Classifying a Business

Before January 1997, business organizations were classified based on historical differences between corporations and partnerships. For tax purposes, we now classify businesses using so-called “check-the-box” regulations, which acknowledge that an organization can be treated as a partnership, as a corporation, or as an LLC by election under state law. The first step in classifying a business is to determine if it is an “entity separate” from its owners under income tax principles. A cost-sharing arrangement is not a separate entity for federal tax purposes, for instance.

The second step is determining if the separate entity is a “business entity.” Trusts and other organizations for which special tax treatment is proscribed (such as REMICs) are not business entities.

The third step is determining if the business entity is an “eligible entity.” Entities taxable as corporations by force of statute, such as domestic corporations, publicly-traded partnerships, banks, insurance companies and certain foreign entities are not eligible entities.

In the fourth step, we determine which options are available to the eligible entity. If the entity has two or more members, it may elect to be treated as either a corporation or a partnership. If it is a single-owner entity, it may elect to be treated as a corporation or to be disregarded as a separate entity for tax purposes. The election must be affirmatively made or default rules will be used to determine the classification. Under the default rules a domestic entity is a partnership if it has two or more members and is disregarded as an entity separate from its owner if it has a single owner. Special rules apply if the entity is a foreign eligible entity. Once an election becomes effective, it cannot be changed for 60-months.

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