Check-the-box final regs. simplify entity classification.

The Sec. 7701 final regulations succeed to a great extent in providing a simple elective method for classifying an entity, while also providing specific classifications for certain types of entities. In addition, the default classification rules (which apply in the absence of an election) seek to match taxpayers' expectations without the need for filing an election. Overall, the final regulations present planning obstacles and opportunities, as detailed in this article.

Late last year, the IRS issued the long-anticipated Sec. 7701 entity classification final regulations (check-the-box regulations).(1) These rules afford welcome relief from the complex, formalistic rules that previously governed the Federal tax classification of domestic and foreign business entities.

The final regulations retain the simplicity and flexibility of the proposed regulations and provide additional needed guidance on the treatment of foreign entities and procedures for electing Federal tax status. In general, the regulations automatically classify certain business entities as corporations and permit other business entities to elect classification. EEs with two or more members may elect to be treated either as a partnership or as (an association taxable as) a corporation; SOEs may elect to be treated as a corporation or be disregarded for Federal tax purposes. The regulations were generally effective Jan. 1, 1997.(2) (Table 1 on page 297 defines the acronyms used in this article.)

Table 1: Acronyms Used in This Article

CPS    =   Corporation per se
DEE    =   Domestic eligible entity
EE     =   Eligible entity
KIN    =   Employer identification number
FEE    =   Foreign eligible entity
JCT    =   Joint Committee on taxation
LLC    =   Limited liability company
PFR    =   Preamble to the final regulations
PPR    =   Preamble to the proposed regulations
REIT   =   Real estate investment trust
SOE    =   Single-owner entity

There are compelling reasons for allowing classification by election. The former regulations were based on historical differences under local laws between partnerships and corporations; as a result, the Federal tax classification of organizations was dictated by the presence (or absence) of certain corporate characteristics under differing state laws.(3) However, the distinctions between corporations and partnerships in the former regulations were often inconsequential, in two ways. First, tax advisers could draft articles of organization or other governing documents virtually ensuring that an entity would possess the characteristics needed to achieve the desired Federal tax classification. (If circumstances warranted, tax assurance was obtained via tax opinion or letter ruling.) Second, the availability of new forms of unincorporated organizations under local law (e.g., LLCs) increased; these entities resembled corporations in most legal aspects, but were classified as partnerships for Federal tax purposes.(4) The final regulations' elective approach assures taxpayers that their entity's tax classification will sustain a subsequent IRS challenge without incurring substantial costs; the IRS avoids expending substantial resources in administering the system.

Recognition of Separate Entity

Under Regs. Sec. 301.7701-1(a), classification begins with a determination whether a separate entity exists for Federal tax purposes (whether or not the organization is recognized as a separate entity under local law). Regs. Sec. 301.7701-1(a)(2) provides that certain joint undertakings not recognized as separate entities under local law may be separate entities for Federal tax purposes (e.g., a separate entity may exist if tenants-in-common actively carry on a trade or business, financial operation, or venture with respect to co-owned property and divide the profits of the joint undertaking).(5) Conversely, under Regs. Sec. 301.7701-1(a)(3), certain entities recognized as separate under local law may not be separate entities for Federal tax purposes (e.g., an organization wholly owned by a state is not a separate entity for Federal tax purposes if it is an integral part of the state).

Regs. Sec. 301.7701-1(a)(4)(b) states that if an organization is recognized as a separate entity for Federal tax purposes, it is classified either as a business entity or a trust unless the Code expressly provides for special treatment (e.g., real estate mortgage investment conduits under Sec. 860A).

Business Entities

The regulations apply only to business entities. A "business entity" is defined by Regs. Sec. 301.7701-2(a) as an entity recognized for Federal tax purposes not properly classified as a trust under Regs. Sec. 301.7701-4 or otherwise subject to special treatment under the Code.(6) A business entity with two or more members is classified either as a corporation or a partnership; an SOE is either classified as a corporation or disregarded; if disregarded, its activities are treated as the owner's sole proprietorship, branch or division.

Corporate Classification

For Federal tax purposes, certain business entities are automatically classified as corporations; entities so classified cannot elect classification and will be taxed as C corporations unless eligible to elect S status.

Regs. Sec. 301.7701-2(b) classifies as corporations business entities denominated as such under applicable Federal or state statutes, as well as associations, joint-stock companies, insurance companies, state-chartered banking organizations, state-owned organizations and organizations taxable as corporations under a Code provision other than Sec. 7701(a)(3) (e.g., publicly traded partnerships under Sec. 7704 and taxable mortgage pools under Sec. 7701(i)).(7) Regs. Sec. 301.7701-2(b)(8)(i) lists 80 business entities in foreign jurisdictions (or the jurisdictions of a U.S. possession, territory or commonwealth) that are automatically classified as CPSs (e.g., France, Societe Anonyme; Mexico, Sociedad Anonima).(8)

The regulations do not indicate the common attributes possessed by the foreign entities that caused them to be included in the CPS list.(9) Because taxpayers will rely on this list in structuring foreign operations, the failure to identify these attributes creates considerable uncertainty from a tax compliance and planning perspective. Another concern is that Treasury will likely make additions to (and deletions from) the CPS list in future years; such modifications could trigger adverse tax consequences if an entity is added to the list, particularly if immediate compliance is required without a grandfather exemption or transition relief.(10)

In its comments to Treasury on the proposed regulations, the AICPA's Partnership and International Taxation Committees (Committee Comments) recommended that the final regulations explain the parameters for determining an entity's inclusion in the CPS list and provide a procedure for taxpayers to challenge an entity's inclusion based on those parameters. The Committee Comments also recommended that the final regulations provide that additions to, and deletions from, the list be effective prospectively only, unless the change was the result of a taxpayer challenge, and only at the taxpayer's election if the taxpayer had previously relied on the list in classifying an entity (alternatively, the regulations should provide transition relief in lieu of such election).(11)

Unfortunately, the final regulations do not address the basis for an entity's inclusion in the CPS list or provide procedures for challenging an entity's inclusion therein. However, the PFR indicated that any further modifications of the list will be prospective only and announced in a notice of proposed rulemaking.

EEs

An EE is defined in Regs. Sec. 301.7701-3(a) as a business entity other than an entity required to be classified as a corporation (including an entity classified as a CPS) under the regulations. This definition is important in two respects. First, only EEs may elect a Federal tax classification; second, the classification of EEs not making an election is automatically determined under the Regs. Sec. 301.7701-3(b)(2) default rules. See Table 2 on page 299 for a summary of the Federal tax classification of EEs under the final regulations.

Table 2: Eligible Business Entity Classification Under the Sec.
7701 Final Regs.

Eligible business                 Elective
entity                         classification

Domestic with                  Partnership or
two or more members            corporation
                               (Regs. Sec. 301.7701-3(a))

Foreign with two or more       Same as domestic
members; at least one          (Regs. Sec. 301.7701-3(a))
member does not have
limited liability

Foreign with two or more       Same as domestic
members; all members           (Regs. Sec. 301.7701-3(a))
have limited liability

Domestic with single           Entity disregarded
owner                          or corporation
                               (Regs. Sec. 301.7701-3(a))

Foreign with single owner      Same as domestic
not having limited liability   (Regs. Sec. 301.7701-3(a))

Foreign with single owner      Same as domestic
having limited liability       (Regs. Sec. 301.7701-3(a))

Eligible business                   Default
entity                         classification(*)

Domestic with                  Partnership
two or more members            (Regs. Sec. 301.7701-3(b)(1)(i))

Foreign with two or more       Same as domestic
members; at least one          (Regs. Sec. 301.7701-3(b)(2)(i)(A))
member does not have
limited liability

Foreign with two or more       Corporation
members; all members           (Regs. Sec. 301.7701-3(b)(2)(i)(B))
have limited liability

Domestic with single           Entity disregarded
owner   or corporation         (Regs. Sec. 301.7701-3(b)(1)(ii))

Foreign with single owner      Same as domestic
not having limited liability   (Regs. Sec. 301.7701-3(b)(2)(i)(C))

Foreign with single owner      Corporation
having limited liability       (Regs. Sec. 301.7701-3(b)(2)(i)(B))

(*) EEs in existence prior to 1997 default to the classification claimed under the former regulations.

FEEs

The Federal tax classification of an FEE is relevant only when it affects the tax liability of any person for Federal tax or information reporting purposes. For example, an FEE's classification would be relevant if U.S. income was paid to it and the amount of income tax withholding (if any) depended on whether it was a partnership or a corporation. The date an FEE's classification is relevant is the date an event occurs that creates an obligation to file a Federal tax return, information return or statement for which its classification must be determined. For example, the classification of an FEE is relevant on the date that a U.S. person acquires an ownership interest requiring the filing of an information return on Form 5471, Income/Information Return--Foreign Corporations.(12)

Example 1: X an FEE, is formed on Sept. 1, 1997. All of X's members are foreign citizens or residents; neither X nor its members have U.S.-source income in 1997. On July 1,1998, domestic corporation Y purchases a 10% interest in X A determination of X's Federal tax classification is not required in 1997, but must be made as of July 1, 1998, either by election or under the default rules.

The date an FEE's Federal tax classification is relevant is also critical in determining which set of default classification rules applies: the default rule for newly formed FEEs (Regs. Sec. 301.7701-3(b)(2)), the default rule for existing FEEs (Regs. Sec. 301.7701-3(b)(3)), or the grandfather rule for existing FEEs (Regs. Sec. 301.7701-3(b)(3)(ii)).

Example 2: M, an FEE, was formed on Sept. 1, 1994. If its Federal tax classification had been relevant prior to Jan. 1, 1997, the default rule applicable to existing FEEs would apply, not the default rule applicable to newly formed FEEs.

State Tax Considerations

One significant uncertainty concerning the check-the-box regulations is state taxing authorities' responses to the change in the Federal tax classification rules. Many states"piggyback" their tax systems on the Federal tax law and, presumably, will make corresponding changes; however, California has announced that it may retain its current law, which treats SOEs with limited liability as corporations.(13) A lack of conformity in Federal and state tax classifications could cause EEs to have to choose between making an election based on the preferred Federal tax status (which creates a tax compliance burden) or conformity with the state tax status (which may not be optimal for tax purposes).

Elective Classification

EEs with at least two members may elect to be classified as either a partnership or a corporation. However, because Regs. Sec. 301.7701-2(c)(1) defines "partnership" as a business entity with at least two members that is not a corporation (as defined in Regs. Sec. 301.7701-2(b)), an SOE cannot elect partnership status(14); consequently, a single-owner LLC cannot be a partnership for Federal tax purposes.

Perhaps the most significant aspect of the check-the-box regulations is that many unincorporated organizations (e.g., nonpublicly traded limited partnerships and LLCs) that potentially could have been classified as corporations under the former regulations will be able to elect partnership tax treatment. The ability to elect partnership status is particularly beneficial in the foreign arena. For example, structuring foreign operations through joint ventures will now focus on avoiding arrangements included in the CPS list. However, the PFR cautioned that Treasury and the IRS will monitor the use of partnerships in the international context and take appropriate action if they are used to achieve tax results inconsistent with the policies and rules of particular Code provisions or U.S. tax treaties.

EEs classified as partnerships may elect to be excluded from subchapter K if they meet the requirements in Regs. Sec. 1.761-2. According to Regs. Sec. 301.7701-3(e), if an EE classified as a partnership is technically terminated under Sec. 708(b)(1)(B) (i.e., due to the sale or exchange of at least 50% of the partnership's interests within a 12-month period), or is divided into two or more partnerships under Sec. 708(b)(2)(B), the successor entity (or entities) will be classified as a partnership unless an election is made to change its Federal tax status.

SOEs

EEs with a single owner may elect to be (1) classified as a corporation or (2) disregarded as separate from the owner, with its activities treated as a owner's sole proprietorship, branch or division. The latter election ignores the entity's separate legal existence under local law for Federal tax purposes; the entity's operations are reported on the owner's tax return. Thus, if the owner is an individual, the tax result is the same as if the individual had conducted the entity's business as a sole proprietorship. A U.S. corporation may make this election to treat its wholly owned foreign affiliate as a branch or division for Federal tax purposes if the affiliate is not classified as a CPS.

The election to disregard the separate entity presents SOEs with significant tax planning opportunities.

Example 3: A single-owner LLC is formed in a state that permits them; its principal asset is undeveloped land that K, the owner, wishes to exchange for land held by an unrelated party. An exchange of K's LLC interest for the unrelated party's land should qualify for Sec. 1031 like-kind exchange treatment; further, the transaction may, in some states, avoid transfer taxes otherwise imposed on the passage of title to land.(15)

In the foreign arena, the election to disregard the entity may negate the application of the Sec. 482 transfer pricing rules to a parent's transactions with its foreign affiliates; because the separate entity is disregarded, it is arguable that the requisite two or more controlled organizations, trades or businesses are not present.

The regulations do not define "SOE" or"member"; this raises the issue of the recognition for Federal tax purposes of nominal owners of interests in EEs. Of particular concern are situations in which U.S. or foreign jurisdictions require that though all but one of the owners may hold only nominal interests in the entity (e.g., in many states, LLCs must have at least two members; a Swiss GmbH must have at least two initial shareholders). Consequently, a single person who would otherwise own 100% of an entity must admit one or more additional owners to meet local law requirements.

One common approach in dealing with the nominal ownership issue is to create a multiple-owner entity in which the owners are controlled through common ownership (e.g., a parent forming subsidiaries for the sole purpose of holding ownership interests in a new entity); such arrangements have been subject to IRS challenge under the former regulations based on the "single-interest concept," which the Service has used to treat commonly controlled entities as a single economic unit.(16) Under this concept, a partnership consisting solely of commonly controlled partners would effectively be converted into an SOE.

Whether nominal owners are recognized for Federal tax purposes is significant, because a single owner who elects to have an EE disregarded for Federal tax purposes can avoid some of the negative tax aspects of partnership status, but retain the tax benefits of flowthrough treatment. For example, generally under Sec. 703(b), a partnership makes the tax elections affecting its operations independent of those made by the partners in their separate capacities. A single owner's election to disregard the separate entity would result in the owner making the tax elections with respect to the entity's operations. Classification of an EE as a partnership also would subject the entity to some adverse tax consequences, such as the Sec. 6698 penalty (for failure to file a partnership return) and the potential to be classified as a tax shelter under Sec. 1256(e)(3)(B) or 6662(d)(2)(C)(ii) (e.g., loss of the recurring item exception under Sec. 461(i)(1)).(17)

Whether a nominal ownership interest is respected may be relevant to using the accrual method of accounting. For example, under Sec. 448, a partnership cannot use the cash method if its gross receipts exceed $5 million and at least one partner is a C corporation.

Example 4: Z Corporation and individual Y own B, an EE, 1% and 99%, respectively; they desire passthrough treatment of B's tax attributes and for B to use the accrual method. If B's gross receipts exceed $5,000,000, it would be preferable to avoid recognizing Z's status as an owner to avoid Sec. 448; conversely, if Z owned 99%, Y owned 1%, and Z and B each had gross receipts of $4,000,000, it would be preferable to recognize Y's status as an owner, because treating Z as the sole owner (with the election to disregard B) would result in combining Z's and B's gross receipts for Sec. 448 purposes.

If the determination of an entity's Federal tax classification is made on a case-by-case basis (involving factors such as the relative size of ownership interests, level of the entity's activities engaged in by the members, degree of common ownership of members and business purpose for having multiple members), an excessive administrative burden would be created. Further, a case-by-case factual analysis would be inconsistent with the regulations' intended objective, which is to provide taxpayers with a simpler, generally elective approach to entity classification.

To deal with the nominal ownership issue, the Committee Comments recommended that the final regulations provide that EEs with more than one member would not be SOEs. An exception would apply if all but one of the members held only nominal interests solely to comply with applicable local law; in such cases, the entity would be able to elect to be treated either as a single-owner or a multiple-member entity.(18)

Unfortunately, the final regulations provide no guidelines for determining when a nominal owner will be treated as a bona fide owner for Federal tax purposes. Consequently, this issue remains a viable concern in structuring operating agreements for business ventures; taxpayers must continue to rely on a facts-and-circumstances approach in making this determination.(19)

Banks

A special rule applies to banks owning 100% of an EE. Under Regs. Sec. 301.7701-2(c)(2)(ii), if the single owner is a bank (as defined in Sec. 581), the special subchapter H tax rules (Sees. 581-597) applicable to banks continue to apply to the single owner as if the wholly owned EE were a separate entity. Thus, if a bank elects to disregard the EE's existence in establishing its Federal tax classification, the bank's separate operations will be subject to subchapter H, regardless of whether the EE qualifies as a bank under Sec. 581.(20)

Tax-Exempt Entities

An EE's claim or determination of tax-exempt status under Sec. 501(c) is a deemed election under Regs. Sec. 301.7701-3(c)(1)(v)(A) to be classified as a corporation. The PPR noted that the majority of exempt organizations (including employee plans qualifying under Sec. 401(a)) would not be EEs, either because they are classified as trusts for Federal tax purposes or are not-for-profit corporations.

REITs

An EE that elects to be taxed as a REIT under Sec. 856(c)(1) is deemed under Regs. Sec. 301.7701-3(c)(1)(v)(B) to have elected to be classified as a corporation for the entire period for which REIT status is claimed. This provision coordinates the Federal tax classification of a REIT under Sec. 7701 with the Sec. 856(c)(1) requirement that a REIT election be made with the entity's first tax return, and provides REITs with an exception to the Regs. Sec. 301.7701-3(c)(1)(iii) general rule (discussed below) that a classification election cannot be effective more than 75 days before its filing date. A REIT has until October 15 to elect to be taxed as a corporation; thus, unlike other calendar-year entities, an EE contemplating electing REIT status does not have to make a classification election in the first 75 days of its first tax year. If a REIT election is made, the EE is treated as a corporation from the beginning of the tax year; if the entity does not elect REIT status, it defaults to nonrecognition or partnership classification.

Default Classification Rules

Regs. Sec. 301.7701-3(b) contains default classification rules for EEs not making an election; according to the PFR, the objective is to provide Federal tax classifications for EEs that match taxpayers' expectations without the need for an election. These rules should reduce the number of elections filed; nonetheless, the PFR noted that protective elections are not prohibited.(21) A protective election might be advisable, for example, if there is uncertainty about whether an organization or arrangement qualifies as a business entity.

In the case of EEs formed after 1996, separate sets of default rules apply to DEEs and FEEs; as discussed below, EEs in existence before 1997 are subject to a different set of default rules. An entity's default classification remains in effect until an election is made to change it. Thus, generally, an election is necessary only if an EE wants to (1) be classified initially as other than under the default rules or (2) change Federal tax status after initial classification.

DEEs

Regs. Sec. 301.7701-3(b)(1) adopts a passthrough default classification for DEEs. DEEs with two or more members default to partnership status; single-owner DEEs default to nonrecognition of the separate entity for Federal tax purposes.

FEEs

The FEE default rules are based on whether the members have limited liability. Under Regs. Sec. 301.7701-3(b)(2)(i)(A), if an FEE has two or more members, at least one of whom does not have limited liability, it will default to partnership status. However, under Regs. Sec. 301.7701-3(b)(2)(i)(B), classification defaults to a corporation if all members have limited liability. If the FEE has a single owner without limited liability, it defaults to nonrecognition under Regs. Sec. 301.7701-3(b)(2)(i)(C). However, if the owner's liability is limited, the FEE defaults to a corporation under Regs. Sec. 301.7701-3(b)(2)(i)(B).

An FEE member has limited liability, according to Regs. Sec. 301.7701-3(b)(2)(ii), if he has no personal liability for debts of (or claims against) the entity by reason of being a member. Although this determination is based solely on the statute or law under which the entity is organized, the organizational documents may also be relevant if such statute or law permits the entity to specify whether its members have limited liability. For example, the entity's organizational documents may need to be consulted if protection from personal liability is optional under the applicable local statute or law. Conversely, a member does not have limited liability if he is personally liable for all (or any portion) of the debts of (or claims against) the entity; thus, personal liability exists if the FEE's creditors may seek satisfaction for the debts of (or claims against) the entity from the member. In making this determination, Regs. Sec. 301.7701-3(b)(2)(ii) provides that a member has personal liability even if he enters into an arrangement under which another person (whether or not a member of the entity) assumes (or agrees to indemnify the member for) such liability. Because personal liability determinations with regard to an entity's obligations may involve complex legal distinctions (particularly in the foreign arena), a protective classification election might be advisable to obtain the desired tax status, even if not required under the default rules.

One of the more significant changes in the final regulations relative to the proposed regulations is in the area of the FEE default classification rules. Regs Sec. 301.77013(b)(2)(ii) focuses on limited liability, rather than using the unlimited liability approach of Prop. Regs. Sec. 301.77013(b)(2)(ii). Essentially, this means that an FEE with two or more members defaults to partnership status if any member has personal liability for some (but not necessarily all) of the entity's obligations; under Prop. Regs. Sec. 301.77013(b)(2)(i)(A), at least one of the entity's members had to have unlimited liability with respect to all of the entity's obligations. According to the PFR, the modification in the final regulations cures a potential problem for certain contractual joint ventures in which the members have unlimited liability for a portion (but not all) of the venture's debts.

Classification of Existing EEs

EEs in existence before 1997 need not elect a classification unless they want to change their Federal tax status. Under Regs. Sec. 301.7701-3(b)(3), such EEs generally retain the classification claimed under the former regulations, except that an SOE will be disregarded if partnership status had previously been claimed for that entity. However, the IRS may challenge the claimed Federal tax classification of existing EEs under the former regulations, unless they qualify for transition relief (discussed below).

Existing FEEs

As was discussed, an FEE is an existing EE only if its classification was relevant for Federal tax purposes at any time during the 60-month period before Jan. 1, 1997. For this purpose, Regs. Sec. 301.7701-3(b)(3)(ii) provides that if an entity claimed different classifications during that period, the last classification claimed is used.(22)

Transition Relief

The final regulations afford certain existing EEs transition relief from IRS assertions that the Federal tax status claimed under the former regulations in previous years was erroneous. This relief provision is particularly important because, as was discussed, an existing EE's claimed classification under the former regulations is used to determine its Federal tax status under the default rules. Under Regs. Sec. 301.7701-3(f)(2), an existing EE's claimed classification for all periods before 1997 will be respected for Federal tax purposes if (1) the entity had a reasonable basis (within the meaning of Sec. 6662) for the classification, (2) the entity and its members recognized the Federal tax consequences of any change in the entity's classification in the 60 months before Jan. 1, 1997 and (3) neither the entity nor any member was notified in writing before May 9, 1996 that the entity's classification was under examination (in which case, classification will be determined in the examination).(23)

When the proposed regulations were issued, there was some question as to whether transition relief would apply to EEs formed after May 8, 1996, but before the effective date of the final regulations. The PFR clarified that the transition rule applies to EEs in existence before 1997 if they otherwise qualify for transition relief.

Another area of concern is that the default rules could result in potentially adverse tax consequences if the IRS successfully challenges an entity's claimed classification for periods before 1997.

Example 5: An existing unincorporated calendar-year entity, Q, has claimed Federal tax status as a partnership. In 1998, the IRS successfully challenges Q's partnership status for 1996; as a result, Q is reclassified as a corporation. However, under the default rule for existing EEs, Q would also be classified as a partnership for 1997, because that was the status claimed on Dec. 31, 1996; thus, Q would be deemed to have undergone a corporate liquidation on Jan. 1, 1997, followed by re-formation as a partnership. This unintended, deemed liquidation occurs because an existing EE's default classification on Jan. 1, 1997 is determined by reference to its previously claimed classification, without regard to whether the entity had a reasonable basis (within the meaning of Sec. 6662) for it.

As stated in the PFR, the objective of the default rules is to provide an EE with the Federal tax classification it would most likely choose, without having to file an election. In most situations, it seems unlikely that an entity would choose a classification that would trigger the tax liability associated with a deemed liquidation. The Committee Comments recommended that the final regulations provide that if an existing EE's claimed classification under the former regulations is successfully challenged, the entity should be permitted to revoke application of the default rule; this recommendation was not adopted in the final regulations.

Grandfather Rule for Certain Foreign Entities

Existing foreign entities classified as CPSs under the final regulations are not EEs; consequently, the default rules applicable to EEs do not apply. Absent a special rule, such entities would automatically be classified as corporations as of Jan. 1, 1997. However, certain foreign entities in existence on May 8, 1996 that would otherwise be classified as CPSs are subject to a special grandfather rule. Under Regs. Sec. 301.7701-2(d)(1) and (2), qualifying foreign entities that have previously been disregarded as a separate entity (e.g., treated as a branch) or claimed Federal tax status as a partnership may retain such classification as of Jan. 1, 1997. Unfortunately, this rule provides no relief for existing foreign entities formed after May 8, 1996 and classified as CPSs; they are locked into classification as corporations.

To qualify for the grandfather rule, (1) an existing foreign entity must have been in existence on May 8, 1996 (or formed after that date pursuant to a written binding contract in effect on that date, and all times thereafter, in which the parties agreed to engage (directly or indirectly) in an active and substantial business operation in the jurisdiction in which the entity was formed); (2) the entity's classification had to be relevant on May 8, 1996; (3) no person (including the entity) for whom the entity's classification was relevant on that date treats the entity as a corporation for purposes of filing such person's Federal income tax returns, information returns and withholding documents for the tax year including that date; (4) any change in the entity's claimed classification within the 60 months prior to that date occurred solely as a result of a change in the entity's organizational documents and the entity's members recognized the tax consequences of any change in classification within the 60-month period; (5) a reasonable basis (within the meaning of Sec. 6662) existed on May 8, 1996 for treating the entity as other than a corporation; and (6) neither the entity nor any member was notified in writing before May 9, 1996 that the entity's classification was under examination.

Regs. Sec. 301.7701-2(d)(3) provides that foreign entities so qualifying may subsequently lose their noncorporate status; the entity (and any successor entity) is permanently classified as a CPS on the earliest of the following: (1) the effective date of an election to be treated as a corporation, (2) a termination of a partnership under Sec. 708(b)(1)(B) or (3) a division of a partnership under Sec. 708(b)(2)(B).

Electing Classification

Regs. Sec. 301.7701-3(c)(1)(i) provides that an EE can elect a classification other than its default classification or request a change in classification by filing Form 8832 with the appropriate IRS service center. An election will not be accepted unless it contains all of the information required by the form and instructions, including the entity's taxpayer identification number and EIN.(24) Form 8832 (issued in December 1996) requires the following information to be furnished: (1) the entity's name and address; (2) the entity's EIN; (3) the type of election (i.e., initial classification by a newly formed entity or change in classification of an existing entity); (4) the form of entity elected (i.e., whether the entity is domestic or foreign and the classification desired); (5) the electron's effective date; (6) the identity of the person to be contacted by the IRS for more information; and (7) consent statement and signatures of owners or other authorized persons making the election.

Regs. Sec. 301.7701-3(c)(2)(i) requires the election to be signed by either (1) each member of the entity who is an owner when the election is filed or (2) any officer, manager or member authorized to make the electron (under local law or the entity's organizational documents) and who represents having such authorization under penalties of perjury. Consequently, the election does not require unanimous consent by the entity's members if authority to make the election is granted by local law or the organizational documents. However, as discussed below, signatures of certain members are required if an election has a retroactive effective date.

In addition, Regs. Sec. 301.7701-3(c)(1)(ii) states that an EE required to file a Federal tax or information return for the tax year for which an election is made must attach a copy of Form 8832 to the return for that year. If the entity is not required to file a return for that year, a copy of its Form 8832 must be attached to the Federal tax or information return of any direct or indirect owner of the entity for the tax year of such owner(s) that includes the effective date of the election; however, an indirect owner does not have to attach a copy of Form 8832 to its return if an entity in which it has an interest is fling a copy of the form with its return.

According to Regs. Sec. 301.7701-3(c)(1)(iii), an EE's classification election (or an election to change classification) is effective on the date specified in Form 8832 if not more than 75 days before, and not more than 12 months after, the date filed. If the election specifies an effective date more than 75 days prior to the date filed, it will be effective 75 days before the date filed. If the specified date is more than 12 months after the filing date, it will be effective 12 months after the filing date; if no date is specified, the election is effective on the date filed. One consequence of these restrictions is that a newly formed entity will generally be forced either to make an election early in its first tax year or rely on the default rules to determine its Federal tax status.

The procedures for filing a classification election raise a number of administrative and compliance issues. Because the election will already be on file with the IRS, the need to file a copy of the electron with the entity's tax return appears to be an unnecessary compliance burden and may pose either a trap for the unwary or a vehicle for abuse. For example, an electing entity may inadvertently fail to attach the election to its return or attempt to void a previous election by deliberately failing to file a copy of the election with its return.

The Committee Comments recommended that this filing requirement be deleted.(25) Alternatively, it was recommended that the final regulations provide that this requirement is solely a tax return filing requirement and that an entity's failure to attach the election to its first return will not affect its validity.

Regs. Sec. 301.7701-3(c)(1)(ii) retained the Prop. Regs. Sec. 301.7701-3(c)(3) requirement to attach a copy of the election to the applicable Federal tax or information return however, the final regulations clarify that, while the failure to do so will not invalidate an otherwise valid election, the non-filing party may be subject to penalties. Further, penalties may also apply to any person who files a tax or information return inconsistent with the entity's election.

One significant change in the election procedures was the imposition of a limit on the selection of an effective date subsequent to the election filing date. The proposed regulations contained no such restriction; an entity could have selected an effective date of several years after the tax year in which the election was filed. The failure to place limits on the selection of an effective date subsequent to the election filing date could have resulted in administrative complexities for taxpayers and the IRS. The Committee Comments recommended that the final regulations bar selecting an effective date later than the first day of the tax year immediately following the tax year of the election(26); Regs. Sec. 301.7701-3(c)(1)(iii) adopts a 12-month limit.

With regard to the authorized signatures for making the election, the proposed regulations did not indicate the relevant date for determining who is required to sign the election; presumably, this determination would be made with respect to either the election's filing or effective date. If the effective date is relevant, a signature may be required of a person who is not a member on the filing date; this could create compliance problems--a former member (when the effective date precedes the filing date) or a newly admitted member (when the filing date precedes the effective date) may not agree to the election, particularly if the entity is seeking a reclassification that would result in adverse tax consequences to that member. Also, if the effective date is subsequent to the filing date, an additional compliance burden would arise if the entity acquired new members after the filing date; in such a case, an amended election would need to be filed. In contrast, if the filing date is the relevant date for determining the necessary signatures, the compliance burden would be reduced, because signatures of former or subsequent members would no longer be required. The Committee Comments recommended that the final regulations provide that the filing date control in determining the required authorized signatures for the election.(27)

Regs. Sec. 301.7701-3(c)(2)(i) uses the election filing date as the controlling date for authorized signatures if the election is made by all of the entity's members. However, Regs. Sec. 301.7701-3(c)(2)(ii) provides that if the election is to be retroactively effective prior to the filing date, each person who was an owner between the effective and filing dates, but who is not an owner at the filing date, must also consent to the election (even if the election is filed by an authorized person (i.e., officer, manager or member authorized to make the election)).

Another concern is that under some foreign legal systems, it may be unclear whether an officer, manager or owner has the authority to make the election. The Committee Comments recommended that the final regulations provide guidance on what constitutes authorization for this purpose and the documentation needed to evidence such authorization. The Committee Comments also noted that a potential compliance burden could result from requiring an election to be signed by each member of a foreign entity, including members who are not subject to U.S. taxation; consequently, the Committee Comments recommended that consideration be given to requiring signatures of only those members for whom the entity's classification is relevant for Federal tax purposes.

Regs. Sec. 301.7701-3(c)(2)(i)(B) retains the basic rule of Prop. Regs. Sec. 301.7701-3(c)(2)(ii) that the election can be made by any person authorized to act on behalf of the entity, but clarifies that such authorization may be derived by statute or from the organizational documents.

Change in Classification

A change in an entity's classification, whether by election or default, can trigger deemed transactions and their tax consequences. As pointed out in the PFR, for example, if an EE that previously claimed Federal tax status as a corporation elects partnership status, the entity and its owners must recognize gain (if any) under the corporate liquidation rules. One issue related to changes in classification that needs guidance is the circumstances that would constitute a conversion of an entity for purposes of triggering a change in classification under the regulations.(28)

Another issue needing clarification is the tax consequences of an entity electing to change classification from a partnership to a corporation. In Rev. Rul. 84-111,(29) the IRS ruled that the tax consequences of incorporating a partnership are determined according to the legal form of the incorporation; the ruling illustrated three forms of incorporating and discussed the tax consequences of each.

Because partnerships can elect classification as a corporation under the regulations or select a legal form of incorporation, the Committee Comments recommended that the final regulations provide a rule promoting consistency in the tax consequences between elective classifications and formal incorporations; specifically, that partnerships electing to change to corporation classification be permitted to select the form of the deemed incorporation (along with the corresponding tax consequences, as determined by the form selected), based on Rev. Rul. 84-111. For example, Form 8832 could contain a separate election for the form of the deemed incorporation. The regulations should also provide for a default form of deemed incorporation if no election is made.

The final regulations do not address the tax consequences of partnership-to-corporation conversions. However, the PFR indicated that this issue is under consideration for future guidance.

Limits on Change in Elective Classification

Regs. Sec. 301.7701-3(c)(1)(iv) provides that an EE electing to change its classification (other than an existing entity that elected to change its classification as of Jan. 1, 1997) may not make another classification election for 60 months following the date of the election. Because this restriction applies only to elective changes in classification, a newly formed EE that elects out of its default classification, effective as of the date of its formation, would not be barred from electing to change classification within the 60-month period.

The IRS can waive the 60-month limit if more than 50% of the ownership interests in the entity (as of the effective date of the subsequent election) are owned by persons who did not own interests in the entity on the filing or effective date of the entity's prior election.(30) In addition, the PFR provided that the 60-month limit does not apply to a successor entity that acquires the business of the electing entity.

Conclusion

The new classification regime represents a substantial improvement over the former regulations. By permitting an election of the Federal tax status of unincorporated business entities, taxpayers and the IRS can achieve certainty in the application of the tax laws and reduced costs of compliance and administration. The primary beneficiaries of the check-the-box regulations will be nonpublicly traded limited partnerships and LLCs and foreign entities not included in the CPS list. These entities will become more attractive, because they will be able to obtain the assurance of partnership classification for Federal tax purposes. In addition, the regulations open new planning opportunities for structuring foreign operations through joint ventures and SOEs. (1) Regs. Secs. 301.7701-1, -2 and -3 (TD 8697, 12/17/96); also amending Regs. Secs. 1.581-1 and -2; 1.761-1; 301.6109-1; and 301.7701-4, -6 and -7. The concept of a simplified classification regime based on elective Federal tax status was initially proposed in Notice 95-14, 1995-1 CB 297, and issued as Prop. Regs. Secs. 301.7701-1, -2 and -3 (PS-43-95,5/13/96).

(2) In a Nov. 7, 1996 letter to practitioner groups (including the AICPA) from Kenneth J. Kies, JCT Chief of Staff, comments were requested as to whether Treasury has legal authority to issue regulations changing the entity classification rules or whether such changes require legislative action. This issue arose as part of a JCT study concerning entity classification, the taxation of partnership income and other developments affecting the corporate tax base (e.g., spin-offs). Congress may need to legislate the check-the-box rules to eliminate potential legal challenges; see "Congress May Need To Codify Check-The-Box Rules, Kies Says," BNA Daily Tax Report (11/26/96), p. G-1; see also "JCT Staff Suggests Legislative Options For Codifying Check The-Box Rules," BNA Daily Tax Report (4/9/97), p. G-8.

(3) The corporate resemblance test was based primarily the four corporate characteristics in Regs. Sec. 301.7701-2: continuity of life, centralized management, limited liability and free transferability of interests Concurrent with the issuance of the final regulations, the IRS also issued Notice 97-1, IRB 1997-2, 22, providing that revenue rulings and procedures applying the former regulations are obsolete to the extent used to differentiate between partnerships and associations; a list of the obsolete documents will be published in a future Internal Revenue Bulletin.

(4) See, e.g., Rev. Proc. 95-10, 1995-1 CB 501.

(5) The examples in Regs. Sec. 301.7701-1 (a)(2) on joint undertakings mirror those in Regs. Sec. 1.761-1(a) as to whether a joint undertaking will be classified as a partnership for Federal tax purposes.

(6) Regs. Sec. 301.7701-1(b) provides that trusts generally do not have associates or an objective to carry on business for profit. The PFR indicates that the regulations do not change the distinctions between trusts and business entities for Federal tax classification purposes.

(7) Because publicly traded partnerships are classified as corporations by Sec. 7704(a), the investment community is requesting that the IRS issue additional guidance on the definition of"qualifying income" for purposes of the Sec. 7704(c) exemption.

(8) The final regulations modified the CPS list set forth in Prop. Regs. Sec. 301.7701-2(b)(8) with respect to entities formed in Aruba, Canada, People s Republic of China, Republic of China (Taiwan), India, Indonesia, Netherlands Antilles and Sweden. Regs. Sec. 301.7701-2(b)(8)(iv) clarified that references to limited companies (public or private) in the CPS list include companies limited by shares or by guarantee.

(9) The PPR stated that the organizations listed as CPSs were limited liability entities, a statement omitted from the PFR. The availability of limited liability to a foreign entity's members is significant in the classification scheme; see, e.g., the distinctions for classifying FEEs under the Regs. Sec. 301.7701-3(b)(2) default rules based on the presence or absence of limited liability.

(10) The CPS list might be modified, for example, as a result of local law changes affecting the legal attributes of foreign entities.

(11) AICPA Document No. 927 (1996); see "AICPA Recommends Election Changes For Final `Check-The-Box' Regulations," BNA Daily Tax Report (8/19/96), p. G-1.

(12) Regs. Sec. 301.7701-3(d)(2) states that if the classification of an FEE was previously relevant, but ceases to be relevant for 60 consecutive months, classification will be determined under the default rules when it again becomes relevant.

(13) See "States Must Address Business Entity Issue following IRS Check-The-Box Rules," BNA Daily Tax Report (2/3/97), p. G-8; California Franchise Tax board Notice 96-5 (12/6/96).

(14) The PPR indicated that an SOE cannot conduct business as a partnership because a fundamental characteristic of a partnership is the presence of associates.

(15) Although the regulations do not address the relationship between Sec. 1031 transactions and the election to disregard an entity for Federal tax purposes, John J. Rooney, Treasury Associate Tax Legislative Counsel, stated that the regulations imply that a single-member LLC would be disregarded in such transactions, but cautioned that guidance may need to be issued to confirm that position; see "Treasury Official Says IRS May Issue Follow-Up Guidance to Check-The-Box," BNA Daily Tax Report (1/15/97), p. G-3.

(16) The single-interest concept has been controversial in the foreign arena under the former regulations; see, e.g., Rev. Rul. 93-4, 1993-1 CB 225, modifying and superseding Rev Rul. 77-214, 1977-1 CB 408. The PFR reiterated the IRS position in Rev Rul. 93-4 that the fact that some or all of the owners of an organization are under common control does not require that the common parent be treated as the sole owner. John J. Rooney, note 15, had indicated that IRS and Treasury were considering clarifying that the single-interest concept would no longer apply; see "No Major Changes Likely In Final Business Entity Rules, IRS Officials Say," BNA Daily Tax Report (8/22/96), p. G-2. However, the final regulations do not address this issue.

(17) For a discussion of additional tax considerations regarding the distinctions between the elections to disregard the separate entity and of partnership status, see Schler, "Initial Thoughts on the Proposed `Check-the-Box' Regulations," 71 Tax Notes 1679 (6/17/96).

(18) Sec. 1504(d) allows taxpayers to disregard (for U.S. tax purposes) a formal legal structure adopted merely to comply with the law of a contiguous foreign country; taxpayers can treat a Canadian or Mexican subsidiary as a U.S. corporation and, thus, as an includible corporation in a consolidated income tax return (assuming other requirements are met), if the subsidiary is maintained solely to comply with local laws regarding title and operation of property.

(19) Under the former regulations, the IRS would not issue an advance ruling on the Federal tax classification of a limited partnership unless, in addition to other requirements, the general partners owned, at all times, an aggregate interest of at least 1% in all material items of partnership income gain, loss, deduction and credit; see Rev Proc. 89-12, 1989-1 CB 798; see also, Rev. Proc. 95-10, note 4, regarding advance ruling requests for LLCs. Based on Notice 97-1, note 3, it appears that these procedures are no longer viable for classification purposes; however, the 1% threshold might continue to be used by the IRS in determining whether to recognize nominal owners for Federal tax purposes.

(20) For subchapter H purposes, Sec. 581 requires a bank to be incorporated; incorporation is also required to be eligible for Federal deposit insurance. The PPR provided that, if an unincorporated organization conducts banking activities but does not have such insurance, an election may be made to disregard the entity for Federal tax purposes (at which point, it would no longer be a bank under Sec. 581).

(21) The instructions to Form 8832, Entity Classification Election, state that the form should not be filed if the entity wants to use the default rules. According to John J. Rooney, note 15, those instructions should be ignored by taxpayers wishing to file protective elections.

(22) If an FEE's classification is relevant prior to 1997 and it did not file a Federal tax or information return, or the tax or information return filed did not indicate a classification, the entity s pre-1997 classification is determined under the former regulations.

(23) Relying on the reasonable basis standard necessitates a careful review of documentation and authority used to support the classification in the entity's prior-year tax returns. Prop. Regs. Sec. 301.7701-3(e)(2)(ii) required the entity to have claimed the same Federal tax classification for all prior periods to qualify for transition relief; Regs. Sec. 301.7701-3(f)(2)(ii) limits the retroactive requirement to 60 months if the tax consequences of the change were recognized and allows relief if an entity had to change classification in a prior year due to an amendment to its articles of organization or other governing documents stemming from a change in local law. (24) Regs. Sec. 301.6109-1(d)(2) has been amended to provide that existing EEs with EINs retain them even if an election is made to change classification. However, one open issue is whether an SOE that elects to be disregarded must have its own EIN or can use the owner's.

(25) This would be consistent with the S corporation rules, which do not require the filing of a copy of Form 2533, Election by a Small Business Corporation, with the first S corporation return.

(26) This would be consistent with the approach taken in Sec. 1362(b) regarding the S election.

(27) This would be consistent with the approach taken in Sec. 1362(a)(2) as to the relevant date for determining which shareholders must consent to an S election.

(28) John J. Rooney, note 15, indicated that future guidance is likely to be issued on this issue.

(29) Rev. Rul. 84-111, 1984-2 CB 88.

(30) This is consistent with the approach taken in Regs. Sec. 1.1362-5, regarding the IRS's discretion to waive the five-year limit on making an S election for a corporation whose election has terminated.

RELATED ARTICLE: EXECUTIVE SUMMARY

* The CPS list does not indicate the common attributes causing the foreign entities listed to be classified as corporations, presenting considerable compliance and planning uncertainty.

* A classification election on Form 8832 is generally effective no more than 75 days before (and 12 months after) the date the election is filed.

* Generally, once a classification election is made, another one cannot be made for 60 months; the Service can waive this limit if there has been a greater-than 50% ownership change.

Editor's note: Dr. Heller chairs the AICPA Tax Division Partnership Taxation Committee. Mr. Carnevale is a committee member.