Forget the 5-Year Rule – Change Entity Classification Early

Many believe that once you elect an entity’s tax classification, you are locked into that choice for at least 5 years. Conventional wisdom says that the tax status cannot be changed within a 5-year or 60-month period. However, a recent IRS private letter ruling shows this is not necessarily the case.

In PLR 202341001, the IRS granted consent for an LLC to change its tax classification from an association taxable as a corporation to a disregarded entity less than 60 months after its previous election. This is contrary to what most think of as the rule.

The Facts & Procedural History

This private letter ruling involves an LLC that was formed under state law on Date 1. The LLC elected to be taxed as a corporation effective Date 2.

Later, on Date 3, over 50% of the ownership interests in the LLC were acquired by new owners. This new majority ownership group wanted the LLC to change its tax classification to a disregarded entity. The problem was that this change was requested during the 5-year or 60-month period for making this type of change.

The taxpayer submitted a private letter ruling request to ask the IRS to allow this change.

Tax Classification of Business Entities

Before getting into the law that applies to this specific ruling, it is helpful to understand how entities are classified for tax purposes in general. This provides context on the options available. We’ll use the limited liability company (“LLC”) as an example.

An LLC is initially classified as disregarded if it only has one owner. In this case, no separate tax return is filed. The LLC is treated as a sole proprietorship. The LLC’s activities are reported directly on the owner’s personal tax return.

If the LLC has two or more owners, the default classification changes to a partnership. Here the LLC must file a partnership tax return. The entity itself does not pay tax. Rather, any profits or losses flow through to the owners’ personal tax returns.

If the LLC elects to be a corporation, then the entity files, reports, and pays tax at the entity level. The individual owner or owners do not directly pay tax on the LLC’s income. Instead, they only pay income tax on any distributions they take out of the LLC.

These default rules can be changed by taxpayers. But there are rules for making the changes.

Changing the Tax Status of an Entity

An entity can elect its tax classification by filing Form 8832. This allows an LLC, for example, to be taxed as a corporation, partnership, or disregarded entity when this was not the original or default classification.

This is provided for in Section 301.7701-3 of the Treasury Regulations. These are the so-called “check the box” regulations.

While taxpayers can make this change, there are limitations. For example, the rules say that the taxpayer cannot change its classification more than once within a 60-month period.

There is an exception. The exception can apply when over 50% of the ownership interests are held by persons who did not own any interest in the entity on the dates of the prior changes. The rules give the IRS discretion to allow a change in the classification of an entity within the 60-month period given this change of control of the entity.

That is what the IRS did in this ruling. Because new owners acquired a majority stake, the IRS had the discretion to permit another change in classification within the 60-month window. The IRS exercised its discretion to allow the second change in tax status within 60 months.

Why Change the Tax Classification?

There are several reasons a business may want to change its tax classification. These can range from business planning to life changes to tax planning. Here are some examples:

1. Converting an LLC to a corporation can provide liability protection. A single-member LLC may not provide full protection as the state law may allow charging orders. A multi-member LLC may be preferable for this reason.

2. Electing S Corp status opens up tax planning options. An S corporation allows income, losses, deductions and credits to pass through to the shareholders’ personal returns. The corporate profits are only taxed once. This avoids double taxation on dividends that occurs with regular C corporations. It can also help avoid self-employment tax that would be incurred in a partnership or sole proprietorship. It can also allow more advanced tax planning, such as valuation freezes.

3. Switching to a partnership can facilitate bringing on investors. As a partnership or LLC taxed as a partnership, different ownership interests can be carved out for new partners. The entity can issue new partnership interests in exchange for capital investments.

4. Disregarded entity status simplifies operations for single-owner entities. Filing a separate tax return for the entity is eliminated. Less administrative work is required if the LLC’s results are simply reported on the owner’s personal tax return—which may mean reporting on the holding company’s return.

5. Change in ownership. If new owners acquire a controlling stake, the new ownership group may want to elect a different classification to fit their tax profile and business objectives. This may come with an F reorganization and an S corporation, which is often used when the acquiring company has shareholders who cannot own an interest in an S corporation.

The change of ownership was at issue in this ruling. As seen in this ruling, new owners gained control and opted to change the classification. This may have been done to achieve disregarded entity status and operational simplicity under the new single-owner structure. Or perhaps they viewed partnership taxation as more suitable for their investment profile and goals. This ruling allowed that to happen.

Takeaway

This ruling debunks the myth that entity classifications cannot be altered within a 60-month period. With the IRS’s consent, changes can in fact be made within 5 years of a prior election. The key is requesting discretionary relief based on the specific circumstances. Here, new majority ownership and their business objectives were compelling factors.

The takeaway is that the commonly held notion of being stuck with an entity’s tax status for 5 years is not always correct. Savvy taxpayers and their advisors should be aware that reclassifications may be possible within 60 months if you make the case to the IRS. Do not assume the door is shut – explore whether discretionary authority can provide the opening.