New Entity Classification Regulations

• Jurisdiction: United States,Federal
• Citation: Vol. 26 No. 4 Pg. 3
• Pages: 3
• Publication year: 1997

26 Colo.Law. 3 Colorado Lawyer 1997.

1997, April, Pg. 3. New Entity Classification Regulations

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Vol. 26, No. 4, Pg. 3

The Colorado Lawyer
April 1997
Vol. 26, No. 4 [Page 3]

Articles
New Entity Classification Regulations
New Entity Classification Regulations
by J. William Callison

J. William Callision, Denver,
is with the firm of Faegre
& Benson LLP. He has
written treatises on
Partnership Law and
Practice (Clark Boardman
Callaghan, 1992) and
Limited Liability Companies
(West, 1994)

On December 18, 1996, the Internal Revenue Service ("Service") issued final regulations ("New Classification Regulations" or "NCR") that create a new simplified and elective regime for classifying unincorporated business organizations.1 The NCR, which became effective January 1, 1997, replaced preexisting classification rules that had become laden with complexity The Service initially indicated it was considering simplification in April 1995,2 and issued proposed regulations in May 1996.3 The proposed regulations were well received, and the NCR follow the general outline of the proposed regulations

Under the New Classification Regulations, most types of domestic business organizations, other than corporations, will be treated as tax partnerships. As a result, domestic limited partnerships ("LPs") and limited liability companies ("LLCs") can now omit or simplify provisions in their governing documents addressing continuity of life, free transferability of interests and centralized management. In addition, the NCR permit single-member LLCs with pass-through tax treatment.

The New Classification Regulations are important because they will accelerate use of LLCs and other unicorporated business entities. This article discusses both the technical rules and planning opportunities created by these new regulations that should be of interest to lawyers representing business clients.

THE PRIOR CLASSIFICATION FRAMEWORK

Historically, unincorporated business organizations, such as general partnerships, LPs and LLCs, have been classified either as "partnerships" or as "associations taxable as corporations" for federal income tax purposes. Partnerships are defined for tax purposes to include syndicates, groups, pools, joint ventures, or other unincorporated organizations, through which any business, financial operation, or venture is carried on, that are not trusts, estates, or corporations.4 Corporations are defined for tax purposes to include associations, joint stock companies, and insurance companies.5 In addition, certain publicly traded partnerships, which would otherwise be taxed as partnerships, are subject to corporate taxation.6

Prior to the New Classification Regulations, the classification regulations ("Old Regulations") had set forth a two-step approach for classifying domestic entities and foreign entities.7 First, an entity was classified as either a trust or as some other form of association, depending on whether the organization possessed (a) associates and (b) a profit motive. Trusts lack both characteristics; associations do not. Second, associations were classified either as partnerships or as corporations based on the presence or absence of four corporate characteristics: continuity of life, free transferability of interests, centralized management, and limited liability.

The Old Regulations provided that unincorporated associations were classified as corporations if they possessed a preponderance (i.e., a majority) of the corporate characteristics, and as partnerships if they lacked a preponderance of the corporate characteristics.8 Therefore, a Colorado LLC in which the articles of organization and the operating agreement created continuity of life and centralized management would be taxed as a corporation since every Colorado LLC possessed the corporate characteristic of limited liability. Conversely, if an LLC possessed one or two corporate characteristics, it would be taxed as a partnership.

The Service supplemented the Old Regulations with numerous Revenue Rulings and Revenue Procedures setting forth rules concerning the four primary corporate characteristics.9 Although unincorporated business organizations typically could achieve partnership status under the Old Regulations, taxpayers and their advisers often spent substantial energy reviewing authority and ensuring that an organization lacked at least two corporate characteristics. This situation was complicated by the fact that, particularly with LLCs, which always possessed the limited liability characteristic and which provided structural flexibility, there often was a client desire for a structure that possessed the corporate characteristics.

For example, LLC clients frequently desire business continuity despite an owner's dissociation from the entity (thereby potentially creating continuity of life under the Old Regulations) and manager management (thereby often creating centralized management under the Old Regulations) When combined with limited liability, a LLC that was structured to meet the client's business goals without sufficient sensitivity to the latest tax authority could have been classified as a corporation under the Old Regulations. Many tax counsel can relate stories of reviewing LLC documentation and discovering that the elements of corporate classification...