Important opportunity for real estate entities.

Business transactions involving real estate typically focus on the fundamental issue of the proper choice of entity. To take advantage of a recent IRS notice, partnership agreements should give general partners the authority to make any election available regarding the classification of the entity.

Most taxpayers have used limited partnerships or limited liability companies (LLCs) as entities for real estate transactions. These entities are typically favored because they allow for passthrough treatment for income tax purposes, thus minimizing the double tax inherent in C corporations. S corporations have generally been less popular. Although they provide passthrough income tax treatment for shareholders, they are more complex and restrictive than partnerships or LLCs.

Under existing statutes, certain technical rules must be followed for an entity to receive partnership status. An incorporated organization will fail the partnership test if it has a preponderance of four corporate characteristics: (1) continuity of life, (2) centralized management, (3) limited liability and (4) free transferability of interests.

Limited partnerships, and more recently LLCs, have been able to satisfy these requirements by lacking continuity of life and free transferability of interests. In other words, with proper tax planning, partnership status can be reasonably obtained through the current rules.

The Service has recently announced in Notice 95-14 that it is considering simplification of the regulations to allow unincorporated business organizations to elect status as a partnership or as a taxable corporation.

Existing regulations setting out classification guidelines have been based on traditional differences under state law between partnerships and corporations. Several states have recently amended their laws, resulting in partnerships and other unincorporated organizations possessing some of the same characteristics. For example, many partnership statutes have been revised to provide that no partner is unconditionally liable for all of the partnership's debts.

In addition, most states have enacted laws concerning the formation of LLCs, which provide limited liability to their members in a manner similar to corporations, but can also qualify as partnerships for Federal and state income tax purposes.

Under IRS guidelines, any organization with two or more associates and an objective to carry on business and divide the gains from it would be entitled to elect to be treated as a partnership or as a corporation. Elections would be prospective only, and would be binding on all members.

Some restrictions apply to the election. Organizations treated currently as partnerships, but publicly traded and taxed as corporations under the publicly traded partnership (PTP) rules, would not be eligible to make the election. Likewise, a change in an elected classification can be made, but not without tax consequences.

For example, if an election were made to be classified as a corporation and the organization later elected to be classified as a partnership, the election would be treated as first, a taxable liquidation of the corporation (resulting in tax consequences to both the corporation and the stockholders), and second, a deemed formation of a new partnership.

Notice 95-14 also indicates that, because the Service believes the current classification of existing organizations should be altered only by an affirmative election, organizations currently in existence would retain their classification unless the organization files an affirmative election to be classified differently.

A primary benefit of this election approach is relief from certain restrictions that now apply in achieving partnership status. Organizations would no longer concern themselves with whether free transferability of partnership interests exists, as long as this transferability does not rise to the level of requiring the partnership to be classified as a PTP.

Partnership agreements currently being prepared should take Notice 95-14 into account and give general partners the authority to make this election once it becomes effective.