Entity Classification

The practical importance is hard to overstate. Nearly every structuring question in exchange practice, from lender demands to estate planning to multi-property acquisitions, is resolved by determining which entities in the chain have separate tax existence and which do not.

19.1 The classification framework

Whether an arrangement is an entity separate from its owners is a federal tax question, determined under federal law rather than by the label a State applies.¹

For a business entity that is not automatically classified as a corporation, the regulations supply defaults keyed to the number of owners. An eligible entity with two or more members is a partnership unless it elects corporate treatment. An eligible entity with a single owner is disregarded as an entity separate from its owner unless it elects corporate treatment.²

The word "disregarded" is meant literally. A disregarded entity does not merely pass its items through to its owner in the manner of a partnership. It has no separate existence for income tax purposes at all. Its assets are the owner's assets, its debts are the owner's debts, and a transfer between the owner and the entity is a transfer from a person to himself, which is to say a nonevent.

Three implications follow for exchange practice.

Title may move freely within a chain of disregarded entities without any exchange consequence, because no transfer has occurred for tax purposes.

The count of owners, not the substance of control, determines classification. A ninety-nine percent owner of a two-member entity is a partner in a partnership, and the partnership is the taxpayer. Control is irrelevant to the question.

An election changes everything. An eligible entity that elects corporate treatment becomes a separate taxpayer, and property held by it is not held by its owner.

19.2 Disregarded entities in exchange practice

The recurring structures follow directly from 19.1, and each solves a real problem.

Lender-driven title. Commercial lenders routinely require a bankruptcy-remote special purpose entity as borrower. A single-member limited liability company satisfies the lender while leaving the taxpayer unchanged, and this is the most common reason title differs between the two sides of an exchange.

Liability segregation. A taxpayer acquiring several replacement properties may wish to isolate each in its own entity. Because each single-member company is disregarded, the taxpayer has acquired all of the properties.

Sequencing into a structure. A taxpayer may relinquish property held individually and acquire through an entity that will later admit other members. The exchange is complete when the taxpayer acquires; the later admission is a separate transaction with its own consequences, and the interval matters for the reasons developed at Chapter 20.

Two failure modes account for most problems in practice.

The inadvertent second member is the first. A spouse added to an operating agreement, a child admitted for succession purposes, or a one percent interest issued to a manager converts a disregarded entity into a partnership.³ Practitioners should read the operating agreement and confirm the current membership rather than rely on the client's description, because clients describe entities as they intended them rather than as they were papered.

The unnoticed classification election is the second. An entity that elected corporate treatment years earlier, often on advice long forgotten, is a separate taxpayer, and property it holds is not the owner's property.

19.3 Grantor trusts and land trusts

Trusts are not business entities and are classified under a different regime, but the practical result for a common category is the same.

Where a grantor is treated as the owner of the entire trust under the grantor trust rules, the Service treats the grantor as the owner of the trust's assets for federal income tax purposes. Revenue Ruling 85-13 so holds, and it adds the corollary that a transaction cannot be recognized as a sale where the same person is treated as owning the purported consideration both before and after.⁴

The consequence for exchanges is that a revocable living trust, which is a grantor trust as to its settlor, is transparent. A taxpayer may relinquish property held individually and acquire in the revocable trust, or the reverse, without changing the taxpayer. This is the single most common trust question in practice and the answer is favorable.

Land trusts required separate treatment because they are more than a title-holding convenience in the jurisdictions that use them. Revenue Ruling 92-105 addressed an Illinois land trust in which a taxpayer transferred legal and equitable title to a corporate trustee subject to a land trust agreement, with the beneficiary retaining the direct obligation to pay liabilities and taxes relating to the property. The Service held that the taxpayer's interest in the land trust is an interest in real property for section 1031 purposes.⁵

Two limits deserve emphasis.

The ruling turns on its facts, and the retained beneficiary obligations were material to the analysis. A land trust arrangement in which the trustee holds genuine powers over the property is a different instrument and may be a separate entity.

Irrevocable non-grantor trusts are separate taxpayers. A transfer from a taxpayer to such a trust changes the taxpayer, and an exchange straddling that transfer fails the requirement of Chapter 18.

19.4 Classification changes during an exchange

An exchange occupies up to one hundred eighty days, and classification is not static across that interval. Three events change it, and each has caused failures.

Admitting a member. A disregarded entity that admits a second member becomes a partnership. If this occurs between the relinquishment and the acquisition, the entity that acquires is not the taxpayer that relinquished.

Losing a member. The reverse also changes classification. A two-member partnership that becomes single-member converts to a disregarded entity, and the transaction is a distribution followed by a termination with its own consequences under subchapter K.

Filing an election. A classification election is effective as of a specified date and may be retroactive up to seventy-five days before filing.⁶ An election filed after an exchange closes can therefore reach back across it, which is a trap in both directions and an opportunity in neither.

The counsel that follows is uniform. Classification changes should be sequenced outside the exchange period. Where a change is unavoidable, the analysis requires determining the taxpayer at each of the two relevant moments rather than assuming continuity, and the answer should be documented contemporaneously.

Chapter 20 takes up the case where the entity is a partnership from the outset and the partners want different things, which is the hardest problem in this Part.