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    by: Rogers

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    1 : L. Andrew Immerman Alston & Bird LLP 404-881-7532 ABA Business Law Section April 12, 2008 Classifying and Converting Business Entities: Basic Tax Issues
    2 : 2 Overview The tax rules for classifying business entities are largely, but not entirely, independent of state law categories. A partnership under state law may or may not be a partnership for tax purposes. An LLC under state law will never be an LLC for tax purposes – there is no such thing. However, a corporation under state law is just about always a corporation for tax purposes.
    3 : 3 Overview If the tax classification rules seem confusing, remember that we are almost always talking about only three major classifications: Corporation. Partnership. Nothing. Nothing – i.e., "disregarded entity" – is actually an important category.
    4 : 4 Before 1997 ("Four Factor" Test): LLCs were classified as partnerships or corporations. If an LLC lacked two or more of the following four "corporate" characteristics, it was classified as a partnership: Continuity of life. Centralized management. Limited liability (liability for entity debts limited to entity property). Free transferability of interests.
    5 : 5 Starting 1997: ("Check the Box") LLCs are classified as corporations or partnerships, or sometimes as disregarded entities (also known as "tax nothings"). The LLC's characteristics are generally irrelevant to classification. Classification is now generally elective – the LLC decides its own tax classification. LLCs cannot be classified as LLCs.
    6 : 6 What are the "Check the Box" Rules? A set of Treasury Regulations, effective in 1997. Treasury Regulations §§ 301.7701-1 to -4. Authorize many business entities, generally including LLCs, to choose whether to be taxed as corporations or partnerships (or sometimes as nothing).
    7 : 7 Do You Really Check a Box? The choice is made by checking the appropriate box on a Form 8832. Most businesses are satisfied with their "default" classification (the classification they are assigned if they don't file the form), and so never literally "check the box."
    8 : 8 The Five Key Questions Is there an entity? If there is an entity, is it a business entity or a trust? If it is a business entity, is it an eligible entity? If it is an eligible entity, what is its "default" classification? Has it properly elected a classification other than the "default"?
    9 : 9 Is There an Entity? "Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law" (Reg. § 301.7701-1(a)(1)). Certain joint undertakings give rise to entities for tax purposes that are not entities under state business law. Certain state business law entities are not entities for tax purposes.
    10 : 10 Is There an Entity? Absence of a state law entity is not dispositive. You cannot avoid the complexities of partnership tax merely by refusing to form a state law entity. Presence of a state law entity is not dispositive. Especially in tax shelter situations, the courts may refuse to recognize the existence of a tax entity despite the existence of a valid state law entity.
    11 : 11 Is There an Entity? There are no clear rules for determining whether an "entity" exists. Many relationships can involve some economic sharing, and may or may not be "entities": Debtor/creditor. Employer/employee. Lessor/lessee. Licensor/licensee. Cost-sharing. Co-ownership. Joint production.
    12 : 12 Is There an Entity? "The question is … whether, considering all the facts—the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent—the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise." Comm'r v. Culbertson, 337 US 733 (1949)
    13 : 13 Is it a Business Entity or a Trust? A trust is "an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries …" (Reg. § 301.7701-4(a)). A trust's purpose is "to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit" (Reg. § 301.7701-4(a)).
    14 : 14 Is it a Business Entity or a Trust? An "investment trust" is a trust if there is a single class of ownership interests, representing undivided beneficial interests in the trust's assets, and there is no power to vary the investment. An investment trust with multiple classes of ownership interests is likely to be a business entity. A "business trust" (sometimes called a "Massachusetts business trust") is likely to be a business entity.
    15 : 15 Is it an "Eligible" Entity? An eligible entity is eligible to select its classification under the Check the Box Regulations. Open-ended definition: an eligible entity is any business entity except for one that is ineligible.
    16 : 16 Is it an "Eligible" Entity? Entities that are normally eligible: Limited liability companies (LLCs). Limited liability partnerships (LLPs). Limited liability limited partnerships (LLLPs). Limited partnerships. General partnerships.
    17 : 17 State Law vs. Tax Law State law partnerships are not necessarily classified as partnerships for tax purposes – in some instances they may be classified as corporations or "nothings." LLCs and state law partnerships (limited partnerships, general partnerships, limited liability partnerships, limited liability limited partnerships) are usually – not always – "eligible" entities.
    18 : 18 State Law vs. Tax Law An "eligible" entity gets a choice on its tax classification. You cannot tell what the tax classification of an eligible entity is just by looking at the characteristics of the entity. In buying or selling an LLC or partnership always verify the tax classification – you might be surprised.
    19 : 19 Partnership vs. S Corporation "S corporations" are not taxed as partnerships. S corporations are generally not subject to corporate-level tax. S corporations are corporations for tax purposes. In that respect, S corporations resemble partnerships, which are never subject to corporate-level tax. Despite some similarities, there are many differences.
    20 : 20 Partnership vs. S Corporation S corporations are subject to many of the same "Subchapter C" tax rules that apply to C corporations. Example: S corporations are subject to the rule that the contributors of property in a tax-free contribution must have 80% control of the corporation. Code § 351.
    21 : 21 Partnership vs. S Corporation Entities taxed as partnerships are subject to Subchapter K and not to Subchapter C. Example: The contributors of property to a partnership do not need to meet the 80% control requirement in order to get tax-free treatment. Code § 721.
    22 : 22 What Entities Are Not Eligible? All entities taxed as partnerships have one thing in common: they are not state law "corporations." If an entity has "inc." in its name, you know it is not taxed as a partnership. If an entity is unincorporated (i.e., is not a state law corporation), however, you can’t assume that it is going to be taxed as a partnership.
    23 : 23 What Entities Are Not Eligible? Corporations under state law are ineligible. If it is called a corporation under state statute it is ineligible. The name is all that matters. The characteristics of the entity are irrelevant.
    24 : 24 What Entities Are Not Eligible? The name "corporation" is dispositive. The IRS couldn't figure out what characteristics distinguished corporations from partnerships, and gave up trying. "Substance controls over form, except where form controls over substance" (Sheldon I. Banoff).
    25 : 25 What Entities Are Not Eligible? Other ineligible entities include: Insurance companies and banks. Most publicly traded partnerships (Code § 7704). Foreign entities listed in the regulations. Exempt organizations and government entities. Specialized forms such as mutual funds and real estate investment trusts ("REITs").
    26 : 26 What Entities Are Not Eligible? A publicly traded partnership is generally ineligible, unless 90% or more of the gross income is passive. Most partnerships are safe under a regulatory "private placement" safe harbor, if: No interests are required to be registered under Securities Act of 1933, and 100 partner maximum. Outside several regulatory safe harbors, the definition of "publicly traded" is unclear.
    27 : 27 What is its Default Classification? Domestic eligible entities. A domestic eligible entity is never classified as a corporation by default. Two or more members: Classified as a partnership unless it elects corporation status. One member: Disregarded absent an election to be treated as a corporation.
    28 : 28 What is a "Member"? Tax advisor’s concept of "member" (or "partner") does not always correspond to state law "member" (or "partner"). Tax concept is closer to what a business lawyer might call "economic interest holder" (or owner of an equity interest). For example, a "bankruptcy remote" LLC can be disregarded for federal tax purposes when one of its two members is there simply to prevent bankruptcy filing and has no economic interest. See PLR 200201024 (Oct. 5, 2001).
    29 : 29 Symbols = Individual = Corporation
    30 : 30 Symbols = Partnership = Disregarded = "Whatever" (anything other than a disregarded entity)
    31 : 31 Multi-Member LLC: Default Rule LLC 50% 50% Multi-member LLC is partnership by default
    32 : 32 Single-Member LLC: Default Rule LLC 100% Single-member LLC is disregarded by default
    33 : 33 Single Economic Owner = Single Tax Owner LLC LP Whatever 99% 1% See Rev. Rul. 2004-77 100% LLC and LP are disregarded by default
    34 : 34 What is its Default Classification? Foreign eligible entities (formed after 1996). Classified as a corporation if all members have limited liability. Two or more members: Classified as partnership, unless it elects otherwise, if it has at least two members, and at least one of the members does not have limited liability. One member: Disregarded, unless it elects otherwise, if the member does not have limited liability.
    35 : 35 Did it Elect Out of its Default Classification? Most domestic entities are happy with their default classification; domestic entities rarely elect out of their default classification. Since foreign eligible entities can be classified as corporations by default, it is much more common for foreign entities to elect out of the default. If an entity wants to elect out of the default, the election is made on the deceptively simple IRS Form 8832.
    36 : 36 Did it Elect Out of its Default Classification? An eligible entity almost always has the right to elect, on Form 8832, to be classified as an "association" (i.e., corporation). Exception: Only one election is allowed every five years (but initial election doesn’t count)
    37 : 37
    38 : 38
    39 : 39 Multi-Member LLC: Election LLC 50% 50% LLC Elects to be taxed as a corporation
    40 : 40 Single-Member LLC: Election LLC 100%
    41 : 41 Consequences of Checking the Box Tax consequences of changing classification by checking the box are generally the same as entering into an actual transaction. Changing classification under the Check the Box rules can have the effect of an incredibly taxable transaction. BE ESPECIALLY CAUTIOUS BEFORE YOU CONVERT FROM A CORPORATION TO SOMETHING ELSE.
    42 : 42 Consequences of Checking the Box Partnership to Corporation. The partnership is deemed to contribute all of its assets and liabilities to the corporation in exchange for the corporation’s stock. Immediately thereafter, the partnership is deemed to liquidate by distributing the stock of the corporation to the partners. These transactions may be tax-free, but check Code §§ 351, 357(c), 704(c)(1)(B), 707(a)(2)(B), 731, and 737.
    43 : 43 Consequences of Checking the Box Corporation to Partnership. The corporation is deemed to distribute its assets and liabilities to its shareholders in liquidation. The shareholders are then treated as recontributing all the distributed assets and liabilities to the partnership. This conversion can be incredibly taxable.
    44 : 44 Consequences of Checking the Box Corporation to Disregarded Entity. The corporation is deemed to distribute all of its assets and liabilities to its sole owner in complete liquidation. There is no further deemed step; the sole owner is treated as continuing to own the assets and liabilities. This conversion can be incredibly taxable (usually except for corporate subsidiaries).
    45 : 45 Consequences of Checking the Box Disregarded Entity to Corporation. The owner of the disregarded entity is deemed to contribute all of the assets and liabilities of the entity to the corporation in exchange for stock of the corporation. The deemed contribution generally will be tax-free if the requirements of Code § 351 and Code § 357(c) are met.
    46 : 46 Change in Number of Members Disregarded Entity to Partnership: A disregarded entity becomes classified as a partnership when the entity begins to have more than one member. Partnership to Disregarded Entity: A partnership becomes a disregarded entity when the entity has only one member left.
    47 : 47 Disregarded Entity to Partnership A 100% LLC Rev. Rul. 99-5 / Situation 1 Before A 50% B 50% After LLC
    48 : 48 Disregarded Entity to Partnership Rev. Rul. 99-5 / Situation 1 B’s purchase of fifty percent of A’s ownership interest in the LLC is treated as the taxable sale by A of a fifty percent interest in each of the LLC’s assets -- assets which previously had been treated as held directly by A for tax purposes. A and B are treated as then contributing their respective interests in those assets to a partnership in exchange for ownership interests in the partnership.
    49 : 49 Disregarded Entity to Partnership A LLC Rev. Rul. 99-5 / Situation 2 A 50% LLC B 50% $10,000 50% Before After 100%
    50 : 50 Disregarded Entity to Partnership Rev. Rul. 99-5 / Situation 2 B is treated as contributing $10,000 to a partnership in exchange for a partnership interest. A is treated as contributing all of the assets of the LLC to the partnership in exchange for a partnership interest. Neither A nor B recognizes any gain or loss on the deemed contributions.
    51 : 51 Partnership to Disregarded Entity B 100% LLC Rev. Rul. 99-6 / Situation 1 A 50% LLC B 50% Before After
    52 : 52 Partnership to Disregarded Entity Rev. Rul. 99-6 / Situation 1 IRS's position is strange and confusing. A is treated as selling a partnership interest. B is not treated as purchasing a partnership interest. B is treated as purchasing half the partnership's assets from A, with a new holding period. B is treated as receiving half the partnership's assets in a liquidating distribution from the partnership, with a "tacked" holding period.
    53 : 53 Partnership to Disregarded Entity E 100% LLC Rev. Rul. 99-6 / Situation 2 C 50% LLC D 50% Before After $10,000 $10,000 50% 50% E E
    54 : 54 Partnership to Disregarded Entity Rev. Rul. 99-6 / Situation 2 Again IRS's position is strange and confusing. C and D are treated as selling a partnership interest. E is not treated as purchasing a partnership interest. E is treated instead as purchasing the partnership's assets from C and D.
    55 : 55 Partnership Incorporation IRS respects three different forms in which a partnership incorporates (Rev. Rul. 84-111, 1984-2 C.B. 88): "Assets-Up" Form "Assets-Over" Form "Interest-Over" Form Note that IRS respect "interest-over" form here, but not for partnership mergers (with the very limited exception noted above).
    56 : 56 Partnership Incorporation IRS respects these forms in the sense that it gives effect to the somewhat different tax consequences of each. Some differences arise because of: Disparities between inside basis (basis of the partnership in its assets) and outside basis (basis of the partners in their partnership interests. Disparities between inside holding period and outside holding. Assets up transaction sometimes offers opportunity to reduce taxable gain under Code § 357(c) on incorporation. Other incidental tax consequences.
    57 : 57 Incorporation of partnership into corporation, under any of these three methods, is often (but not always) tax-free. The reverse is rarely tax-free; exercise extreme caution before changing a corporation (even an S corporation) into a partnership. Partnership Incorporation
    58 : 58 Tax Consequences of Incorporation Generally, provided that the partners will continue to own at least 80% of corporation, the incorporation is tax-free. Possible exceptions under Code §§: 357(c) 704(c)(1)(B) 731(c) 737 751(b) Taxpayer should choose method of incorporating based on specific facts.
    59 : 59 Assets-Up Form Partnership liquidates, distributing property to members. Members immediately contribute the distributed property to the corporation. Corporation LLC (1) liquidating distribution of LLC’s assets & liabilities LLC’s assets & liabilities Members shares of corporation’s stock (2)
    60 : 60 Assets-Over Form Partnership contributes property to corporation, and then liquidates, distributing corporation’s stock to members. Corporation (1) LLC’s assets and liabilities shares of corporation’s stock LLC Members (2) liquidating distribution of corporation’s shares
    61 : 61 Interests-Over Form Members contribute partnership interests to corporation; partnership automatically terminates under Code § 708(b)(1)(A) (because it has only one member after the transfers). Members Corporation LLC LLC shares of corporation stock LLC interests
    62 : 62 Mergers and Conversions State law conversion: Deemed to be an assets-over transaction. Rev. Rul 2004-59, 2004-1 C.B. 1050. State law merger: Probably also deemed to be an assets-over transaction. Cf. Treas. Reg. §301.7701-3(g)(1)(i).
    63 : 63 Mergers and Conversions Partnership merger or conversion into corporation is not respected as a distinct form, but is likely deemed to be "assets over." If you want "assets up" or "interests over" form, do not use a state law merger or conversion.
    64 : 64 Incorporating Before a Disposition Incorporation in anticpation of a sale of the stock (or issuance of new stock) should be carefully analyzed. The incorporation may be taxable (a "failed § 351") if there was a binding commitment by owners of the corporation to dispose of more than 20% of the stock, or of the corporation to dilute the owners down by more than 20%. Definite plans, even without a binding commitment, may cause concerns.

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