Classification of entities for tax purposes; just "check the box."

• Author: Nott, Sheri E.

After many years of debate over the proper classification of entities, the Treasury Department has promulgated new regulations that permit certain entities to elect to be classified as partnerships or associations taxable as corporations for federal income tax purposes.(1) The regulations, known as the "check-the-box regulations," became effective on January 1, 1997.

The prior regulations were based primarily on historical differences under local law between partnerships and corporations.(2) Taxpayers and the Internal Revenue Service expended considerable resources in determining the proper classification of unincorporated business entities adhering to and explaining these differences. The Treasury Department and Service finally concluded that it was appropriate to replace such increasingly formalistic rules with a much simpler approach. The new check-the-box regulations are therefore intended to eliminate waste of resources by both taxpayers and the Service, and to facilitate the formation of business entities by reducing uncertainty over the federal tax classification.

Code [sections] 7701(a)(2) defines a partnership to include a syndicate, group, pool, joint venture, or other unincorporated organization, through which any business, financial operation, or venture is carried on, that is not a trust, estate, or corporation.(3) Code [sections] 7701(a)(3) defines a corporation to include associations, joint-stock companies, and insurance companies. Over the years, the Service issued a number of revenue rulings and procedures to interpret these Code sections and the applicable regulations. The Service recognizes that the check-the-box regulations cause a significant number of these' revenue rulings and procedures to become obsolete, and announced in Notice 97-1 that a list of these obsolete documents will be published in the Internal Revenue Bulletin.(4)

This article briefly discusses the historical underpinning to the prior regulations. Regarding the new check-the-box regulations, this article identifies the organizations that are eligible to elect a classification, how an election is made, and the default classifications which apply in the absence of an election. This article also recommends that practitioners give serious consideration to the regulations because, although they afford greater certainty in the classification of business entities than the prior regulations, they may provide planning opportunities or lead to unexpected tax liability.

Historical Background

Classifying an entity for federal tax purposes as either a partnership or corporation has received widespread attention for years because of the desire to avoid the entity-level tax imposed on corporations. Throughout the history of the federal income tax, Congress has focused on whether business entities should be taxed as separate entities or should be permitted to receive pass-through or integration treatment so that income is taxed only at a single level. In 1894, Congress decided to tax corporations and associations as a regulatory measure by which the government could gain knowledge of private sector business transactions.(5) Congress consciously chose not to tax partnerships. However, distinguishing between a corporation and a partnership was not always easy. The Treasury Department promulgated regulations that sought to distinguish between them ever since Congress chose to tax them differently.(6)

The Supreme Court issued four opinions regarding the classification of organizations in 1935.(7) The most famous of these is Morrisey v. Commissioner, 296 U.S. 344 (1935), in which the Court held that a business trust formed to develop and operate a real estate project should be classified as an association taxable as a corporation because the trust "resembled" a corporation. The Court identified the various characteristics that distinguish associations taxable as corporations from ordinary trusts and partnerships, and found that the trust in the Morrisey case possessed many of the corporate characteristics.(8) In so doing, the Court ruled that federal tax classification of an entity depends on the "resemblance" of the entity to one of these three business forms based on the existence of certain characteristics. The regulations promulgated in 1953 carried out this classification concept.

United States v. Kinter, 216 F.2d 418 (9th Cir. 1954), prompted the Treasury Department to modify the regulations further. In Kinter, a group of physicians formed an association to handle their practice and endowed it with all the attributes of a corporation. The organization sought association classification to enable it to establish qualified corporate pension plans for its employees. Under state law, the organization constituted a general partnership and the practice of medicine by corporations was prohibited. Despite the existence of tax motives, the Ninth Circuit held that the organization had sufficient corporate characteristics to qualify as an association taxable as a corporation.

In response to Kinter, the Treasury adopted new regulations in 1960, commonly referred to as the "Kinter regulations."(9) These regulations listed characteristics commonly found in corporations that could be used to distinguish them from other forms of entities. Under the Kinter regulations, four factors were used to distinguish whether an entity should be classified as an association taxable as a corporation...