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Entity Classification Election

Entity Classification Election generally refers to the choice made by an entity, such as a corporation or partnership, about how it should be classified for federal tax purposes. The term isn’t exclusive to the Delaware statutory trust (DST) industry, but it’s certainly very relevant.

A Delaware Statutory Trust is a legally recognized trust that provides a way for one or more investors to hold fractional ownership in property. A DST is typically used in conjunction with a 1031 exchange, a provision in the U.S. tax code that allows investors to defer paying capital gains taxes on investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.

The Internal Revenue Service (IRS) has specific rules and regulations that govern how a DST is taxed. When a DST is established, an Entity Classification Election (also known as a “check-the-box election”) may be made using IRS Form 8832, “Entity Classification Election”. The election will determine if the DST is treated as a disregarded entity, a partnership, or a corporation for federal tax purposes.

  1. Disregarded Entity: A single-member LLC (limited liability company) or trust that is not recognized for tax purposes as an entity separate from its owner. Taxes are reported on the owner’s personal tax return. This option is not generally applicable to DSTs, which usually have multiple investors.
  2. Partnership: If the DST has more than one owner, it can be treated as a partnership for tax purposes. This means the DST itself is not subject to income tax. Instead, income, deductions, gains, losses, etc., “pass-through” to the owners, who report these items on their personal tax returns.
  3. Corporation: The DST can elect to be treated as a corporation for tax purposes. This would subject the trust to “double taxation”, meaning that income is taxed at the corporate level when earned and then again at the individual level when distributions are made to the owners.

The choice of tax classification can have significant implications for the DST and its owners, and the best choice will depend on a variety of factors. Therefore, these decisions should be made with the guidance of legal and tax professionals.