A. Taxation as a Partnership or Corporation
In order to distinguish between taxation as a partnership or corporation, a brief description of the default classification rules should be provided. The classification rules will be discussed in greater detail at the end of this presentation (see, infra, F. “Check the Box” Income Tax Regulations”). To begin with, an eligible entity will be classified under the default rules if it does not elect its desired entity classification. Unless the “eligible entity” elects otherwise, it will be classified as a disregarded entity if it has a single owner or as a partnership if it has two or more members. 2 An eligible entity having two or more members has the option of electing classification as either an association or a partnership. 3 A single member eligible entity can elect to be classified as a corporation or as a disregarded entity separate from its owner. 4 An entity electing to be disregarded will be treated as a sole proprietorship.
Equity based compensation is used by many corporate employers to motivate their employees. A limited liability company (“LLC”) can transfer an interest to an employee or existing member in the form of a capital and profits interest, a capital interest or a profits interest, or as an option to acquire either a capital or profits interest or both. This type of transfer may be treated as an ordinary income distribution of property, but in some cases, it may be treated as a nontaxable distribution of unit interests.
LLCs can issue nonqualified options to purchase LLC units. The grant of an option to purchase LLC units to either an existing member or an employee does not have a taxable consequence for the LLC. It would be treated as a guaranteed payment. The difference between the fair market value of the option and the strike price would be a "payment" in the year received or the year the restriction lapses. This creates a deduction for the LLC and income to the LLC member.
Any change in income interests is recognized in the year the partner recognizes his distributive share of the partnership profits. The amount recognized shows the change in the income interests.
The acceptance by a partner of an additional capital interest in the partnership may be treated as an income event or the receipt of a gift from another partner, or be classified in accordance with its economic consequences.
Cash or property distributions received by a partner from a partnership will reduce the partner's basis in his interest. Unless the cash distribution is in excess of the basis, it will usually not be a taxable event to the partner or the partnership. Property distributed to a partner takes the same basis and holding period it had in the partnership. Cash distributions will reduce the partner's basis in his interest dollar for dollar. 5 Gain is recognized by the distributee partner only if the cash received exceeds his basis in his interest before the distribution. 6 Gain recognized is taxed as gain from the sale or exchange of a partnership interest. 7 Distributions of non-cash property will reduce the partner's basis in the partnership interest to the extent of the adjusted basis of the property in the hands of the partnership. 8
A partner does not recognize loss in a non-liquidating distribution. 9 A partner also does not recognize gain as a result of a non-liquidating distribution, unless the amount of cash is greater than the partner's outside basis. 10 Cash distributed up to the amount of the basis represents amounts the partner has already accounted for under the income tax system. Only cash distributions in excess of outside basis represent income for the partner.
A partner does not recognize gain with respect to property distributions in a non-liquidating distribution. The partner's previously unrecognized gain or loss in the partnership interest is preserved by allocating the adjusted basis to the distributed property and making a reduction to the partner's basis. The basis of the distributed property in the partner's hands is the same as the basis of the property in the partnership's hands. But it cannot be greater than the partner's adjusted basis in the partnership. 11
Because the goal is to preserve the partner's tax position in regard to the partnership investment in a non-liquidating property distribution, the partner's basis is reduced by the amount of money distributed, and the adjusted basis of the distributed noncash property.12 The partner is treated as having converted a single asset, a partnership interest, into multiple assets, the partnership interest, the distributed property and the distributed money, and the partner's basis is divided among these assets.
Much of the planning concerning the use of and choice between different taxable entities has evolved from the historic differences between the treatment of employees and self-employed individuals for purposes of tax qualified retirement plans. H.R. 10 or "Keogh" plans are the income deferral arrangements most commonly used by self-employed individuals.
However, the Tax Equity and Fiscal Responsibility Act of 1987 (TEFRA) made modifications that included "top heavy plan" limitations. As a result, tax qualified retirement plan choices are now a neutral factor in the decision concerning the choice of entity.
When a corporation elects to be a disregarded entity, the corporation is deemed to have liquidated by distributing its assets and liabilities to its sole owner. 13 If an LLC classified as a partnership becomes a single-member LLC, the partnership status terminates.
The Internal Revenue Service (“IRS”) issued guidance in Revenue Ruling (“Rev. Rul.”) 99-6 14 on an LLC classified as a partnership that becomes a single member LLC. The IRS ruled that Internal Revenue Code (“Code”) §708(b)(1)(A) states that the LLC's partnership status will terminate because the operations of the partnership are no longer carried on by any of its partners as a partnership. If no election is made to treat the LLC as a corporation for federal tax purposes, the LLC then becomes a disregarded entity.
The payment to a partner for services or the use of capital that is determined without regard to the income of a partnership is classified as a guaranteed payment and generally is treated as a non-partnership transaction. 15 The partner includes the payments in income using the same standards as a non-partner. 16 The partnership may be permitted to deduct the guaranteed payment. 17 The guaranteed payment is treated as an ordinary partnership transaction.
On the other hand, the use of LLC interests to compensate LLC employees may result in the employees being treated as members of the LLC rather than as employees for federal tax purposes. There is a difference in the treatment of compensation paid to an employee and compensation paid to a LLC member.
Code §707(a) states that if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction will be considered as occurring between the partnership and one who is not a partner. It is possible an LLC member could be classified as an employee if he provided services and there was a related allocation or distribution to him.
If payments are made to a partner for services, without regard to partnership income, under Code §707(c) the partnership deducts such amounts and the partner has ordinary income.
Compensation to a member must be analyzed to determine the relationship between the member and the LLC for tax purposes. The following five factors must be considered:
Whether the payment is subject to entrepreneurial risk. An employer-employee relationship would be supported by a lack of entrepreneurial risk.
Whether partner status is transitory.
Whether the payment closely follows the performance of service.
Whether the recipient became a partner primarily for tax benefits.
Whether the recipient's interest in the partnership is small in relation to the payment or allocation in question.
A nonqualified deferred compensation plan is a contractual arrangement between employer and employee providing for the deferred payment of compensation in the future. An effective deferral requires avoiding constructive receipt.
An LLC member's distributive share of the LLC's income and losses cannot be "deferred." 18 These items pass through to the LLC member under Code §702 and are taxable. Special allocations can be made in the LLC operating agreement to allocate certain items away from specific LLC members if the other partners agree.
It is possible to set up a nonqualified arrangement to defer the guaranteed payments the LLC member is to receive under Code §707(c). Treasury Regulations (“Regulations,” or “Reg.”) §1.707-1(c) states these payments will be ordinary income that is taxable to the member. Because of the deferred compensation arrangement between the LLC and the member, the LLC may control when the payment is made. The deferred amounts will increase the distributable income of the LLC members based on the LLC agreement to allocate income. Because the member receiving the guaranteed payments cannot defer his allocable share of LLC income, a portion of the deferred income will flow through to him in the year of deferral.
A partnership or limited liability company treated as a partnership may distribute ownership units to its partners.
When property is distributed by a partnership to a partner, its character is determined under the Code’s general principles of characterization.19 A limited set of principles serves to prevent the conversion of ordinary income into capital gain. First, unrealized receivables distributed to a partner are permanently classified as ordinary assets, and any gain or loss recognized from their disposition is treated as ordinary gain or loss.20 Second, inventory items distributed to a partner are subject to mandatory classification as ordinary assets for the first five years after distribution. If a partner disposes of the inventory during the five-year period following the distribution, any gain or loss must be classified as ordinary gain or loss.21 After that five-year period, the gain is classified according to the general characterization rules. A partner's holding period for distributed property includes the partnership's holding period for that property.22
The "hot asset" rules limit the taxpayers' ability to route capital gain and ordinary income selectively among the partners.23 The term "hot assets" refers to unrealized receivables, and substantially appreciated inventory items.24 Inventory is "substantially appreciated" if its fair market value is at least 120% of its basis.25
The “hot asset” rules apply to any disproportionate distribution of property that alters a partner's share in the partnership's “hot assets”. This can be accomplished by a disproportionate distribution of the “hot assets” themselves or a disproportionate distribution of other assets. The partner is treated as though he has received a proportional share of each partnership asset, to which the basic distribution rules apply, and then engaged in a taxable exchange with the partnership in which he exchanged a fractional interest in the assets received for a fractional interest in the assets the partnership retained.26 This is accomplished in a four-step process:27
These “hot asset” rules also apply if the distribution is a liquidation of the distributee partner's complete interest, but only to the extent that he either receives “hot assets” in exchange for his interest in other property, or he receives other property in exchange for his interest in the “hot assets”28
The general rule is that the sale or exchange of a partnership interest is treated as the taxable sale of a single asset.29 The normal rule is the gain is the excess of the amount realized over the selling partner's outside basis.30 The partnership interest is classified as a capital asset, which makes the gain or loss recognized as capital gain or loss.31
This is then modified in two respects. First, a portion of the sales price is allocated to the selling partner's share of the partnership's unrealized receivables and inventory, converting a portion of the capital gain or loss into ordinary income or loss. Second, an adjustment is made to the partnership's inside basis in its assets to reflect the gain or loss recognized by the disposition of the partnership interest.
A portion of the sales price for a partnership interest reflects the value of the selling partner's share in the partnership's unrealized receivables and inventory. If the partnership recognizes income with respect to these items, it is ordinary income, a portion of which is allocated to the selling partner. The Code §751 "hot asset" rule ensures that a partner who accesses this value by selling his partnership interest does not convert ordinary income into capital gain.32
This is very much like the “hot asset” rule that applies to disproportionate distributions of property, but with two significant differences. First, in the disproportionate distribution the rule applies only to inventory items that have substantially appreciated in value, but in the sale of partnership interests, the rule applies to all inventory items.33 Unrealized receivables are subject to the “hot asset” rule in both cases.34
Second, the application of the “hot asset” rule is simpler in the disposition of a partnership interest. Its implementation requires a four-step procedure:35
It is possible to generate ordinary income in a transaction that generates an overall loss, which would make the capital loss amount greater than the overall loss.
The “hot assets” may generate an ordinary loss in a transaction that generates an overall gain, thereby making the capital gain amount greater than the overall gain.
An individual is subject to either social security tax as an employee, or self-employment tax as an equivalent to the social security tax. The employer is required to match the social security contribution of the employee. The self-employed person is required to pay the full cost of this tax.
Sole proprietors, members of a partnership and members of a limited liability company treated as a partnership are subject to the self-employment tax. The distributive share of partnership income is included in a partner’s net earnings from self-employment. A limited partner does not include the distributive share of partnership income or loss from self-employment income. Unless a limited partner’s distributive share of income or loss from the self-employment income is received as guaranteed payments, it will not be included in his self-employment income.36
It is not clear how self-employment taxes apply to members of an LLC classified as a partnership. The members are not either general partners or limited partners. There are proposed regulations defining which partners of a federal tax partnership are considered limited partners. These regulations apply to all entities that are classified as partnerships for federal tax purposes.
"Net earnings from self-employment" includes the gross income derived from any trade or business carried on by a sole proprietor or partner in a partnership, less any deductions. Code §1402(a). Any partner's share of income or loss from any trade or business carried on by a partnership is also considered as net earnings from self-employment.
There are exceptions to what must be included in self-employment earnings. Some of the exceptions are:
A limited partner's distributive share of income or loss is excluded from self-employment net earnings. A limited partner's guaranteed payments in exchange for services are subject to the self-employment tax.37 When a partner is a general and a limited partner, only the general partnership income and loss is subject to self-employment tax. 38
Proposed regulations define which partners are considered limited partners for purposes of Code §1402(a)(13). They are to apply to all entities classified as a partnership for federal tax purposes. 39 The same standards will apply when determining the status of an individual owning an interest in an LLC. The proposed regulations will adopt an approach that depends on the relationship between the partner, the partnership and the partnership's business.40
The proposed regulations will treat an individual as a limited partner unless the individual: has personal liability for the debts of, or claims against, the partnership because he is a partner; has authority to contract on behalf of the partnership; or participates in the partnership's trade or business for more than 500 hours during the year.41 If substantially all of the activities of a partnership involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting, the proposed regulations state an individual will not be considered a limited partner.42
An individual who is not a limited partner is allowed to exclude from his net earnings from self-employment a portion of his distributive share if he holds more than one class of interest in the partnership.43
The Taxpayer Relief Act of 1997 added a provision that prevented the IRS from finalizing these regulations until July 1, 1998.44 To date these regulations have not been finalized by the IRS.
The exclusion for limited partners was incorporated into the statute at a time when there essentially were only two types of partnerships, the general partnership, and the limited partnership. With the advent of limited liability companies, limited liability partnerships and other types of entities that are being treated as partnerships for federal tax purposes, a great amount of confusion has arisen as to what type of partners may exclude their distributive share of income or loss in determining net earnings from self-employment.
The first case to consider is Johnson v. Comr.45 This case involved the determination as to whether the taxpayer's net income from oil and gas working interests should be taxed as net earnings from self-employment. The taxpayer argued that she was not involved in a trade or business and her role was passive participation. The Tax Court held her involvement in a trade or business to be irrelevant since she was a partner in a partnership. The taxpayer also argued that if she is a partner, she should be considered a limited partner due to her limited involvement. The court rejected her argument stating "limited partnerships are creatures of agreement cast in the form prescribed by State law . . . Petitioner's argument is not persuasive because she and the other working interest owners did not take the necessary steps to comply with Texas law.”46
The partnership in Mammoth Lakes Project, et al. v. Comr. was a general partnership. These taxpayers argued they were entitled to include their share of net losses from the partnership in calculating their net earnings from self-employment. The government argued that there was limited liability and they did not participate in the management of the partnership. The court considered the government's argument to be a "superficially correct argument." Because the taxpayer did not address that argument, the court considered the taxpayer to have conceded the issue.
The Tax Court in Perry v. Comr47 ruled on the status of a person holding a working interest in an oil and gas venture. The court rejected the taxpayer's argument that he should be treated as a limited partner. The court stated, "[s]tate law requires that certain formalities be observed to create a limited partnership . . . There is no evidence of such formalities having been observed by the owners of interests in the wells.”48
The status of a passive state law general partner for Self-Employment Contributions Act (“SECA”) tax purposes was ruled on by the Tax Court in Norwood v. Comr.49 The taxpayer previously had been an active partner in a medical supply partnership. He had reduced his hours to only forty-one. He still held a 50.95% capital and profits interest in the partnership. He argued his interest in the partnership was passive and he should not be subject to SECA tax on his partnership income. The court rejected this argument. The court stated, "[t]hat petitioner spent a minimal amount of time engaged in the operations of [the partnership] is irrelevant . . . Petitioner's lack of participation in or control over the operations of [the partnership] does not turn his general partnership interest into a limited partnership interest. A limited partnership must be created in the form prescribed by State law."50
A member forms an S corporation to hold his or her interest in an LLC. The S corporation would then employ the individual and lease him to the LLC. Because the S corporation is not an individual, there is no SECA tax due with respect to the S corporation's distributive share of the LLC's income or the lease payments made for the individual's services. Employment taxes are due on the individual's salary paid by the S corporation, but the individual generally will take income from the S corporation in part as salary and in part as a distribution. The distribution of S corporation income is not subject to SECA or employment tax.
A taxpayer's business with both service and capital-intensive components may be segregated into separate entities.
Effective January 1, 1997, the IRS issued final regulations that implemented the entity classification system. These "Check-the-Box" rules allow unincorporated organizations to elect to be treated as either corporations or partnerships for federal income tax purposes. Certain business entities that are excluded from these rules are corporations organized under state statutes, foreign entities that resemble U.S. corporations, entities taxable as corporations under special Code provisions, and trusts. 51
An entity that does not elect a particular classification is classified under the default rules that state, for federal tax purposes, non-corporate domestic organizations with more than one member are treated as partnerships, and single-member domestic entities are disregarded.
There are three steps that must be performed in order to determine if an organization qualifies to choose its entity.
It must first be determined if the organization at issue is a separate entity. The “business entity” concept is the basis of the “Check-the-Box” rules. The federal tax law determines if the entity is separate from its owners for federal tax purposes and does not depend on the organization being recognized as a separate entity under local law. 52 "Business entity" is defined by the Regulations as any entity recognized for federal tax purposes that is not classified as a trust or subject to special treatment under the Code. 53
A disregarded entity is a business entity that is not a corporation, has a single owner, and is disregarded as an entity separate from its owner. 54 The Check-the-Box Regulations allow a single owner to elect to be disregarded as an entity separate from its owner. The disregarded entity may retain its entity status for state law purposes, but is disregarded for federal tax purposes.
The IRS has stated that it will respect the taxpayers’ choice of the entity as either a disregarded entity or as a partnership, in the case of a qualified entity owned exclusively by a husband and wife as community property. This qualified entity is a business entity entirely owned by a husband and wife as community property under the law of a state, is not treated as a corporation, and is one in which no other person would be considered an owner for tax purposes. 55
The definition of a business entity other than a corporation is based on the number of members. Being defined as a "partnership" means the business entity is one with at least two members and is not a corporation. 56
An entity meeting the description in any of the following eight categories is classified as a corporation for federal tax purposes: 57
The second step is to determine whether the entity in question qualifies as an "eligible entity." Only an "eligible entity" may elect the federal tax classification it wishes. The definition of an "eligible entity" is a business entity that is not classified as a corporation under Regs. §§301.7701-2(b)(1), 301.7701-2(b)(3), 301.7701-2(b)(4), 301.7701-2(b)(5), 301.7701-2(b)(6), 301.7701-2(b)(7) or 301.7701-2(b)(8).
There are only two situations that require an eligible entity to file a classification election. 61 The first situation is if the entity wishes to be classified differently than it would be under the default rules. The second situation is if the entity wishes to change its classification.
In order to make a classification election, an eligible entity must file Form 8832, Entity Classification Election. 62 A copy of Form 8832 must be attached to the federal tax or information return of the entity for the taxable year for which an election is made. 63 Where an entity is not required to file a return for the year an election is made, a copy of the Form 8832 must be attached to the federal income tax or information return of all direct or indirect owners of the entity for the taxable year of the owner that includes the date on which the election was effective. 64 Failing to attach a copy of a Form 8832 to the return will not invalidate the election.
An election must be signed by either (i) each member of the electing entity who is an owner at the time the election is filed, or (ii) an officer, manager or member of the electing entity who is authorized to make the election. 65
An entity that has an employer identification number (“EIN”) will keep its EIN even if the entity's federal tax classification changes under Regs. §301.7701-3. 66 A single owner disregarded entity must use the owner's taxpayer's identifying number (“TIN”) for federal tax purposes, 67 except when the entity chooses to have employment taxes, as opposed to other federal tax obligations, reported and paid with respect to its employees at the entity level rather than the owner level, in which case the entity must use its EIN with respect to such employment tax obligations.68 With respect to wages paid on or after January 1, 2009, however, a single owner disregarded entity will automatically be treated as a corporation for purposes of its employment taxes and required to use its EIN with respect to such employment tax obligations.69 When a single owner entity's classification changes and becomes recognized as a separate entity for federal tax purposes, that entity must use the EIN, not the TIN of the single owner.
An election is effective either on the date specified on Form 8832 or on the date the election is filed. A specified effective date will be allowed as long as it is not more than seventy-five days before the filing date or more than twelve months after the filing date. A specified date more than seventy-five days before the filing date will be effective only seventy-five days before the filing date. A date specified more than twelve months from the filing date will be effective twelve months after the filing date. 68
An eligible entity that elects to change its classification cannot change its classification by election again during the sixty-month period following the effective date of the original election. The IRS has the authority to waive the sixty-month restriction if more than fifty percent of the ownership interests in the entity on the effective date of the election are owned by persons that did not own any interests on the filing date or on the effective date of the entity's prior election. 69
Only an election to change classification will begin a sixty-month waiting period. If a new eligible entity elects out of its default classification effective from the beginning, that election is not a change in the entity's classification and does not prevent the entity from changing its classification by election within the next sixty months.
A change in tax classification will have tax consequences.
When a partnership elects to be classified as a corporation, it will be considered to have contributed all of its assets and liabilities to the corporation in exchange for stock in the corporation. 70 The partnership is deemed to liquidate by distributing stock in the corporation to its partners.
If a disregarded entity elects to be classified as a corporation, the owner of the eligible entity is considered to contribute all of the assets and liabilities of that entity to the corporation in exchange for stock of the corporation. 71
When a corporation elects to be classified as a partnership, it is considered to liquidate by distributing its assets and liabilities to its shareholders. The shareholders are deemed to contribute all of the distributed assets and liabilities to the partnership. 72
References
1Nearly all of this presentation is drawn from and based on materials previously prepared by Richard M. Colombik, JD, CPA & Linda Godfrey, JD, CPA.
2Treasury Regulations (“Regs.”) §301.7701-3(b)(1).
3Regs. §301.7701-3(a).
4Regs. §301.7701-3(a).
5Internal Revenue Code (“Code”) §733.
6Code §731.
7See Code §751(b).
8Code §§732, 733.
9Code §731(a)(2).
10Code §731(a)(1).
11Code §732(a).
12Code §733.
13Regs. §301.7701-3(g)(1)(iii).
141999-6 I.R.B. 6.
15Code §707(c).
16Code §61.
17Code §707(c). See Code §§263, 263A.
18410 U.S. 441 (1973).
19Code §1221.
20Code §735(a)(1).
21Code §735(a)(2).
22Code §735(b).
23Code §751.
24Code §751(b)(1).
25Code §751(b)(3)(A).
26Code §751(b)(1).
27Regs. §1.751-1(b).
28Regs. §1.751-1(b)(1)(i).
29Code §741.
30Code §1001.
31Code §741.
32Code §751(a).
33Code §751(b)(1)(A)(ii).
34Code §§751(a)(1), 751(b)(1)(A)(i).
35Regs. §1.751-1(a).
36Code § 1402(a)(13).
37Code §1402(a)(13).
38Proposed Regulations (“Prop. Regs.”) §1.1402(a)-2(h).
39Preamble to REG-209824-96, 62 Fed. Reg. 1702 (1/13/97).
40Prop. Regs. §1.1402(a)-2(g).
41Prop. Regs. §1.1402(a)-2(h)(2).
42Prop. Regs. §1.1402(a)-2(h)(5).
43Prop. Regs. §1.1402(a)-2(h)(3).
44P.L. 105-34, §935.
4560 T.C.M. 603 (1990).
4660 T.C.M. 603 (1990).
4767 T.C.M. 2966 (1994).
4867 T.C.M. 2966 (1994).
4979 T.C.M. 1642 (2000).
50Id.
51Regs. § 301.7701-2(b).
52Regs. § 301.7701-1(a)(1) ; Regs. §301.7701-1(a)(3).
53Regs. §301.7701-2(a).
54Regs. §301.7701-2(c)(2).
55 Revenue Procedure 2002-69, 2002-45 I.R.B. 831.
56 Regs. §301.7701-2(c)(1).
57Regs. §301.7701-2(b).
58Regs. §301.7701-2(b)(3).
59Regs. §301.7701-2(b)(4).
60Regs. §301.7701-2(b)(5).
61Regs. §301.7701-3(c)(1)(i).
62Regs. §301.7701-3(c)(1)(i).
63Regs. §301.7701-3(c)(1)(ii).
64Regs. §301.7701-3(c)(1)(ii).
65Regs. §301.7701-3(c)(2)(i).
66Regs. §301.6109-1(h)(1).
67Regs. §301.6109-1(h)(2)(i).
68Revenue Ruling 2001-61, 2001-50 I.R.B. 573.
692007-39 I.R.B. 675; Regs. §§301.7701-2(c)(2)(iv), (e)(5).
68Regs. §301.7701-3(c)(1)(iii).
69Regs. §301.7701-3(c)(1)(iv).
70Regs. §301.7701-3(g)(1)(i).
71Regs. §301.7701-3(g)(1)(iv).
72Regs. §301.7701-3(g)(1)(ii).