The check-the-box proposal: simpler classification for both foreign and U.S. companies.

The Internal Revenue Service has proposed regulations that would replace the current rules for classifying entities as either partnerships or corporations. The proposed regulations would implement the "check-the-box" system in Treasury Department notice 95-14 (1995-1 C.B. 297), allowing an eligible business to choose its classification simply by making the appropriate election on its tax return. The proposed rules would apply for periods beginning on or after publication of the final regulations in the Federal Register.

A complex test

Classification has really ramifications to the owners of an entity--if an entity is classified as a partnership, the income would flow through to the owners, whereas if-it is classified as a corporation, it would be taxed at the entity level. Under the current IRS classification rules, an unincorporated entity's classification is based on whether it exhibits a preponderance of the following corporate characteristics: continuity of life, centralization of management, limited liability, and free transferability of interests. The test is based on the historical differences under state law between partnerships and corporations. The determination requires an analysis of the statutes under which the entity was formed and the governing documents of the entity, such as the articles of association. Currently, all foreign entities are considered unincorporated and therefore potentially subject to this analysis.

Recent changes in state laws, specifically the statutes for limited liability companies (LLCs) and for limited liability partnerships, blur the traditional distinctions between corporations and partnerships and increase the complexity of determining proper classification. It is even more difficult for foreign entities, because they must apply other foreign laws that are very different from U.S. laws.

A simple solution

The IRS has proposed the new check-the-box rules to alleviate these complexities for all eligible entity, defined by the IRS as any business entity that is not required to be treated as a corporation. For domestic companies, a corporation would be any entity formed under a state statute that refers to the entity,T as incorporated or as a corporation and certain other specific types of entities, including most banks. The proposed regulations contain a list of over 80 foreign entities that would be treated as corporations. They mainly are LLCs that are publicly traded, such as British public limited companies and German Aktiengesellschafts. A grandfather rule would be available for entities listed as corporations that claimed partnership status before publication of the proposed regulations.

Under current law, the guidance on whether a single-owner entity is a flow-through entity, such as a partnership, is unclear. The proposed rules clarity the treatment of such entities by allowing a noncorporate status election, in which there is no distinction between the entity and its owner, such as a branch or sole proprietorship. The default classification for a domestic entity, that does not make an election and for a foreign entity with one or more members having unlimited liability would be partnership. If all members have limited liability,, the default classification would be corporation. However, each existing eligible entity that chooses a reasonable classification (as of the effective date of the regulations) generally would retain that classification without making an election.

Simply check the box Entities would make the election under the check-the-box rules by filing a form containing certain specified information with the appropriate service center. The entity would specify the date the election becomes effective, provided it is not more than 75 days before the date the election is filed. A copy of the form would have to be attached to the federal tax return for the first year in which the election is effective. The classification generally could not be changed for 60 months after the election.

The proposed regulations would significantly simplify the entity classification process, particularly for foreign companies. They also would maintain much of the flexibility for structuring the taxation of international investments. However, it is important to note that the IRS said it would monitor international partnerships and provide substantive guidance if the partnership classification is used to achieve results inconsistent with the policies and rules of a particular tax code or U.S. tax treaty.

--Kenneth Kral and Jack Serota, Price Waterhouse, New York, New York.