Check the timing of the check-the-box election.

• Author: Harris, Deanna Walton

In the late 1990s, the IRS and Treasury published entity classification regulations under Sec. 7701 (check-the-box regulations) that were designed to simplify the lives of both taxpayers and the government. The purported simplicity of those regulations, however, may give rise to traps for the unwary in certain

situations. This item describes one such potential trap, involving the effective date of an election, and discusses how to address it.

To appreciate the issue fully, some background information is necessary. Specifically, one must have some knowledge of the check-the-box regulations, the liquidation-reincorporation doctrine and exceptions to its application, and the consequences of the regulatory repeal of the Bausch & Lomb doctrine.

Overview of the Check-the-Box Regulations

The check-the-box regulations set forth rules for classifying business entities for federal tax purposes. Under those rules, an eligible entity with just one owner may elect to be classified as a corporation or as an entity disregarded as separate from its owner (disregarded entity). Under Regs. Sec. 301.7701-3(g), if an eligible entity classified as a corporation elects to change its classification to be treated as a disregarded entity (disregarded entity election), the corporation is deemed to liquidate by distributing all of its assets and liabilities to its single owner (the deemed liquidation). The tax treatment of the deemed liquidation is determined under all relevant provisions of the Code and general principles of tax law, including the step-transaction doctrine.

Regs. Sec. 301.7701-3(g)(3) (the effective date provision) provides that the deemed liquidation occurs immediately before the close of the day before the effective date of the disregarded entity election. Thus, if an entity classified as a corporation files a disregarded entity election effective on January 1, the deemed liquidation is treated as occurring immediately before the close of December 31.

It is the effective date provision that raises the potential issue discussed in this item. To illustrate, consider the following examples.

Example 1: X, an entity classified as a corporation, owns all the stock of both Y and Z, each of which is also classified as a corporation for federal tax purposes. On January 1, 2008, x contributes all Y's stock to Z (the stock contribution). Immediately thereafter and pursuant to the same plan, Y files a disregarded entity election (Y's election) effective on January 2, 2008. Under the effective date provision, the deemed liquidation of Y occurs at the end of January 1, 2008 (and thus at a time when Y is owned by Z). Thus, for federal tax purposes, the transactions to be examined (and potentially recast) are X's contribution of all Y's stock to Z, followed by a liquidation of Y in which Y distributes all its assets (subject to its liabilities) to Z.

Example 2: Assume the same facts as in Example 1, except that Y's election is effective on January 1, 2008--the date of the stock contribution. Now, under the effective date provision, the deemed liquidation of Y occurs at the end of December 31, 2007--a time when Y is owned by X. Thus, for federal tax purposes, the transactions to be examined (and potentially recast) are a liquidation of Y into X, followed by X's contribution of the former Y assets (subject to the former Y liabilities) to Z.

The Liquidation-Reincorporation Doctrine

It has long been the IRS's position that a corporation's purported liquidation that is preceded or followed by a transfer to another corporation of all or part of the...