Entity classification simplification not that simple.

• Author: Carson, Shawn

For the past several years (especially at election time), politicians have come before the American people stating that the IRS needs to simplify (or, better yet, sunset) the entire tax law. An examination of the brief history of the check-the-box (CTB) rules is an example of Service simplification that is anything but simple. The IRS should take credit for taking steps to establish regulations meant to ease entity classification problems. However, it appears that the rules have currently left the tax practitioner in a quandary about hybrid entities. The Service has not afforded any guidance as to how it will resolve the issues concerning the clarity of the CTB rules.

Background

In 1997, the IRS issued Regs. Sec. 301.7701-1 on entity classifications. The rules were enacted to ease the difficulties taxpayers had when determining whether, for U.S. tax purposes, an entity was a corporation, partnership or branch. Before 1997, a taxpayer had to examine an entity's characteristics to determine its classification.

Prior to the CTB rules, U.S. classification of an entity was based on six characteristics: (1) intent to carry on business, (2) associates, (3) limited life, (4) restricted transferability of interest, (5) decentralization of management and (6) unlimited liability. The first two characteristics (business objective and associates) are characteristics of both corporations and partnerships. Thus, to determine whether an entity was a partnership or a corporation, the latter four characteristics needed to be examined, weighted equally. Accordingly, if an organization had two or fewer of the remaining characteristics, it would avoid corporate classification. The CTB regulations replaced the four-factor classification scheme, allowing most entities just to "check the box" to elect corporate or partnership status, or to be disregarded as an entity.

The tax profession was pleased with the CTB rules and immediately embraced them, especially in international tax planning.

Problems

In 1998, the Service realized that the CTB rules were not being applied as originally intended. Therefore, it issued Notice 98-11, which curtailed the use of the original CTB rules. After much outcry by the tax community and Congress, the IRS issued Notice 98-35, superseding Notice 9811 and putting limits on the CTB rules. However, these will not go into effect until five years after the issuance of final regulations.

Unfortunately for the Service, Notice 98-11 actually...