What Is a Change in Entity Classification?
Understand the strategic process of changing your entity's federal tax classification, a choice that operates independently of its legal structure.
A change in entity classification is a formal election made to the Internal Revenue Service (IRS) that alters how a business is taxed for federal purposes. This process is separate from a business’s legal structure, which is determined by state law. The IRS “check-the-box” regulations permit certain business entities to choose a tax status that differs from their default classification, allowing them to align their tax structure with financial objectives without changing the company’s legal formation.
Eligible Entities and Default Classifications
Only “eligible entities,” which are businesses not automatically classified as corporations by the IRS, can elect a tax classification. The most common examples are limited liability companies (LLCs) and partnerships. These entities are created under state law but have flexibility in how they are treated for federal income tax.
The IRS assigns a default tax classification to eligible entities if no election is made. For a domestic business with a single owner, such as a single-member LLC, the default classification is a “disregarded entity,” meaning its activities are reported on the owner’s personal tax return. If an eligible entity has two or more owners, it defaults to being classified as a partnership for tax purposes.
Some business structures are not eligible to change their classification. A business incorporated as a corporation under state law is automatically taxed as such by the IRS and cannot elect a different status. Likewise, entities like tax-exempt organizations and real estate investment trusts (REITs) are subject to specific tax rules and cannot change their classification through this process.
Tax Treatment of Classification Changes
When an entity changes its classification, the IRS treats it as a series of “deemed” legal and financial steps, even though no actual transactions occur under state law. These deemed events have tax consequences, such as the potential for recognizing gains or losses and adjustments to the tax basis of assets. The specific treatment varies depending on the starting and ending classifications.
If a partnership elects to be taxed as a C corporation, the partnership is deemed to contribute all its assets and liabilities to a new corporation for stock. The partnership is then considered to have liquidated by distributing the stock to its partners. This can be a tax-free transaction under Section 351 of the Internal Revenue Code if the partners control the corporation after the contribution.
When a corporation elects to be treated as a partnership, it is deemed to have distributed all assets and liabilities to its shareholders in a complete liquidation. The shareholders are then deemed to contribute those assets and liabilities to a new partnership. This corporate liquidation is a taxable event for both the corporation and its shareholders.
When a disregarded entity elects to be classified as an association, its owner is deemed to contribute the business’s assets and liabilities to a new corporation for stock. If an association with a single owner elects to be a disregarded entity, the corporation is deemed to have distributed all its assets and liabilities to the owner in a liquidation, which is a taxable event.
Required Information and Forms for Election
To initiate a change in tax classification, a business must have its legal name, official address, and Employer Identification Number (EIN). The filer also needs to know the number of owners, the specific tax classification being elected, and the intended effective date for the change.
The primary document for this process is Form 8832, Entity Classification Election, which eligible entities use to choose or change their tax classification. However, if a business like an LLC wishes to be taxed as an S corporation, it must file Form 2553, Election by a Small Business Corporation. Filing Form 2553 also serves as an election to be classified as a corporation, so a separate Form 8832 is not required.
Form 8832 requires the business’s identifying information and details about the election. An important part of the form is selecting the effective date for the new classification. The chosen date cannot be more than 75 days before the form is filed or more than 12 months after the filing date. If no date is specified, the election becomes effective on the filing date.
The Filing Process and Post-Election Rules
After completing Form 8832 or Form 2553, it must be filed with the appropriate IRS service center. A copy of the filed Form 8832 must also be attached to the entity’s federal tax return for the year the election is effective. If the entity is not required to file its own return, a copy must be attached to the personal federal income tax return of any owner.
After the IRS processes the election, it will send a confirmation letter noting the acceptance and the effective date. Businesses should retain this letter with their permanent records as proof of the election.
A 60-month limitation rule applies to classification changes. An entity that changes its classification cannot change it again for 60 months from the election’s effective date, binding most businesses to their choice for five years. For businesses that miss the filing deadline, the IRS provides a path for late election relief if there is reasonable cause.