Rev. Rul. 65-229

Advice has been requested whether under the circumstances described below a new election is required to be made under the provisions of section 1361 of the Internal Revenue Code of 1954, where a sole proprietorship changes to a partnership.

A was the sole proprietor of an enterprise doing business as the X company. X was being taxed as a corporation pursuant to a proper election under section 1361(a) of the Code. A subsequently formed a partnership with B , one of the employees of X . Under the partnership agreement, B was to receive 25 percent of the profits and bear 25 percent of the losses of X , for each year thereafter. B contributed no capital to, and acquired no capital interest in, X when he entered into the partnership. No new election was made under section 1361 of the Code for the partnership to be taxed as a corporation.

Section 1361(a) of the Code provides, in general, that the proprietor or partners of a proprietorship or partnership owning an unincorporated business enterprise may elect to have the enterprise taxed as a corporation.

Section 1361(f) of the Code provides that, in any taxable year in which the electing proprietor or partners have an interest of 80 percent or less in profits and capital of such an enterprise, the enterprise will not be considered a domestic corporation for such year or for subsequent years unless the proprietor or partners made a new election in accordance with section 1361(a) of the Code.

The 80-percent requirement of section 1361(f) of the Code refers to 80 percent of the profits and 80 percent of the capital. Compare sections 708(b)(1)(B) and 708(b)(2)(A) of the Code and section 1.708-1(b)(1)(ii) of the Income Tax Regulations.

The acquisition by B of a 25-percent interest in the profits of the partnership at the close of the taxable year reduces the interest of the original elector (sole propietor) to 80 percent or less in the profits of the enterprise and thus is a change of ownership within the meaning of section 1361(f) of the Code.

Accordingly, since in this case there was a change in ownership within the meaning of section 1361(f) of the Code, in order to continue the section 1361 status of the X company, a new election in accordance with subsection 1361(a) of the Code is required to be made by the partners.