On December 17, 1996, the Treasury Department issued the eagerly awaited final "check-the-box" regulations. In general, the regulations are effective beginning on January 1, 1997.
The regulations significantly simplify the tax rules for determining whether an enterprise is considered a corporation, a partnership, a sole proprietorship or a branch for federal tax purposes.
This is very good news for taxpayers, for it will simplify tax planning, eliminate certain tax traps, and avoid the requirement of structuring partnership or limited liability company agreements primarily to avoid classification as a corporation. It also provides an unprecedented opportunity to reexamine existing structures that were created or used merely to accommodate technical legal requirements and whose business structure would be better served by operating in another form.
There are two key features of the new regulations. First, they completely eliminate the arcane tax rules that historically governed the determination of partnership status -- in favor of a simple elective ("check-the-box") system. Second, the new rules permit single-owner entities to be ignored for federal tax purposes, creating planning possibilities using these new "see-through" entities.
Taken together, these changes will reorient virtually all tax planning. The old ways of structuring business and investment vehicles must now be fundamentally rethought in order to use the simplification and planning opportunities created by the new regulations to best advantage.
Rules in a Nutshell
Except for certain entities that must be treated as corporations, all new entities can now elect their federal income tax status. Entities with two or more members may select either corporate or partnership status; entities with a single member may select corporate or branch/sole proprietorship status. If no affirmative election is made, the federal tax classification of a new entity will be made under prescribed "default" rules. (Details of the new rules, including transitional rules for existing entities, are provided below.)
Partnerships. Qualification as a partnership for tax purposes is no longer constrained by the federal tax rules that, for example, required restrictions on transfers, dissolution provisions, or the infusion of significant additional capital into corporate general partners. Accordingly, while it is not necessary to take action for entities in existence before January 1, 1997, it may be wise both to revisit existing partnership arrangements and to evaluate new joint venture opportunities in light of the new rules to take advantage of the new and more liberal classification regime.
Corporations. The new regulations permit limited liability companies (and similar entities) with just one owner to elect to be treated as a branch of the owner. Corporations and other taxpayers are now able to use single-member LLC's to obtain the liability protection of a corporate subsidiary, without the tax complexities that flow from separate incorporation; this can be particularly important to consolidated groups. These new single-owner rules will also provide an important, more flexible, alternative to the use of S corporations, and will increase borrowing flexibility.
Change in Status. Filing an election that changes the tax status of an existing entity will have the same tax consequences as if an incorporation or liquidation had occurred. While the exact mechanics by which a change of status will be considered to occur are not entirely clear, such a change may cause recognition of gain or loss. It is therefore important to review the facts of each situation carefully before filing an election.
Wide Variety of Applications
Although their full ramifications will best be appreciated over time, it is apparent that the new regulations will impact many areas, among which are the following:
Acquisitions and Financings. Together, the liberalized partnership rules and the opportunity to elect to ignore the separate existence of single-owner entities considerably expand the choices of vehicles to be used in acquiring new businesses and structuring borrowings, including project financings. Of course, new issues may arise when acquiring interests in, or borrowing through, an entity that, for federal tax purposes, is ignored. For example, additional thought will have to be given to the definition of nonrecourse indebtedness, since it will be a simple matter to create a single-asset, single-owner entity in order to limit the reach of creditors.
Personal and Estate Planning. The new regulations will be very helpful in implementing gift and estate planning, as well as certain aspects of personal federal income tax planning. By removing the traditional income tax constraints on partnership classification, the new regulations give individuals and families considerably more flexibility in planning for the long-term transfer of wealth. For example, the new regulations will permit more management alternatives, and opportunities to continue entities even upon the bankruptcy or death of the managing member. Single member entities may also be quite useful for trusts, private foundations and public charities, as well as for facilitating real estate transactions such as like-kind exchanges.
Foreign Transactions. The new rules expand international tax planning opportunities to avoid double taxation, as well as to defer taxation in certain circumstances. For example, electing to eliminate the separate existence of certain wholly owned lower-tier entities can help reduce or eliminate Subpart F income. A single-owner entity treated as a branch can also avoid immediate tax on "outbound" transfers. Similarly, the new classification rules may prove helpful in avoiding adverse tax consequences arising from the application of certain gross receipts, gross income, or gross or net asset tests (such as those applied for purposes of the passive foreign investment company and foreign personal holding company rules). And of course the new rules vastly simplify the work required to find and create a foreign "hybrid" entity (which is treated as a partnership for U.S. tax purposes but as a corporation for foreign tax purposes) or a "reverse hybrid" (which is treated as a corporation for U.S. tax purposes but as a partnership for foreign tax purposes).
Multi-State Tax Planning. In the area of state and local tax planning the new rules present planning opportunities and raise new issues. The potential uses for see-through entities are enormous. For example, see-through entities may permit effective combination in states where combination is not otherwise available. There are, however, many other areas in which the impact of the new federal tax rules is not yet clear. For example, some states may not follow the new federal classification rules. In particular, California revenue officials have already announced that their State does not automatically follow the new federal treatment of single-member unincorporated entities, and will instead treat such entities as corporations. Similarly, certain states like Florida presumably will continue to subject limited liability companies to entity-level taxation. Other important aspects of state and local taxation do not derive from the federal income tax and, therefore, may be unaffected by the new federal income tax rules. For example, issues of "nexus" (namely the question of who is conducting business within a state), and factor apportionment, may be determined under principles having nothing to do with the new federal classification rules. Thus, the form of organization of an unincorporated business will often continue to have state and local tax ramifications.
Details of the New Classification Regulations
Where Corporate Treatment is Mandatory
Under the Regulations, certain entities must (i.e., "per se") be treated as corporations, including:
Elections. Except for entities whose classification as a corporation is mandatory, an entity may be treated:
(1) either as a corporation or as a partnership (in the case of an entity with two or more owners); or
(2) either as a corporation or as a directly owned activity (in the case of an entity with one owner).
Such treatment can be chosen simply by filing an election on Form 8832 with the Internal Revenue Service. The election must be signed either by all the owners of the entity or by an officer or other official of the entity authorized to file the election. An election may have prospective effect or may be retroactive for up to 75 days prior to the date of filing. In the event of a retroactive election, however, all potentially affected former owners must also sign.
Except for elections that are filed and effective on January 1, 1997, an election cannot be changed unless (a) 60 months have passed from the effective date of a prior election, or (b) a ruling is obtained following a greater-than-50% change in the ownership interests in the entity.
Default Rules. For entities that are not "per se" corporations and have not made valid elections, the regulations set forth different "default" rules for domestic entities and for foreign entities. In order for these rules to apply to a foreign entity, the classification of such an entity must be "relevant," which means that its classification must affect the liability of any person for federal tax or information reporting purposes. Thus, an existing foreign entity may be treated as newly created on the date its classification first becomes relevant. (For example, the status of a foreign entity may become relevant if it is the recipient of income from U. S. sources (the status of the foreign entity might affect U. S. withholding taxes and associated IRS reporting requirements); similarly, if a U. S. person becomes an officer, director, or 5% shareholder of a foreign corporation, an information return with respect to the corporation must be filed.) Under these default rules:
Several relief provisions apply to entities in existence prior to January 1, 1997. Under the rules described briefly below, such entities may continue to have the same classification they previously had, absent an election to change their status.
Pre-1997 relief generally. For 1996 and prior years, the IRS will not challenge the classification of an entity that has consistently claimed the same classification for prior periods and that had a reasonable basis for claiming that classification, unless an audit had raised the issue on or before May 8, 1996.
Going forward. Except as noted below, existing entities will continue to maintain their pre-1997 status until an election to change status is made. One exception is that single-owner entities previously claiming partnership status will be considered branches (or sole proprietorships) effective on January 1, 1997. More narrow grandfather relief applies to a foreign entity that is included in the list of "per se" corporations in the new regulations: if the entity has been reasonably treated as a partnership at all times on and after May 8, 1996, the entity may be able to continue to be treated as a partnership (e.g., until a valid election is made changing that status or until a partnership "termination" occurs).
Properly utilized, the new regulations, and the entity classification system they represent, can be very helpful in domestic and international tax planning. While a discussion of the full extent of the planning opportunities is beyond the scope of this letter, we hope we have given you a sense of what is now possible.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.