The final "check the box" regulations.

This is a series based on questions from the AICPA tax certificate of educational achievement (CEA) courses.

Small Business
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In December 1996, the Internal Revenue Service issued final regulations—often referred to as the check the box regulations—that allow unincorporated entities to choose whether to be taxed as partnerships or as corporations. How do these new rules work?

Under Treasury regulations sections 301.7701-1 through 301.7701-3, effective January 1, 1997, all business entities, other than those classified as corporations for federal tax purposes (referred to as eligible entities), may elect to be taxed as partnerships or corporations. A business entity is any entity recognized for federal tax purposes that is not classified as a trust or otherwise subject to special treatment under the Internal Revenue Code. According to regulations sections 301.7701-2(a) and (b), business entities required to be classified as corporations for federal tax purposes include entities incorporated under federal or state law, associations, joint stock companies, insurance companies, banks, state-owned entities, publicly traded partnerships and certain foreign entities.

An eligible entity with at least two members can elect to be classified as a partnership or as a corporation for federal tax purposes. An eligible entity with a single owner can elect to be classified as a corporation or can be disregarded as an entity separate from its owner under regulations section 301.7701-3(a). If the entity is disregarded, it is treated as a sole proprietorship if it is owned by an individual; if it is owned by a corporation, it is treated as a branch or division.

Under default rules, unless the entity elects otherwise, a domestic eligible entity is classified as a partnership if it has at least two members; if it has a single owner, it is disregarded. Accordingly, a domestic general partnership, a limited partnership or a limited liability company (LLC) is classified as a partnership for federal tax purposes if an election is not filed. A foreign entity is classified as a corporation if all members have limited liability. If it has a single owner, it is disregarded if the owner does not have limited liability (regulations section 301.7701-3[b]).

An eligible entity that wants to elect out of its default classification or change its classification can do so by filing Form 8832, Entity Classification Election. If an eligible entity makes an election to change its classification (other than an existing entitys election to change its classification as of January 1, 1997), under regulations section 301.7701-3(c) the entity cannot change its classification again for five years. This limit applies only to changes by election. Accordingly, a new eligible entity that elects out of its default classification may change its classification by election at any time. In addition, an entity generally may change its classification if the entitys business is transferred to another entity.

A domestic eligible entity in existence before January 1, 1997, retains the classification it claimed before that date. However, an eligible entity with a single owner that claimed to be a partnership is disregarded as a separate entity. A foreign eligible entity is treated as being in existence before the effective date only if the entitys classification was relevant at any time during the five years before January 1, 1997.

For periods before January 1, 1997, the IRS generally respects an eligible entitys claimed classification if

  • The entity had a reasonable basis for it.
  • The entity and all members recognized federal tax consequences for any change in the entitys classification within the five years before January 1, 1997.
  • Neither the entity nor any member was notified in writing on or before May 8, 1996, that the entitys classification was under examination.

A change in an entitys classification has income tax consequences. For example, if an entity that was previously classified as a corporation elects to be classified as a partnership, the entity and its owners are subject to the tax rules applicable to both corporate liquidations and to the formation of a partnership.

The regulations both offer businesses planning opportunities and raise questions. For example, for affiliated corporations filing a consolidated return, a single-owner LLC may offer benefits—altering the separate return limitation year (SRLY) and intercompany transaction rules. There also may be state tax benefits associated with using an LLC—losses of a single-owner LLC are reported by the owner for federal tax purposes. If a state follows the federal treatment, it would allow these losses to be currently used by the owner. It is unclear, however, whether the states will follow the federal tax treatment. Some states may treat an LLC like a corporation for tax purposes.

The area where the greatest planning opportunities exist is with foreign entities — minimizing subpart F income, avoiding the 10-50 foreign tax credit basket and avoiding IRC sections 367 and 1491 by using a single-owner LLC, which is disregarded for U.S. tax purposes. Julian R. Sayre , CPA, JD, PhD, is retired from Clifton Gunderson LLC in Tuscon, Arizona. Robert L. Weitzner CPA, JD, LLM, is assistant director of federal tax research, planning and policy with AT&T in Morrisontown, New Jersey. Both are authors in the AICPA tax CEA series.

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