Determining number of owners for entity classification elections.
Some classification limits found in Regs. Sec. 301.7701-3(a) depend on the number of owners and the nature of ownership, which may require an exacting inquiry. For example, for foreign entities, it is necessary to determine whether the owner of an entity has limited liability (i.e., the owner has no personal liability for the debts of or claims against the entity). That determination is made under the local law where the owner was organized.
As to the number of owners, Regs. Sec. 301.7701-3(a) provides in part:
An eligible entity with at least two members can elect to be classified as either an association ... or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner.
Although that general rule seems straightforward, its application may jeopardize the validity of a classification election made on Form 8832, Entity Classification Election, because an improper classification may be made based on the number of owners. If invalid, an election may generally be remedied only through requesting relief from the I1KS either under 1Kev. Proc. 2002-59 (for initial elections effective on the date of formation) or under Regs. Sec. 301.9100-1 (a formal letter ruling request).
When "counting" the number of owners, it is not sufficient merely to base that determination on the number of legal owners of the entity. Instead, it is necessary to determine the Federal tax classification of the owner entity or entities. According to Rev. Rul. 2004-77, if an eligible entity has two legal owners, one of which is disregarded as an entity separate from the other owner, the eligible entity has only one owner and, thus, cannot be a partnership. Instead, the eligible entity either may be disregarded as an entity separate from its owner or is an association taxable as a corporation.
Example: Two partners of a domestic eligible entity are a domestic corporation, D, and a domestic limited liability company, L. L is treated as a disregarded entity of D; thus, it has only one owner and cannot be a partnership.
A cursory view of the entity structure might lead one to believe that the entity in the example can be treated as a partnership because it has two legal owners. However, in this situation, that would be incorrect. On the other hand, if two commonly owned subsidiaries (corporations rather than disregarded entities) owned the interests in the entity at issue, the entity would have two owners and could be treated as a partnership. The analysis in Rev. Rul. 2004-77 stresses the importance of determining the classification of the entity owners prior to "counting" the actual entity owners.
Nature of Ownership Interest
The classification of a partner for "counting" purposes sometimes reaches beyond the partner's Federal tax classification. There may be an issue of an owner being counted when it has only a minority or "nominal" interest in an eligible entity.
Some countries require two owners for an entity to be considered a corporation under local law. Thus, to meet this requirement, a nominal owner is added to the ownership structure. This nominal interest, for entity classification purposes, is sometimes not considered an owner and thus not counted when determining the entity's classification. If the owner's interest has no dividend, voting or liquidation rights (beyond return of the initial contribution), the IRS may ignore the entity as an owner. However, even a small percentage of true equity interest (including profits and liquidation rights) cannot be ignored. Thus, the nature of the owner's interest needs to be considered when determining the number of owners.
FROM RUTH PEREZ, J.D. (NOT AFFILIATED WITH PRICEWATERHOUSECOOPERS LLP), AND DANIEL J. WILES, J.D., WASHINGTON, DC
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|Author:||Wiles, Daniel J.|
|Publication:||The Tax Adviser|
|Date:||Jul 1, 2006|
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