By:
Kenneth K. Yoon
New York
On May 9, the Internal Revenue Service issued the long-awaited proposed rules for entity classification known as "check-the-box." The rules are aimed at simplifying the tax status of domestic and foreign business entities, which in the past had to satisfy several mechanical and facts-and-circumstances tests to be classified as partnerships or corporations for U.S. tax purposes. Specifically, a corporation for U.S. tax purposes, as opposed to a partnership, had to have three or more of the following "corporate characteristics": continuity of life; centralized management; free transferability of interest; and limited liability. A partnership had to have nomore than two. The existence of such tests (in the old regime) made classification essentially elective on the part of taxpayers, but sometimes at considerable cost in terms of uncertainty and planning (and lawyers' fees) in close cases. The new regime allows the taxpayer to literally "check the box" on an IRS form to elect the status of the entity in question.
There had been disagreement within the IRS and Treasury Department concerning the appropriateness of allowing check-the-box elections in some cases, particularly in the case of partnerships in the international context, which had apparently delayed the issuance of the proposed rules. The preamble to the currently proposed rules warns that the IRS and the Treasury "will continue to monitor carefully the uses of partnerships in the international context and will use appropriate substantive guidance when partnerships are used to achieve results that are inconsistent with the policies and rules of particular Code provisions or of U.S. tax treaties." In other words, the IRS and the Treasury reserve the right to deny check-the-box election for partnerships in the international context.
The proposed rules provide that unless a business entity is automatically required to be classified as a corporation for U.S. tax purposes, the entity can elect the classification it wishes to apply. A list of such types of de-facto corporations is provided in the rules, and includes: corporations denominated as such under applicable law; joint-stock companies; insurance companies; organizations that conduct certain banking activities; organizations wholly owned by a State; organizations that are taxable as corporations under a provision of the Code other than I.R.C. 7701(a)(3); and certain organizations formed under the laws of a foreign jurisdiction or a U.S. possession, territory, or commonwealth. Among the foreign entities that are listed in the proposed regulations as de-facto corporations are limited liability entities such as the British Public Limited Company, the French Sociéé Anonyme, the Dutch Naamloze Vennootschap, the Netherlands Antillian Naamloze Vennootschap, and the German Aktiengesellschaft.
As for already existing entities, a special grandfather rule in the proposed regulations provides that the I.R.S. will not attack the classification of an already existing (i.e., as of May 8, 1996) entity if such entity had a reasonable basis for the classification, the classification was relevant to any person for federal tax purposes at any time during the period including May 8, 1996, the entity claimed the same classification in all previous years, and the entity is not currently under IRS examination (i.e., has not received written notice on or before May 8, 1996 that it is being examined).
With respect to an entity which has a single owner, the preamble to the proposed regulations notes that a partnership election is not available, since a fundamental characteristic of a partnership is the existence of associates. However, the proposed rules do allow an entity that is not required to be classified as a corporation to elect to be disregarded as a separate entity from its owner (i.e., to be treated as a sole proprietorship, branch, or division of the organization's owner).
The regulations are proposed to apply generally for periods beginning on or after the date the final regulations are published in the Federal Register. Before the proposed regulations are adopted as final regulations, written comments will be considered, and a public hearing will be held on August 21, 1996 in Washington, D.C. Persons who wish to present oral comments at the hearing must submit written comments by August 12, 1996,including an outline of topics to be discussed and the time to be devoted to each topic.
