Changing The Status Of Entities
Organizations that are eligible and wish to change their classification may do so by filing an election. Once the classification has changed, the organization must keep that classification for at least five years.
Potential Tax Impact on Changing Classification
A change in tax classification will have tax consequences.
Corporation Status Elected
When a partnership elects to be classified as a corporation, it will be considered to have contributed all of its assets and liabilities to the corporation in exchange for stock in the corporation. 23 The partnership is deemed to liquidate by distributing stock in the corporation to its partners.
Election by Disregarded Entity to Be a Corporation
If a disregarded entity elects to be classified as a corporation, the owner of the eligible entity is considered to contribute all of the assets and liabilities of that entity to the corporation in exchange for stock of the corporation. 24
Changing from Corporation to Partnership Status
When a corporation elects to be classified as a partnership, it is considered to liquidate by distributing its assets and liabilities to its shareholders. The shareholders are deemed to contribute all of the distributed assets and liabilities to the partnership. 25
Corporation or Partnership Elects to Be Disregarded Entity
When a corporation elects to be a disregarded entity, the corporation is deemed to have liquidated by distributing its assets and liabilities to its sole owner. 26 If an LCC classified as a partnership becomes a single member LLC, the partnership status terminates.
The IRS issued guidance in Rev. Rul. 99-6 27 on an LLC classified as a partnership that becomes a single member LLC. The IRS ruled that §708(b)(1)(A)state the LLC’s partnership status will terminate since the operations of the partnership are no longer carried on by any of its partners as a partnership. If no election is made to treat the LLC as a corporation for federal tax purposes, the LLC then becomes a disregarded entity.
Changing from Single Member Disregarded Entity to Partnership
A single member disregarded entity may sell an interest in that business and become a partnership. Both partners should treat the conversion of a single member entity to a multiple member entity as §721 contributions to the entity.
The IRS issued guidance on the conversion of a single member LLC that is a disregarded entity to a partnership in Rev. Rul 99-5.541. Section 721(a) states no gain or loss is recognized by the previous sole owner or the unrelated purchaser as a result of the conversion to a partnership.
- Compensation Planning and Use of Guaranteed Payments, Distributive Shares and Keogh Plans
The payment to a partner for services or the use of capital that is determined without regard to the income of a partnership is classified as a guaranteed payment and generally is treated as non-partnership transaction. 28 The partner includes the payments in income using the same standards as a non-partner. 29 The partnership may be permitted to deduct the guaranteed payment. 30 The guaranteed payment is treated as an ordinary partnership transaction.
Deferred Compensation Arrangements
A nonqualified deferred compensation plan is a contractual arrangement between employer and employee providing for the deferred payment of compensation in the future. An effective deferral requires avoiding constructive receipt.
An LLC member’s distributive share of the LLC’s income and losses cannot be “deferred.” 31 These items pass through to the LLC member under §702 and are taxable. Special allocations can be made in the LLC operating agreement to allocate certain items away from specific LLC members if the other partners agree.
It is possible to set up a nonqualified arrangement to defer the guaranteed payments the LLC member is to receive under §707(c). Reg. §1.707-1(c) states these payments will be ordinary income that is taxable to the member. Because of the deferred compensation arrangement between the LLC and the member, the LLC may control when the payment is made. The deferred amounts will increase the distributable income of the LLC members based on the LLC agreement to allocate income. Since the member cannot defer his allocable share of LLC income, a portion of the deferred income will flow through to him in the year of deferral.
Equity-Based Compensation for Members
Equity based compensation is used by many corporate employers to motivate their employees. An LLC can transfer an interest to an employee or existing member in the form of a capital and profits interest, a capital interest, or a profits interest, or as an option to acquire either a capital or profits interest or both.
Options to Acquire LLC Interests
LLCs can issue nonqualified options to purchase LLC units. The grant of an option to purchase LLC units to either to an existing member or an employee does not have a taxable consequence for the LLC. It would be treated as a guaranteed payment. The difference between the fair market value of the option and the strike price would be a “payment” in the year received or the year the restriction lapses. This creates a deduction for the LLC and income to the LLC member.
271999-6 I.R.B. 6.
/Footnote/ 30§707(c). See §§263, 263A.
/Footnote/ 31410 U.S. 441 (1973).
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.