Entity classification simplification not that simple.

For the past several years (especially at election time), politicians have come before the American people stating that the IRS needs to simplify (or, better yet, sunset) the entire tax law. An examination of the brief history of the check-the-box (CTB) rules is an example of Service simplification that is anything but simple. The IRS should take credit for taking steps to establish regulations meant to ease entity classification problems. However, it appears that the rules have currently left the tax practitioner in a quandary about hybrid entities. The Service has not afforded any guidance as to how it will resolve the issues concerning the clarity of the CTB rules.

Background

In 1997, the IRS issued Regs. Sec. 301.7701-1 on entity classifications. The rules were enacted to ease the difficulties taxpayers had when determining whether, for U.S. tax purposes, an entity was a corporation, partnership or branch. Before 1997, a taxpayer had to examine an entity's characteristics to determine its classification.

Prior to the CTB rules, U.S. classification of an entity was based on six characteristics: (1) intent to carry on business, (2) associates, (3) limited life, (4) restricted transferability of interest, (5) decentralization of management and (6) unlimited liability. The first two characteristics (business objective and associates) are characteristics of both corporations and partnerships. Thus, to determine whether an entity was a partnership or a corporation, the latter four characteristics needed to be examined, weighted equally. Accordingly, if an organization had two or fewer of the remaining characteristics, it would avoid corporate classification. The CTB regulations replaced the four-factor classification scheme, allowing most entities just to "check the box" to elect corporate or partnership status, or to be disregarded as an entity.

The tax profession was pleased with the CTB rules and immediately embraced them, especially in international tax planning.

Problems

In 1998, the Service realized that the CTB rules were not being applied as originally intended. Therefore, it issued Notice 98-11, which curtailed the use of the original CTB rules. After much outcry by the tax community and Congress, the IRS issued Notice 98-35, superseding Notice 9811 and putting limits on the CTB rules. However, these will not go into effect until five years after the issuance of final regulations.

Unfortunately for the Service, Notice 98-11 actually gives the taxpayer an advantage. Because the IRS has revoked Notice 98-11, it has all but issued tax consulting advice to taxpayers. Notice 98-11 was issued to stop taxpayers from establishing structures under the CTB rules that avoided the principles of subpart F. However, taxpayers can now use Notice 98-11 to their advantage, up to five years after the regulations are finally issued. In the future, it does not appear that the Service will be as generous in assisting taxpayers in structuring their foreign operations.

Recently, the IRS has again proposed changes to the regulations, limiting the use of the CTB rules in extraordinary transactions. In brief, the proposal would apply to a CTB election made to treat a foreign entity as a disregarded entity, in which, within 12 months of the election, an actual disposal of the entity took place. The potential application of these provisions is extremely wide, but the proposal is, at best, vague about the abuse it is seeking to combat. The rules are arguably also redundant, due to the fact that the Service already has various tools to combat perceived abuses, including the step-transaction doctrine, substance-over-form principles and other such rules determined by case law.

Future Implications

At a recent public hearing on the CTB rules, the Service requested comments on how the new rules may affect transactions under Notice 98-35. Apparently, it is still unaware of all the ways taxpayers are using the CTB rules to their advantage and is now asking taxpayers for assistance in limiting the CTB rules.

It is ironic that the original rules, established to ease the complexity and save time in classification issues, have made the issue more complex. In addition, it appears that the IRS must now spend more time dealing with these issues. In addition, rules meant to give certainty to taxpayers regarding entity classification are becoming so beset by scattergun anti-avoidance fears that certainty is being lost.

To what extent and for how long the current rules can be useful remains to be seen. It is also unclear how the IRS will come to grips in finally dealing with these rules. Will the Treasury attack the rules one notice at a time, or will it attempt to rewrite the regulations entirely? For the time being, there appears to be a window of opportunity to use the rules in their current form. Thus, it appears that tax practitioners should do so, with the warning that the regulations issued to simplify will be made more complex at some date in the near future.

FROM SHAWN CARSON, ACA, AND JOHN SANTA MARIA, CPA, NEW YORK, NY