State conformity to the check-the-box regs.

• Author: Boucher, Karen J.
• Position: IRS regulations

The Federal entity classification ("check-the-box") rules allow some entities to elect how they will be taxed for Federal purposes. This can pose a problem for entities that do business in multiple states, because the states themselves differ as to whether they adopt the check-the-box rules. Adding to this complexity is the fact that, prior to 1997, many states did not permit the formation of single-member limited liability companies. This article explains the 1997 state legislative and other activity on this issue.

Near the end of 1996,Treasury promulgated "check-the-box" regulations (FCBRs).(1) Under the FCBRs, entities not automatically treated as corporations (referred to as"eligible entities") may elect their Federal tax classification. An entity with more than one owner can elect to be classified as either a corporation or a partnership. An entity with only one owner can elect to be (1) classified as a corporation or (2) disregarded as an entity separate from its owner (i.e., treated as a sole proprietorship, branch or d vision).

Regs. Sec. 301.7701-3(b) prescribes certain default rues that apply if no election is made. If a domestic eligible entity makes no election, it will be treated as a partnership if it has more than one owner and disregarded if it has only a single owner. If a foreign eligible entity makes no election, it will be treated as (1) a partnership if it has more than one owner and any owner does not have limited liability, (2) an association if all owners have limited liability or (3) disregarded if it has a single owner that does not have limited liability.

While the FCBRs make selecting the type of business entity relatively easy, the state and local tax consequences of such an election can become very complex for multistate taxpayers. Although an entity's classification can affect the resulting apportionment percentage for a given state and whether the entity may be included in a combined or consolidated state return, the most significant state and local tax issue associated with the FCBRs is whether there is state income tax law conformity with the FCBRs in general and the state tax treatment of single-member limited liability companies (SMLLCs).(2)

The FCBRs resulted in a flurry of state activity during 1997. Many states needed to amend their LLC laws to permit the formation of SMLLCs; state revenue departments were faced with determining whether the state's laws permitted or required conformity with the Federal classification. For business entities with at least two members, most states have followed the FCBRs, either by (1) expressly adopting them or (2) having existing law that expressly adopts the Internal Revenue Code (IRC) (in whole or in part) or uses Federal taxable income as the starting point for determining state taxable income.

However, a significant problem was presented by the advent of SMLLCs, because they were not expressly recognized by either Federal or state tax law as partnerships and some states did not (or do not) permit SMLLC formation. Absent the enactment of state laws or regulations, SMLLCs may be taxed as corporations or partnerships in some states, even though they may be disregarded at the Federal level if no election is made. For example, in Revenue Procedure, No. 97-002,(3) the Alabama Department of Revenue (DOR) announced that it will not follow the Service's disregarded entity classification of SMLLCs; instead, any SMLLC classified as a disregarded entity under the FCBRs will be classified as a partnership. Below is a summary of the states' activities regarding conformity to the FCBRs.

Alabama

Under Revenue Procedure, No. 97-002, all LLCs (including SMLLCs) organized after 1996 will be classified as partnerships for Alabama tax purposes, unless the LLC elects to be classified as a corporation under the FCBRs. For LLCs organized before 1997, the DOR will conform to the LLC's Federal tax classification for tax years before 1997, and, unless the entity elects otherwise, will conform to the LLC's Federal tax classification for tax years beginning after 1996.

Revenue Procedure, No. 97-002 superseded Revenue Procedure, No. 97-001,(4) which had provided that an LLC composed of two or more members would be classified as a partnership unless it had elected to be classified as a corporation under the FCBRs. SMLLCs would have been taxed as corporations under both the income and franchise tax.

Legislation enacted during 1997(5) permits the formation of SMLLCs and requires the DOR to conform to the Federal tax classification of multi-member LLCs, but classifies an SMLLC as a partnership.

Alaska

Although the Alaska DOR has not publicly announced its position regarding the FCBRs, in response to a survey it indicated that the state conforms to the Federal rules for both single- and mutt-member LLCs.(6)

Arizona

Based on legislative intent as stated in A.R.S. [sections] 43-102(A), the Arizona DOR has ruled(7) that an entity has to have the same classification (i.e., corporation, trust, partnership) for Arizona tax purposes as it does for Federal tax purposes. Thus, the classification of an entity under the FCBRs determines its classification for Arizona tax purposes.

Legislation enacted during 1997 provides that an LLC's classification for Arizona tax purposes is consistent with its classification under the FCBRs.(8)

California

Under 1997 legislation,(9) California conforms to the FCBRs, effective for income and tax years beginning after 1996. While an LLC formed under California law must have two or more owners, the new law permits non-Californian SMLLCs to check-the-box to be treated as a disregarded entity. The owner of the disregarded entity remains subject to the LLC minimum tax and fee.

Colorado

The state permits SMLLCs, under C.R.S. [sections] 7-80-203; however, the Colorado DOR has not publicly announced its position regarding conformity to the FCBRs. In responding to surveys and practitioner letters, the DOR has indicated that, because the state conforms to the IRC, it also conforms to the FCBRs.

Connecticut

Effective May 27, 1997, the state permits SMLLCs.(10) Although the DOR Services has not publicly announced its position regarding the FCBRs, in response to a survey, it indicated that the state conforms to the Federal rules for both single- and multi-member LLCs.

Delaware

The Delaware Division of Revenue recently proposed a regulation, effective Jan. 1, 1997, that an entity's classification for Delaware tax purposes is as prescribed for Federal tax purposes.(11) Unless inconsistent with Delaware law, the FCBRs are adopted for Delaware purposes.

A business entity electing to be classified as a corporation for Federal tax purposes must attach a copy of Federal Form 8832, Entity Classification Election, to its Form 1100, Delaware Corporate Income Tax Return.

Members or partners of a business entity that has not elected to be classified as a corporation and does business in Delaware must file Delaware income tax returns. A SMLLC classified as a disregarded entity that derives income from the state or has a member residing in Delaware must file partnership income tax information and business license and gross receipts tax...