Most of the time the state-law classification of an entity and its federal income tax classification match. A corporation will be taxed as a corporation and a partnership will not be taxed, instead merely filing an information return about the income and loss that flows through to its partners. There are, however, intentional and unintentional circumstances that change the default classification.
In 1997, the U.S. Internal Revenue Service issued the “check-the-box” Treasury Regulations, providing that (1) entities formed as corporations (and a long list of corresponding non-U.S. entities) would be taxed as corporations (other than certain exceptions such as REITs or S corporations), and (2) other forms of business entities would default to a non-corporate status but could elect to be taxed as a corporation. A non-corporate entity like a partnership or limited liability company (LLC) with at least two owners would be a partnership and a non-corporate entity with only one owner (i.e., a single member LLC) would be disregarded (i.e., ignored). However, a non-corporate entity can elect to be treated as a corporation (in a filing made no later than 75 days after the desired effective date, which is the same timing as the election to be treated as an S corporation) and can also elect to change back after the fifth anniversary of the election. This provides the opportunity to mix and match forms and tax status so that the flexibility of limited liability companies could also provide the corporate status required by some investments (such as for a real estate investment trust).
There are some pitfalls to the application of the default rules. For example, a limited partnership whose general partner is an LLC owned by a person, whether an individual or an entity, who is also the sole limited partner will not be a partnership for tax purposes, but will be treated as only having one owner and therefore will be ignored, unless either the LLC elects to be classified as a corporation for tax purposes, or the limited partnership makes such election. If the limited partnership does not make an election, and any interest in the GP LLC is acquired by a new person, then suddenly the limited partnership will cease to be disregarded and will be treated as if a new tax partnership were formed, even though no activity occurred at the partnership level.
On the other hand, some states permit a person to be a partner of a partnership or member of an LLC without having any economic interest in the entity; this structure is commonly used in bankruptcy-remote financing vehicles. Such a partner or member is not a partner for federal income tax purposes, so if there is only one other partner or member, then the entity will be considered owned by only a single person and therefore will be disregarded, rather than being treated as a partnership.
The consequences of the flexibility and mismatch of state law and tax status permitted by the Treasury Regulation should be kept in mind while drafting entity documents. Partnerships and LLCs with two or more partners for state-law purposes that are actually disregarded entities do not require, and should not include, the customary partnership tax allocations or “tax matters partner” provisions unless it is likely that a new owner will be admitted that will actually cause the entity to become a tax partnership. It is probably less confusing and more convenient for the initial formation documents to reflect the entity as disregarded from its owner, and to be restated as a tax partnership, if necessary, in order to avoid even more complicated provisions governing tax treatment for alternate tax classifications and provisions related to the formation of a tax partnership. Although tax provisions are sometimes not as scrutinized as other types of provisions in documents, tax returns and entity documents should match with respect to the tax classification to avoid confusion, calls from accountants, and questions from revenue authorities.
This issue should also be considered in preparing transaction documents. The classification for tax purposes of an entity that is a party to, or the subject of, an agreement for the issuance or transfer of equity interests should not be taken at face value, either by buyer, seller or the drafter of the documents. Appropriate review of ownership documents and tax returns should backstop any representation as to the classification, especially because the persons preparing and negotiating the agreements may not be aware of the actual classification.