Tax & Business Insights

Check The Box?

Volume 9 Issue 3 -- May/June 1997

Effective January 1, 1997, the IRS put into effect new Regulations dealing with entity classification, which is a complicated way of saying, "Is it taxed as a partnership or a corporation?"

What is this all about, and, more importantly, do I have to do anything affirmatively with regard to the new Regulations? For most taxpayers and entities, the answer is, "no."

From 1960 through last year, the IRS Regulations determining whether an association or entity was taxed as a corporation or partnership looked at six characteristics of businesses. The first two -- carrying on a business and dividing profits -- applied equally to partnerships and corporations, so the IRS reasoned that if three of the remaining four characteristics were present, then the entity was a corporation.

These four "corporate" characteristics were: continuity of life, centralized management, limited liability, and free transferability of interests. If you have ever read a private placement memorandum for a limited partnership interest, you will have read about the last four characteristics ad nauseam.

As states adopted Limited Liability Company "LLC" laws, the old "three out of four characteristics" test became increasingly out of touch with reality. Limited liability, in varying degrees, is now available to many partnerships and LLCs, and in many states, like Virginia, one person can own all of the interests in an LLC. Despite the IRS's usual, congenital myopia, the "check the box" rules are a refreshing step in the right direction.

If one disregards foreign entities, which this newsletter does, the "check the box" approach is fairly simple. It depends on Form 8832, technically called "Entity Classification Election," not "Check the Box" as nearly all articles and speeches refer to it.

In reality, Form 8832 is a series of boxes to be checked, and (if foreign entities are ignored) there are basically only two boxes (choices) for most entities which elect to use the form.

For most unincorporated entities, there is no need to file the form. This is because of the manner in which the default mechanism operates. By doing nothing, most unincorporated entities will be taxed as pass-through entities.

If, for example, your entity is created as an LLC or partnership, doing nothing (not filing Form 8832) will, by default, cause you to be taxed as a partnership.

The Regulations begin the choice-making by defining essentially what constitutes a "corporation." If your entity is a corporation, then it will be taxed as such (unless an "S" election is filed).

Any entity that is not a corporation (or considered to be one) is an "eligible entity." The choices on the Form relate to three types of "Domestic Eligible Entities." These choices allow a domestic eligible entity (i.e., an unincorporated entity) to elect to be taxed as a corporation or as a partnership, while a single-owner eligible entity (such as a one-person LLC) can elect to be taxed as a corporation or be disregarded as a separate entity (i.e, sole proprietorship). By default, one-owner entities are taxed as sole-proprietorships.

Are You Puzzled Yet?

Probably you are now scratching your head, and puzzling over why any entity that defaulted to "flow-through status" would elect to be (double) taxed as a "C" corporation. Or perhaps you are wondering why a single-owner entity would want to elect to have the entity disregarded for tax purposes?

The answers usually involve specific or unusual situations that require careful planning. For example, combinations of corporations, individuals, or other entities may have different needs that require the help of professionals. A relatively short newsletter is not an appropriate medium for considering unusual needs.

Nearly all corporations, LLCs, or partnerships formed before 1997, where there is no doubt about the status of the entity, will not need to make an election.

Some states, like California (which are not "piggy-back" states), are still holding out and it is not clear if they will accept the "check the box" approach. If you are living or practicing in such a state, you need to inquire locally.

If your entity is a "C" corporation, you cannot avoid the double tax on liquidation by dissolving the corporation and electing a different status using Form 8832.

The governing agreements for many partnerships and LLCs organized before 1997 may contain termination or management provisions that were included solely to insure taxation as a partnership under the prior Regulations. With the advent of "check the box," these provisions are no longer necessary for tax classification purposes and therefore can, if desired, be eliminated or changed.

Finally, the "check the box" rules do not lessen the need to take correct administrative actions at the local level about things like filing annual reports and the like.

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