IRS CONSIDERING PROPOSAL TO PERMIT ELECTION OF PARTNERSHIP OR ASSOCIATION STATUS.

Notice 95-14

The Internal Revenue Service and the Treasury Department are considering simplifying the classification regulations to allow taxpayers to treat domestic unincorporated business organizations as partnerships or as associations on an elective basis. The Service and Treasury also are considering adopting similar rules for foreign business organizations. Comments are requested regarding this and other possible approaches to simplifying the regulations.

BACKGROUND

Section 7701(a)(2) of the Internal Revenue Code defines a partnership to include a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not a trust or estate or a corporation. Section 7701(a)(3) defines a corporation to include associations, joint-stock companies, and insurance companies. In addition, certain business entities are taxed as corporations under various sections of the Code, such as publicly traded partnerships under section 7704 and taxable mortgage pools under section 7701(i).

Sections 301.7701-2 and 301.7701-3 of the Procedure and Administration Regulations (the classification regulations) provide rules for determining whether an unincorporated organization that has associates and an objective to carry on business and divide the gains therefrom is classified as a partnership or as an association for federal tax purposes. These regulations classify such an organization as an association if it has a preponderance of four specified corporate characteristics: (1) continuity of life, (2) centralization of management, (3) liability for organization debts limited to the organization's assets, and (4) free transferability of interests. The classification regulations, together with numerous revenue rulings and revenue procedures, provide guidance in determining when an unincorporated organization possesses these characteristics.

The existing classification regulations are based on the historical differences under local law between partnerships and corporations. However, many states recently have revised their statutes to provide that partnerships and other unincorporated organizations may possess characteristics that have traditionally been associated with corporations, thereby narrowing considerably the traditional distinctions between corporations and partnerships. For example, some partnership statutes have been modified to provide that no partner is unconditionally liable for all of the debts of the partnership. Similarly, almost all states have enacted statutes allowing the formation of limited liability companies. These entities are designed to provide liability protection to all members and to otherwise resemble corporations, while generally qualifying as partnerships for federal tax purposes. See, e.g., Rev. Rul. 88-76, 1988-2 C.B. 360.

One consequence of the narrowing of the differences under local law between corporations and partnerships is that taxpayers can achieve partnership tax classification for a non-publicly traded organization that, in all meaningful respects, is virtually indistinguishable from a corporation. Taxpayers and the Service, however, continue to expend considerable resources in determining the proper classification of domestic unincorporated business organizations. For example, since the issuance of Rev. Rul. 88-76, the Service has issued seventeen revenue rulings analyzing individual state limited liability company statutes, and has issued several revenue procedures and numerous letter rulings relating to classification of various unincorporated organizations under the classification regulations. In addition, small unincorporated organizations may not have sufficient resources and expertise to apply the current classification regulations to achieve the tax classification they desire.

POSSIBLE SIMPLIFICATION OF THE CURRENT CLASSIFICATION RULES

A. Domestic Unincorporated Business Organizations

The Service and Treasury are considering simplifying the existing classification regulations to allow taxpayers to elect to treat certain domestic unincorporated business organizations as partnerships or as associations for federal tax purposes. This approach would apply to all such organizations that have two or more associates and an objective to carry on business and divide the gains therefrom, unless the organization's classification is determined under another Code provision. For example, an entity that is treated as a partnership, but which is publicly traded and is taxed as a corporation under section 7704, would continue to be taxed as a corporation under this approach. Similarly, a taxable mortgage pool under section 7701(i) would continue to be taxed as a corporation, and an entity that makes an election to be a real estate mortgage investment conduit (REMIC) under section 860D(b) would continue to be taxed under the REMIC rules. This approach generally would not affect the existing rules for classifying trusts (other than trusts that are classified as associations or partnerships under sections 301.7701-2 and 301.7701-3).

Under this approach, all affirmative elections would be prospective from the date the election is filed or a later date designated in the election. Retroactive elections would not be permitted. The elections would have to be executed by all members of the organization and would be binding on all members thereafter, until superseded by a subsequent election.

The Service and Treasury recognize that there is considerable flexibility under the current rules to effectively change the classification of an organization at will (for example, by forming a new organization with different factors that would result in a different classification, and merging the old organization into it). On the other hand, the purpose of this approach is to simplify the rules in order to reduce the burdens on both taxpayers and the Service. The Service and Treasury are concerned that allowing taxpayers to change their classification simply by filing an election could result in a significant increase in the number of organizations changing their classification, thereby increasing burdens for some taxpayers and the Service. Accordingly, the Service and Treasury will consider whether the elections provided under this approach should be restricted.

Under this approach, an election to change the classification of an organization would have the same federal tax consequences as a change in classification under current law. For example, if an organization were classified as an association taxable as a corporation and later elected to be classified as a partnership, the election would be treated as a complete liquidation of the corporation and a formation of a new partnership. Thus, a final return for the corporation and a first-year return for the partnership each would have to be filed. In addition, the new partnership would have to ensure that its allocations were in compliance with section 704(b) and the regulations thereunder.

This approach would include mechanisms for classifying organizations that do not make affirmative classification elections. Because the Service and Treasury believe that domestic unincorporated business organizations typically are formed to obtain partnership classification, those organizations generally would be classified as partnerships for federal tax purposes unless the organization files an election to be classified as an association taxable as a corporation. However, because the Service and Treasury believe that the current classification of existing organizations should be altered only by affirmative election, those organizations that are in existence on or prior to the effective date of the revised regulations would retain their current classification unless an affirmative election to be classified differently is filed.

B. Foreign Business Organizations

All foreign business organizations are currently considered unincorporated for federal tax purposes and, therefore, must be analyzed under the regulations that apply to domestic unincorporated business organizations. See Rev. Rul. 88-8, 1988-1 C.B. 403. The classification of a foreign organization involves not only a review of organizational agreements, but also a thorough understanding of the governing foreign law. Because the complexities and resources devoted to classification of domestic unincorporated business organizations are mirrored in the foreign context, the Service and Treasury are considering simplifying the classification rules for foreign organizations in a manner consistent with the approach described above for domestic organizations.

The Service and Treasury must, however, take into account a number of special considerations that arise in the foreign area. The first is that presently there is no foreign analogue to a state-law corporation and, therefore, no foreign organization that is automatically treated as a corporation for federal tax purposes. Thus, an elective system that follows exactly the approach described above for domestic unincorporated organizations would apply to all foreign organizations, without exception. The Service and Treasury are considering the appropriateness and feasibility of identifying particular forms of foreign organizations that, like state-law corporations, would automatically be treated as corporations.

A second consideration in the foreign area is the possibility of inconsistent, or hybrid, entity classification; that is, classification as a taxable entity in one country but as a flow- through entity (e.g., a partnership) under the tax laws of another country. An elective approach could expand the potential that exists under the current classification regulations for hybrid structures. The Service and Treasury are considering whether it is appropriate to address inconsistent classification in any rules to be proposed and also are considering how the tax benefits or detriments that may result from inconsistent classification can be addressed through the tax treaty process.

A third consideration in the foreign area is that a purely elective approach could have a substantive effect on entity classification by increasing taxpayers' flexibility to achieve their desired classification of certain foreign organizations. Under the present rules, taxpayers holding interests in foreign organizations are not always as able as those holding interests in domestic organizations to achieve their desired result. Because any change in the existing classification regulations is intended generally to simplify the rules without resulting in a substantial change in the classification of unincorporated organizations, the Service and Treasury must consider whether an elective approach should be modified with respect to foreign organizations.

To the extent the Service and Treasury determine that taxpayers may elect the classification of a foreign organization for federal tax purposes, consideration also must be given to the appropriate mechanism for classifying organizations that do not make affirmative elections. While domestic unincorporated organizations are typically formed to obtain partnership classification, the desired classification of foreign organizations is likely to be less uniform. The classification of a foreign organization as an association for federal tax purposes can be beneficial in many circumstances, while the classification as a partnership can be beneficial in others. Because of compliance requirements and excise tax provisions that apply to foreign partnerships and their partners, the Service and Treasury believe that it would be appropriate to treat a foreign organization that fails to make an affirmative election as an association, subject to a rule for existing organizations similar to that described above for domestic organizations. This rule would avoid inadvertently subjecting taxpayers to the partnership compliance rules and excise tax provisions and is likely in many circumstances to coincide with taxpayers' desired classification.

REQUEST FOR COMMENTS AND HEARING

The Service and Treasury invite comments on simplification of the current classification regulations, including alternate methods for simplifying those regulations. In addition, comments are invited on the approach described in this notice, including (1) whether adoption of the simplified approach described in this notice would be appropriate; (2) whether this approach would result in a greater proportion of newly formed businesses choosing unincorporated organizations rather than state-law corporations; (3) the mechanics of this approach, including the election requirements, the classification of organizations that do not file an affirmative election, and transition issues; (4) whether the ability to elect to change the classification of an organization should be restricted, and if so, in what manner; and (5) the proper treatment of unincorporated organizations that have a single owner or member.

In the international context, comments also are invited on (1) whether the approach should be extended to the classification of foreign organizations, and if so, whether the approach should be modified with respect to those organizations; (2) the appropriateness and feasibility of identifying foreign entities that, like state-law corporations, should automatically be classified as corporations; (3) the likely effect of the approach on the ability to achieve hybrid classification of foreign and domestic organizations and the appropriateness and viability of achieving international consistency in the classification of these organizations; (4) whether this approach would substantially change the federal tax classification of foreign organizations; and (5) whether the mechanics of the approach described for domestic organizations should be modified with respect to foreign organizations.

Written comments (a signed original and eight (8) copies) should be addressed to: Internal Revenue Service, Room 5228, P.O. Box 7604, Ben Franklin Station, Attn: CC:CORP:T:R (Notice 95-14), Washington, D.C. 20044. In the alternative, comments may be hand delivered between the hours of 8:00 a.m. and 5:00 p.m. to: CC:DOM:CORP:T:R (Notice 95-14), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. Comments must be received on or before July 3, 1995. All comments will be available for public inspection and copying.

A public hearing has been scheduled for July 20, 1995, at 10:00 a.m. in the Auditorium of the Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington, D.C. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 15 minutes before the hearing starts.

Persons who wish to present oral comments at the hearing must submit written comments by July 3, 1995, and submit an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by July 6, 1995. A period of ten minutes will be allotted for each person making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

The Service and Treasury will consider scheduling additional hearings in other locations if taxpayers so request and there is sufficient interest.

EFFECT ON CURRENT LAW

While the Service and Treasury consider simplifying the current classification regulations, the Service will continue to apply the current rules without regard to the approach described in this notice. No inference is intended concerning the proper interpretation and application of the current rules.

DRAFTING INFORMATION

The principal authors of this notice are Armando Gomez of the Office of Assistant Chief Counsel (Passthroughs & Special Industries) and Ronald M. Gootzeit of the Office of Associate Chief Counsel (International). For further information regarding this notice contact Mr. Gomez on (202) 622-3050; concerning foreign organizations, Mr. Gootzeit, (202) 622-3880; concerning submissions and the hearing, Mike Slaughter, (202) 622-7190 (not toll-free numbers).