An update on the "check-the-box" proposal to entity classification.

On Mar. 29, 1995, the IRS issued Notice 95-14. The notice proposed simplifying the current classification regulations under Sec. 7701 to allow domestic unincorporated business organizations to elect (i.e., "check the box") to be classified either as partnerships or corporations.

Current law requires that unincorporated business organizations use the classification rules of Regs. Secs. 301.7701-2 and -3 to determine whether for Federal income tax purposes they are treated as associations taxable as corporations or partnerships. These classification rules require that an entity analyze four factors: limited liability; continuity of life; centralized management; and free transferability of interests. Any entity that possesses more than two of these characteristics will be classified as a corporation. Rather than using the four-factor test, the notice would allow certain domestic unincorporated business organizations with two or more associates and an objective to carry on business and divide the gains therefrom to elect the form of tax treatment. The election would be made by simply checking a box on a form to be filed with the Service.

On July 20, 1995, the IRS held hearings on the notice. According to the most recent comments made by Treasury and Service personnel, taxpayers can expect proposed regulations in the early part of 1996. Difficulty in resolving certain foreign entity issues will not delay the issuance of regulations for domestic entities. In addition, it appears doubtful that the regulations will be extended to apply to single-member entities.

It also appears, from comments made by the Deputy and Associate Tax Legislative Counsel, that the regulations will not apply retroactively. Therefore, existing entities that are considering making an election should carefully analyze how such an election affects them. It is clear that caution needs to be exercised, for example, if an entity is classified as a corporation under Sec. 7701 and decides to elect to be classified as a partnership. By electing partnership status, such entity will be treated as completely liquidating, potentially causing gain under Sec. 336.

In addition, no amnesty as to classification is provided by making an election. Checking the box does not offer protection from an IRS audit of classification in prior tax years. For example, if an entity was operating as a partnership and it is determined under audit that it should have been classified as a corporation, making an election to be classified as a partnership would result in a complete liquidation of the corporation, again causing potential Sec. 336 gain.

Although several issues remain unresolved, it appears that domestic taxpayers can expect proposed regulations on the notice sometime in 1996. Most practitioners welcome the change.