FINAL CHECK-THE-BOX RULES
By:
Kenneth K. Yoon
New York
On December 17, 1996, the Internal Revenue Service ("IRS") issued the long-awaited final rules for tax entity classification known as "check-the-box," which finalize and essentially follow the proposed rules issued on May 9, 1996. The rules are aimed at simplifying the tax status of domestic and foreign business entities, which in the past were classified as partnerships or corporations for U.S. tax purposes based on the application of several facts-and-circumstances tests. Specifically, a corporation for U.S. tax purposes, as opposed to a partnership, had to have more than two of the following "corporate" characteristics: continuity of life; centralized management; free transferability of interest; and limited liability. A partnership had to have no more than two. The existence of such tests (in the old regime) arguably made classification essentially elective on the part of taxpayers, although 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 IRS Form 8832 to elect the status of the entity in question. Such election can be made retroactively (no more than 75 days prior to the date the election is filed) but in no event can such election take effect before January 1, 1997.
Initially, 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. The preamble to the final rules warns that "as stated in the preamble to the proposed regulations," the IRS and 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."
The final 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 per se 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 rules as per se corporations are limited liability entities such as the British Public Limited Company, the French S. A. and the Dutch Naamloze Vennootschap.
As for certain already existing (i.e., existing before May 8, 1996) foreign entities which are now listed on the list of per se corporations, a special grandfather rule provides that the IRS will not attack the classification of an already existing foreign entity if: (i) such entity had a reasonable basis for the classification on May 8, 1996; (ii) the classification was relevant for federal tax purposes on May 8, 1996; (iii) no person (including the entity) for whom the entity's classification was relevant on May 8, 1996 treats the entity as a corporation for filing such person's federal income tax returns; (iv) neither the entity nor any of its members was notified in writing on or before May 8, 1996 that the classification of the entity was being examined; and (v) any change in the entity's claimed classification within 60 months prior to May 8, 1996 occurred solely as a result of a change in the organizational documents of the entity, and the entity and all members of the entity recognized the federal tax consequences of any change in the entity's classification within the 60 months prior to May 8, 1996. The IRS removed the requirement in the proposed rules that the entity must have claimed the same classification in all previous years, in response to criticism that such requirement imposed an unduly harsh result on entities that had at one point in the remote past changed their status.
With respect to an entity that has a single owner, the final rules retain the result under the proposed rules that an entity that is not a per se corporation may 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 final rules are effective as of January 1, 1997. With respect to a business entity that already exists as of January 1, 1997, if such entity is not a per se corporation under the final rules, the entity's claimed classification will be respected for all periods prior to January 1, 1997 provided (i) the entity had a reasonable basis for its claimed classification; (ii) the entity and all its members recognized the federal tax consequences of any change in the entity's classification within the sixty months prior to January 1, 1997; and (iii) neither the entity nor any member was notified in writing on or before May 8, 1996 (not January 1, 1997) that the classification of the entity was under examination (in which case the entity's classification will be determined in the examination).
With respect to new entities formed on or after January 1, 1997, if a Form 8832 election is not made, default classification rules will apply. For a domestic entity with at least two members (and which is not on the list of per se corporations), the default classification is as a partnership. With respect to foreign entities, if all members have limited liability, the entity's default classification is as a corporation. If a foreign entity has at least two members, and if at least one member has unlimited liability, the default classification is as a partnership (unless the entity is on the list of per se corporations). If a foreign entity has a single owner, and such owner does not have limited liability, the entity will be disregarded (unless the entity is on the list of per se corporations).
