photo: hobvias sudoneighm on Flickr, license, no change
Back in 1996, IRS decided to simplify entity classification by allowing certain non-corporate entities (1) to elect how they would be taxed. Typically, an entity uses Form 8832 (PDF) to make the election. If the entity is not a corporation and it wants to be taxed as a corporation under Subchapter S of the Internal Revenue Code, then the entity should file Form 2553 (PDF) instead of Form 8832.
Therefore an entity can elect (choose) to be taxed as though it was a corporation even though it is not legally a corporation under other laws. For example, in the U.S. a general partnership can be formed with a handshake (2) between two or more co-owners. A general partnership provides no legal liability protection and each owner can commit the partnership to a contract without the other owner’s permission and input. The general partnership is treated as a flow-through entity meaning the income, losses, and many other items “flow-through” to the owners to be taxed on the owners’ income tax returns.
If the general partnership then elects to be taxed as a corporation under Subchapter C of the Internal Revenue Code, it files and pays most federal taxes the same as a state law corporation that has not elected to be taxed under Subchapter S. In other words, the electing general partnership now pays its own income taxes and the partners only pay tax on wages or dividends they receive. It is important to keep in mind that the election is for tax purposes only. The legal entity does not change, the general partners still have unlimited liability for all purposes other than taxes.
Finally, if you are considering such an election you should check to see if the state or states in which your business operates recognizes the election or not. NC recognizes the federal election without you having to do anything else. Some states require an additional form to be filed to notify them of the election.
- General partnerships, limited partnerships, limited liability companies (LLCs), professional limited liability companies (PLLCs), trusts, sole proprietorship and limited liability partnerships are the most common types of entities that can elect to be taxed as a corporation instead of under their default classification. Foreign entities are more tricky and outside the scope of this post.
- It is best to form a general partnership in writing to avoid any misunderstandings, memorialize your initial understanding, and provide a method for splitting up or selling the general partnership.