20.3 LLC Tax Classification

20.3 LLC Tax Classification

REG Area V, Group E asks you to recall the tax classification options for a limited liability company. This is Remembering and Understanding, not a full entity-planning simulation. State-law formation of an LLC — articles of organization, members' limited liability, member-managed versus manager-managed — is Section 10.1. This section is federal income-tax classification under the check-the-box regulations. A Delaware LLC is still an LLC under state law if it elects to be taxed as a C corporation. The reverse is also true: filing Form 1065 does not convert the entity into a RUPA general partnership for liability purposes.

Eligible entities and per se corporations

Treas. Reg. §301.7701-1 through §301.7701-3 separate what exists under local law from how the IRS classifies that thing for tax. A per se corporation — a business entity incorporated under a federal or state statute, specified insurance companies, and certain other listed entities — is always a corporation. It cannot elect partnership or disregarded status. An eligible entity is any business entity that is not a per se corporation. A domestic LLC is the classic eligible entity.

Check-the-box does not let a state-law corporation elect to be a partnership. If the facts say “incorporated,” you are in C corporation or S corporation territory, not here.

Default classification — Treas. Reg. §301.7701-3

For a domestic eligible entity, the default is mechanical. Count members for federal tax, not the number of managers and not the number of classes of economic rights described in the operating agreement.

Disregarded means the LLC is ignored as an entity separate from its owner for federal income tax. It is not a partnership, it issues no K-1, and calling it an “LLC” on the door does not create a Form 1065 filing obligation. That trap is the same one Section 15.1 uses on the individual return.

A multi-member LLC that does nothing — no Form 8832, no Form 2553 — is a partnership. Ordinary income, guaranteed payments, and outside basis then follow Sections 20.1 and 20.2. The members' limited liability under state law does not make the entity a corporation and does not by itself make the tax partnership an S corporation.

Electing association — Form 8832

An eligible entity may elect to be classified as an association taxable as a corporation. The election is filed on Form 8832, Entity Classification Election. After a valid election, the LLC is a C corporation for federal tax: it files Form 1120, it is subject to entity-level tax, and it does not issue partnership K-1s.

The election can be effective on the date specified, subject to the regulation's timing window (generally not more than 75 days before the filing date and not more than 12 months after). REG tests that an election exists, not the last day of the 75-day count. A later change of classification is generally restricted for 60 months once an election has been made, absent a more-than-50-percent ownership change or IRS consent. Changing classification is a taxable event in form (deemed contribution to or liquidation of a corporation, depending on the direction). REG Core asks you to know that consequence exists; it does not ask you to compute a full deemed-liquidation gain on a TBS.

S election of an LLC that is an association

An LLC is not an S corporation by default. S status is a further election available only to a small business corporation — a domestic corporation (including an association) that meets the shareholder, class-of-stock, and other eligibility rules in Section 19.1.

Path:

1. The LLC is an eligible entity.
2. It is classified as an association — either because it filed Form 8832, or because a timely Form 2553 is treated as a deemed association election when the entity was previously a partnership or disregarded.
3. It files Form 2553, Election by a Small Business Corporation, and meets S eligibility.
4. It then files Form 1120-S and issues shareholder K-1s. Guaranteed payments disappear; owner-employees take W-2 wages.

Filing Form 1065 and writing “we meant to be an S corp” on the operating agreement does not elect S status. Filing Form 2553 while remaining a default partnership is not a coherent REG answer: the S election is an election of a corporation.

Membership changes can change the default

Classification follows the number of members unless an association election is in force.

• A disregarded single-member LLC that admits a second member becomes a partnership on that date (deemed contribution of the assets to a new partnership).
• A partnership LLC that is left with one member becomes disregarded (deemed liquidation of the partnership).
• Neither event, by itself, creates a corporation.

Foreign eligible entities have different defaults (a multi-member foreign eligible entity is a partnership only if at least one member has unlimited liability; otherwise it defaults to association). REG Core stems are almost always domestic LLCs. Do not import the foreign default onto a Wyoming LLC.

Worked: two members, no IRS filing

Facts. Casey and Drew form a Wyoming LLC, file articles of organization with the state, split profits 50/50, and operate a retail shop. They file nothing with the IRS for entity classification. No Form 8832. No Form 2553.

Analysis. State law: LLC, limited liability, as in Section 10.1. Federal tax: two members, eligible entity, no election. Default classification is partnership. They file Form 1065. They do not file Form 1120. They do not file Form 1120-S. The LLC is not disregarded — disregarded is the single-member default. Articles of organization are not Form 8832.

If Casey later buys Drew's entire interest and is the sole member, the entity becomes disregarded going forward unless an association election is in effect. If instead they file Form 8832 electing association from day one, they are a C corporation. If they also file a valid Form 2553 and meet S eligibility, they are an S corporation.

/practice/cpa-regPractice questions with detailed explanations