Notice 95-14: check-the-box procedure for entity classification.

On July 20, 1995, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning Notice 95-14, which seeks comments on a proposal proposal to implement a simplified method of entity classification, commonly referred to as a "check-the-box" system. The comments were prepared under theaegis of TEI's International Tax Committee, which is chaired by Philip J. Bergquist of Apple Computer, Inc. Mr. Bergquist testified on the Institute's behalf at a July 20 public hearing on the notice. TEI's comments were developed by a task force that was chaired by Joseph S. Tann, Jr., of Ameritech Corporation and whose members included Harry L. Cox of the Prudential, Melody Johnson of Mission Energy Co., and Lisa Norton of Ingersoll-Rand Co.

On March 29, 1995, the Internal Revenue Service issued Notice 95-14, asking whether a simplified method of classifying unincorporated business organizations should be adopted (commonly referred to as the "check-the-box" system). The notice was published in the INTERNAL REVENUE BULLETIN on March 29, 1995 (1995-14 I.R.B. 7).

Tax Executives Institute is pleased to present these comments on Notice 95-14. Although the notice requests comments on both the domestic and international aspects of the proposal, these comments focus primarily on the Department of Treasury and IRS's authority to issue regulations in this area and on the use of the check-the-box system in the international area. The Institute shall supplement these comments as necessary to address significant domestic issues, as well as to respond to issues raised at the scheduled July 20 hearing on Notice 95-14.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 5,000 members represent more than 2,500 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by Notice 95-14, concerning the adoption of a simplified method of entity classification.

Introduction

In Notice 95-14, the IRS and Treasury announced their intention to consider simplifying the existing entity classification regulations to permit taxpayers to elect to treat certain domestic unincorporated business organizations as partnerships or as associations for federal tax purposes. As outlined in the Notice, the election would be available to all such organizations with two or more associates and an objective to carry on business and divide the gain therefrom, unless the organization's classification is determined under a specific provision of the Internal Revenue Code. The affirmative, binding election would be prospective from the date the election is filed or a later date designated in the election. Retroactive elections would not be permitted and the new method would not apply to state-chartered corporations, which would continue to be treated -- and taxed -- as corporations. All partners or shareholders in the entity would be required to agree to the classification election.

TEI commends the IRS and Treasury for proposing a bold, elective approach to resolving the manner in which business entities are classified for tax purposes. Government and taxpayers alike have expended far too many limited resources addressing entity classification issues, and the proposal holds the promise of conserving those resources without undermining any legitimate tax policy goal. More important, it provides an opportunity for clarity, certainty, and simplicity without significant technical compromises or revenue loss. The Institute urges the IRS and Treasury to move swiftly to implement the simplified method in both the domestic and international tax areas as soon as possible.

IRS Rulemaking Authority

TEI is aware that questions have been raised concerning the government's authority to implement a check-the-box system of classification. Although the questions are appropriate ones, we are satisfied that the Government has ample authority to simplify this area by establishing an essentially bright-line, albeit elective, procedure for classifying entities.

The starting point for entity classification is the definitions set forth in section 7701 of the Internal Revenue Code. Section 7701(a)(3) defines the term 'corporation" to include associations, joint-stock companies, and insurance companies, but fails to elaborate on the scope or meaning (or inclusiveness) of those terms. The seminal case in this area is the Supreme Court's 1935 decision in Morrissey V. Commissioner, 296 U.S. 344 (1935), upon which the section 7701 regulations are based. That case did not, however, prescribe the definition of the term "corporation" for federal tax purposes. Rather, it outlined six features of an unincorporated entity (specifically, a trust) that rendered it an "association" and therefore subject to taxation as a corporation.(1)(*) Since the trust at issue in the case possessed all six characteristics, the Court was not obliged to address whether all -- and, if not, how many -- of the characteristics must be present for an entity to be taxable as a-corporation under the Code.(2) Rather, the Court stated that it is within the 'the permissible bounds of administrative construction" for the Treasury to issue rules defining the term "association," and that its regulatory authority was not so restrictive that "the regulations, once issued, could not later be clarified or enlarged so as to meet administrative exigencies or conform to judicial decision." The Morrissey case is therefore not a bar to permitting taxpayers to elect the classification of an unincorporated entity for tax purposes. Indeed, the case confirms Treasury's authority to amend the regulations "to meet administrative exigencies."

The Government's authority, of course, is not unfettered. Hence, we agree that it lacks authority to find that a state-chartered corporation is not a corporation for federal tax purposes.(4) Outside the boundaries of a state-chartered corporation, there are obviously areas where there is a great deal of overlap between the characteristics of a corporation and a partnership (e.g., limited liability companies).(5) In other words, the emergence of new forms of business enterprises confirms that there are many shades of gray. It is in these gray areas where the Government's authority to issue rules and procedures lies.

Thus, we believe that Treasury and the IRS have a great deal of discretion to determine the status of entities that are not state-chartered corporations, including the establishment of bright-line methods that reduce administrative burdens. This conclusion flows not only from the use of the term "corporation" in the statute, but from the broad definition given the term "partnership."(6) This is all the more true in the international area, where myriad non-corporate forms of organizations exist. We strongly urge the government to move forward in issuing guidance to simplify the method of classifying unincorporated business organizations.(7)

Application in the International Area

The IRS and Treasury are considering whether the check-the-box system should be expanded to include foreign entities. Specifically, comments have been requested on the following issues:

* Whether the approach should be extended to the classification of foreign organizations, and, if so, whether it should be modified with respect to those organizations;

* The appropriateness and feasibility of identifying foreign entities that, like state-law corporations, should automatically be classified as corporations;

* The likely effect of the approach on the ability to achieve hybrid classification of foreign and domestic organizations and the appropriateness and viability of achieving international consistency in the classification of these organizations;

* Whether this approach would substantially change the federal tax classification of foreign organizations; and

* Whether the mechanics of this approach should be modified with respect to foreign corporations.

TEI believes unequivocally that future regulations should be expanded to include foreign entities. Taxpayers -- and the IRS -- need an entity classification system that yields clear and predictable results, and the need is not confined to the United States, but extends overseas. The Morrissey approach to entity classification has been marked by ambiguity, confusion, and controversy.(8) No sound reason exists to limit the benefits of a simplified method of classification to domestic entities.

In addition, there is a practical reason for applying the system across the board: business enterprises are generally able to obtain the tax-law result that they want, i.e., corporate or partnership status. This ability owes itself not to taxpayer cleverness or chicanery, but to the non-tax flexibility taxpayers have in structuring their businesses. In other words, they may have to jump through a few hoops, but eventually they get to where they want to be. The question, however, is, should they be required to pay the cost to overcome the uncertainty inherent in applying the Morrissey multi-factor test? We believe that the transaction costs that go into establishing partnership or corporation status would be better directed to other efforts. Complex rules and structures to reach a desired result benefit no one -- including the IRS which currently expends considerable resources validating or challenging taxpayers' application of the Morrissey factors to their particular, often quite changeable, facts.(9) We therefore answer the government's first query with a resounding "yes."

A. Automatic Classification of Foreign Entities. In the domestic context, state-law corporations are automatically treated as corporations for federal tax purposes.(10) No statutory counterpart exists, however, in the foreign area. In Rev. Rul. 88-8, 1988-1 C.B. 403, the IRS ruled that all foreign entities are considered to be "unincorporated organizations" for purposes of Treas. Reg. [sections] 301.7701-2(a)(3). As a result, no foreign organization or entity is classified as an association (and hence taxable as a corporation) unless it has more corporate than noncorporate characteristics.

TEI believes that all foreign entities should continue to be considered unincorporated organizations. Attempts to determine whether a state-chartered analogue exists in the foreign area would simply throw the tax-payer (and the Government) back into the morass of examining each foreign structure and measuring it against the Morrissey factors. Absent an election under the check-the-box regime, foreign entities should be treated as unincorporated organizations (i.e., branches or partnerships) for U.S. tax purposes.

B. International Consistency and the Use of Hybrid Entities. TEI believes that it is neither feasible nor appropriate to prescribe international consistency in entity classification. Permitting the foreign law classification of an entity to dictate its classification for U.S. tax purposes and hence the attendant U.S. tax consequences would be contrary to the general thrust of U.S. tax policy.(11) The U.S. tax law is generally not "piggybacked" on foreign tax law,(12) and we believe that to do so would set a dangerous precedent. Indeed, in another context the IRS has vehemently opposed efforts to tie the determination of U.S. tax consequences to foreign law treatment.(13) To the extent that inconsistency is an issue at all, it already exists under our present system(14) and thus should not bar adoption of the check-the-box approach.

The Institute questions the feasibility of international consistency. Relying on interpretations of foreign law provisions may result in more uncertainties than exist under the current regime. The difficulty of interpreting provisions of foreign tax law is evidenced by Rev. Rul. 93-4, 1993-1 C.B. 225, which corrects an interpretation of German law the IRS had adopted 16 years earlier in Rev. Rul. 77-214, 1977-1 C.B. 408. Further, changes in foreign law might subject taxpayers to unforeseen U.S. tax consequences (e.g., taxable gain on deemed liquidation of a foreign corporation that becomes a partnership). This would particularly be a concern in developing countries, where tax laws tend to be in flux and joint ventures are often used or required to penetrate these markets.

More fundamentally, the foreign tax treatment of an entity does not always correspond neatly to classification as a corporation or partnership for U.S. tax purposes. For example, in the United Kingdom, a "corporation" owned equally by two U.K. corporations may be treated as a "consortium," permitting each shareholder, on an elective basis, to reduce its taxable income by all or part of its share of the consortium's loss (or vice versa). The election is made independently by each shareholder, rather than at the entity level, resulting in the imposition of tax partly at the entity level and partly at the shareholder level.

Finally, TEI questions the need for international consistency in the classification of entities. In this regard, it may be useful to consider two types of situations: those where the U.S. tax consequences are the same regardless of the inconsistent foreign and U.S. status, and those where there is a divergence of U.S. and foreign treatment.

Where a foreign entity is treated as a corporation for foreign tax purposes and a partnership for U.S. tax purposes, the divergence does not have any U.S. tax relevance. The U.S. partner includes its share of income (or losses) currently and is entitled to a foreign tax credit under section 901. This flow-through tax effect is the same, regardless of whether the foreign entity is treated as a corporation or a partnership under foreign law.

Where an entity is treated as a partnership for foreign tax purposes and a corporation for U.S. tax purposes, the divergence has limited U.S. tax relevance and should not vitiate the merits of the check-the-box proposal. If the entity is profitable, a U.S. shareholder may be able to generate current foreign tax credits while deferring U.S. tax on the related income. Because foreign tax is imposed at the U.S. taxpayer level, the foreign tax is creditable under section 901; the use of the credit would not depend upon the entity's generating taxable income so long as sufficient foreign income from other sources exists. If the entity is not profitable (or the U.S. taxpayer is in an excess limitation position), however, the U.S. shareholder will generate neither foreign tax credits nor losses that can be used to offset the shareholder's U.S. taxable income. In the long-run, a taxpayer can rarely, if ever, predict whether any business -- and particularly a foreign one that is not wholly-owned -- will be consistently profitable. The opportunities afforded by such U.S.-foreign disharmony are extremely limited and would not be increased under a check-the-box system.

C. Effect on Federal Tax Classifications. Notice 95-14 raises a concern that a purely elective approach could have a substantive effect on entity classification by increasing taxpayers' flexibility to achieve their desired classification of certain foreign organizations, explaining:

Under the present rules, taxpayers holding interests in foreign organizations are not always as able as those holding interests in domestic organizations to achieve their desired results. Because any change in the existing classification regulations is intended generally to simplify the rules without resulting in a substantial change in the classification of unincorporated organizations, the Service and the Treasury must consider whether an elective approach should be modified with respect to foreign organizations. 1995-14 I.R.B. at 9.

The Institute believes that use of the check-the-box system in the international area will not have a "substantive effect on entity classification by increasing taxpayers' flexibility." As a practical matter, a de facto classification systems already exists, i.e., taxpayers are generally able to obtain the entity classification that they desire.(15) Indeed, in those countries, where the preferred classification may not be achieved through the artful drafting of organizational documents (such as Australia), there are often other means of reaching the desired result. For example, to obtain the practical equivalent of a flow-through entity without sacrificing limited liability in a foreign jurisdiction, the taxpayer may use a domestic subsidiary with a foreign operating branch. Such results, however, may often be obtained only at the sacrifice of non-tax, business objectives, such as operating efficiency or the lack of a desired "presence" in the foreign country. In a competitive, global business arena, this "price" undercuts the principle of tax neutrality.

In any event, the "undue flexibility" concern rings hollow when considered in light of the myriad factors entering into a choice of entity. The check-the-box proposal permits taxpayers to base their decisions on economic or business considerations, doing directly what they may already do indirectly -- albeit at a significant expenditure of resources. Flexibility in establishing entities exists today. The check-the-box proposal is not merely a simplification issue, but it also permits businesses to make decisions without being unduly hampered by tax considerations. The benefit for the vast majority of taxpayers should not be overshadowed by chimerical concerns arising in an insignificant minority of cases.

D. Mechanics of Classification.

(i) Failure to Elect Classification. Notice 95-14 provides a "default" mechanism for foreign entities formed after the effective date of the revised regulations that fail to make an election; such entities would be classified as "associations" taxable as corporations for U.S. tax purposes.(16) Thus, the notice evidences a desire not to overturn taxpayers' intent, noting that foreign entities in an inbound situation will often prefer corporate status. Imposing corporate classification for non-electing entities, however, could upset taxpayers' intent and spawn significant adverse tax consequences by, e.g., adding tiers for foreign tax credit purposes or requiring withholding on certain transfers. TEI believes that there should be no default mechanism. In the absence of an election, therefore, the classification of an entity would continue to be determined under the Morrissey factors.

To avoid harsh results, if a default rule is retained, then taxpayers should be permitted to make protective elections in respect of all entities for which a specific corporation/partnership election has not been made. Alternatively, if a protective election mechanism is not permitted, the regulations should specify that taxpayer intent is controlling. Thus, the filing of a Form 1065 (U.S. Partnership Return of Income) or Form 5471 (Information Return of U.S. Persons with respect to Certain Foreign Corporations) should be treated as an affirmative election of classification. Similarly, whether distributions from joint ventures are included in the 10/ 50 foreign tax credit basket should be indicative of an intent to elect an entity classification.

(ii) Elections to Confirm Classification. Notice 95-14 suggests that retroactive elections will not be permitted. Absent a showing of abuse, TEI questions why the benefits of the new procedure should be so restricted.

A prospective-only rule will not resolve controversies in open tax years -- a particularly acute problem in the international area. The past few years have seen an accelerating growth in the use of international joint ventures. Many taxpayers have legitimately chosen to form these joint ventures as partnerships rather than corporations for federal income tax purposes.(17) Taxpayers have had to structure their transactions, however, in an environment where neither U.S. nor foreign authorities provided meaningful guidance. Thus, taxpayers have often been required to make distinctions based on vague criteria, spawning an undesirable -- but heretofore unavoidable -- level of uncertainty. Issuing regulations on a prospective-only basis will do nothing to staunch controversies between taxpayers and the IRS in open tax years, even though it is those controversies that have prompted the check-the-box procedure in the first place.

Where taxpayers have consistently treated an entity as a corporation or a partnership, TEI sees no reason not to permit that taxpayer to "confirm" the classification of an existing entity. Such an approach will further the goal of eliminating controversies. Moreover, not permitting such elections may discourage taxpayers from making affirmative elections for existing entities out of concern that their actions may prompt IRS scrutiny of a heretofore unchallenged classification and thereby inadvertently trigger a taxable liquidation or incorporation.

Elections to confirm classifications will encourage taxpayer participation by eliminating uncertainty. For existing organizations, a prospective-only election could trigger disastrous tax results. For example, there could be an unintended liquidation if the entity elects to be classified as a partnerships, but is found under the current regulations to have been a corporation prior to the election. This situation would be exacerbated if an entity were a foreign organization in which a U.S. taxpayer was a direct participant and hence arguably subject to section 1491 on the post-liquidation deemed contribution to a new partnership.

In the domestic context, confirming elections should be allowed where the domestic entity is an unincorporated organization and the owners have consistently treated the entity as a partnership by, e.g., filing partnership tax returns. The same standard should also be applied to foreign partnerships that are required to file U.S. tax returns. In the case of foreign organizations that are not obligated to make such filings, taxpayers should be able to rely on evidence relating to the intended status of the organization and consistency in reporting such status. For example, internal documents, the terms of the articles, and the reporting of a flow-through of earnings and profits could all be evidence of how the entity should be classified.

(iii) Unanimity Requirement. Notice 95-14 would require all members of the organization to agree to the election. In the international context, however, the U.S. tax consequences of entity classification will generally have little, if any, effect on the foreign members of the venture. We therefore suggest that unanimous consent not be required in the foreign context and that the election be made by the majority U.S. equity-interest member.

(iv) One-Member Organizations. TEI believes that limiting an election-based classification scheme only to unincorporated organizations with "two or more associates" undermines a primary goal of Notice 95-14: to avoid giving substantive effect to formalistic differences.(18) For example, in order to achieve partnership status for essentially one-owner foreign organizations, many taxpayers have used a structure where ownership is split 99:1 (or even 99.9:0.1). By inserting a de minimis second owner, the organization may qualify as a partnership. This exaltation of form over substance is exactly what the new classification regime is meant to avoid.(19) Thus, TEI urges that the check-the-box system be made available in such circumstances.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on Notice 95-14, relating to the adoption of a simplified method of entity classification. If you have any questions, please do not hesitate to call Philip J. Bergquist, chair of TEI's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone]. (*) Footnotes are listed on page 327.

Notes

(1) Treas. Reg. [sections] 301.7701-2(a) enumerates six corporate characteristics that are commonly called the Morrissey factors: (1) associates; (2) an objective to carry on business and divide the gains therefrom; (3) continuity of life; (4) centralization of management; (5) liability for corporate debts limited to corporate property; and (6) free transferability of interests. (2) 296 U.S. at 357. (3) Id. at 354-55. (4) See O'Neill v. United States, 410 F.2d 888 (6th Cir. 1969) (invalidating the 1960 professional corporation regulations on the ground that the statutory term "corporation" of necessity encompasses state-defined corporations). Referring to the legislative history of the term "corporation" in the tax statutes, the Sixth Circuit found that "Congress consistently has intended that corporations as created under state laws be corporations for tax purposes." Until the professional corporation regulations were issued in 1960, the IRS -- and the courts -- had treated all organizations bearing the moniker "corporation" under state law as such for federal tax purposes. Professor Bittker noted at the time that the "only debate in this area [concerned] the classification of organizations not labeled `corporations' by state law." Boris I. Bittker, Professional Associations and Federal Income Taxation: Some Questions and Comments, 17 Tax L. Rev. 1, 25-26 (1971). (5) See, e.g., Baughn v. Commissioner, T.C. Memo 1969-282 ("[p]lainly, the statutory definition of partnership is considerably broader in scope than the common law meaning of the term") (emphasis in original). (6) Section 761(a) of the Code defines "partnership" as "a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of [the Code], a corporation or a trust or estate." Accord I.R.C. [sections] 7701(a)(2). (7) The Institute is not suggesting that the Morrissey factors be abandoned in their entirety; the threshold question of whether the parties have an agreement to carry on business for joint profit remains. For purposes of these comments, we assume that a business entity exists that satisfies the initial profit-seeking test and that the taxpayer has an equity interest in that entity (as opposed to a cost-sharing or co-ownership arrangement). We also assume that the new method would not affect the ability of taxpayers to elect out of partnership treatment under section 761 of the Code. (8) Boris I. Bittker & James S. Eustice, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS [sections] 2.01 at p. 2-5 (6th ed. 1994). (9) One commentator has observed that the "only real loser under a check-the-box classification regime appears to be the tax professional." Daniel Shefter, Check the Box Partnership Classification: A Legitimate Exercise in Tax Simplification, 67 TAX NOTES 279, 282 (Apr. 10, 1995). We may not approve the commentator's cynicism (he added that the billable hours required to form a partnership or LLC would be substantially reduced), but cannot help but think that both taxpayers and the Government will benefit from a check-the-box procedure. (10) I.R.C. [sections] 7701; O'Neill u. United States, supra. (11) See Biddle v. Commissioner, 302 U.S. 573, 578 (1938), holding that tax provisions should generally be read to incorporate domestic tax concepts, absent a clear congressional intent that foreign concepts control. Accord United States v. Goodyear Tire Rubber Co., 493 U.S. 132 (1990). (12) See, e.g., I.T. 2676, XII-1 C.B. 48, 50 (1933), where the IRS noted that, in defining the credits available under section 902, it is important that the amount of accumulated profits be based as a fundamental principle upon all income of the foreign corporation available for distribution to its shareholders "whether such profits be taxable by the foreign country or not." (13) See, e.g., Proctor & Gamble v. United States, 961 F.2d 1255 (6th Cir. 1992), and the so-called Aramco Advantage cases. (14) Perhaps in recognition of this fact, many treaties have incorporated language to take these situations into account. See U.S. Model Income Tax Treaty, Art 3 (1981 Draft); OECD Model Treaty, Art. 3. When not addressed in a treaty, protocols are often employed to provide rules for entity classification. (15) Treasury's Deputy Tax Legislative Counsel Michael Thomson has acknowledged that entity classification is functionally elective. Single Member LLCs: Basic Entities Raise Complex Problems, 68 142 (July 10, 1995). (16) Under Notice 95-14, foreign organizations already in existence are to be treated similarly to domestic organizations; those organizations in existence before the effective date of the revised regulations would retain their current classification unless an affirmative election to be classified differently is filed. (17) The current anti-abuse regulations explicitly approve the use of partnerships in U.S. international tax planning. See, e.g., Treas. Reg [subsections] 1.701-2(d), Ex. 3 & 1.701-2(f), Ex. 3. (18) In the domestic context, at least 12 states permit single-member LLCs. Those states that require two members may well do so only to ensure partnership classification for federal income tax purposes. Excluding one-owner LLC's from the new classification scheme leaves a significant form of business organization unaddressed and subject to continuing uncertainty and controversy. Again, this seems contrary to the fundamental goal of an elective system. (19) Under current law, an absence of associates may mean that an entity will not be classified as a partnership, but it does not automatically follow that it will be taxed as a corporation. A one-person business entity may still be entitled to flow-through treatment. See Treas. Reg. [sections] 301.7701-2(a)(2); Hynes v. Commissioner, 74 T.C. 1266 (1980); Barnette v. Commissioner, 63 T.C.M. (CCH) 3201 (1992); and General Counsel Memorandum 39395 (Aug. 5, 1985).