Learn about: Unincorporated Associations Part II

paystubmakr.com presents the second part of the article Unincorporated Associations

First part

before the effective date of the regulations if:

(1) The entity had a “reasonable basis” for the claimed classification,

(2) The entity and its members recognized the federal tax consequences of any change in the entity’s classification within 60 months before the regulations’ effective date, and

(3) Neither the entity nor any member was notified in writing on or before May 8, 1996, that the classification was under examination. The IRS is also notifying taxpayers of the effect of the final regulations on certain revenue rulings and revenue procedures. Effective Jan. 1, 1997, rulings and procedures are now obsolete to the extent that they use the former classification to differentiate between partnerships and associations. The IRS will show a list of the old documents in the Internal Revenue Bulletin. (Notice 97-1; TD 8697)

Note: Perhaps the best way to appreciate what these new regs do is to imagine that the worst drafted LLC agreement in existence, which has all four of the distinguishing corporate characteristics under the “old” Kintner regs., will no longer jeopardize the tax status of the underlying entity. The owners

can rest assured that it will be treated as a partnership for federal tax purposes without any fear that the Service will come in and challenge it as really being a corporation. This is, of course, provided that the entity was not under IRS exam for this issue as of May 8, 1996. These new “check-a-box regs” also let the practitioner off the hook for a poorly drafted LLC agreement. Or, as long as the entity, consisting of two or more owners, is not formally incorporated under applicable state laws, it will be a partnership for federal tax purposes. Only if the entity’s’ owners were not satisfied with the default classification for tax purposes would they have to file Form 8832, Entity Classification Election.

Sub-chapter S Corporations

S Corporation (S Subchapter)

A qualifying corporation may choose to be generally exempt from federal income tax. Its shareholders will then include in their income their share of the corporation’s separately stated items of income, deduction, loss, and credit and their share of no separately stated income or loss. A corporation that makes this choice is typically referred to as an S corporation.

Subchapter S of the Code permits certain small business corporations to elect special tax treatment. Generally, S corporations avoid all federal income taxation at the corporate level. Like partnerships, all items of income, deduction, credit, gain, and loss are passed through directly to the individual shareholders on a pro-rata basis.

Note: Although it generally will not be liable for federal income tax, an S corporation may have to pay a tax on excess net passive investment income, a tax on capital gains, or a tax on built-in gains. An S corporation files its return on Form 1120 S (§1361). In addition to this tax treatment, S corporations (which are ordinary corporations for all purposes except federal income taxation), also enjoy the limited liability of the shareholders to corporate creditors that is generally associated with ordinary corporations. S corporations will be discussed in more detail later.

Ordinary “C” Corporations

The advantages of ordinary corporate existence are mitigated somewhat by the imposition of corporate income taxation. “For purposes of federal income taxes, the corporation is recognized as a separate tax-paying entity. This causes, in the case of most corporations, double taxation. Income is taxed first to the corporation that earns it, and secondly to the shareholders when the earnings and profits are distributed as dividends.”

How To Decide If A C-Corp Is Appropriate For Your Trading – Forbes


A “C” corporation will show several tax advantages over S corporations and unincorporated businesses:

(1) As a separate taxpayer, it can be used to divide income between itself and its owner(s), with potentially lower the total tax rates as a result;

(2) A “C” corporation can deduct money paid for fringe benefits for its employee/owners, such as medical insurance or medical reimbursement plans, disability insurance, or group term life insurance;

Note: An S corporation cannot deduct any such expenses paid on behalf of employees who are 2% (or larger) shareholders, and unincorporated businesses cannot deduct such payments on behalf of the owners.

(3)“C” corporations can choose a fiscal tax year; and

Note: “S” corporations and partnerships must generally be on a calendar year, except for those that were already on a fiscal year and elected on a timely basis to retain such fiscal year or new S corporations or partnerships which may be allowed to elect a year ending in September, October, or November, instead of the calendar year.

(4)“C” corporations can deduct up to 80% of the dividends (70% of the benefits received if the corporation receiving the dividend owns less than 20% of the distributing corporation) they receive from investments in other corporations (§243).

Note: The dividends received deduction is not available on dividends received by an S corporation or an unincorporated business.


Disadvantages of a “C” corporation include:

(1) Accrual method of accounting may be required (see the §448(b) personal service corporation and five million or less gross receipts exceptions);

Note: “S” corporations and unincorporated businesses can use the cash method of tax accounting unless they have inventories of goods they sell.

(2) “C” corporations are charged  double taxation where income is paid out as dividends;

Note: In fact, few closely held corporations go through the formality of paying a dividend.

(3)“C” corporations with certain forms of income such as interest, dividends, rents, and royalties are potentially subject to the personal holding company tax on such income; and

(4) 75% of the difference between a “C” corporation’s adjusted current earnings and taxable income is an alternative minimum tax preference item.

Personal Service Corporations

Personal service corporations are subjected to use a calendar tax year unless they can establish a business purpose for a different period, or make a §444 election. For this purpose, a personal service corporation generally is a corporation in which the principal activity is the performance of personal services that are substantially performed by employee-owners (Reg. §1.441-4T(d)). Personal Service Corporation


must own more than 10% of the fair market value of the corporation’s stock on the last day of the testing period (Reg. §1.441-4T(d)).

Testing Period

The testing period for a tax year is the prior tax year. [Reg.§1.4414T(d)(2)(i)]


Corporation A has been in existence since 1990. “It has always used a January 31 fiscal year for its accounting period.” IRS

To determine if A is a personal service corporation for its tax year beginning February 1, 2017, the testing period is A’s tax year ending January 31, 2017.

The testing period for a new corporation for its first tax year “starts with the first day of the tax year and ends on the earlier of” IRS

(1) The last day of its tax year, or

(2) “The last day of the calendar year in which the tax year begins” IRS(Reg.§1.441-4T(d)(2)(ii)).


“B Corporation’s first tax year begins June 1, 2017. B wants to use a September 30 fiscal year for its accounting period. B’s testing period for its first tax year is June 1, 2017, through September 30, 2017. If B wants to use a March 31 fiscal year,” IRS   B Corporation (certification)

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