s classification is figuring out whether it’s a corporation.

 According to the regulations, the following entities are corporations:

  1. an entity organized under a federal or state law that describes the entity as a corporation, body corporate, body politic, joint-stock company, or joint-stock corporation;

  2. an insurance company;

  3. an FDIC-insured, state-chartered bank;

  4. an entity wholly owned by a state, political subdivision of a state, or a foreign government;

  5. a foreign entity specifically identified as a corporation in the treasury regulations; or

  6. an entity that’s treated as a corporation under some other provision of the Internal Revenue Code.

Again, if an entity isn’t a corporation, it’s an eligible entity. The classification of eligible entities is split into two sets of rules, one for domestic entities and one for foreign entities. According to the Internal Revenue Code, an entity is “domestic” if it’s organized in or under the law of the United States or of any state; if not, it’s “foreign.”

A domestic eligible entity with only one owner is classified by default as a disregarded entity; if it has more than one owner, it’s by default a partnership. However, a domestic disregarded entity or partnership can elect to be classified as an association.

Things are a little different for foreign eligible entities. A foreign eligible entity with two or more owners all of whom have limited liability is classified by default as an association but can elect to be classified a partnership. If a foreign eligible entity has two or more owners and not all of them have limited liability, it’s classified by default as a partnership but can elect to be classified as an association. Lastly, if a foreign eligible entity has only one owner and this owner doesn’t have limited liability, then the entity is classified by default as a disregarded entity but can elect to be classified as an association.

OK, so why does classification matter? Well, it determines how an entity is taxed. Absent an election to be taxed as an S corporation, a corporation or association’s income is potentially subject to double taxation: Its income can be taxed at the entity level when earned and then again at the ownership level when the entity makes a distribution. On the other hand, a partnership’s or a disregarded entity’s income is taxed only once, at the ownership level, when the income is earned.

In addition, each classification has its own specific rules governing the taxation of certain basic transactions, such as contributions and liquidations. For instance, a contribution of property to a partnership in exchange for an interest in the partnership generally doesn’t result in any immediate additional tax to either the partnership or the new partner. However, a contribution of property to a corporation or association in exchange for stock in the entity is tax-free only if certain requirements are met (such as that the persons making the contributions end up with 80 percent of the vote and value of all classes of stock in the corporation after the exchange). Thus, an entity’s classification can have a real impact not only on how the entity is taxed big-picture but also on how the entity undertakes basic transactions.

Elections to change an entity’s tax classification can be made by filing a Form 8832. But if an entity makes an election to change its classification, it won’t be able to change again for five years. Also bear in mind that an entity’s election to change its classification may itself be a taxable event, meaning that it could give rise to additional tax.

If a disregarded entity elects to be classified as an association, the owner is deemed to have contributed the assets and liabilities of the entity to an association in exchange for the association’s stock. If a partnership elects to be classified as an association, the partnership is deemed to contribute all of its assets and liabilities to the association in exchange for stock in the association, which stock the partnership is deemed to have made a liquidating distribution to its partners. If an association elects to be classified as a partnership, the association is deemed to have made a liquidating distribution of its assets and liabilities to its owners, and the owners are deemed to have contributed the assets to a new partnership. Finally, if an association elects to be classified as a disregarded entity, the association is deemed to make a liquidating distribution to its owner.

Determining whether any of these deemed contributions and liquidating distributions give rise to additional tax requires a careful examination of the rules for such transactions under each tax classification.

Then there are things that may not seem like they would affect an entity’s classification but, in fact, do. For instance, an entity classified as a disregarded entity will be classified as a partnership if it gains more than one owner. If an entity classified as a partnership loses all but one owner, it will be classified as a disregarded entity.  Furthermore, if a disregarded entity or partnership elects to be taxed as an S corporation, the entity is deemed to have made an election to be classified as an association under the regulations.

This last possibility could be disastrous if the entity loses its status as an S corporation, because after the loss, the entity will still be classified as an association. (As explained in another post, it can be fairly easy for a company to lose its status as an S corporation.) In other words, the entity has gone from being classified by default as a partnership (with its income taxable only once at the ownership level) to being classified as an association that is an S corporation (with its income taxable only once at the ownership level) to being classified as an association that is not an S corporation (with its income taxed at both the entity and the ownership level).

Considering the potentially tragic consequences of getting it wrong, care should be taken when choosing or changing an entity’s classification or engaging in the sorts of transactions that might potentially cause a classification to change.