Check-the-box: a trap for the unwary.

• Author: Weber, Mindy Tyson

The check-the-box (CTB) regulations (Regs. Secs. 301.7701-1 through 301.7701-3) have provided taxpayers with ease and flexibility with regard to choice of entity. It has never been easier to effect the choice of operating as a sole proprietorship, partnership, or corporation for federal income tax purposes. Overall, this is a good thing. However, sometimes when a choice becomes easy, unforeseen problems can result. Consider the following example.

Example: P is a C corporation that conducts two businesses, Business A and Business B. P conducts Business A directly and conducts Business B indirectly. Business B is operated by LLC, a disregarded entity wholly owned by P. Over the years, Business B has not been as profitable as anticipated, and P has loaned money to LLC to help provide needed working capital. As a result of these loans, LLC has a debt outstanding to P of $500. Because LLC is a disregarded entity for federal income tax purposes, this $500 debt has no federal income tax impact, and Business B is treated as if it were merely a division of P. Thus, the debt owed by LLC to P is treated as owed by one division of P to another. Obviously, P cannot be both debtor and creditor with respect to the same debt, and the debt, like LLC itself, is disregarded for federal income tax purposes.

Suppose P decides it would make sense for Business B to be operated in a bona fide corporate subsidiary rather than through a disregarded entity. Thanks to the CTB regulations, P can implement this decision with little more than a snap of its fingers. With the simple filing of the proper election form, LLC will become a bona fide C corporation wholly owned by P.

What are the tax consequences of P's implementing this simple decision? Because LLC was previously treated as a division of P. the election to have LLC taxed as a C corporation is treated as if P took all of the assets and liabilities of Business B and transferred them to New LLC, a corporation, in exchange for 100% of the stock of New LLC. This type of exchange falls under the rules of Sec. 351 and is typically both routine and tax free.

However, there may be a trap for the unwary. One of the liabilities P transferred to New LLC is the $500 that Business B had owed to P. While this debt was previously ignored for federal income tax purposes, the CTB election changes that treatment.

After LLC becomes a stand-alone corporation, one bona fide entity (New LLC) owes $500 to another bona fide entity (P)...