Is all calm, now that check-the-box is final?

Representatives of the AICPA, on request from Kenneth J. Kies, Chief of Staff of the Joint Committee on Taxation (JCT), met on Dec. 11, 1996, with congressional staffers and a Treasury official to discuss, among other things, the overall impact of the entity classification regulations (finalized on Dec. 19, 1996) known as "check-the-box." Although most practitioners and affected taxpayers are thrilled by this simplification development, some doubt remains as to whether this is the last word on the subject.

While there is reason to rejoice at the IRS's actions, a few practitioners may continue to feel that, due to questions that have been raised as to the legitimacy of the regulations, there remains a burdensome obligation (for both practitioners and their clients) to continue to structure an entity's organizational documents and activities in such a way that they would meet the old Morrissey and Kintner standards when Federal passthrough treatment is desired--even though the default classification under the new regulations might allow partnership (or branch) status.

In his letter requesting the meeting with the AICPA, Mr. Kies indicated that the JCT staff had ". . . undertaken a review of the recent developments...governing entity classification and taxation of the income of partnerships." He noted that "[o]ver the past few years, the tax rules governing the form in which business income is taxed have been changed significantly by developments other than Federal tax legislation." In the meeting, Mr. Kies stated his opinion that, while the check-the-box rules could be viewed as a natural consequence of the IRS's position on limited liability companies (LLCs), the IRS should have consulted with Congress before issuing the string of LLC-related rulings, and that the Treasury Department and the IRS "made a mistake" by not consulting more with Congress before going ahead with the new regulations. He clearly questioned whether or not Treasury had legal authority to promote such a change in entity classification through regulations. The AICPA noted that this was not a significant concern of its members, but urged Mr. Kies to address the issue quickly if the JCT believes there is a problem. Informally, Mr. Kies also questioned the validity of the partnership anti-abuse regulations issued under Sec. 701.

Further, the JCT seemed to fear that the two-tier system of corporate taxation was unraveling due to the increased ease in achieving partnership status. The Institute assured the Committee that most entities that default to partnership status under the check-the-box regime would, in its opinion, have been structured to achieve such status anyhow, the only difference being that the process of drafting agreements and related documents would now be much simpler. It was pointed out that de facto corporate integration was not a significant factor in the international context and that, in the international joint venture and multinational company structuring context, check-the-box would serve to stimulate international competitiveness because of the cost and time efficiencies inherent in the new regulations.

Another concern of the JCT staff centered around the developments and increasing sophistication in partnership business transactions since the enactment of subchapter K in 1954 and, more recently, since the burgeoning of LLCs. The JCT questioned whether changes should be made to subchapter K in light of all these developments. Such changes might carve out a specific statutory roadmap for LLCs when divergence from or clarification of the current treatment of partnerships would be reasonable. An example, noted Kies, might include provisions that distinguish between general and limited partners. The AICPA noted that, in general, subchapter K works well for LLCs, but reserved further comment for any specific proposals that might be developed at a later date.

While the JCT asked for suggestions for the general improvement of subchapter K, its main interest seemed to be to stop abuses, particularly in the area of basis shifting. The Committee questioned whether there were many property distributions involving partners seeking to take advantage of basis-shifting opportunities, and how the abuses might be curtailed. The Committee asked us if it made sense to reconsider the current nonrecognition treatment for distributions of partnership property under Sec. 731 and whether basis shifting could be minimized by improving the basis rules. AICPA representatives responded that attacking distributions would be inconsistent with the aggregate theory of partnership taxation and that most property distributions occurred for good business reasons. In the discussion that followed there seemed to be some interest in allocating basis according to the property's fair market value; while this is a reasonable alternative worthy of more thought, the Institute generally supported the idea of fixing basis shifting. There was no support for the idea of addressing the issue by repealing or modifying cornerstone principles of partnership distribution treatment.

Lastly, tax-free spin-off matters were briefly discussed, particularly because of recent IRS Letter Ruling 9637043, allowing favorable treatment for Viacom. The AICPA reassured Mr. Kies that General Utilities was not being subverted by taxpayers who were taking unfair advantage of the Sec. 355 exception.

Overall, the Joint Committee's attempt to assess-the revenue impact of check-the-box, as well as basis shifting and future spin-off transactions, was a common thread that ran through the meeting. The AICPA believes simplification, rather than revenue, drove the check-the-box process and that the use of basis shifting and spin-off transactions is typically business-driven; any revenue implications of these are collateral issues which should not undermine their policy-related benefits.