Check-the-Box Regulations Are Valid

The U.S. Supreme Court declined to review a case in which a business owner argued that “check-the-box” entity classification rules represent an invalid exercise of the IRS’s authority to issue interpretive regulations under IRC § 7805(a). In so doing, the court let stand a ruling by the Sixth Circuit Court of Appeals, which had upheld a district court decision against the taxpayer.

Frank Littriello, the sole owner of several Kentucky limited liability companies providing health care services, failed to “check the box” as prescribed by Treas. Reg. § 301.7701-3, thereby electing that the LLCs be treated as sole proprietorships rather than corporations for federal tax purposes. While this election protected Littriello from double taxation, it also meant that as a sole proprietor he would be held individually liable not only for taxes on business income but also for federal employment taxes. The latter, however, were not paid for 2000 through 2002. The IRS assessed Littriello more than $1 million and in 2003 informed him it would enforce liens against his property. Littriello filed suit in district court challenging the validity of the regulations. He contended they conflicted with the principles enunciated by the Supreme Court in Morrissey v. Commissioner (16 AFTR 1274 (1935)) and disregarded the separate existence under Kentucky state law of an LLC from its owner. The district court ruled against him, and Littriello appealed.

The Sixth Circuit, like the district court, cited Chevron USA Inc. v. Natural Resources Defense Council Inc. (467 U.S. 837 (1984)), ruling that the regulations were a reasonable interpretation by the IRS of a tax statute (IRC § 7701) that was otherwise ambiguous. Under Chevron , a court must first determine “whether Congress has directly spoken to the precise question at issue.” If congressional intent is clear, “that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress.” However, “if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency’s answer is based on a permissible construction of the statute.”

The circuit court decided that section 7701 is ambiguous regarding newer hybrid business entities such as LLCs. Treasury regulations dealing with them—including the check-the-box provisions—reflect a reasonable exercise of the agency’s authority, it said. The court also rejected Littriello’s argument that Morrissey should control in this case, since it had simply identified certain attributes of a corporation. If anything, Morrissey supported the government’s position, the Sixth Circuit said. The earlier case noted that the Code’s definition of a corporation was lacking, and therefore the IRS “had the authority to supply rules of implementation that could later be changed to meet new situations.”

The Sixth Circuit also rejected Littriello’s argument that the IRS must recognize the separate existence of his LLCs as a matter of state law. Again citing Morrissey , the court said common-law definitions of corporate forms do not control interpretation of federal tax laws.

In August 2007, the Treasury and IRS issued final regulations (Treasury Decision 9356) treating single-owner disregarded entities as separate entities for purposes of employment taxes and related reporting requirements. These provisions will apply to wages paid on or after Jan. 1, 2009. Littriello also argued that these regulatory amendments, proposed in 2005 after he had filed a notice of appeal, should apply retroactively to him. Ruling before the changes became final, the Sixth Circuit rejected that argument as well, saying that the amendments were intended to simplify employment tax collection, not repudiate the check-the-box rules.

Littriello v. U.S., 99 AFTR2d 2007-2210

Prepared by Laura Jean Kreissl , Ph.D., assistant professor of accounting, and Darlene Pulliam , CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.