On May 9, 1996, the IRS issued proposed regulations under Section 7701 of the Internal Revenue Code to simplify entity classification for federal tax purposes. The "check the box" regulations will replace the four factor test currently contained in the regulations and should significantly reduce tax planning problems that arise in connection with the organization of business entities. Under the existing rules, an entity is classified as either a corporation or a partnership based upon an examination of four factors (i.e. limited liability, free transferability of interest, continuity of life, and centralized management). An entity that lacks two or more of these characteristics is treated as a partnership for tax purposes. An entity that possesses three or more of these characteristics is treated as a corporation for tax purposes.
Under the new regulations, the classification of an entity will depend upon the type of legal entity involved, the number of owners and whether or not an election is made. This should significantly enhance the ability of taxpayers to create tax "pass-through" business entities and should simplify the drafting of partnership and limited liability company (LLC) operating agreements.
The most significant aspects of the "check the box" regulations are:
Entities formed as corporations under state law will automatically be classified as corporations for federal tax purposes.
Unincorporated domestic business entities (such as limited liability companies and limited partnerships) having two or more members will be classified as partnerships for federal tax purposes unless the entity affirmatively elects to be taxed as a corporation.
Unincorporated domestic business entities that have one member will be disregarded for federal tax purposes (i.e. they will be taxed as sole proprietorships) unless the entity affirmatively elects to be taxed as a corporation.
Automatic "Corporation" Classification. Any business entity that is organized under a federal or state statute that describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic, will be a corporation for federal tax purposes. Thus, corporations formed under state corporation statutes, such as the New Jersey Business Corporations Act, will be automatically classified as corporations for federal tax purposes.
Elective Classification for Unincorporated Entities. Domestic entities that are not automatically classified as corporations, such as a limited liability company and a limited partnership, may elect to be treated as either (i) a corporation or a partnership (if the entity has two or more members) or (ii) a non-entity i.e. sole proprietorship (if the entity has only one member). Because partnership/non-entity classification will apply under the default rules, with respect to the formation of new entities, an election generally will be necessary only if corporate status is desired.
Classification of Foreign Entities.
A number of foreign limited liability business entities listed in the proposed regulations are automatically classified as corporations for federal tax purposes. If a foreign entity is not automatically classified as a corporation for federal tax purposes, the following default classifications will apply unless the entity affirmatively elects otherwise: (i) partnership classification if the entity has at least two members and any member has unlimited liability; (ii) the entity will be disregarded if it has a single owner with unlimited liability and (iii) corporation classification if no member has unlimited liability.
Default Rules.
If an entity fails to check any box, the proposed regulations provide certain default rules. The default rules differentiate between new and existing entities. "New" entities would be those formed after the regulations become final. "Existing" entities are those formed at any time before the regulations are final. Any "new" domestic unincorporated entity with two or more members would be classified as a partnership if it fails to make any election. Any "existing" entity that is eligible to make an election but fails to do so generally would have the same classification that it claimed under the four factor test in effect immediately before the "check the box" regulations become final. Note: It will be important to review existing limited partnership agreements and limited liability company operating agreements to evaluate whether modifications should be made now that it is no longer necessary to satisfy the mechanical four pronged test of present tax regulations. For example, many of these agreements (for the sole purpose of complying under the four-part test) impose more severe restrictions on transferability of interests than the partners/members would otherwise have imposed; once the tax regulations are finalized, these provisions can and should be modified.
Mechanics of the Election. The IRS is expected to issue a form for making the election. The election will generally be effective on the date it is filed. However, the regulations permit an entity to specify an effective date 75 or fewer days prior to filing. Once an election is filed, an entity must generally wait 60 months prior to making another election. Although the first version of the proposed regulations provided that all members of an entity must consent to the election, the latest version provides that an election can be made unanimously or by any officer, manager, or member of the electing entity who is authorized to make the election and who represents to having such authorization under penalties of perjury.
Effective Date. At the present time, the "check the box" provisions are only in proposed form. They will become effective when finalized and published in the Federal Register; we anticipate that may occur by year end.
Transition Rules. The proposed regulations indicate that the IRS will not challenge the classification of any unincorporated business entity formed prior to the time the regulations are finalized if (i) the entity had a reasonable basis for its claimed classification (ii) the entity claimed the same classification in all prior years; and (iii) neither the entity nor any member was notified in writing on or before May 8, 1996, that the classification of the entity was under examinations. This will protect partnership tax status of many existing limited liability companies and limited partnerships.
The "check the box" regulations reflect a very positive approach by the IRS to the long-standing problem of the tax classification of entities. We think it will have a significant affect on the organization of businesses in the U.S., and we would encourage our business clients to discuss the potentially favorable application of these anticipated new rules to their particular businesses.
