Chapter 2 - Classification

Classification is a matter of

federal law -the classification place on an organization under state law will not control its code classification

Unless the check the box election is made a business entity with only one owner is treated as a

sole proprietorship--> as part of the owner

Check-the-Box

some unincorporated entities can choose to be treated as a corporate entity for tax reasons

Unless a a contrary election is made, a foreign entity that is not a corporation is

-a partnership if it has two or more member and at least one member does not have limited liability -a corporation if all members have limited liability -disregarded as an entity if it has a single owner that does not have limited liability

Series LLCs

-allowed in some states -debts are only enforceable against that series and a series is not liable for the debts of the LLC -Advantage - it is one entity for state law purposes and costs may be reduced because each series does not have to separately comply with state law -check the box rules are applied to determine whether each series is an entity separate from its owners and its ultimate classification for federal tax purposes

LLC-Limited Liability Companies

-avoid entity level tax and provide limited liability to all owners -more flexible than S Corps --issue different classes of ownership interests and enjoy other tax benefits -may pass through losses

Limited Partnerships

-enjoy most of the same benefits as LLCs but partners do not have limited liability under state law

The classification of a business relationship may have major tax consequences

-entities classified as corporations are subject to double taxation -income realized by a partnership is taxed directly to a partner through flow-through -the operation of the code also varies depending on whether the taxpayer is an individual partnership or corporation

Publicly Trade Partnerships

-generally classified as corporations - partnerships whose interests are traded on an established securities market or are readily tradable on a secondary market

Closely Held Businesses

-must choose whether to be taxed as a C corp or a pass-through entity - the new 21% flat rate will make this decision much more complex

Check-the-Box Election Requirements

-must file an election -The election may be effective up to 75 days before or 12 months after it is filed -Must be signed by: each member of the entity (including any prior members affected by a retroactive election, an officer, manager or member authorized to make the election -if the election is made it may not make another to change its classification for 60 months unless the service permits the change and 50% of the entity's ownership interests are owned by persons who did not own any interests when the first election was made

Business Trusts can be classified as a business entity

-need to determine whether a business objective is present or the trust was established merely to protect and conserve trust property -it will be classified as a partnership if it has two or more owners or members unless an election is made for it to be classified as a corporation

S. Corp Restrictions

-no more than 100 shareholders -one class of stock -no special allocations -no shareholder basis credit for entity debt

S Corp Decision

-only a tax status, even though incorporated you will still be treated as a flow through entity -only subject to one level of tax --losses pass through to its shareholders --have simpler and easier governance structure than LLCs or partnerships -easily convert to C corps -have traditional stock option plans -strict, eligibility restrictions

C Corp Decision

-primary disadvantage is the double tax -if the corporation holds highly appreciated assets, the additional tax cost when the business is sold and liquidated -used by: closely held businesses able to take advantage of the then lower corporate income tax rates by limiting their taxable income to $75000 or less and companies intending to reinvest their earnings for the reasonable needs of the business rather than paying dividends -allow the minimization of corporate-level tax and avoid the shareholder-level tax upon the shareholder's death -used by start-up ventures -permitted to have different types of ownership interests .

Whether or not an entity should be classified as a corporation or partnership for federal tax purposes

-whether an entity formed under state law as a limited partnership, limited liability company, or trust will be classified as a corporation under the code

Whether an unincorporated business relationship is an entity separate from its owners

-whether the business relationship among the parties is such that a separate entity is recognized for tax purposes -if a separate entity is recognized, it generally will be classified as a partnership for federal tax purposesq

4 characteristics common to corporations

1. continuity of life 2. centralization of management 3. limited liability of investors 4. free transferability of interest

Principal Classification Issues

1. whether an unincorporated business relationship is an entity separate from its owners 2. whether or not an entity should be classified as a corporation or partnership for federal tax purposes

State Tax Considerations

Converting a C corp to a partnership or LLC requires a complete liquidation, which is a taxable transaction to the corporation and its shareholders -all of the property is treated as if it is a liquidation for tax purposes --it will be a taxable transaction with two levels of tax ---> corporations will pay tax on the difference on what is has on its book and the fair value ---> shareholders will be taxed on the difference between the amount distributed and the value of the basis they had in the stock

Certain business entities are automatically classified as corporations

Includes business entities organized under a federal or state statute if the statute describes or refers to the entity as "incorporated"

Publicly Traded Businesses

almost always are taxed as C corporations, except for publicly traded partnerships that qualify for the passive investment income exception

Business Trusts

are formed to carry on a profit making business rather than for the protection and conservation of property, the business purpose is what allows it to later be classified as a trust

Ordinary Trusts

arrangements created by will or inter vivos declaration under which trustees take title to property in order to protect and conserve it for beneficiaries

Certain entities formed under foreign law are

automatically classified as a corporation

If a separate entity is not a trust then it is a

business entity

"Co-ownership" of property does not

constitute separate entities for federal tax purpose -must carry on a trade or business -needs a profit motive

An entity that is solely owned by a married couple as community property may be treated by the owners as either a disregarded entity or a partnership unless

it elects to be taxed as a corporation

Converting from Corp to pass-through

it is easier to go from C Corp to S Corp -subchapter S prevents avoidance of the double tax on built-in gains attributable to the period when the business operated as a C Corp

A business entity with two or more members that is not automatically classified as a corporation is classified as a

partnership unless the election is made to be a corporation

Separate Entities

regs provide that a joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation or venture and divide the profits - generally classified as a partnership -matter of federal law