Similarly, a partnership or an LLC may allow its investors to share differently in the risks and rewards of entity operations. Investors with varying tastes for risk may be willing to assume a greater portion of the risk of losses, while sharing profits in accordance with their contributions to capital. One partner, for example, may be willing to be allocated 50% of partnership losses, while sharing in only 33% of partnership profits. Partnerships or LLCs offer complete flexibility to the partners to enter into these kinds of arrangements. The result is that it is often easier to bring investors with different backgrounds together into a partnership or LLC than in other forms of organization.
Lynn owns a large tract of ranch land that she would like to develop into a dude ranch. Unfortunately, she does not have sufficient cash resources to develop the property herself, and she cannot obtain bank financing with favorable terms. She decides to approach the owner of a dude ranch in another state whom she met while on vacation last year. The other ranch owner is interested but is a little wary about investing in an area with which he is unfamiliar. Lynn, however, is confident that a dude ranch on her property would be successful. She is so confident that the venture will succeed that she offers to bear 75% of the risk of loss, while taking only 50% of the profits from the venture, if the other partner will invest the $250,000 needed for improvements to make the dude ranch operable. Assume the other partner makes the necessary investment, and that the dude ranch loses ($50,000) in its first year of operations. Lynn will be allocated 75% of this loss, or ($37,500). Her partner will bear only ($12,500) of the loss. If the dude ranch turns around in its second year, and generates taxable income of $40,000, Lynn's share of the second-year profit will be $20,000 (50%). Therefore, although the partnership's net profit or loss for the two-year period is ($10,000), Lynn has been allocated a loss of ($17,500) [$37,500 - $20,000], whereas her partner has been allocated profits of $7,500 [$20,000 second-year profit less ($12,500) first- year loss]. Lynn is indeed assuming a much larger portion of the risk of loss from their joint activities than is her partner. This disparity may, however, be worthwhile if Lynn is right and the dude ranch develops into a profitable enterprise.
Finally, note that it is possible in a partnership or an LLC to share differently in profits and losses from one year to the next. For example, it is not unusual for a partner to receive a disproportionate share of partnership profits until he or she receives a pre-determined amount, and for profits to be shared equally after that point. To illustrate, in the preceding example, the partners might write the partnership agreement to provide that Lynn's partner will receive 60% of profits until he has recouped his $250,000 investment in the venture, with profits realized after that point being shared equally. Again, this type of flexibility is extremely difficult to achieve in any other form of organization.
Electing to be taxed as a partnership: The “check-the-box” rules
Prior to 1997, entities had to satisfy the cumbersome and highly complex requirements of Reg. Sec. 301.7701 to be classified as partnerships for federal income tax purposes. These regulations required that the entity could not be taxed as a partnership if it possessed more than two of a list of four so-called “corporate” characteristics (limited liability, unlimited life, free transferability of interests, and centralized management).6 However, the criteria were rendered largely meaningless by the numerous exceptions and limitations imposed in the regulations, so that entities that truly wished to be taxed as partnerships could write their partnership agreements in such a way that partnership status was virtually guaranteed. The result was that the regulations served principally as a trap for the unwary.
To simplify the classification process, and to eliminate the potential that taxpayers who thought they were operating as legitimate partnerships would be subjected to onerous penalties upon discovering that they did not satisfy the technical criteria of the regulations, the IRS in 1996 implemented new rules under which eligible entities will be classified as partnerships unless they file Form 8832, Entity Classification Election, and elect to be classified as a corporation or different type of entity.7 These rules remove any uncertainty about the classification process, and are particularly helpful for limited liability companies, which may freely choose between being taxed as either partnerships or corporations (including S corporations). Uncertainty is further reduced by Reg. Sec. 301.7701-3(b)(1)(i), which provides that in the event an entity neglects to properly file an election, the default classification for domestic entities with at least two members is a partnership. Such entities will automatically be treated as partnerships for federal income tax purposes unless they elect to be classified as a different type of entity.8 Further reducing uncertainty is the rule that any entity that is incorporated under state law is treated as a corporation for tax purposes. If that entity wants some of the benefits of having its income pass through to the shareholders, it can elect S corporation status.
Moreover, the regulations provide that the entity choice election is not permanent. Once an entity elects its tax status, it retains such status so long as it does not make an election to change to a different status. Revised status generally cannot be elected during the 60-month period following the previous election, although the commissioner is authorized to permit a change in status if more than 50% of the ownership interests in the entity as of the effective date of the subsequent election are owned by persons that did not own any interests in the entity on the filing date or on the effective date of the entity's prior election.
Therefore, an LLC can elect to be taxed as a partnership for the first five years of its life and then change its status to a corporation for federal income tax purposes thereafter. It is important to recognize, however, that a change in status will not necessarily be tax free. The regulations treat the election to change an entity's status as a liquidation of the old entity accompanied by the formation of a new one.9 In the case of a partnership electing to be taxed as a corporation, the regulations treat the partnership as if it transferred all its assets and liabilities to a newly formed corporation (requiring a new taxpayer identification number) in exchange for stock, and then liquidated, distributing the corporate stock to its partners. Because liquidation of a partnership is generally a tax-free transaction, this deemed transaction will seldom have any tax consequences for the members.10
L is a 50% partner in the LT Partnership. L's tax basis in his partnership interest was $200,000 when the partnership opted to be classified as a corporation and made the election to be taxed under subchapter S. (The partners hoped to reduce their self-employment tax liability by making this change in status.) To accomplish the conversion to a regular corporation, the partnership transferred all its assets to a newly formed corporation in exchange for stock. Assume that the partnership had no liabilities at the date of the conversion. The partnership then liquidated, distributing the newly acquired stock to its partners in liquidation of their interests in the partnership. L received stock with a tax basis to the partnership of $350,000 and a fair market value of $425,000 in liquidation of his interest in the LT Partnership. L will recognize no gain or loss on the transaction and will take a tax basis in his stock in the new corporation of $200,000.
In contrast, where the entity has been operating as a corporation, the election to change its status to a partnership is treated under the regulations as if the corporation first liquidates, distributing all its assets and liabilities to its shareholders, who then transfer these assets and liabilities to a new