Professor Tom Geu forwarded the following comments to the Internal Revenue Service on Friday. I am also expecting comments from the ABA Tax Section (Stuart Levine spearheaded that effort) and Professor Larry Ribstein to be posted shortly. John -------------------------------------------------------------------------- American Bar Association Real Property, Probate and Trust Law Section June 30, 1995 Internal Revenue Service Room 5228 P.O. Box 7604 Ben Franklin Station Att: CC:CORP:T:R (Notice 95-14) Washington, D.C. 20044 To Whom It May Concern: We enclose Comments on Notice 95-14 prepared by members of the Council of the Section of Real Property, Probate and Trust Law of the American Bar Association and members of its LLC/Partnership Task Force. The Comments represent the individual views of the members who prepared them (as identified in the Comment itself) and do not necessarily represent the position of the American Bar Association, the Section of Real Property, Probate and Trust Law, or any committees thereof. Although many members of the Real Property, Probate and Trust Law Section who participated in the preparation of these Comments necessarily have clients affected by federal taxation, including the federal tax rules applied in the subject area addressed by these Comments, no such member (or the firm of such member) has been engaged by a client with respect to the specific subject matter of these Comments. Sincerely, Max Gutierrez, Jr. Chair, Section of Real Property, Probate and Trust Law Stephen A. Cowan Chair-Elect, Section of Real Property and Trust Law COMMENTS CONCERNING NOTICE 95-14 The following Comments represent the individual views of the individuals who prepared them and do not necessarily represent the position of the American Bar Association, the Section of Real Property, Probate and Trust Law, or any committees thereof. These Comments were prepared by individual members of the Section of the Real Property, Probate and Trust Law of the American Bar Association. They were prepared by members of the Council, members of the informal LLC/Partnership Task Force which consists of members of various committees as well as members of other committees from both the Real Property Division and the Probate and Trust Division. Principal responsibility was exercised by Dennis I. Belcher. Substantive contributions were made by Thomas C. Baird, Temple, Texas; Gurdon H. Buck, Hartford, Connecticut; John W. DeBruyn, Denver, Colorado; David L. Johnson, Billings, Montana; Robert Reed Keatinge, Denver, Colorado; David N. Dorough, Jr. Atlanta, Georgia; Sanford J. Liebschutz, Rochester, New York; Louis A. Mezzulo, Richmond, Virginia; Pam H. Schneider, Philadelphia, Pennsylvania; Richard A. Shapack, Bloomfield Hills, Michigan; and, Daniel Shefter, New York, New York of the Section of Real Property, Probate and Trust Law of the American Bar Association. Although many members of the Real Property, Probate and Trust Law Section who participated in the preparation of these Comments necessarily have clients affected by federal taxation, including the federal tax rules applied in the subject area addressed by these Comments, no such member (or the firm of such member) has been engaged by a client with respect to the specific subject matter of these Comments. Contact persons: Dennis I. Belcher 804/775-4304 (voice) Thomas Earl Geu 605/677-6347 (voice) Sanford J. Liebschutz 716/232-3730 (voice) Date: June 30, 1995 I. INTRODUCTION On March 29, 1995, the Internal Revenue Service and Treasury issued Notice 95-14. Therein the Service proposes simplifying the classification regulations to allow taxpayers to treat domestic unincorporated business organizations as partnerships or as associations on an elective basis. The Notice also states that the Service and Treasury are considering adopting similar rules for foreign business organizations and requested comments regarding this and other possible approaches to simplifying the regulations. Notice 95-14 specifically invited comment concerning (1) whether adoption of the simplified approach described in the Notice would be appropriate; (2) whether this approach would result in a greater proportion of newly formed businesses choosing unincorporated organizations rather than state-law corporations; (3) the mechanics of this approach, including the election requirements, the classification of organizations that do not file an affirmative election, and transitional issues; (4) whether the ability to elect to change the classification of an organization should be restricted, and if so, in what manner; and (5) the proper treatment of unincorporated organizations that have a single owner or member. Other comments also were specifically invited in the international context. As an introductory matter, this Comment strongly supports the Service and Treasury's efforts to simplify the classification regulations and to treat unincorporated business organizations as partnerships or as associations on an elective basis. II. THE ADOPTION OF THE SIMPLIFIED APPROACH DESCRIBED IN THE NOTICE WOULD BE APPROPRIATE As Notice 95-14 observes, "many states recently have revised their statutes to provide that partnerships and unincorporated organizations may possess characteristics that have traditionally been associated with corporations, thereby narrowing considerably the traditional distinctions between corporations and partnerships." Indeed, it appears that the state law concerning organizational forms is experiencing the most rapid and dramatic change since the adoption of corporate enabling legislation. In the past decade the use of the limited liability company (LLC) has become commonplace and the past five years have seen not only waves of amendments to the LLC Acts of the various states but also the statutory evolution of limited liability partnerships, limited liability limited partnerships, and the beginning of resurgent interest in organizations such as business trusts and partnership associations. Undeniably the statutes governing these entities attempt to comply with Sections 301.7701-2 and 301.7701-3 of the Procedure and Administration Regulations (the classification regulations) and the ability to achieve partnership income tax classification status has been important in their development. We think it important to remember, however, that the classification regulations were already part of the rubric of State and Federal law at the inception of the first of these organizations, the LLC, in 1977. Certainly, there is evidence that one of the primary purposes of the first LLC Act (Wyoming) was to design an entity which qualified as a partnership for purposes of Federal taxation under the existing classification regulations. Nonetheless there existed other primary purposes of the Wyoming legislation of equal importance to tax classification and it seems that each of these purposes were condition precedents to the use of LLCs. These other purposes included flexibility in organization and limited liability for members. These non-tax purposes, particularly limited liability, in our view are co-equal with partnership tax classification in the current rapid development and evolution of business organization law. Indeed, we believe that the evolution and development of business organization law is shaped, but not driven, by State and Federal law. It is driven by the needs of business. Business authors such as Tom Peters and Peter Drucker (among many others) can be cited as independent authority for the proposition that in the current business and economic climate businesses need the ability to make decisions quickly, to decentralize management, and to form flexible tactical and strategic network alliances. Our experiences support the opinions of these business authors. Our experience also supports the proposition that these business and economic forces are important factors in choosing the new kinds of organizations now available under State law but taxed as partnerships for federal tax purposes. We believe it instructive to repeat that the new forms of business organizations were developed within the rubric of the existing classification regulations but that the grant of limited liability to LLCs required a change in State law. We further believe that this evidences the economic demand and business necessity of flexible organizations offering members limited liability and flow-through taxation. Finally, the attributes of limited liability and partnership tax classification have been available by using a combination of entities in the past quarter-century. Unfortunately, these combination entities are complicated to establish, difficult and inefficient to operate and understand, and often less flexible in design than necessary. Thus, simplified tax classification as broadly outlined in Notice 95-14 would decrease real disincentives to both small businesses and businesses owned by relatively unsophisticated business people. Such simplification would also provide the flexibility necessary for businesses of tomorrow. Much of the existing complexity in the State LLC Acts, for example, could be eliminated if the tax classification regulations were simplified to allow taxpayers to treat domestic unincorporated business organizations as partnerships or as associations on an elective basis. Therefore, it would be appropriate to adopt a simplified approach as contemplated in Notice 95-14. III. AFFECT ON THE PROPORTION OF ORGANIZATIONS CHOOSING UNINCORPORATED ENTITIES AS A RESULT OF SIMPLIFICATION We anticipate that the simplification of classification will not substantially affect the choice of business organization. Limited liability companies have been available since 1977 and in the main stream use since 1988. By 1992 over half the states had limited liability company legislation. Although somewhat counterintuitive based on our personal experiences, the statistical increase in the number of S corporations and the decrease in the number of partnerships filing federal tax returns shows that LLCs have not replaced S corporations. According to the Statistics of Income Bulletin, the number of S corporations has increased from 1.536 million in 1990 to 1.905 million in 1993 with a projection of over 2 million in 1995 (Statistics of Income ("SOI")(Spring 1995) Publication 1136, Table 20 (Rev. 4-95)). During the same time period partnership filings dropped from 1.751 million in 1990 to 1.567 in 1993 with further projected decrease to 1.510 in 1995. While the number of S corporations jumped precipitously after the enactment of the 1986 Tax Act which included mechanisms to curb the use of "tax shelters" (from 736 thousand in 1985 to 1.536 million in 1990) there was no similar increase in the number of partnerships (1.755 million in 1985 to 1.751 million in 1990). Limited liability companies are generally properly treated as partnerships for federal income tax purposes, and should be included in the numbers of partnerships. Further, while there are no statistics for limited liability companies, it should be noted that historically the vast majority of partnerships are general partnerships. For example of 1.554 million partnerships that filed for tax year 1990 (note, these differ from the returns received in 1990 described above) only 285 thousand were limited partnerships. Similarly, of 1.485 million partnership returns filed for 1992 only 271 thousand were limited partnerships (Timothy Wheeler, "Partnership Returns," 1992, Statistics of Income Bulletin (Fall 1994) at page 75). Another SOI article noted "Partnership projections are expected to decline by 1.0 percent overall through 2001, in part as a result of the effect of the Tax Reform Act of 1986 in curbing tax shelters. This decline started in calendar year 1987 and has continued as indicated by the partial 1994 (January 1 - September 30, 1994) returns counts." (Andre Palmer, "Projections of Returns to be filed in Calendar Years 1995-2001," Statistics of Income Bulletin (Winter 1994-1995) 131 at page 137). These statistics indicate that, although the rules applicable to partnerships (and coincidentally, LLCs) have become more workable over the past decade, there has not been a rush to move from corporate form to unincorporated entities. Rather, there seems to have been a movement from C corporations to S corporations (See Amy Gill, "S Corporation Returns," Statistics of Income (Spring 1995) Publication 1136, Table 20 (Rev. 4-95) at page 73). Taken as a whole, these statistics indicate that there is an inelasticity in moving between corporate form and unincorporated organizations. The year 1986, which was when both the General Utilities doctrine was repealed and the ability to use partnerships as tax shelters was eliminated, represented the high water mark of partnership use. Even when people had the ability to avoid gain on conversion from corporations to partnerships (prior to December, 1986), the statistics indicate that they chose the corporate alternative, rather than a partnership. Thus, it seems that the facilitation of the use of LLCs and other similar new organizations should have no more effect on the choice of LLCs over corporations than did the simplification of the classification rules as reflected in other recent developments (Rev. Proc. 89-12, Rev. Rul. 88-76, and the relaxation of the 7701 regulations). It could possibly change the proportion of the use of unincorporated organizations like LLCs to general partnerships on the margin, in part because the "new" unincorporated organizations might encourage economic growth. IV. ELECTION REQUIREMENTS, ABILITY TO CHANGE ELECTION, RETROACTIVITY OF ELECTION AND TRANSITIONAL RULES Ability to Change Notice 95-14 invited comment on whether any restrictions should be imposed on an organization's ability to change its classification, and if so, in what manner. The Notice recognizes that there is "considerable flexibility under the current rules to effectively change the classification of an organization at will." Thus, an unincorporated entity can incorporate if it wishes to achieve the legal and tax consequences of the corporate form. Likewise, a corporation can liquidate and thereafter continue business as an unincorporated organization. We believe this flexibility should continue under the elective procedure. The Notice states that the Service and Treasury are concerned that a simplified election might lead to a "significant increase in the number of organizations changing their classification" which, in turn, would increase the "burdens for some taxpayers and the Service." We think it unlikely that adoption will result in massive classification changes by existing businesses. Most corporations, whether taxed under Subchapter C or Subchapter S, will want to continue with their present tax status. Of those that might consider a change, especially C corporations that cannot qualify under Subchapter S because of shareholder eligibility limits and other restrictions, it is doubtful that many would want to incur the tax liabilities arising from a deemed liquidation. For some corporations, there may also be costs or other complexities arising under state law that would deter a classification change. That would seem to leave only a very small percentage of corporations that would actually elect to convert to classification as a partnership. Likewise, it would appear that there would be few legal or tax incentives for unincorporated entities to elect to be taxed as associations. In addition, an unincorporated entity should have the unrestricted ability to change its legal form to another form of unincorporated entity, such as from a partnership to an LLC, or from a limited partnership to a partnership, without the need to seek a classification change that would add to the administrative duties of, and administrative burdens on, the Service. Overall, the burden on the Service to review the relatively small number of classification changes would appear to be minimal. Accordingly, restrictions on making an election to change the classification of an organization should be kept to a minimum. Frequency of Change Knowledge that a change in tax status from an association to a partnership can result in tax liabilities is a strong deterrent that would keep most organizations from making frequent changes. However if the Service still perceives frequent classification changes to be an administrative problem, time restrictions could be considered. Once an election is made, for example, an entity could be required to wait a period of time before another election could be made. For example, a corporation that has terminated its election to be taxed as an S corporation must wait 5 years to again elect under current law. I.R.C. 1362(g). A similar time period might be suitable for a classification change. Retroactive Elections and Transitional Rules We applaud Notice 95-14's goal of simplification. Another extremely important goal for the Service, Treasury, and for taxpayers however, is certainty. This is particularly important to existing organizations, thus, retroactive protective elections should be permitted. Unincorporated domestic business organizations that were formed prior to issuance of Notice 95-14, and prior to any future Treasury Regulations implementing the Notice (the implementing regulations), should be entitled to make a retroactive election to be treated as a partnership provided several qualifying conditions are met. First the entity, in form, must be a partnership (either limited or general), LLC, LLP, or trust that the owners intended to treat as a unincorporated entity for state law purposes. This intent could be evidenced in a variety of ways, but one important objective manifestation could be filings required under State law and previously filed tax returns. Second, the owners must have intended to treat the entity as a partnership for federal income tax purposes consistently throughout the period for which the retroactive election is being made. Consistently filing partnership tax returns (and consistent reporting by the partners on their individual returns) should create a strong (perhaps irrebuttable) presumption that the taxpayers intended to treat the entity as a partnership. An entity that meets these qualifying conditions should be entitled to make a retroactive election on its tax return for the first taxable year after the implementing regulations are promulgated. The election should generally be retroactive to the date of formation of the entity. Such an election, if allowed, would be consistent with the general policies behind Notice 95- 14. These policies include (1) preventing formalistic factors from distinguishing between unincorporated entities treated as partnerships from those treated as associations and (2) preventing entities with limited assistance from tax professionals from being subject to tax in a manner inconsistent with their intent due to their lack of sound professional advice. Allowing retroactive elections would also prevent taxpayers from being "blind-sided" by an election to be taxed as a partnership. This could occur if a taxpayer making an election to be treated as a partnership thought it was always a partnership, but later determined it was an association at the time of the election. In such a situation, the entity would be deemed to have been converted from an association to a partnership pursuant to the election, thereby resulting in a large potential tax liability that in some situations could have severe adverse effects on the entity's financial position. Further, allowing retroactive elections would also reduce the continuing burden on the IRS with respect to the current entity classification regulations as many tax years would remain open and subject to audit years after the implementing regulations are promulgated. Alternatively, if the Service and Treasury are not willing to permit retroactive elections, taxpayers should be allowed to make prospective elections on a contingent basis. For example, an entity should be permitted to elect to be treated as a partnership, but be allowed to retroactively retract the election if it is later determined that the partnership was an association which was inadvertently converted into a partnership solely due to the election. Allowing contingent elections would protect taxpayers from undergoing unexpected taxable conversions from corporate to partnership form. Classification of Existing Organizations that Do Not File an Affirmative Election If existing organizations are permitted to make retroactive elections, there will still be many entities that will not make an affirmative election. Some may fail to make the election on the basis of an informed decision, others will do so because of lack of knowledge of the new elective procedure. The relevant question, anticipated by the Notice itself, then becomes: How should these entities be classified? Notice 95-14 states that organizations would retain their "current classification unless an affirmative election to be classified differently is filed." The Notice further provides that unincorporated entities would "generally" be classified as partnerships for federal tax purposes unless a contrary election is filed. We believe that the partnership classification of unincorporated business should be the result in all cases, without exception. To promote certainty and to minimize classification disputes between taxpayers and the Service, we suggest that an existing organization's classification be determined by the last federal tax return filed by the entity prior to the issuance of Notice 95-14. That determination should be binding on both the Service and the taxpayer. Obviously, this approach also sounds to the retroactivity issue. That is, the organization's prior filings would be deemed conclusive of its status for the open tax years. This rule would eliminate the need for existing entities to file an affirmative retroactive election for the sole purpose of confirming status for the prior tax years, in turn, eliminating the need for technical transitional rules and (consistent with the stated purpose of simplification) make the transition as user friendly as reasonably possible. V. THE CLASSIFICATION OF SINGLE-OWNER AND FOREIGN ENTITIES In conjunction with the overall effort to simplify the classification of unincorporated business organizations, Notice 95-14 also requested comments on the application of the suggested simplified approach to single-owner organizations. We welcome the extension of the election procedure to single-owner and single-member organizations. This relief is particularly appropriate for single-owner enterprises allowed by state law where the existing rules make federal income tax classification as a pass-through entity ambiguous or difficult to achieve. The current classification rules significantly increase transaction costs for sole-proprietor entities by requiring the introduction of an additional near-nominal owner or the use of especially Byzantine structures to satisfy the rules. Nonetheless, we would not desire your consideration of this aspect of entity classification to delay the expeditious development of streamlined regulations for domestic multi-member organizations. In the international context, we would encourage you to extend the suggested elective-classification proposal to foreign entities to the fullest extent practicable. With the Presidential mandate to reduce regulatory burdens, we hope that the cooperative effort between the Service, Treasury, and the groups representing the international community will result in rules for foreign entities and transactions that track the domestic classification rules in as many respects as possible. This may take some time to work out and, if that is the case, we again hope that you can expedite the regulations for domestic entities by dealing with the international aspects of entity classification independently. -- --- John DeBruyn, 2100 East 14th Avenue, Denver, Colorado 80206