Classification of business entities that are not corporations.

• Author: Ellentuck, Albert B.

AN ORGANIZATION WITH TWO OR MORE owners that is an entity separate from the owners and that is not a corporation is an eligible entity that can be classified as a corporation or a partnership. (See Regs. Sec. 301.7701-2(b) for a list of entities that are always classified as corporations.) The regulations provide a set of default rules that establish the classification of an eligible entity if no classification election is made. Entities that want to be classified under the default rules do not need to make an election. Entities that do not want to be classified under the default rules must file a written election on Form 8832, Entity Classification Election.

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Observation: 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 therefrom. For example, a separate entity exists for federal tax purposes if co-owners of an apartment building lease space and provide services to the occupants. However, a joint undertaking to share expenses does not create a separate entity. This means, for example, that two persons who jointly construct a ditch merely to drain surface water from their properties have not created a separate entity for federal tax purposes.

Default Rule for Newly Formed Domestic Entities

A newly formed domestic eligible entity that does not file a classification election will be classified as a partnership (if it has two or more members) or a disregarded entity (if it has only one owner) (Regs. Sec. 301.7701-3(b)(1)).

Example: J and S formed A LLC to sell wholesale computer hardware and software to retail computer stores. Since A is considered a separate entity (because it operates a business), has two or more members, and is not a corporation, its default classification is partnership status. If J and S want A to be classified as a partnership, they do not need to file an election. If they want A to be classified as a corporation, they should file an election on Form 8832.

Default Rule for Newly Formed Foreign Entities

The default classification of newly formed foreign eligible entities depends on the personal liability of their members for the entity's debts. Regs. Sec. 301.7701-3(b)(2) provides three possible default classifications:

* A foreign eligible entity with two or more members is classified as a partnership if at least one member does not have limited...