Check-the-box final regs. simplify entity classification.

• Author: Heller, Kenneth H.

The Sec. 7701 final regulations succeed to a great extent in providing a simple elective method for classifying an entity, while also providing specific classifications for certain types of entities. In addition, the default classification rules (which apply in the absence of an election) seek to match taxpayers' expectations without the need for filing an election. Overall, the final regulations present planning obstacles and opportunities, as detailed in this article.

Late last year, the IRS issued the long-anticipated Sec. 7701 entity classification final regulations (check-the-box regulations).(1) These rules afford welcome relief from the complex, formalistic rules that previously governed the Federal tax classification of domestic and foreign business entities.

The final regulations retain the simplicity and flexibility of the proposed regulations and provide additional needed guidance on the treatment of foreign entities and procedures for electing Federal tax status. In general, the regulations automatically classify certain business entities as corporations and permit other business entities to elect classification. EEs with two or more members may elect to be treated either as a partnership or as (an association taxable as) a corporation; SOEs may elect to be treated as a corporation or be disregarded for Federal tax purposes. The regulations were generally effective Jan. 1, 1997.(2) (Table 1 on page 297 defines the acronyms used in this article.)

Table 1: Acronyms Used in This Article CPS = Corporation per se DEE = Domestic eligible entity EE = Eligible entity KIN = Employer identification number FEE = Foreign eligible entity JCT = Joint Committee on taxation LLC = Limited liability company PFR = Preamble to the final regulations PPR = Preamble to the proposed regulations REIT = Real estate investment trust SOE = Single-owner entity

There are compelling reasons for allowing classification by election. The former regulations were based on historical differences under local laws between partnerships and corporations; as a result, the Federal tax classification of organizations was dictated by the presence (or absence) of certain corporate characteristics under differing state laws.(3) However, the distinctions between corporations and partnerships in the former regulations were often inconsequential, in two ways. First, tax advisers could draft articles of organization or other governing documents virtually ensuring that an entity would possess the characteristics needed to achieve the desired Federal tax classification. (If circumstances warranted, tax assurance was obtained via tax opinion or letter ruling.) Second, the availability of new forms of unincorporated organizations under local law (e.g., LLCs) increased; these entities resembled corporations in most legal aspects, but were classified as partnerships for Federal tax purposes.(4) The final regulations' elective approach assures taxpayers that their entity's tax classification will sustain a subsequent IRS challenge without incurring substantial costs; the IRS avoids expending substantial resources in administering the system.

Recognition of Separate Entity

Under Regs. Sec. 301.7701-1(a), classification begins with a determination whether a separate entity exists for Federal tax purposes (whether or not the organization is recognized as a separate entity under local law). Regs. Sec. 301.7701-1(a)(2) provides that certain joint undertakings not recognized as separate entities under local law may be separate entities for Federal tax purposes (e.g., a separate entity may exist if tenants-in-common actively carry on a trade or business, financial operation, or venture with respect to co-owned property and divide the profits of the joint undertaking).(5) Conversely, under Regs. Sec. 301.7701-1(a)(3), certain entities recognized as separate under local law may not be separate entities for Federal tax purposes (e.g., an organization wholly owned by a state is not a separate entity for Federal tax purposes if it is an integral part of the state).

Regs. Sec. 301.7701-1(a)(4)(b) states that if an organization is recognized as a separate entity for Federal tax purposes, it is classified either as a business entity or a trust unless the Code expressly provides for special treatment (e.g., real estate mortgage investment conduits under Sec. 860A).

Business Entities

The regulations apply only to business entities. A "business entity" is defined by Regs. Sec. 301.7701-2(a) as an entity recognized for Federal tax purposes not properly classified as a trust under Regs. Sec. 301.7701-4 or otherwise subject to special treatment under the Code.(6) A business entity with two or more members is classified either as a corporation or a partnership; an SOE is either classified as a corporation or disregarded; if disregarded, its activities are treated as the owner's sole proprietorship, branch or division.

Corporate Classification

For Federal tax purposes, certain business entities are automatically classified as corporations; entities so classified cannot elect classification and will be taxed as C corporations unless eligible to elect S status.

Regs. Sec. 301.7701-2(b) classifies as corporations business entities denominated as such under applicable Federal or state statutes, as well as associations, joint-stock companies, insurance companies, state-chartered banking organizations, state-owned organizations and organizations taxable as corporations under a Code provision other than Sec. 7701(a)(3) (e.g., publicly traded partnerships under Sec. 7704 and taxable mortgage pools under Sec. 7701(i)).(7) Regs. Sec. 301.7701-2(b)(8)(i) lists 80 business entities in foreign jurisdictions (or the jurisdictions of a U.S. possession, territory or commonwealth) that are automatically classified as CPSs (e.g., France, Societe Anonyme; Mexico, Sociedad Anonima).(8)

The regulations do not indicate the common attributes possessed by the foreign entities that caused them to be included in the CPS list.(9) Because taxpayers will rely on this list in structuring foreign operations, the failure to identify these attributes creates considerable uncertainty from a tax compliance and planning perspective. Another concern is that Treasury will likely make additions to (and deletions from) the CPS list in future years; such modifications could trigger adverse tax consequences if an entity is added to the list, particularly if immediate compliance is required without a grandfather exemption or transition relief.(10)

In its comments to Treasury on the proposed regulations, the AICPA's Partnership and International Taxation Committees (Committee Comments) recommended that the final regulations explain the parameters for determining an entity's inclusion in the CPS list and provide a procedure for taxpayers to challenge an entity's inclusion based on those parameters. The Committee Comments also recommended that the final regulations provide that additions to, and deletions from, the list be effective prospectively only, unless the change was the result of a taxpayer challenge, and only at the taxpayer's election if the taxpayer had previously relied on the list in classifying an entity (alternatively, the regulations should provide transition relief in lieu of such election).(11)

Unfortunately, the final regulations do not address the basis for an entity's inclusion in the CPS list or provide procedures for challenging an entity's inclusion therein. However, the PFR indicated that any further modifications of the list will be prospective only and announced in a notice of proposed rulemaking.

EEs

An EE is defined in Regs. Sec. 301.7701-3(a) as a business entity other than an entity required to be classified as a corporation (including an entity classified as a CPS) under the regulations. This definition is important in two respects. First, only EEs may elect a Federal tax classification; second, the classification of EEs not making an election is automatically determined under the Regs. Sec. 301.7701-3(b)(2) default rules. See Table 2 on page 299 for a summary of the Federal tax classification of EEs under the final regulations.

Table 2: Eligible Business Entity Classification Under the Sec. 7701 Final Regs. Eligible business Elective entity classification Domestic with Partnership or two or more members corporation (Regs. Sec. 301.7701-3(a)) Foreign with two or more Same as domestic members; at least one (Regs. Sec. 301.7701-3(a)) member does not have limited liability Foreign with two or more Same as domestic members; all members (Regs. Sec. 301.7701-3(a)) have limited liability Domestic with single Entity disregarded owner or corporation (Regs. Sec. 301.7701-3(a)) Foreign with single owner Same as domestic not having limited liability (Regs. Sec. 301.7701-3(a)) Foreign with single owner Same as domestic having limited liability (Regs. Sec. 301.7701-3(a)) Eligible business Default entity classification(*) Domestic with Partnership two or more members (Regs. Sec. 301.7701-3(b)(1)(i)) Foreign with two or more Same as domestic members; at least one (Regs. Sec. 301.7701-3(b)(2)(i)(A)) member does not have limited liability Foreign with two or more Corporation members; all members (Regs. Sec. 301.7701-3(b)(2)(i)(B)) have limited liability Domestic with single Entity disregarded owner or corporation (Regs. Sec. 301.7701-3(b)(1)(ii)) Foreign with single owner Same as domestic not having limited liability (Regs. Sec. 301.7701-3(b)(2)(i)(C)) Foreign with single owner Corporation having limited liability (Regs. Sec. 301.7701-3(b)(2)(i)(B)) (*) EEs in existence prior to 1997 default to the classification claimed under the former regulations.

FEEs

The Federal tax classification of an FEE is relevant only when it affects the tax liability of any person for Federal tax or information reporting purposes. For example, an FEE's classification would be relevant if U.S. income was paid to it...