Don't even bother to check the box (but you should probably file a form instead.)

On May 9, 1996, the IRS issued Notice PS-43-95, proposing new regulations under Sec. 7701 to simplify the existing entity tax-classification rules. The new proposed regulations follow from hearings last August. The notice announced more hearings on July 20, 1996 (held after this issue went to press). However, as the proposals take a big jump toward simplification, it is instructive to take a look at them now. It is probably best to start with what the proposals do not do. Most of these provisions apply to entities that are outside the mainstream of small business, but they are interesting for perspective.

Entities Still Taxable as Corporations

The proposals list seven kinds of organizations that cannot elect partnership treatment.

1. Business entities formed under Federal, state or Indian tribal statutes as corporations, bodies corporate, bodies politic or incorporated entities.

2. Business entities formed under state statutes as joint-stock companies or associations.

3. Insurance companies taxable under subchapter L.

4. State-chartered banks with Federal deposit insurance.

5. Business entities wholly owned by states.

6. Business entities taxable as corporations under Code sections other than Sec. 7701(a)(3) (e.g., Sec. 7704 publicly traded entities and Sec. 7701(i) taxable mortgage pools).

7. Eighty-plus specific kinds of foreign entities, listed by formation country.

Note: The new proposals do not affect publicly traded partnerships.

The foreign entities appearing on the corporate-status list may have some grandfathering relief (discussed later).

The proposals do not affect most trusts, tenancies-in-common without business operations, state-owned entities integral with state governments, Indian tribes and cost-sharing arrangements under Regs. Sec. 1.482-7.

Good News for Most Taxpayers

Entities that do not appear on the corporate-classification list are called "eligible entities." Those with two or more members are eligible to elect partnership tax treatment; single-owner entities are eligible to be taxed as proprietorships. Alternatively, both can choose to be taxed as corporations.

Perhaps the Best News for Simplification Advocates

The proposals contain three specific default rules that require no election whatsoever:

1. Nonelecting domestic entities will be taxed as partnerships or proprietorships.

2. Nonelecting but eligible foreign entities with two or more members and at least one member with unlimited liability will be taxed as partnerships.

3. Nonelecting but eligible singleowner foreign entities will be taxed as proprietorships if the owner has unlimited liability. The proposals define "unlimited liability" as personal liability even when a third party has assumed such liability or provided indemnification against it.

What Most Tax Advisers Will Want to Do

While the default rules may ultimately rescue some, professional advisers will probably want to make protective elections. Elections are required to avoid default classification as a passthrough or to change preexisting tax status. The election provisions refer probably to a new form, but specify something simple, requiring only seven pieces of information:

1. Entity name.

2. Address.

3. Taxpayer identification number.

4. Tax classification chosen.

5. Whether the election is for a tax-classification change.

6. Whether the entity is domestic or foreign.

7. The desired effective date of the election, if other than the date filed and not more than 75 days prior to it.

The proposals permit one authorized officer, manager or member to consent to the election on behalf of all members. The election must be filed in two places: at the appropriate IRS Service Center; and with either the entity's required tax return for the initial election period, or if the entity falls short of a filing requirement, with any director or individual owner's tax return for the period in which the election is filed.

One Other Default Provision

If a partnership terminates under Sec. 708(b)(1)(B), the post-termination entity will be a partnership.

Exempt Organizations

Applying for exempt status under Sec. 501(a) is a de facto election of corporate tax status. Losing an exemption requires an affirmative election to be taxed as a partnership.

Effective Dates and Transition Rules

Conventional wisdom is that the real pitfalls of a tax change lie in the transition rules and effective dates. In this instance, the rules actually seem fairly logical and straightforward, even for foreign entities. The basic effective date of the regulations will be when the final regulations are published.

A foreign entity on the corporate-classification list can continue pre-existing partnership classification when (1) it existed on and claimed partnership status at all times prior to May 8, 1996; (2) its partnership status was relevant to "any person for Federal tax purposes at any time during the period that includes May 8, 1996" (there may be some room for debate here); (3) the entity had reasonable (i.e., Sec. 6662) basis for claiming to be a partnership; and (4) neither the entity nor any member had been notified on or before that date that the entity's tax classification was under examination.

An election to change an entity's tax classification is binding for 60 months following its effective date. For this purpose, an election as of the effective date of the regulations, and an election made at an entity's inception, do not count. There are also some fairly liberal rules permitting early election revisions when the business moves from one entity to another. Reorganizations should not be hindered by in-place partnership-status elections.

Falling Short of Too-Good-to-Be-True

As friendly as these proposals are, they contain no provision exempting an existing corporate-status entity from liquidation tax issues if it elects partnership status. The otherwise-anticipated rush may not achieve stampede status. We await the next development in what may be a sincere effort on the IRS's part to make our lives easier.